Courtesy of Davidson Heath and Mark Mitchell*
Recent movements in financial markets illustrate the proverb: “The market takes the stairs up and the elevator down.” After rising steadily through 2019 and reaching a new all-time high of 3,386 on February 19, 2020, over the next seven trading days the S&P 500 fell by 432 points, losing over 12% of its value. Over the next fifteen trading days, it contracted another 20%. Market corrections or crashes are not uncommon: Of the thirty-three years from 1986 to 2018, fifteen saw at least one episode when the market fell 10% or more in a month. We can now add 2020 to the list. The recent sharp drop in the market has investors running for the exits, and was followed by an impromptu fifty basis point cut, and then a one hundred basis point cut, by the Federal Reserve. Our research suggests that it also affected the market for corporate control.
Mergers and acquisitions must be announced well before they are completed – an average of 139 market days in our sample. As a result, a primary concern in mergers and acquisitions is the risk that the deal may be cancelled before it is completed. From 1986 to 2018, one in eight mid-size or large M&A deals that were announced were ultimately cancelled. In our new paper, Market Crashes and Merger Completions, we document that interim risk — the risk that a merger or acquisition is cancelled after being announced — varies asymmetrically with the aggregate stock market.
Market Crashes, Cash Deals, and Stock Deals
A market crash, defined for our purposes as the market falling 10% or more in the month after a deal is announced, more than doubles the probability that the deal will be cancelled. Conversely, a positive market return does not affect the likelihood of deal completion. This nonlinear effect is present for large and small deals, buyouts and operating mergers, horizontal and unrelated deals, and hostile and friendly deals. The evidence suggests that a market crash during the interim period lowers the expected value of the deal to a level that extinguishes the expected gain to the acquiror, leading the acquiror firm to walk away.
Strikingly, we find that the effect of market crashes on merger completion is present only for deals to be paid in cash and is absent for deals to be paid in stock. A market crash post-announcement nearly triples the likelihood that a cash deal will be cancelled, while for stock deals there is no effect. This is because a deal to be paid in cash is effectively a fixed-price purchase contract on the target firm, while a deal to be paid in stock is a floating-price contract that specifies a ratio of acquiror shares per target share.
If the market as a whole falls, the acquiror’s stock price generally falls as well. Thus, a stock deal shares the interim risk between the acquiror and target firm. By contrast, in a cash deal, the acquiror bears all of the interim risk. However, if the expected value of the deal to the acquiror falls below the acquiror’s reservation value, then the target bears the risk that the acquiror will cancel the deal outright.
Why Not Renegotiate?
Why don’t the acquiror and target firm simply renegotiate the terms of the deal – as implicitly happens for deals to be paid in stock? Examining the scope for renegotiation, we find that when a definitive agreement is in place, market crashes have no effect on the completion of either cash or stock deals. The definitive agreement spells out the merger plan in detail and almost always includes a material adverse change, or MAC, clause that formally assigns major risk factors between the parties. The fact that the signing of a definitive agreement prevents the acquiror from ex post strategic default is consistent with a mechanism of costly renegotiation, and suggests that the definitive agreement represents a critical milestone in the M&A process.
Finally, the risk of market crashes varies over time, and we also find that this variation affects the terms of mergers that are announced and eventually completed. The VIX index measures expected future market volatility, and a higher VIX predicts a higher risk of a market crash. We find that, controlling for other macroeconomic factors, a high VIX predicts fewer deals to be paid in cash and a higher premium for cash deals. Also, when the VIX is high, the firms that are targeted and acquired in cash deals are smaller and have lower market betas.
These findings suggest that interim risk directly affects the market for corporate control — the method of payment, the deal premium, and even which firms are targeted and acquired. Consistent with this theory, during the extraordinary volatility of the last month, three large mergers were announced. Only one of the three was a cash deal, and that deal was an acquisition of a relatively small target (Forty Seven, Inc) by a large and well-capitalized acquiror (Gilead Sciences). Our results add to a growing body of evidence that interim risk — the risk that a merger or acquisition is cancelled after being announced — is a primary factor in the M&A market.
*Mark Mitchell is Founding Principal of CNH Partners, LLC
The views and opinions expressed are those of the authors and do not necessarily reflect the views of CNH Partners, LLC, its affiliates, or its employees; do not constitute an offer, solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such.
 The reservation value is the lowest expected acquisition value that the acquiror would accept. Below this level, the acquiror will cancel the deal.