The Impact of Go-Shop Provisions in Merger Agreements

Target firms typically employ either an auction or a negotiation method during merger negotiations. In auction deals, the pre-public takeover process involves contacting several potential bidders, signing confidentiality/standstill agreements and accepting private bids. In negotiation deals however, the target engages with only one bidder in the pre-public takeover process. Using either selling method, the target board negotiates with the bidder(s) and if an acceptable price is obtained from a bidder, a definitive merger agreement is signed and a public announcement is made. Typically, after the public announcement of a merger agreement, target boards do not actively solicit new bids although unsolicited superior bids can still be considered.

When directors put a company up for sale (by initiating an active bidding process, by seeking an alternate buyer in response to an unsolicited acquisition proposal, or by approving a transaction resulting in the sale or change of control) their fiduciary duty changes from preservation of the company as a corporate entity to obtaining the highest possible price for their shareholders. Further, directors have the burden of proving that they were adequately informed and acted in the best interests of shareholders.

Demonstration of fiduciary duties is relatively more evident if the target board adopts an auction selling method since there appears to be a robust market check of target firm value prior to signing of the merger agreement. However, nearly half of all merger deals are structured as negotiations. In such cases, target boards may fulfill their fiduciary duty by signing a merger agreement and testing the transaction with post-signing market check.

Go-shop provisions are contractual devices that allow target firm to actively solicit other bids during a go-shop period of typically 30-45 days starting on the day of the public announcement of a merger agreement with a particular bidder. Most deals with go-shop clauses also include target termination fee clauses. If a successful bidder emerges during the go-shop period, the go-shop clause allows for a reduced target termination fee, typically 50-60 percent of the termination fee, which lowers the cost of terminating the initial deal. By actively seeking superior bids after a definitive merger agreement is announced and by lowering the cost of deal termination, target boards claim to fulfill their fiduciary duty to target shareholders to obtain the highest possible price.

However, like any contractual provision, go-shops may be used by target boards either to further shareholder interests or for entrenchment purposes. Using a large sample of merger agreements of publicly traded US firms from 2003 to 2012, we undertake a detailed analysis of go-shop provisions to shed light on whether these provisions are motivated by agency reasons or to benefit target shareholders. The agency problem based explanation argues that target management use go-shop provisions as window dressing to secure deals with favored bidders at the expense of shareholders. Since most deals with go-shop provisions also have target termination fee clauses, new bidders face a termination fee, albeit a reduced one, and are thus disadvantaged relative to the initial bidder. This could curb the bidding interest of potentially higher value bidders, to the detriment of target shareholders. This explanation suggests that go-shop provisions may be used as window dressing to cosmetically demonstrate fiduciary duty to shareholders.

The shareholder interest explanation argues that targets use go-shop provisions to improve incentives for bidding while protecting shareholder interests.  Potential bidders are more likely to participate in the bidding process and bid aggressively if they are compensated for negotiation costs and information externalities and perceive a timely end to the takeover process. This can be achieved through offering bidders a favored position in the takeover process and compensation for deal break-up. Hence, go-shop provisions could improve incentives for bidding while still allowing superior bids to be solicited after the initial merger agreement.

We first examine which firm and deal characteristics are correlated with the use of go-shop provisions. We find that go-shop provisions are more likely in deals involving negotiation selling method, financial buyers, all cash financing and targets with less valuation uncertainty. A negotiation deal signals commitment to the initial bidder with no bidder competition before the initial merger agreement. Such deals while improving incentives to bid would likely benefit more from the features of go-shops that make it less costly to solicit superior bids after the initial agreement is signed and would demonstrate fiduciary duty to target shareholders.

Financial buyers may find go-shops attractive, particularly in negotiation deals, since they are incentivized to complete deals and deploy capital and having a signed merger agreement increases the probability of ultimate deal success. Initial bidders also typically have matching rights and are assured of a minimum return to their negotiation cost due to the termination fee. Targets with less valuation uncertainty appear more suitable for go-shops since less time and resources are needed to prepare a bid and there are fewer information externalities, resulting in potential bidders valuing deal protection less.

We then examine the effect of go-shop provisions on initial offer premiums.  Initial offer premiums and contract provisions such as a go-shop are likely to be jointly determined during negotiations between the bidder and the target. In the presence of a go-shop provision, the strategy of the initial bidder could be (1) incorporate the likelihood of a competing bid due to the go-shop provision and provide a lower initial bid so as to maintain a margin of safety to subsequently match a competing bid or (2) provide a higher initial bid to deter any competing bid that could result from the go-shop provision.

After taking into account the endogenous nature of go-shop provisions and initial premiums, we find that initial premiums are higher or at least, no lower in deals with go-shop provisions compared to deals without go-shop provisions. Further, the market reacts more favorably to the inclusion of go-shop provisions in merger agreements. Cumulative abnormal returns measured as actual stock returns less expected stock returns are higher for go-shop deals compared to no go-shop deals around the public announcement of the merger.

We next examine whether go-shop provisions impact the probability of eliciting competing bids. We find that this is indeed the case.  Our analysis suggests that the inclusion of go-shop provisions increases the probability of attracting a competing bid by approximately 73.3%. We find that the higher incidence of competing bids in go-shop deals translates into economically meaningful revisions to initial offer premiums. Results suggest that initial offer price is revised upwards in 19.3% of deals with go-shop provisions compared to 6.37% of deals without go-shop provisions and that on average the magnitude of offer price increase is 4.06% in deals with go-shop provisions compared to 1.41% in deals without go-shop provisions.

Overall, our analysis suggests that go-shops do not appear to be a superficial attempt to demonstrate fiduciary duty: active solicitation of new bids and the tiered termination fee structure of go-shop deals appear to be effective in eliciting superior bids. These price revisions ultimately result in target shareholders in go-shop deals receiving final premiums that are no lower than those received by target shareholders in no go-shop deals. The above benefits of go-shops appear to occur primarily in deals employing negotiation-selling method.

The preceding post comes to us from Sridhar Gogineni, Assistant Professor at the University of Wyoming – College of Business – Department of Economics and Finance, and John Puthenpurackal, Professor at the University of Nevada, Las Vegas – Department of Finance.  The post is based on their paper, which is entitled “The Impact of Go-Shop Provisions in Merger Agreements” and available here.