The Effect of Prohibiting Deal Protection in M&A: Evidence from the United Kingdom

Fernán Restrepo is John. M. Olin Fellow and Gregory Terrill Cox Fellow in Law and Economics at Stanford Law School. Guhan Subramanian is Joseph H. Flom Professor of Law and Business at Harvard Law School and H. Douglas Weaver Professor of Business Law at Harvard Business School. This post is based on a recent paper by Mr. Restrepo and Professor Subramanian.

In any public-company acquisition, the need for shareholder and regulatory approvals creates a window between the date of the deal signing/announcement and the date that the acquirer can close the deal. This window, which is approximately three months on average, introduces the possibility that a higher-value bid will emerge between the signing and the closing. Because the target board’s fiduciary duty typically requires consideration of any such higher offer, the acquirer cannot eliminate this risk through contracting with the target. Instead, the typical solution in public-company M&A is “deal protection” (equivalently, a “lockup agreement”) which provides value to the first bidder in the event that the target board accepts a higher-value bid. Coates and Subramanian (2000) define a deal protection device as “a term in an agreement related to an M&A transaction involving a public company target that provides value to the bidder in the event that the transaction is not consummated due to specified conditions.”

Deal protections can have two main effects in the M&A marketplace: first, they can encourage a first bidder to bid, by compensating that bidder for (e.g.) opportunity costs, reputational costs, and out-of-pocket expenses; and second, they can discourage second bidders from bidding, because they siphon value out of the target company for the first-bidder’s benefit, in the event an overbid. These two effects have directionally opposite implications for overall social welfare. The ex ante inducement effect for first bidders promotes value-enhancing deals; but the ex post deterrent effect for second bidders discourages potential overbids that would increase target shareholder returns and increase allocational efficiency in the M&A marketplace.

Since September 2011, the United Kingdom has prohibited all deal protections—including termination fees—in acquisitions of U.K. public companies (hereinafter, the “2011 Reforms”). In contrast, for the twelve-year period from 1999 to 2011, the U.K. permitted termination fees up to 1% of deal value and there was no restriction on other deal protection devices. This regulatory change presents the opportunity for a natural experiment: what happened to deal volumes, the incidence of competing offers, deal jumping, deal premiums, and deal completion rates in the U.K. M&A marketplace after the 2011 Reforms? To our knowledge, this paper presents the first investigation of these questions. The results permit an assessment of the 2011 Reforms, and also shed light on the social welfare implications of deal protection in M&A markets more generally.

Using a database of public-company M&A deals in the U.K. and a control group of other European G-10 countries over the period 2000-2015, we find that the incidence of deal volumes in the U.K. decreased approximately 50% after the 2011 Reforms, relative to the control group. The incidence of competing offers, deal jumping rates, deal premiums, and deal completion rates for first bidders did not change. In terms of dollar value, we estimate that U.K. shareholders have lost USD19.3 billion per quarter through deterred M&A deals in the five years after the 2011 Reforms. In sensitivity analyses, we obtain estimations that are directionally and statistically consistent with these results if we use the U.S. as a control group instead of using the control group of European G-10 economies.

Taken together, the results indicate that deal protections provide an important social welfare benefit by facilitating the initiation of M&A deals, and that the loss in shareholder value from reduced deal volumes in the U.K. was not offset by higher bidding competition or deal premiums.

Our paper is organized as follows. Part 2 reviews the motivation for deal protection devices, provides relevant background on the U.K. takeover marketplace and the takeover law of the control group, reviews the prior literature, and describes the 2011 Reforms. Part 3 describes our methodology and data. Part 4 presents our results. Part 5 discusses the findings. Part 6 concludes.

The full paper is available here.

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