Contingent Value Rights in Acquisitions: Theory and Empirical Evidence
51 Pages Posted: 20 Jul 2003
Date Written: July 2003
A CVR is a commitment by an issuing firm to pay additional cash or securities to CVR-holders contingent on the issuer's share price falling below a pre-specified level. It has been offered together with cash or stock, or both (or with other securities) as a means of payment in a number of recent corporate restructurings such as takeovers, debt restructuring, lawsuit settlements, etc. Since a CVR provides a hedge against downside price risk of the issuing firm, many practitioners argue that a CVR is a way to guarantee a minimum value for the payment package. However, this argument raises the question that, if a firm only intends to guarantee the value of its payment, then why doesn't the firm pay with cash and why does it choose CVRs instead of (or in addition to) cash? In this paper, we develop a theoretical model to address this issue and related questions. We consider a firm making a payment to acquire an asset from outside investors and we assume that the firm has more information about its intrinsic value than outsiders. If the firm is of a higher intrinsic value, then it is concerned about mispricing of its equity in the capital market (in addition to the mispricing of its payment). In this setting, we show that, when the extent of asymmetric information is severe, a higher valued firm can reveal its type by offering CVRs with other securities, but not by offering cash payment. We then test the empirical implications of our model in the context of M&As by using a comprehensive sample of U.S. public acquisitions in which CVRs are used. We find that, when CVRs are offered in acquisitions, the announcement period abnormal stock return is significantly more positive than comparable stock deals that involve no CVRs. We also find that firms offering CVRs in their acquisitions face more severe asymmetric information problem than firms offering cash or firms offering stock with no CVRs. Both findings are consistent with the implications of our model.
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