The vast majority of mergers and acquisitions (M&As) in recent years employ fairness opinions (FOs). FOs are provided by an outside advisor (typically an investment bank) and reflect the advisor’s opinion that the terms of the transaction are “fair” to the shareholders from a financial perspective. To justify their opinion, the advisor performs valuation analyses using methods such as comparing the target firm to similar peer firms (peer comparables analysis) and discounted cash flow (DCF) analysis, among others. Early studies examining the use of FOs argued that their primary role was to improve transaction outcomes by providing relevant information about the firm’s value to the key parties involved in negotiations (e.g., firm management and the board of directors). However, more recent studies have questioned the usefulness of FOs, pointing to potential bias and a lack of evidence that they influence deal outcomes. Despite their long history of use and their importance in the market for corporate control, the question of why FOs exhibit bias remains largely unanswered. In our study, “The Strategic Choice of Peers in M&A Valuations,” we aim to answer this question by examining how litigation risk influences FO valuations through the strategic choice of peer comparables.
Litigation arises in M&As when target shareholders believe the transaction price was too low. To test how litigation risk affects FO valuations, we focus specifically on appraisal lawsuits, which have been a particularly important development in the M&A market in recent years. Originating as a mechanism to protect minority shareholders who may be forced to give up their shares without consent, appraisal laws give target shareholders the right to oppose a merger offer, and to receive a judge’s appraised value of their shares in place of the original merger price. Appraisal lawsuits are potentially costly because they can increase the transaction price as well as generate deadweight costs that damage the combined firm’s post-merger value. Furthermore, appraisal lawsuits are lengthy ordeals, with most appraisal petitions taking 1-3 years following merger completion to either settle or receive a judicial ruling.
Our central prediction is that heightened appraisal risk leads to the selection of lower-valued peers as peer comparables in target-sought FO valuations to portray the deal price as “fair” and, consequently, ward off costly appraisal lawsuits. Since FO valuations feature a range of values that could be considered fair to target shareholders, such a strategy predicts the range of values will be downward-biased so as to place the agreed-upon takeover price at or near the upper end of the range. The implication of this bias for peer comparables is that lower-valued peers will be selected to make the target valuation appear attractive in comparison.
We test our prediction by employing a landmark 2007 ruling by the Delaware Court of Chancery In re Appraisal of Transkaryotic Therapies, Inc., which significantly strengthened appraisal rights in Delaware. The ruling substantially increased the frequency and magnitude of appraisal claims related to Delaware-incorporated target firms, driven by hedge funds engaging in an investment strategy referred to as “appraisal arbitrage.” The success of the investment strategy has been such that nearly one in three Delaware mergers faced appraisal lawsuits in the 2013–2016 period, with the total value of dissenting shares reaching $1.5–2.0 billion annually. Accordingly, our research design compares the change in peer firm selection for target firms incorporated in Delaware (“treated” firms) following the 2007 ruling to the change in peers selected by targets incorporated elsewhere (“control” firms).
Our sample consists of hand-collected peer comparables data from 663 target-sought FO valuations relating to mergers completed over 2000–2015. We measure bias in peer firm selection by comparing the median valuation multiple (enterprise value-to-sales, or EVS) for the portfolio of chosen peers to the distribution of median valuation multiples for all possible peer firm portfolios that could have been chosen. We refer to this measure as the Peer Portfolio Percentile (PPP), as it represents where the portfolio of chosen peer firms sits relative to the distribution of all potential peer firm portfolios.
Our main finding is that lower-valued peers are selected among Delaware target firms in response to heightened appraisal risk following the 2007 Transkaryotic court decision, compared to non-Delaware target firms. In terms of economic magnitude, we find a relative decrease of 32.8% in the value of peer firms selected among Delaware targets. This finding is consistent with target firms strategically selecting lower-valued peers to make the takeover price appear more attractive, and consequently deter appraisal lawsuits. We also find that the strategic behavior is concentrated among deals with a high dollar value (Large deals) but is not present among deals with a low dollar value (Small deals), suggesting that appraisal lawsuit risk (and therefore strategic peer selection) is most prevalent when significant wealth is at stake. Furthermore, we find that the downward bias in peer selection is more pronounced when the target CEO is retained by the merged firm and has relatively little ownership in the target firm. In other words, the bias in peer selection is stronger when the target CEO’s incentives are more closely aligned with the future performance of the post-merger firm, which may be adversely impacted by a costly appraisal lawsuit. This finding suggests that the strategic choice of peer comparables in FO valuations may stem from an agency conflict between the target’s CEO and shareholders.
Next, we show evidence of two important consequences from the strategic selection of lower-valued peers. First, we show that although there is a substantial (14.2%) overall increase in the likelihood of appraisal lawsuits among Delaware target firms following the Transkaryotic decision, we find that the strategic selection of lower-valued peers mitigates the increase. Specifically, Delaware targets with a highly valued portfolio of selected peers exhibit a 20.3% increase in appraisal lawsuit likelihood, whereas Delaware targets with a lower-valued portfolio of selected peers exhibit an increase of just 6.4%, suggesting that strategically selecting lower-valued peers can improve the post-merger value of the combined firm by reducing the likelihood of appraisal lawsuits. Second, we find that although Delaware targets overall experience an increase in merger premiums following the Transkaryotic decision, consistent with acquirers paying higher takeover prices to avert potential appraisal lawsuits, the increase is mitigated among targets with a lower-valued portfolio of selected peers. Viewed together, these findings imply that strategically selecting lower-valued peers reduces the threat of appraisal lawsuits, but may also lead to a lower takeover price for the target firm.
Overall, our study provides evidence that litigation risk is an important driver of FO valuations as target firms strategically select downward-biased peers to decrease the threat of subsequent lawsuits. This behavior can increase the post-merger value of the combined firm, but it can also lead to a lower takeover price, thus calling into question the notion that the primary purpose of FOs is to inform the parties involved in merger negotiations.
Claudia Imperatore is an Assistant Professor at Bocconi University, Department of Accounting
Gabriel Pundrich is an Assistant Professor at the University of Florida
Rodrigo S. Verdi is an Associate Professor at Massachusetts Institute of Technology
Benjamin Yost is an Assistant Professor at Boston College, Carroll School of Management
This post is adapted from their paper, “The Strategic Choice of Peers in M&A Valuations” available on SSRN.
