October 12, 2006 5:09 pm
Business school, law school and professional development programmes generally argue that there are three main tasks that are worth undertaking to make sure a transaction succeeds.
The first is identifying good acquisition targets – this often turns out to be as much about theories of market mispricing as it is about an individual target or transaction. The second is valuing specific targets as prospective income streams by asking: “What would this asset be worth going forward?” The third is integrating targets and running them effectively after the transaction. All of these tasks are certainly important. But even if transactions are taken to be no more than M&As, a view we think is overly restrictive, something is still missing: the design of the deal.
Transactions are agreements between two or more parties to work together to create and allocate value. They can take a range of forms that include: the sale of an asset; the formation and running of a business; initial public offerings (IPOs); debt financings; buyouts; sales out of bankruptcy; leases; real estate development and redevelopment agreements; venture capital fund agreements; joint ventures and alliances; and corporate restructurings, such as the recent reorganisation of Royal Dutch Shell.
Deals occur, and value is created, when deal professionals design structures that make value more ascertainable, constrain future misbehaviour by participants and limit the potential costs of long-term commitment by preventing the parties from taking advantage of a counterparty’s sunk investments. If problems like these are not adequately addressed, the deal may not happen. But if the terms of the deal can be designed to respond to such problems, the transaction is more likely to be viable and the potential gains from it achievable.
This article will discuss the structure of deals, and argue that if parties address the economic issues underpinning transactions, they will be more likely to create value. While the documentation that implements a deal can run to hundreds of pages, there are just a few core problems that the designers of transactions must address.
Problems and responses
The problems that a deal must address fall into four categories derived from situations that economists call market failures. The first two problems arise in situations where one party has better information than the other. The third occurs when one actor depends on continuing co-operation from the other. And the fourth emerges when elements of the business environment or the potential project change in such a way that uninsurable burdens are imposed on at least one of the parties. (Although a deal can include more than two parties, for the purposes of this article, we will refer to only two actors.)
Adverse selection is when one party – typically the seller – has greater knowledge than his counterpart – the buyer – regarding the value of what is being sold. For example, in the insurance context, an applicant for health insurance knows his need for medical services better than the insurer does, so the insurer will always need to guard against a one-sided deal.
Or consider another example. The seller of a used car knows the car’s condition better than potential buyers. Potential buyers will suspect that the seller is hiding the car’s defects and asking too high a price. But a seller will balk at accepting a price below what he knows the car to be worth. In extreme cases, unless the information gap is bridged, a deal will not be done. The insurer will not accept the application, and the car owner, rather than sell at a low price, will keep the car until its value is greatly reduced.
This underlying problem is common in business deals. A seller of a business might exaggerate the value of his business, an entrepreneur might not be honest with a venture capitalist regarding the limits of his technology, and a company’s management might paint a rosy picture of its projected cash flows on a loan application.
The strategies for remedying this situation within the structure of the deal are clear: find a way to equalise access to information (or at least come close); or shift the risk of loss to the party with the better information. In the used car example, the market has come up with a toolbox of fixes: the seller can allow the buyer to choose a mechanic to look at the car; he can provide maintenance records to the buyer; or he can assume the risk of poor quality by offering a warranty to the buyer.
The second challenge also has its origins in the insurance context. Unlike adverse selection, however, moral hazard refers to post-contractual conduct. The basic conditions for moral hazard problems are divergent interests between the parties and a post-contractual relationship in which one party can take actions that harm the other. In the insurance industry, the concern is that, once insurance has been provided, the insured party will take advantage of the fact that someone else is paying for his healthcare and will overuse medical services.
Once again, this concern is pervasive in business deals. How hard will a joint venture partner work when it has business interests outside the joint venture? Once a loan has been made, will the borrower take actions that increase the risk of default beyond what the lender contemplated when it agreed to a particular interest rate? If these kinds of questions cannot be answered to the satisfaction of all parties, the deal will not be made.
Moral hazard arises when the actions of the actors in the transaction cannot be observed easily. The issue is common in employment relationships. How can an employer know whether an employee is working hard or not? How can shareholders, or the board of directors looking out for their interests, know whether a CEO is doing his best? If effort could be easily observed, the parties could simply agree from the outset to exert full effort and care. With this easy solution often unavailable, however, the designer of the deal must come up with a less direct solution.
Although the details can be complex, and some situations require creativity, the main approaches to solving this problem are quite clear: improve information or align incentives, or do both. In the insurance example, the insurer forces the insured to share the cost of his healthcare – through deductibles, co-payments and ceilings on how much coverage. Similarly, a CEO and other managers can provide assurance to shareholders by taking performance-based compensation. Joint ventures are governed by a management committee with the authority and incentives to maximise the profits of the enterprise, and the joint venturers themselves are provided with financial incentives.
The transaction specificity of assets
In contrast to adverse selection and moral hazard, the third problem is not related to information asymmetry among parties. Instead, it derives from the nature of the assets involved in certain transactions.
Sometimes, a party contemplating an ongoing agreement must commit to an up-front investment that is more valuable as part of the deal than it would be in any alternative use. Consider the construction of a plant designed to create a chip used in one party’s technology. Once the investment has been made to build the plant, that party may be vulnerable to exploitation – what economists call, “holdup” – by its counterparty.
A classic lower-tech example
concerns the drilling of a gas well. Suppose the well has no value without a pipeline to transport the gas to market and that there is only one pipeline in the region. Once the well is drilled, the pipeline operator will be able to charge a price that extracts nearly all of the well owner’s potential profits. Anticipating this, no deal involving drilling would be made in the absence of a commitment in advance on pricing from the pipeline operator.
This basic idea may be familiar to viewers of the television drama The Sopranos and some of its fictional events: blackmail, labour peace deals on construction sites and miscellaneous shakedowns. Or, in real life, from attempts by some actors in the series to renegotiate their compensation just before shooting the final season.
Similarly, all three movies in the Lord of the Rings series were made before the first was released to avoid just this problem. The studio clearly wanted to avoid a situation in which Elijah Wood, who played central character Frodo Baggins, could negotiate a new and highly lucrative contract on the strength of the success of the first film before completing the final part of the trilogy, Return of the King.
One solution to such problems is to structure a party’s payments to coincide with the counterparty’s investments. Another is to write an enforceable long-term contract. Merging the businesses of the involved parties amounts to an extreme version of this, but more process-oriented approaches are also possible. For example, mandating hierarchies of dispute resolution mechanisms, a technique common in pharmaceutical research joint ventures, encourages companies to resolve tactical differences of opinion before they threaten the overall strategic relationship. Withdrawal fees – the equivalent of breakup fees in M&As – increase the incentives for parties to co-operate by making dissolution costly.
In each of the problems discussed so far, the source of risk comes from the actions (or inactions) of the contracting parties. These problems might, therefore, be characterised as endogenous risks. In contrast, the fourth problem is exogenous: the risk of changing external circumstances, such as alterations in prices, demand or costs in the relevant industry or in the broader economy, for which neither party is responsible but for which insurance is unavailable. Changes in the market prices of inputs, for example, can disrupt a long-term supply deal that was attractive to both sides at the beginning of a relationship. The same is true of changes in demand for the purchaser’s final product.
One response is to use financial instruments to hedge risk, but that is not always feasible. Another might be to agree on an adjustment mechanism, such as cost-plus pricing or a broader index scheme. A deal agreement can include language specifying when one party can demand renegotiation, and third-party dispute resolution techniques can also be used. The solution may be to allow the purchaser to reduce its purchases, but only if it makes a payment to the supplier.
Clearly, the problem is complicated. It is not the type of situation that simply requires insuring against an unfavourable turn of events. The parties may have different capacities and incentives to anticipate risk or respond to it, while the allocation of risk will have consequences for the activities underpinning the value creation anticipated in the deal.
Another possibility is that information that affects risk emerges only incrementally over time; many product development initiatives, for example, work in this way. In these cases, option-to-abandon techniques are helpful, whereby projects can be structured to provide more or fewer moments when the current state of information about prospects can be assessed and go/no go decisions made. Increasing the number of such moments makes risk management easier.
The following examples illustrate transactional settings in which these problems arise. One is a corporate acquisition and the other a public utility contract for fuel.
■ How does the buyer of a company actually know what it is getting? The acquisition agreement addresses the problem of the seller knowing more about the business than the buyer in a number of ways. The seller provides pages of representations and warranties that set out the condition of the business: assets, liabilities, financial statements, taxes, litigation, contracts, pension commitments, environmental exposure and so on. In effect, the buyer is given a detailed profile of the business being sold. The buyer then has the opportunity to verify the accuracy of the profile through due diligence and walk away from the transaction if the information proves incorrect.
In some cases, the accuracy of information is vouched for by the seller’s lawyers and public accountants, actors who, in effect, rent their reputations to the seller. Sellers can strengthen the credibility of information by committing to indemnify the buyer if a material inaccuracy comes to light after the deal is closed. Or they can make a portion of the price contingent on future performance via an “earnout”, whereby part of the purchase price is paid out of future revenue rather than at the time the transaction is agreed. Such strategies enable the seller to signal its confidence about the quality of the company being sold. This technique also has the incidental virtue of shifting risk to the party with the best information.
Acquisitions often have a significant delay between execution and closing. This delay may be necessary for the parties to obtain regulatory or shareholder approval for the deal. But the delay exposes the deal to two potential problems: moral hazard and exogenous risk.
Moral hazard generally takes two forms. First, the seller might siphon off assets, pay bonuses or otherwise reduce the company’s value by the time it is acquired. The acquisition agreement’s covenants and conditions, which specify how the business will be run in the pre-closing period, can guard against seller moral hazard.
Second, one of the parties may try to back out of the deal by failing to take the steps necessary to close. For example, a party might not co-operate with a regulator to have the deal approved. Once again, in these instances the deal agreement will provide that each party must take the steps necessary to complete the deal. If the seller misbehaves, it will be subject to a suit for damages.
However, what happens if the equity market crashes, interest rates spike, the seller loses a major customer or the seller’s business slows down? The effect of events that occur between signing and closing not specifically addressed elsewhere in the acquisition agreement are covered by the material adverse change (MAC) clause. This clause concerns events that materially affect the seller’s business, including both those whose impact the seller may be able to influence and those it may not.
Until the late 1980s, MAC clauses were typically brief, and did little more than assign to the seller the risk of material adverse events. This left sellers bearing the consequences of events they could neither influence nor mitigate. Often, buyers would have been better equipped to bear the risk of some of those events. In the 1990s, operating environments and the capital market became more volatile and the value of allocating risk more efficiently went up. The typical length of these clauses expanded considerably as a result.
The changes in MAC clauses reflect an effort by buyers to constrain sellers’ moral hazard, and an effort by sellers to allocate to buyers the risk of exogenous events that they are best able to bear. Both efforts should help deals get done and increase their value.
■ An electric utility considering construction of a power plant relying on coal for fuel. Power plants represent large and substantially sunk investments. If transportation costs are high, a utility’s ability to store coal inventory is limited and the costs of having the plant sit idle are high. The utility would require assurance of the availability of coal before it would be willing to invest. The greater the utility’s vulnerability to a supply interruption, the greater its need for a long-term supply contract.
Because the demand for power will be uncertain over the life of the agreement, the utility would also want to be able to determine the quantity of coal it would take. Typically, this would take the form of a requirements contract.
At the same time, since the coal company’s bottom line would probably be affected by the exercise of that discretion, the contract would usually have some mechanisms for allaying those concerns as well. One common device is a take-or-pay clause. This requires that the utility pay for a minimum amount of coal even if it does not take it all. The greater the coal company’s investment specific to supplying the power plant, the higher the minimum.
By balancing the costs and benefits of flexibility, the parties can create value and share it.
These examples are relatively simple and well understood. More exotic situations can present complex problems that require innovative solutions. But the core problems will be variants of the four we have described here, and the solutions will be fundamentally similar to those that we have outlined.
Understanding the problems inherent in transactions and the responses needed can help businesses bridge gaps that would otherwise kill deals or interfere with the achievement of optimum value from them.
Ronald Gilson teaches in the law schools of Columbia and Stanford Universities.
Victor Goldberg teaches at Columbia Law School.
Michael Klausner teaches at Stanford Law School.
Daniel Raff teaches at the Wharton School of the University of Pennsylvania.
The authors are writing a book exploring these ideas for law and business students, and professionals.
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