Related Literature and Testable Hypotheses

In an M&A deal the managers of the merging firms face valuation risk when negotiating the premium and payment currency of the transaction.24 As a means of mitigating this risk, contingent payments methods such as stock (Hansen, 1987; Officer, Poulsen and Stegemoller, 2009), or EPs (Kohers and Ang, 2000) are often selected. Under EP-financing, part of the consideration is contingent upon the post-merger performance of the target, under its existing management, over a pre-determined period. EP-financing is often employed in deals involving

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Golubov et al. (2012) find ‘no effect of financial advisor reputation on bidder returns in acquisitions of unlisted firms’ (p. 273). In unreported results, the presence of top-tier FAs in EP-financed deals, the vast majority of which includes unlisted targets, yields insignificant wealth effects.

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Valuation risk in M&As is predominately influenced by asymmetric information between the merging firms, which is likely to be more severe when private, or unlisted, targets are involved in the deal (Chang, 1998).

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targets that are subject to high valuation complexity, i.e. unlisted firms operating in intangible- rich sectors, such as the hi-tech, or other service-based ones. In such deals the value of the target often depends on the skill, creativity and flair of key personnel. To this end, EP-financing offers a solution when the merging firms ‘agree to disagree’ over the outcome of the merger, often due to their dichotomous expectations about the implied synergies. Specifically, it allows them to continue to disagree and, still, manage to reach an agreement. The above originate from the ability of EPs to promote information sharing ex-ante, leading to a reduction of adverse selection, and enhance managerial commitment ex-post, leading to a reduction of moral hazard considerations. The above effectively ‘bridge the gap’ in valuation disagreements between the merging firms (Kohers and Ang, 2000; Cadman, Carrizosa and Faurel, 2014). Along with the commitment of the target’s owners to remain part of the combined entity in the post-merger period, EP-financing sends a strong signal to market participants regarding the high synergies that are likely to be extracted.

Evidence presented in earlier studies confirms that EP-financed deals, especially those exposed to high valuation risk, yield higher short- and long- run abnormal returns to acquirers, relative to deals financed with conventional single up-front payments (Kohers and Ang, 2000; Barbopoulos and Sudarsanam, 2012). Barbopoulos and Sudarsanam (2012) further show that when EP-financing is used as the ‘correct’ payment currency, as classified via a logit model that predicts ‘correct’ earnout use, bidders’ shareholders enjoy even higher short- and long- run abnormal returns. Lastly, Mantecon (2009) investigates alternative methods of valuation uncertainty avoidance in foreign deals and shows that the use of EPs benefits predominantly bidders of domestic targets.

Moreover, recent studies argue that the efficient design of EPs presents an important condition under which their successful implementation is more likely to be accomplished. Specifically, Cain et al. (2011) and Lukas et al. (2012) illustrate the multidimensional nature of the structure of EPs, involving significant intricacies during the deal process. A failure to properly account for the inherent complexities of an EP can ultimately offset its implied benefits. Nevertheless, the channels through which merging firms engaging in EP-financed deals can enhance the efficiency of their design are yet to be identified.

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To this end, a wide array of studies illustrates the greater set of skills and expertise characterizing FAs, particularly investment banks, when involved in M&A deals. Specifically, Hunter and Walker (1990) argue that FAs may possess specialized knowledge about firms with particular characteristics, including information on financial, or product market potential, which would-be acquirers may not have. Similarly, Bowers and Miller (1990) portray FAs as better able to identify firms with which an acquisition would lead to greater economic benefits, while Servaes and Zenner (1996) identify transaction costs and, in part, contracting costs and information asymmetry as major determinants of their involvement. They also argue that the probability of FA-inclusion increases when the acquisition is complex, when acquirers have limited M&A experience and when targets operate in an unrelated industry.25

FAs are also portrayed for the specific contributions that they can make towards the efficient design of an M&A deal. Specifically, Sudarsanam (1995) indicates that FAs, counselling the acquirer, provide, among others, a ‘fair value’26 for the target firm, devise the appropriate financing structure and advise the acquiring firm on negotiating tactics. The above are illustrated to affect the market’s perception of an announced takeover. Bowers and Miller (1990) identify superior gains enjoyed by the acquiring firms’ shareholders when the latter consult FAs. More recently, Bao and Edmans (2011) illustrate the presence of a positive investment bank fixed effect in the distribution of acquirers’ announcement period abnormal returns. Similarly, Golubov et al. (2012) illustrate the ability of top-tier (reputable) FAs to generate superior acquirer gains in public-to-public deals.27

While top-tier FAs are less likely to be involved in EP-financed deals, given their small transaction size relative to counterparts financed with single up-front payments such as stock, the complexity involved in the estimation of synergies is still likely to invite non-reputable FAs. To

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Hunter and Jagtiani (2003) also suggest that the advisor’s quality and the number of advisors that are involved in a deal are important in determining the probability of its completion, as well as the time required for the latter. Within our sample of EP- financed deals, we observe that the involvement of multiple FAs is very limited, potentially due to their small size and the acquiring firms’ constrained resources, yielding insignificant effects in unreported estimations.

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Evidence suggests that the advisor’s valuation of the target is unaffected by its past provision of financial advisory services to the target (Calomiris and Hitscherich, 2007).

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Kale, Kini, and Ryan (2003) also focus on a measure of the relative reputation of the merging parties’ FAs in the US and report that the absolute wealth gain, as well as the share of the total takeover wealth gain accruing to the acquirer increase as the reputation of the acquiring firm’s advisor increases, relative to that of the target firm’s. Despite the limited frequency of target- side FA-presence within our sample of UK M&As, for deals exhibiting target-side FA-presence we construct an FA reputation scale, based on both aggregate deal value and number of deals completed, and investigate in unreported estimations the effect of the relative FA reputation in EP-financed deals. Our results yield insignificant effects.

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this end, Golubov et al. (2012) further illustrate that the positive effect of FA reputation does not persist in acquisitions of unlisted targets. This is also linked to the findings of McLaughlin (1992) who demonstrates that acquiring firms consulting less-reputable FAs, yet in public target deals, offer significantly smaller premia and enjoy higher abnormal returns.28 Along these lines, Siming (2014) shows that the offered premia in mainly large deals involving private equity acquirers consulting FAs are affected by a network effect which exists if a former employee of the financial advisory firm is among those private equity professionals who constitute the deal team. Specifically, the exchange of information flow between the two firms is illustrated to lead to lower premia and better post-merger target performance.29

Overall, the aforementioned studies portray FAs as able to reduce the uncertainty over the outcome of the concentration and identify substantial synergies in cases that are characterized by significant valuation risk. Moreover, they are illustrated to actively engage in the design of a deal, while the presence of their advice sends a positive signal to market participants regarding its outcome. Evidently, such advice should be more valuable in valuation-complex deals, such as deals including unlisted targets that appeal to the use of EPs, in which there is more scope for negotiation. This is further supported by current evidence indicating that FA-involvement is positively related to the complexity of the deal, which is also one of the major determinants of the choice to employ an EP. Consequently, despite the risky idiosyncratic nature of the assets being exchanged and the intricate structure of this contingent payment mechanism, the involvement of FAs is expected to contribute to its efficient design. This is expected to increase the deal’ likelihood of success sending, in turn, a strong signal for value creation to the market. Therefore, our first hypothesis (H1) is stated as follows: M&As involving an EP and FA- presence advising the acquirer (EPFA) yield higher gains to acquirers’ shareholders than deals involving an EP without FA-presence.

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Agrawal, Cooper, Lian and Wang (2013) also suggest that conflict of interest issues are more likely to arise when firms engaging in an M&A consult the same advisory firm as a result of the latter’s incentives towards deal completion, rather than deal quality. While this is possibly true for larger deals, our earnout-specific analysis is less likely to be exposed to such concerns. Specifically, the frequency of common FA-deals appears to be almost negligible within our sample of EP-deals as, in unreported statistics, only 2 of 1,505 EP-deals (331 of which include FAs) exhibit the same advisory firm between the merging parties.

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This partly supports the well known findings of Bargeron, Schlingermann, Stulz and Zutter (2008) illustrating private equity bidders offering lower premia than public and private bidders. Our study excludes deals involving firms from the Financial Services sector, which limits the exposure of our results to such considerations.

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If true, the above suggest that the involvement of (less reputable) FAs in small, yet risky, deals involving unlisted targets and financed with complex instruments, such as EPs, is value- enhancing. However, it would be imperative to also investigate the impact of EP-financing on the gains associated with EPFA-deals. Taking into consideration the increased potential for synergy realization characterizing EP-financing, relative to single up-front payment methods, our second hypothesis (H2) is stated as follows: M&As involving an EP and FA-presence advising the acquirer (EPFA) yield higher value gains to acquirers’ shareholders than deals involving FA-presence without an EP.

The above hypotheses, if verified, portray a strong interaction between EP-financing and FA-presence that increases the likelihood of success of valuation-complex deals. Thus, they suggest the existence of a complementarity effect between EPs and FAs that is sourcing from: (a) the properties of earnouts in addressing disagreements over the intrinsic value of the deal and setting the incentives towards the realization of the implied synergies and, (b) the contribution of FAs towards the efficient design and structure of earnouts.