How Do Representations and Warranties Matter? Risk Allocation in Acquisition Agreements

Abstract

In merger agreements, the seller makes contractual representations and warranties (“reps”) about the state of the target, e.g., attesting to the accuracy of the target’s financial statements. We obtain a proprietary sample of claims for breaches of the reps in acquisition agreements related to 1,690 acquisitions comprising $470 billion in enterprise value. We analyze this claims data to study how and when reps matter. Financial statement misstatements are the most common type of breach. Parties appear to negotiate reps consistent with the risk allocation necessary in an agreement, utilizing reps to reduce information asymmetry and create value depending upon the industry, firm volatility, and governing law. Our findings also show that more experienced acquirers such as private equity appear to utilize reps more efficiently to create value. These results highlight the importance of reps in risk allocation, reducing information asymmetry and creating value, but they also highlight the role of investor skill in creating value from reps.

Keywords: mergers and acquisitions, representations and warranties, material misstatements, indemnification, insurance, private equity, valuation uncertainty, adverse selection, moral hazard

JEL Classification: D82, G22, G24, G34, K12, K22, K41, L14, M41