Major Shareholder Tunneling Under Performance Commitment Clauses

Abstract

This study investigates how major shareholders with cross-holdings in both acquiring and target firms exploit performance commitment clauses in M&A deals to engage in tunneling at the expense of minority shareholders. Using data on Chinese M&A transactions, we find that while performance commitments lead to positive short-term stock returns for acquirers, they are associated with negative long-term performance, particularly when major shareholders have cross-holdings. We show that major shareholders with cross-holdings exploit performance commitments (1) by inflating the target’s valuation to secure higher payouts and (2) by profiting from the acquirer’s short-term positive stock returns to cash out. To minimize legal risks and protect their reputation, they set achievable targets and may subtly manipulate performance to meet these thresholds, enabling value extraction with limited scrutiny. This suggests that performance commitments, intended to align interests and ensure fair valuations, can be manipulated for tunneling purposes. Our findings highlight an important agency problem in M&A contracting and have implications for protecting minority shareholders.

Keywords: mergers and acquisitions, performance commitment clauses, tunneling, cross-holdings, agency problems

JEL Classification: G34, G38, G14