A Buy-Side Model of M & A Lockups: Theory and Evidence

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INTRODUCTION

Lockups(2) are an increasingly important element of M&A deals in the United States. In friendly U.S. mergers greater than $50 million in value, lockups appeared in 80% of deals in 1998, compared to 40% of deals a decade ago.(3) Despite growing importance in practice, lockups have been largely misunderstood in the academic literature. Prior theories have failed to fully incorporate the tools of agency theory or behavioral economics. They have not fully considered real-world factors such as tax effects, informational effects, switching costs, and reputational effects. Moreover, prior theories have not been tested against the available empirical evidence to assess their predictive (or even descriptive) power. This article attempts to address these gaps in our understanding of lockups. In doing so it arrives at substantially different conclusions regarding the role of lockups in the market for corporate control.

M&A transactions involving public company targets face a (law-derived) risk of non-consummation that is unique (or at least rare) in three respects: (1) the law requires that shareholders of the target be given some opportunity to decide for themselves whether to accept or approve the transaction; (2) compliance with disclosure and other rules regulating the process of obtaining target shareholder acceptance or approval entails delay, ranging from a minimum of thirty days up to six months in some situations; and (3) shareholders may decide not to accept or approve the transaction for any reason, including a third-party bid that emerges after agreements for the initial transaction are signed.(4) In effect, an M&A agreement gives shareholders of a public company target the option to accept the deal, and does not effectively bind the target (or its shareholders) to the deal.(5) Lockups have emerged as a second-best way for bidders to protect their expectancy interests in the transaction. Even if bidders cannot be sure to consummate a deal for a given target, they can at least get the consolation prize of a lockup payout.

Prior lockup scholarship has been premised on several problematic assumptions relating to the "buy-side" of M&A transactions. First, it has made the implicit assumption that bidders are monolithic, and bidder managers, by extension, are perfect agents for their shareholders. Buy-side agency costs have been ignored. Second, prior scholarship has ignored tax effects and the additional information that bidders gain from the decisions of other bidders. Third, prior scholarship has implicitly assumed that bidders can costlessly abandon an acquisition strategy whenever the expected value of a lockup payout exceeds the ex ante expected value of completing the deal. Fourth, prior scholarship has treated lockup decisions in a static, single-period model, without considering the effect of accepting a lockup payout on bidder reputation. Finally, prior scholarship has treated bidder managers as perfectly rational actors, and has neglected even the most basic and robust findings of cognitive psychology in predicting how lockups might affect bid outcomes.

In addition, prior scholarship has been almost entirely uninformed by statistical evidence.(6) At best, it has been built on armchair empiricism. None of the many conflicting positive predictions implicit in prior scholarship has been tested in a rigorous way. Despite the theoretical gaps in prior scholarship, and despite the lack of empirical scholarship, prior scholarship has also been uniformly normative in nature. Scholars have offered prescriptions ranging from a near-complete ban on lockups(7) to near-complete judicial deference to manager decisions on lockups.(8) Yet because of the lack of empirical testing, scholars have had no valid basis even for the implicit assumption that legal rules on lockups affect bidder strategy, target behavior, or bid outcomes.

This article attempts to address both the theoretical and empirical gaps in prior scholarship. …