Over commitment in valuation adjustment mechanism agreements

Abstract

In the past decade, the number of Merger and Acquisition transactions in China’s capital market has grown tremendously, and Valuation Adjustment Mechanism agreements (also known as bet on agreements) have gradually become a common tool in such transactions. Although Valuation Adjustment Mechanism agreements and their accompanying performance commitments can play a positive role in regards to signalling and incentive restraint, some actual realised in practice cases also reflect that this tool may indeed encourage both parties to focus more on short term benefit realisation and utilise such an agreement as a legal means to collude in order to further their respective interests. This has obvious negative long term effects and defeats the original purpose of Valuation Adjustment Mechanism agreements to reduce Merger and Acquisition market asymmetry and market volatility. This paper pairs and collates information on Merger and Acquisition transactions, key performance commitment terms, and relevant financial data of the target firms of all domestic listed companies from 2010 to 2019; uses the Qixing Iron Tower case and the Huayi Brothers case as representative Merger and Acquisition cases for in depth analysis, and empirically examines whether excessive performance commitments in Merger and Acquisition transactions negatively affect the medium- and long term performance of both parties to the transactions, and explores the motives of both parties to the transactions to engage in Merger and Acquisition transactions with excessive commitment pledges. This study found that some companies are prone to making and accepting unconscionably high performance commitments, but that such commitments do not sustainably improve the performance of the company in the long term, and that companies may instead suffer a short-sighted sudden reversal in firm performance at the end of the commitment period, and that the higher the level of over commitment, the greater the subsequent fall in performance. In addition, both parties to the merger have a strong incentive to participate in over commitment transactions. The target firm stakeholders obtain higher premium acquisition payments through excessive performance commitments; the acquirer, in turn, obtains more free cash flow through equity pledge financing upon completion of the over committed transaction, with both parties to the transaction using excessive commitment Valuation Adjustment Mechanism agreements as a vehicle for collusive profit-making through market signalling and taking advantage of insiders' information. Further research found that firms which tend to engage in over committed Merger and Acquisition typically have the following characteristics: first, acquirers with higher equity concentration are more likely to accept over committed transactions; second, over commitment is more likely to occur in cross industry Merger and Acquisition transactions, especially in cross industry acquisitions of companies in light-asset industries by companies in traditional industries; third, acquirers with higher valuations but poor earnings growth are more likely to accept over commitment. This paper enriches the study of performance compensation commitments inducing short-sighted and speculative behaviour by examining the negative impact of excessive performance commitments on long term business performance and the mechanisms at play, and by exploring the characteristics of participating firms, provides a reference for improved guidelines for the formulation and implementation of market regulatory policies.