Using IPOs to prove value of M&A targets
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Several years ago, eBay was in negotiations to acquire PayPal in order to boost its payments settled online and obtain PayPal’s antifraud capabilities. At the time, PayPal was privately held, and the two parties were unable to come to terms on price. PayPal opted to go public, the equity market certified the value that the company claimed it was worth, and eBay completed the acquisition for $1.5bn a few months later – at a 20 per cent premium.
This deal illustrates the widespread phenomenon of “dual tracking”, whereby a company’s initial public offering (IPO) and sell-out occur in sequence over a short period of time. The PayPal example represents public dual tracking, whereby a company carries out the IPO only to be acquired shortly thereafter. Private dual tracking has become increasingly frequent and involves companies filing to go public and selling out before the equity offering takes place. Recent cases of private dual-tracked businesses include Noveon, Advertising.com, Borden Chemical and Brightmail.
These examples challenge some of the received wisdom on IPOs and the decision to go public. Traditionally, IPOs have been viewed as pure financing choices that are independent from overall strategy and “real” investment decisions. IPOs are also routinely portrayed as natural end-states for successful entrepreneurial companies. However, these cases reveal that IPOs have implications for M&A markets, the corporate development decisions of other companies and the strategic direction of entrepreneurial companies. Therefore, rather than evaluating the benefits or costs of going public in isolation, companies need to account for a broader set of considerations, such as how the IPO might affect their future growth plans or even their ability to exit through a takeover.
At first glance, the dual-tracking phenomenon is puzzling. Why would businesses work to go public, only to be acquired by another company? Why would they bear all of the direct and indirect costs of going public rather than simply selling outright? In fact, using IPOs to “tee up” companies for sale appears to be a costly proposition. Aside from the direct loss of managerial time, registration and underwriting costs alone average 14 per cent of the proceeds raised. Moreover, the practice of discounting the share price on the day of the offering, or “underpricing,” can also represent a substantial indirect cost of going public.
The answer to this puzzle can be found in the intrinsic features of some M&A deals, as well as in the ways IPOs work to address fundamental problems in acquisitions. In this article, we will discuss some of the economic rationales for the dual-tracking phenomenon. Subsequently, we will cover some of the evidence that is emerging on dual tracking and the alternatives that buyers and sellers have at their disposal in conducting M&As.
How M&A targets can be like used cars
In 2001, George Akerlof, A. Michael Spence and Joseph Stiglitz shared the Nobel Memorial Prize in Economic Sciences for their work on information economics. The classic market for “lemons” example offered by Prof Akerlof describes how the market for used cars can fail because of the information asymmetries between a buyer and seller that arise due to the latter’s experience with the vehicle. In the absence of appropriate remedies, such as warranties, reputation and so on, buyers will discount their offer prices for all used cars and, as a consequence, the sellers of high-quality vehicles will no longer be willing to trade.
Indeed, information asymmetries crop up in an array of settings, including M&As. During M&A valuation and negotiation processes, an acquirer needs to be able to discern the value of a target, and the parties need to agree on a price for the transaction. The acquiring company collects information on the target during the due diligence process, yet it often still remains at an information disadvantage in M&A negotiations. Buyers, therefore, face the risk of “adverse selection”, or overpaying and winding up with a “lemon”. Because M&A targets can have attributes that are only understood after purchase, costly surprises emerge during the post-merger integration process.
For their part, sellers have an incentive to misrepresent the quality of the company and realise higher gains from the deal. In short, the seller has a credibility problem that is rooted in the one-shot nature of sell-outs, and its claims will be discounted accordingly. As a result, sellers of good companies run the risk of not receiving fair value for their assets. Therefore, it is in each party’s interest to address the problems posed by information asymmetries in M&As.
Academics in strategic management and financial economics are now using the insights from information economics to understand when asymmetric information can adversely affect the efficiency of acquisitions, what remedies might be available, and how buyers and sellers can design deals to address these challenges.
The value of dual tracking
To understand why the IPO process can facilitate M&A transactions, it is important to recognise that the problems noted above are especially likely to be present for entrepreneurial targets. Little historical or codified information tends to be available on privately held targets, particularly younger ones. Moreover, many entrepreneurial companies suffer from the lack of legitimacy that comes with time and the accumulation of business relationships. It is also the case that the bulk of the value of entrepreneurial companies comes from future growth opportunities and intangible assets, which are notoriously difficult to value.
Going public can reduce the problem of adverse selection in two ways. First, an IPO can directly reduce the information asymmetries between the company and prospective bidders. This is due to the credible information that becomes available through disclosures made in response to regulations for registration and subsequent listing. Moreover, in valuing companies, the equity market works to aggregate heterogeneous information on the issuer.
Second, by going public, a company sends signals to potential acquirers, and these signals reduce the effects of information asymmetries that are bound to remain. For instance, the mere fact that the company is able to bear the costs of going public can suggest to bidders that there is a higher probability that it is of higher quality, compared with companies that remain private. In effect, the new issue market works as a screening device, and it will be tougher for companies to pass through this screen in cold, rather than hot, IPO markets. Targets can also signal value through the underwriter that assists in taking the company public. The market for underwriters’ services is segmented in such a way that the best companies tend to be taken public by the most prominent underwriters, so potential bidders can use these associations to help screen targets.
Going public offers many possible opportunities for companies to send signals about their quality. These include choices such as how much ownership to dispose of rather than retain, how to price the offering, and so on. David Langstaff, CEO of Veridian, an IT security company acquired by General Dynamics in 2003, has emphasised the need to make the right “first impression” when going public. He maintains that this is achieved by thinking through which exchange to list on, which investment banker to use for the IPO, and which analysts will cover the company once the offering has taken place.
Recent research is offering evidence that IPOs can have important implications for M&A deal-making. This research concerns overall M&A patterns as well as performance outcomes, so it can inform a business’s acquisition policies and tactics on both the buy and sell sides of deals. Below are a few of the conclusions coming out of this emerging work by us and others.
■ Dual tracking can offer higher premiums to targets than outright sales A recent study by James Brau of Brigham Young University and Ninon Kohers of the University of South Florida found that public dual-track targets generally earned a 24 per cent higher premium than private companies that sold outright. Private dual-track targets enjoyed a 26 per cent higher premium compared with private targets selling outright.
■ Buyers can also benefit from targeting IPO companies Despite paying higher premiums for private companies pursuing IPOs, buyers do not earn lower abnormal returns. A recent study by Qin Lian at the University of Kansas attributes this to the IPO registration process improving the matching of companies in the M&A market.
■ Certain companies are better candidates for dual tracking than others Our analyses have shown that companies with substantial intangibles are more likely to go public and then sell out, rather than divest outright. By contrast, companies with modest intangibles are relatively easy to assess and can be sold efficiently while still being closely held.
■ Some IPO companies are particularly likely to be acquired Going public can offer signals on company value, but the strength of these signals will vary significantly from issuer to issuer. For instance, companies that are taken public by venture capitalists are more likely to be acquired after they go public than companies that did not have such backing. Also, companies that are associated with prominent underwriters are more likely to be acquired after their IPOs than companies taken public by less reputable investment banks.
■ Dual tracking affects M&A deal structures The risk for acquirers of adverse selection will be greatest when they pay for the target using a lump sum cash payment. In contrast, by using stock to finance the transaction, buyers can transfer part of the overpayment risk to the target, since the value of stock received by the target will reflect the performance of the combined entity.
Targets can be reluctant to accept the bidder’s stock, since buyers are more likely to pay with overvalued shares, but high-quality targets are able to enjoy higher stock prices, instead of receiving a lump sum in cash. Our research found that the odds of using stock rather than cash to finance M&As are one-and-a-half times greater for outright acquisitions of private targets compared with newly public targets.
■ Dual-tracked companies can attract a broader set of acquirers IPO companies that become acquisition targets are more likely to be bought out by geographically distant acquirers when their IPOs are backed by venture capitalists or prestigious underwriters. The likelihood of a newly public company being acquired by a remote, rather than a geographically close, bidder also increases with the offering’s underpricing.
Managing adverse selection in M&As
It is important to emphasise that acquirers will need to find other means of dealing with adverse selection when choosing to acquire privately held targets. Moreover, dual tracking is only one way for sellers and bidders to address the risk of adverse selection in M&As.
Our discussion has specifically focused on how IPOs can reveal information on target companies and send signals on their quality, but there are alternative ways to tackle the problem of adverse selection, particularly when conducting deals with privately held targets. One way around the problem is to form a limited alliance before proceeding with the acquisition.
A joint venture allows companies to combine assets in a distinct, jointly controlled business which can help the acquiring business understand the target’s resources better. Philips, for example, sold a 53 per cent stake in its domestic appliances unit to Whirlpool, so that the latter could understand the strength of the dealer network before completing the acquisition.
If a company decides to proceed with an acquisition of a private company, what might it do to manage the risk of an adverse selection? There are two additional tactics. First, target selection needs to be considered carefully because the risk of adverse selection will be higher for certain closely held targets than others.
Companies are less likely to be at an information disadvantage when acquiring companies in their sector or that are geographically close. In particular, acquirers are better positioned to understand and evaluate the resources, products, relationships and claims of a nearby target or direct rival than other sellers. It follows that bidders that are geographically distant or that hail from other industries have the most to gain from the signals a target company sends when undertaking an IPO.
Second, deal structuring needs to be given careful consideration. Companies can address the risk of adverse selection by the way they put together M&A transactions. The acquisition of Skype is a case in point. In the summer of 2005, the internet telephony operator contemplated a partial acquisition by News Corp, but the companies could not agree on price. Several months later, eBay acquired Skype for $2.6bn in cash, and Skype would receive an additional $1.5bn by 2009, provided it met performance targets.
This deal structure, which is known as a contingent earnout, reallocates overpayment risk from the bidder to the target, and is most often used in acquisitions of private companies. High-quality sellers benefit by being able to obtain a greater total payment and are able to provide a credible signal of their worth. However, earnouts present several important drawbacks, one of which is the need to measure the target’s independent performance after the deal has been completed. This consideration implies that earnouts are not suitable for deals with high integration requirements.
The phenomenon of dual tracking and these alternative ways of addressing adverse selection in M&As have important implications for acquisition deal-making. On the sell side, companies need to consider IPOs not as pure financing choices or as natural end-states. Rather, IPOs need to be considered as strategic choices that have consequences for future transactions.
On the buy side, corporate development staff and advisers need to add IPOs to their M&A toolkits. IPOs can play important roles in facilitating M&A transactions and reducing costly surprises that crop up during post-merger integration. They are particularly relevant for certain types of transactions (diversifying acquisitions) and they influence the design of M&A deals (cash versus stock versus earnout). By paying attention to the risk of adverse selection in M&As, sellers and buyers alike can improve their odds of capturing value from such transactions.
Jeffrey J. Reuer is an associate professor at the Kenan-Flagler Business School, University of North Carolina. His research concerns corporate investments such as alliances and acquisitions using information economics and real options theory.
Roberto Ragozzino is an assistant professor at the University of Central Florida’s College of Business Administration. His research concerns the structuring and performance of entrepreneurial acquisitions.