Analyzing the likelihood and the impact of earnout offers on acquiring company wealth gains in India

Emerging Markets Review 16 (2013) 203–222

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Analyzing the likelihood and the impact of earnout offers on acquiring company wealth gains in India Reena Kohli a,⁎, Bikram Jit Singh Mann b a b

Finance, Accounting and Control Area, Room No. 2, Faculty Block 3, Indian Institute of Management, Kozhikode, India Department of Commerce and Business Management, Guru Nanak Dev University, Amritsar, India

a r t i c l e

i n f o

Article history: Received 13 August 2012 Received in revised form 10 May 2013 Accepted 13 May 2013 Available online 26 May 2013 Keywords: Acquisitions Cross border acquisitions Earnout offers Cash offers Stock offers India

a b s t r a c t The study seeks to assess the likelihood and impact of earnout offers on the acquiring company wealth gains in cross border acquisitions in India. The study highlights two cases where earnouts are preferred choices of the acquirer. Firstly, in those cases where the target company is in hi-tech and services sector employing high level of intangible assets that are difficult to value. Secondly, in those cases where the acquirers are mature and already have some international exposures. The results of the event study indicate that earnout offers create significantly higher wealth gains compared to the cash offers only and not the stock offers. © 2013 Elsevier B.V. All rights reserved.

1. Introduction The fundamental requirement in any merger and acquisition transaction is that the acquirer must know the value of the resources at the target's disposal. However, the information gap on the part of the acquirer regarding the true value of the target's resources pose the risk of adverse selection for the acquirer in an asymmetric information market. This risk is more pronounced in the case of cross border acquisitions (Contractor et al., 2007; Datar et al., 2001; Reuer et al., 2004) and has been defined as liability of foreignness by Zaheer (1995). The reason being, unfamiliarity of the foreign acquirer with the local industrial environment makes it difficult for the foreign acquirer to assess the true value of assets at the disposal of the target company. Chang and Tsai (2013), Donohoe (2006) and Mantecon (2009) also argue that information disadvantage on the part of a foreign acquiring company is the often cited reason for the losses of the firms engaged in international operations. A priori research suggests that an acquiring company uses stock as a mode of payment to manage the risk of adverse selection in case of imperfect information market (Faccio and Masulis, 2004; Hansen, 1987; ⁎ Corresponding author. Tel.: +91 495 2809422, +91 9539761429 (mobile); fax: +91 495 2803010 11. E-mail addresses: [email protected], [email protected] (R. Kohli), [email protected] (B.J.S. Mann). 1566-0141/$ – see front matter © 2013 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.ememar.2013.05.004

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Loughran and Vijh, 1997; Martin, 1996; Travlos, 1987). The reason being, stock has a contingent pricing effect that enables the acquiring company share the risk of mis-valuation of the target's resources with the target's shareholders in the post acquisition period, through shared ownership. Although, the acquiring companies can use stock financing as a hedge to mitigate the risk of adverse selection in case of cross border acquisitions, nevertheless in certain circumstances the acquirer may not be able to use the stock as a mode of payment. For instance, target companies are often reluctant to accept the stock of the acquiring company as a mode of payment when the acquiring company belongs to an emerging market1 and hence, the acquiring company may have to forcibly employ cash (Conn et al., 2005; Moeller and Schlingemann, 2005; Tebourbi, 2005). The reason for such reluctance is the vagaries of the stock market in the emerging markets that make the stock of the acquiring company an unattractive proposition for the target shareholders (Mathew and Jain, 2006). Thus, a situation may arise, in a cross border acquisition, where the acquirer who faces the risk of mis-valuation is unwilling to offer cash as it will shift the entire risk to the acquirer in the post acquisition period. On the other hand, the target is not willing to accept stock due to the skepticism regarding the valuation of the acquirer's shares as a currency of exchange. In such cases, the risk of losing the deal due to valuation disagreement between the target and the acquiring companies can be resolved by entering into a two part payment contract known as an earnout offer. An earnout is a contractual agreement in which the acquiring company makes payment to the target in two or more parts, namely, an upfront payment made at the time of entering into the contract and a deferred payment or an earnout that is linked to the attainment of pre-specified performance milestones by the target company at pre-specified time periods. The amount of upfront payment reflects the mutually agreed upon portion of transaction value while the earnout reflects the extent of disagreement between the target company and the acquiring company (Kohers and Ang, 2000). An earnout offer enables an acquiring company to share the risk of overpayment ex post with the target company by making the part payment contingent upon future performance benchmarks. Linking part payment to future performance targets also signals the inherent strengths of the target company because only that target company, which believes in its own potential to create value in the post acquisition period would accept such an offer where part payment is premised on its ex post performance. Besides information asymmetry, acquiring companies are also motivated to employ earnouts as a tool to retain the managers of the target company who may possess the expertise and the specific knowledge in relation to the operations of the company that can otherwise not be duplicated (Kohers and Ang, 2000). Datar et al. (2001) state that in cross border acquisitions the acquirer may prefer to retain the target's owners/ managers due to possession of the country specific expertise. Earnouts try to align the managerial objectives with organizational objectives by retaining the target managers and linking their earnings to their future performance. This in turn resolves the agency problem as highlighted by Reeb et al. (1998) which arises due to the difficulty faced by foreign acquiring companies in overseeing the actions of the overseas managers. During the years 2005–2007, the value of outbound cross border acquisitions pursued by Indian companies rose dramatically from $1876.99 million in the year 2005 to $29,083.37 million in the year 2007, which was the highest value of outbound acquisitions among the emerging economies represented by the BRIC countries.2 Further, during the years 2005–2007, Indian companies have financed a large number of their outbound cross border acquisitions via earnout mechanism. However, earnout offers are restricted only to outbound cross border acquisitions pursued by the Indian companies. Instances of domestic acquisitions or the inbound cross border acquisitions being financed via earnout mechanism are quiet rare in India. As far as domestic acquisitions are concerned, there is only one deal whereby WNS acquired Marketics Technologies and employed earnouts as a mode of payment. In case of inbound acquisitions, there are two instances (Greater Pacific Capital Plc. acquired Azure Knowledge Capital Private Limited; Serco Group Plc. acquired Intelenet Global Services) where deal value is structured in terms of 1 Madhok and Keyhani (2012) have further refined the concept of liability of foreignness and have coined the term “liability of emergingness” for those firms which belong to emerging economies when such firms diversify their operations, internationally, especially in developed markets. They attribute the liability of emergingness to the handicaps and the resultant costs incurred by the firms from developing markets in their country of origin due to factors like underdeveloped markets, weak institutional environments, infrastructure bottlenecks, lack of strategic resources viz. technical and managerial expertise, etc. This in turn reduces the credibility of such firms in the eyes of host country stakeholders and restricts the mutually beneficial deals. 2 World Investment Report on mergers and acquisitions by UNCTAD for the years 2005, 2006 and 2007.

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earnout mode. Thus, the questions of interest are to know the factors that motivate Indian companies to employ earnouts in outbound cross border acquisitions and also to know how these acquisitions have fared in terms of shareholder wealth gains as compared to those of cash and stock offers. An analysis of the extant literature on earnout offers highlights that most of the a priori research with respect to earnout offers is restricted to the developed countries viz. the US (Cain et al., 2011; Datar et al., 2001; Reuer et al., 2004) and the UK (Barbopoulos and Sudarsanam, 2012; Fabregat, 2005). Moreover, existing studies have not exclusively explored the issue of earnout offers in outbound cross border acquisitions except for Reuer et al. (2004). However, Reuer et al. (2004) define contingent payouts as the combination of stock and earnout offers and have not exclusively studied the earnout offers in outbound cross border acquisitions. Thus, keeping in view an increasing trend towards earnout offers in outbound acquisitions by Indian companies and a commensurate lack of research in this area for emerging economies,3 it is interesting to explore whether the extant conceptual framework and empirical evidence pertaining to earnout offers can be extended to the Indian outbound cross border acquisitions or not. Thus, the present study has been conducted with the following objectives: 1. To evaluate the factors affecting the probability of an offer being financed via earnout mechanism in outbound cross border acquisitions in India. 2. To assess the acquiring company announcement gains in earnout offers, cash offers and stock offers. 3. To compare the acquiring company announcement gains across all modes of payment. 4. To assess the determinants of the acquiring company wealth gains in outbound cross border acquisitions in India. The first objective aims to assess the conditions wherein the acquiring companies in India find it attractive to make earnouts as a feature of cross border acquisitions. The second objective aims to evaluate the impact of earnout offers on the wealth of the acquiring company shareholders. The third objective aims at comparing the announcement gains in earnout offers with those of cash offers and stock offers to discern which of the three modes of payment yield superior returns to the acquiring company shareholders in the presence of information asymmetry. The fourth objective aims at assessing the determinants of wealth gains in cross border acquisitions besides the mode of payment. The study contributes to the existing literature as, to the best of our knowledge; this is the pioneering study to explore the issues pertaining to earnout offers in India. Thus, the present study extends the nascent body of existing literature on earnout offers to an emerging market like India. 1.1. Hypotheses development A priori research highlights two issues being explored by the researchers with respect to earnout offers. Firstly, researchers (Barbopoulos and Sudarsanam, 2012; Datar et al., 2001; Kohers and Ang, 2000; Reuer et al., 2004) have assessed the factors that determine the likelihood of earnout offers. Secondly, researchers (Barbopoulos and Sudarsanam, 2012; Fabregat, 2005; Kohers and Ang, 2000; Mantecon, 2009) have evaluated the announcement gains of earnout offers and have compared such gains with those of cash offers and of stock offers. A detailed explanation on both the issues is given as follows: 1.2. Likelihood of the earnout offers While analyzing the determinants of earnout offers, researchers have highlighted various bid specific and company factors viz. industry context, industry relatedness, legal system in the target's country, listing status of the target company, relative size of the target company, size of the acquiring company, age of the acquiring company, degree of internationalization of the acquiring company, as the factors affecting the

3 Researchers like Boateng et al. (2008), Deng (2010), Gubbi et al. (2010), Kale (2009), Kohli and Singh, 2012, Kumar (2008), Nayyar (2008), Ray and Gubbi (2009) and Sun et al. (2012) have studied the patterns, strategic motives, shareholders' wealth gains and determinants thereof for cross border acquisitions pursued by the acquiring companies from emerging markets viz. India and China while Bhagat et al. (2011) have studied it for the acquiring companies from seven emerging markets collectively viz. India, China, Brazil, Malaysia, Mexico, Philippines, Russia and South Africa. However, none of these studies has explored the issue of earnout offers.

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likelihood of the earnout offers. A detailed explanation of these variables and corresponding hypotheses developed is stated as follows. 1.2.1. Industry context Prior evidence suggests that earnout offers are preferred by an acquirer in those acquisitions where level of information asymmetry is higher due to the quality of assets being possessed by the target company. For instance, in those cases where the acquisition is for a target company in hi-tech industry employing high level of intangible assets and in those cases where the target company is in the service industry having operations which are more reliant on its manpower (Barbopoulos and Sudarsanam, 2012; Datar et al., 2001; Kohers and Ang, 2000; Reuer et al., 2004). The reason being, in such cases the value of resources (the intangible assets and the human resource), that drive the value of the firm, is not adequately reflected in the financial statements and it becomes difficult for the acquirer to assess the true value of the target's resources. Moreover, the acquirer tries to retain valuable human resources of the target by providing them with greater incentives in the form of higher earnout premiums linked to the pre-specified performance targets. Hypothesis 1. The likelihood of a cross border acquisition financed with earnout is more for a target company in hi-tech and service industry than in other industries. 1.2.2. Industry relatedness Researchers like Barbopoulos and Sudarsanam (2012), Kohers and Ang (2000), Datar et al. (2001) and Reuer et al. (2004) argue that the acquirer's tendency to use earnout offer is higher when it moves into unrelated business territories. This is so because the acquirer generally lacks knowledge about the value of the resources at the target company's disposal, thus posing a risk of mis-valuation. Moreover, the target company managers may not fully understand the modalities of such businesses and hence may prefer to retain the target company's managers via earnout offers. Hypothesis 2. The likelihood of a cross border acquisition financed with earnout is more when a target company is in unrelated business than in related business. 1.2.3. Legal system in the target's country The essence of an earnout contract is to enable the acquirer make payment in two or more parts in the future. It implies that such contracts are essentially incomplete unless the pre-specified performance targets are achieved and the related compensation is paid to the target managers. Thus, the legal system for protecting investor's right should be strong in the target company's country for successful implementation of such offers. Otherwise the cost of enforcing an earnout contract would increase as compared to the expected benefits from such contracts. Porta et al. (1997, 1998) while examining the quality of laws governing protection of investor's rights, find that the countries that follow civil law legal system4 offer lesser protection to the rights of investors. On the other hand, countries that follow common law legal system, offer strongest protection to investors' rights. The findings are further validated by Moeller and Schlingemann (2005) and Tebourbi (2005). Hence, it is easier to enforce an earnout offer in countries following common law system than those that follow civil law legal system. Hypothesis 3. The likelihood of a cross border acquisition financed with earnout is more when a target company is in a country following common law legal system than in country with civil law legal system. 1.2.4. Listing status of the target company Previous research states that the probability of an earnout offer is also higher in cases where acquiring companies acquire private/unlisted target companies (Datar et al., 2001; Kohers and Ang, 2000). The reason being, the extent of information asymmetry is higher in such cases as private companies do not 4 Among the various prevalent civil law legal systems viz. French civil law legal system; German civil law legal system; and Scandinavian civil law legal system, the French civil law legal system offers weakest legal protection to shareholders rights (Porta et al., 1997, 1998).

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have readily available market price and also have to adhere to lesser disclosure requirements. Further, it is easier to negotiate an earnout contract with few sellers as in the case of a private company, than for a public company with a large number of dispersed sellers (Kohers and Ang, 2000). Hypothesis 4. The likelihood of a cross border acquisition financed with earnout is more for an unlisted target company than for a listed target company. 1.2.5. Relative size of the target company The size of the target company relative to the acquirer is also an important determinant of earnout offers. However, the findings of a priori research are ambiguous on this account. Kohers and Ang (2000) opine that the probability of an earnout contract increases as the size of the target company increases relative to that of the acquirer and propose that larger targets pose various managerial problems viz. problems in integrating the operations in the post acquisition period. Hence, the cost of adverse selection (mis-valuation) in ex-post period is higher in the case of acquisition of larger target companies. However, Datar et al. (2001) find that probability of earnout offers is more in case of smaller target companies due to lesser disclosure on the part of such companies. Likewise, Cain et al. (2011) propose that the size of earnout offer is large in case of smaller target companies as there is more uncertainty regarding the valuation of such companies. Hypothesis 5a. The likelihood of a cross border acquisition financed with earnout is more for a large sized target company. Hypothesis 5b. The likelihood of a cross border acquisition financed with earnout is more for a small sized target company. 1.2.6. Size of the acquiring company Barbopoulos and Sudarsanam (2012) and Kohers and Ang (2000) opine that the probability of an acquisition being financed with an earnout mechanism decreases with the increase in size of the acquiring company. The reason being, larger acquiring companies are more knowledgeable and thus have better access to information regarding the target's value than the smaller acquirer. Moreover, larger acquirers are in a better position to bear the risk of adverse selection, if any. Hypothesis 6. The likelihood of a cross border acquisition financed with earnout is less for a large sized acquiring company. 1.2.7. Age of the acquiring company Barbopoulos and Sudarsanam (2012) propose that age of the acquiring company, which in turn, measures the experience on the part of the acquiring company, also affects the likelihood of the earnout offers. They find that the probability of earnout offers is lesser on the part of experienced acquiring companies as these are in a better position to assess and cope up with the valuation risk. Hypothesis 7. The likelihood of a cross border acquisition financed with earnout is less for an experienced acquiring company. 1.2.8. Internationalization Reuer et al. (2004) propose that the probability of an earnout offer is lesser on the part of those acquiring companies who have already diversified their operations internationally, as in such cases these companies are in a position to understand the nuances of international business environment. Hypothesis 8. The likelihood of a cross border acquisition financed with earnout is less for an acquiring company with experience of international operations. 1.3. Wealth gains of the earnout offers As regards the wealth gains of the earnout offers, Kohers and Ang (2000) find that the announcement gains in earnout offers are significantly higher than those of cash and of stock offers. However, Barbopoulos and

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Sudarsanam (2012) suggest that earnout offers yield insignificantly lesser gains to the acquiring company shareholders as compared to those of cash offers and stock offers in cross border acquisitions. Further, Fabregat (2005) does not find any significant difference in wealth gains of earnout mergers as compared to those of cash offers and stock offers. Mantecon (2009) finds that earnout offers yield insignificantly negative announcement gains to the acquiring companies in cross border acquisitions and proposes that there is no evidence of the acquiring companies being benefitted from earnout offers in such acquisitions. Thus, results regarding the wealth gains of earnout offers are still conflicting vis-à-vis cash offers and stock offers. Hence, commensurate with the a priori research the hypotheses are: Hypothesis 9a. Earnout offers generate higher wealth gains to the acquiring company shareholders than cash offers and stock offers. Hypothesis 9b. Earnout offers generate lesser wealth gains to the acquiring companies than cash offers and stock offers. 2. Database and sample selection For achieving the aforementioned objectives, acquisitions announced during the period 1st January, 1997 till 31st March, 2008 are considered. Information regarding announcement date, outcome date and bid specific factors like mode of financing, relatedness and competition among acquirers has been obtained by scanning two leading Indian financial dailies namely, The Economic Times and The Financial Express for the above stated period. Moreover, the official websites of the Securities Exchange Board of India (SEBI) and the Bombay Stock Exchange (BSE) have also been consulted to cross check the announcement and outcome dates of mergers and takeovers. Further, data regarding the daily returns of individual stock of acquiring companies is obtained from PROWESS, the database software developed by the Centre for Monitoring Indian Economy. The sample is restricted to only those acquisitions that are successful and where the objective of the acquirer is to acquire a majority control of the target company. Such acquisitions have been deleted where the mode of payment is not clear. Deletions have also been made for those companies where data regarding daily returns of the acquiring company is not available. Yearly and sector wise distribution of the sample acquisitions is detailed in Tables 1 and 2, respectively. The year-wise distribution of acquisitions in Table 1 clearly depicts that the trend of earnout offers has picked up from the year 2003, with the maximum number of earnouts being pursued during the year 2006. Furthermore, cash is the most preferred mode of financing followed by earnout offers while stock is the least preferred mode of financing employed in cross border acquisitions. The trend of financing is consistent with the suggestion of Conn et al. (2005), Moeller and Schlingemann (2005) and Tebourbi (2005) who state that the probability of cross border acquisitions being financed with the stock of the acquiring companies is less prevalent due to the reasons discussed earlier in this article. Further, the sectoral distribution of the deals in Table 2 shows that across different modes of payment, cross border Table 1 Year wise distribution of the outbound cross border acquisitions segregated according to mode of payment.

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 (till March 08) Total

Cash offers

Earnouts

Stock offers

Total

1 1 2 6 3 7 14 16 30 38 40 7 165

0 0 1 0 0 0 2 2 7 9 1 2 24

0 0 0 4 2 0 1 1 2 1 2 0 13

1 1 3 10 5 7 17 19 39 48 43 9 202

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Table 2 Sector wise distribution of the outbound cross border acquisitions segregated according to mode of payment. Cash offers Agro products Automotive Chemicals and fertilizers Electric equipment Engineering and energy Credit rating services FMCG Gems and jewelry Hospitality Information technology Laminated tubes Wine and liquor Logistics Media and entertainment Metals Pharmaceuticals and healthcare Printing and publishing Telecom Textiles Total

3 14 18 1 4 0 7 1 1 58 1 3 1 1 5 31 2 5 9 165

Earnouts 1

1

20

2

24

Stock offers

Total

0 1 0 0 0 0 0 1 0 8 0 0 0 1 1 1 0 0 0 13

4 15 18 1 4 1 7 2 1 86 1 3 1 2 6 34 2 5 9 202

acquisitions are concentrated in hi-tech and services sector comprising of information technology, pharmaceuticals and healthcare and credit rating services coupled with a good number of acquisitions in chemicals and fertilizers, automotive, textiles, FMCG and metals sector. The sectoral distribution of cross border acquisitions is also in consonance with the findings of the studies by Nayyar (2008) and Ray and Gubbi (2009) who propose that 60–70% of the cross border acquisitions by Indian companies are in sectors like IT/ITES, pharmaceuticals and healthcare, automotive and chemicals and fertilizers. Barring information technology, pharmaceuticals and healthcare and credit rating services, no other deal initiated by the acquirers in other services sectors like telecom, media and entertainment, logistics and hospitality are financed via earnout mechanism. 3. Methodology The entire sample is segmented on the basis of mode of payment into three categories viz. cash offers, earnouts and stock offers, to assess the impact of earnout offers in hedging the problem of adverse selection in outbound cross border acquisitions. Further, the analysis of the data is conducted in three parts in order to achieve the objectives of the study. Firstly, logistic regression analysis is applied to study the conditions where the acquirer would finance an acquisition with an earnout offer. Secondly, the standard event study methodology is employed to assess the announcement returns over different event periods separately for the sample of cash, earnout and stock offers. Further, a comparison of the announcement gains over different event periods across the different modes of payment is made with the help of independent sample t-test. Thirdly, cross sectional regression analysis is conducted to evaluate the factors, besides mode of payment, that affect the wealth gains of the acquiring company shareholders in cross border acquisitions in India. A detailed description of the methodologies adopted is given as follows. 3.1. Logistic regression analysis Logistic regression analysis has been applied to know the situations where probability of using earnout offers is higher compared to the other two modes of payment that is cash offers and stock offers. For this purpose, a variable ‘Earn’ has been taken as a dependent variable that takes a value = 1, when an acquisition is financed with earnout mechanism while 0 value has been assigned to the variable if either cash or stock has been used for financing an acquisition.

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Further, the independent variables5 used in the study are explained as follows. 3.1.1. Industry context To assess the industry effect on acquirer's choice of mode of payment, a variable ‘Hi-tech’ has been introduced that takes a value of 1 for a target company either in hi-tech or in service sector and value equal to 0 in other cases. The companies are divided into hi-tech and services sector based on the definition of SDC Thompson database. The SDC Thompson database classifies the companies into various industrial sectors based on US SIC codes. As per the US SIC codes, the SDC Thompson Financial database classifies companies in telecommunication sector having primary business activities like providing telecommunication services or manufacturing telecom equipment; pharmaceutical sector dealing in vaccines, specialty drugs, companies engaged in drug research and development, as companies in technology intensive sector. Besides, companies whose primary business activity involves computer related services, viz., development of application software, computer consulting services, data processing services, internet and BPO services are also classified as companies in technology intensive sector. However, as per two digit SIC codes, certain companies defined as companies in hi-tech sector (having SIC codes as 28, 35–38, 48, 73, 87) are also defined as companies in services sector (having SIC codes as 70–89). Due to the overlap between the codes, the present study tries to assess the combined effect of a target company belonging to the hi-tech and the service sector by introducing a variable ‘Hi-tech’. 3.1.2. Legal system in the target's country A variable ‘Common’ has been introduced that takes a value of 1 if the target country follows common law legal system and 0 if it follows civil law legal system to measure the impact of legal enforceability of investor's rights. 3.1.3. Listing status of the target company A variable ‘Private’ is introduced that takes a value = 1 if the target company is an unlisted private company and 0 otherwise to measure the impact of the listing status on the probability of an acquisition being financed with an earnout offer. 3.1.4. Relative size of the target company Two variables have been introduced to measure the impact of size of the target company on the likelihood of an offer being financed via earnout mechanism. The First variable is ‘RelsizeT’ which measures the impact of relative size of the target company while the second variable is ‘LogDV’ which measures the impact of the deal value on the probability of an earnout offer. The relative size of the target company is defined as follows: Relative size of target company ¼

0

Deal value as a proxy of target company s assets : Deal value þ Market value of acquiring company

The market value of the acquiring companies is considered for the financial year ending immediately before the year of acquisition announcement.

5 A priori research has also studied the impact of relatedness in the operations of the target and the acquiring companies on the likelihood of the offer being financed via earnout mechanism. Following Chatterjee (1986), the entire product lines of the target and the acquiring companies have been matched to decide whether a particular acquisition is in related or unrelated area. The transaction is defined as a related one if both the acquiring and the target companies have similar product lines, as well as, similar areas of operations and unrelated otherwise. However, scanning of the entire database reveals that the acquiring companies in India prefer to diversify their operations into related areas only in cross border acquisitions. Since all acquisitions are in related areas, hence the variable relatedness has not been introduced in the present study and hence, Hypothesis 2 has not been examined. Further, Reuer et al. (2004) has used percentage of stake acquired in an acquisition as the determinant of mode of payment to be selected by an acquirer in cross border acquisitions. They propose that the higher the stake acquired, the larger is the probability of an offer being financed via earnout mechanism as higher proportion of risk is being transferred to the acquirer. However, in the present study, the variable ‘stake’ has not been used in analysis as the acquiring companies have acquired majority stake (that is between 51% and 100% stake of the target companies) in all acquisitions. While explaining the patterns of cross border acquisitions in India, Nayyar (2008) and Ray and Gubbi (2009) also find that 80–85% of the cross border acquisitions pursued by Indian companies are for complete ownership or majority stake of the target companies.

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The second variable, ‘LogDV’ is defined as the log of the absolute deal value. 3.1.5. Size of the acquiring company A variable ‘logmvA’ is introduced to measure the impact of the acquirer's size on the probability of a transaction being financed with earnout mechanism. The size of the acquiring company has been measured by taking the log of market value of the acquiring company for the financial year ending immediately before the year of acquisition announcement. 3.1.6. Age of the acquiring company A variable ‘age’ has been introduced to measure the experience on the part of the acquiring companies and the impact of such experience on the probability of an earnout offer. The age of the acquiring company has been measured as the difference between the year of incorporation of the acquiring company and the year of acquisition by the acquiring company. 3.1.7. Internationalization To measure the impact of internationalization on the likelihood of an earnout offer a variable ‘international’ has been introduced. It has been computed as the ratio of foreign sales to total sales for an acquiring company. For computing the ratio, foreign and total sales of the acquiring company for the financial year ending immediately before the year of acquisition announcement have been considered. The definition and the expected signs of the independent variables for the logistic regression analysis are summarized and explained in Table 3. 3.2. Event study In the second part of the analysis, the announcement gains to the acquiring companies across different modes of payment have been ascertained with the help of standard event study methodology as propounded by Fama and Macbeth (1973) and Fama (1976). Further, the risk and market adjusted variant of standard event study methodology which is better known as the market model has been used. The rationale for applying event study is that it measures the impact of a specific unanticipated event related to a company on the wealth of its shareholders by analyzing the abnormal returns around that event period (Brown and Warner, 1980, 1985). The sign (either positive or negative) and the magnitude of the abnormal returns reflect the market's assessment of the impact of such a decision on the long term future prospects of the company. To calculate the abnormal returns for examining the market reaction to the announcement of cross border acquisition, firstly, an estimation period is selected for computing the parameters (α and β) of the market model. The estimation period used here is t = −251 to t = −51, relative to the first public announcement date of an acquisition (t = 0). Daily abnormal return on a particular day t is the excess of the actual return on day t over the expected return on that day. The expected return for a particular day t is computed as follows: ^ ¼α þβR þε R it i i mt it Table 3 Definition and expected signs of the independent variables for acquiring companies for logistic regression analysis. Variables

Definition of variables

Expected signs

Hi-tech Common Private

For target companies in technology intensive and services sector = 1 and =0 otherwise Common law legal system = 1 and =0 for civil law legal system Private target company = 1 and =0 for publicly listed target company

+ + +

RelsizeT

Deal value as a proxy of target company0 s assets Deal valueþMarket value of acquiring company

+/−

‘LogDV’ LogmvA Age International

Measured by the log of the absolute deal value Measured by the log of market value of the acquiring company Measured as the difference between the year of incorporation of the acquiring company and the year of acquisition by the acquiring company Measured as the ratio of foreign sales to total sales

+/− − − −

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Where αi presents the normal return of the security i when Rmt is zero, βi measures the risk of security i that is, the sensitivity of Rit to the market wide factors. Rmt is the return on market index (BSE Sensex in this case). Thus, βiRmt collectively capture the effect of variables that affect the return on all securities or at least most of the securities while εit captures the effect of variables more specific to the prospects of a security i. The abnormal return (AR) for a security i on day t is calculated as follows: ^ : ARit ¼ Rit −R it ^ it is the expected return on Where Rit, is the actual return of a particular company's security i on day t and R the same day. Daily abnormal returns for each company are calculated over the interval t = − 50 to t = + 50. Further, daily abnormal returns (ARs) have been averaged over N companies for each day t and are computed as follows: AARt ¼ ∑ARit =N: Where, AARt is the average abnormal daily return on day t and N is the number of companies. Further, cumulative average abnormal returns (CAARs) are derived by summing the AARs over various time intervals. For example, CAARs for a particular time interval t1 to tn are derived as follows: CAARs ¼

tn X

AAR:

t1

The following test statistics has been employed to comment upon the significance of CAARs: ! tn X pffiffiffiffi AAR=δAARt  N , where AAR is Test of significance of cumulative average abnormal returns ¼ t1

average abnormal return of all securities from day t1 to tn and N is the number of days over which AARs are cumulated. δAARt is the standard deviation of AAR over the estimation period (t = − 251 to t = − 51). After assessing the announcement gains for different modes of payment individually, these have been compared across the modes of payment viz. cash versus stock offers, cash versus earnout offers and stock versus earnout offers across various event windows by employing independent sample t-test. 3.3. Regression analysis Cross sectional regression analysis is conducted in the final part of analysis to identify the factors, besides mode of payment, that affect value creation in cross border acquisitions. In addition to the mode of payment, a priori research has identified various other bid related factors and company related factors like relatedness, hostility, competition among bidders, technology intensity of the acquiring and the target companies, relative size of the target company, the size of the acquiring company and experience of the acquiring companies as the determinants of wealth gains in cross border acquisitions. Hence, these variables, except for the variable relatedness and hostility,6 are taken as explanatory variables in the various regression models to assess their influence on wealth gains in cross border acquisitions in India. Further, CAARs of the three day window ranging from day − 1 to day + 1 (CAAR3) are taken as the dependent variable7 for regression analysis. The CAARs of the three day window is used as it captures a major portion of the stock price effect on the announcement of an acquisition and is usually employed by the researchers in regression models (Andrade et al., 2001; Cakici et al., 1996; Cebenoyan et al., 1992; 6 Since all acquisitions are related and also there is only one hostile acquisition, hence the variables related and hostility have not been introduced as independent variables. 7 In order to test the robustness of the results, cross sectional regression analysis has also been conducted taking CAARs of other event windows viz., day −1 to day 0, day 0 to day +1, and day −5 to day +1 as dependent variables and similar results have been found. These event windows (day −1 to day 0, day 0 to day +1, day −5 to day +1) have been extensively used in a priori research for communicating similar findings (Cakici et al., 1996; Cebenoyan et al., 1992; Conn et al., 2005; Danbolt, 2004; Goergen and Renneboog, 2004; Lowinski et al., 2004; Moeller and Schlingemann, 2005). For the sake of brevity, the result of the three day window (day −1 to day +1) has only been reported here. The results of other event windows are available from the authors on request.

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Chari et al., 2004; Cheng and Chan, 1995; Conn et al., 2005; Danbolt, 2004; Goergen and Renneboog, 2004; Lowinski et al., 2004; Moeller and Schlingemann, 2005; Rieck and Doan, 2007; Wiegerinck and Eije, 2007). Independent variables introduced in various regression models are ‘earn’, ‘stock’, ‘multiple’, ‘logmvA’, ‘relsizeT’, ‘logDV’, ‘age’, ‘HTSA’ and ‘HTST’. Further, interaction variables like ‘earn ∗ HTST’, ‘earn ∗ relsizeT’, ‘earn ∗ logDV’, ‘earn ∗ age’ and ‘HTSA ∗ HTST’ have also been introduced as explanatory variables in various models. Specifically, interaction variables like ‘earn ∗ HTST’, ‘earn ∗ relsizeT’, ‘earn ∗ logDV’ and ‘earn ∗ age’ have been introduced to infer whether earnout offers have outperformed non-earnout offers in all cases or only in those cases where these are preferred choices of the acquiring companies. However, these variables have been introduced one by one and also without the variable ‘earn’ in some models due to the presence of high multicollinearity between the variables as depicted in correlation matrix in Appendix 1. Moreover, ordinary least squares regression analysis has been applied, however, to control for the problem of heteroscedasticity, standard errors are corrected for heteroscedasticity by using White's (1980) heteroscedasticity consistent standard errors. An explanation of the various independent variables used in the regression models along with the expected signs of the same are given in Table 4. 4. Analysis and interpretation 4.1. Analysis of the likelihood of an earnout contract in cross border acquisitions The results of the logistic regression analysis measuring the likelihood of an earnout offer in cross border acquisitions are summarized in Table 5 and explained as follows. The results of model 1 as detailed in Table 5 show that the variable ‘hi-tech’ has positive and statistically significant impact on the choice of an acquirer regarding use of an earnout contract in cross border acquisitions. It implies that, in consonance with the result of extant research, the acquiring companies in India as well prefer to use earnouts as a mode of payment for the target companies that employ high level of intangible assets or are in the services sector, thus, supporting Hypothesis 1. Another variable which is positively and significantly affecting the choice of mode of payment for the acquiring companies in cross border acquisitions is the variable ‘international’. It means that probability of earnout offers is more on the part of those acquirers which are already having international experience. Our findings are in contrast with those of Reuer et al. (2004) who propose that the probability of earnout offer is lesser on the part of the acquiring companies already having international exposure; as such acquirers are in a better position to comprehend the risks associated with cross border acquisitions. An interaction variable age ∗ international, is introduced in Model 2 in order to further explore the issue. From the results of model 2, it is clear that the interaction variable, age ∗ international has a significant positive coefficient, whereas with the introduction of the interaction variable, the variable ‘international’ becomes negative and loses its significance. It implies that, in India, earnout offers are employed by those acquiring companies that are mature (experienced) and have some international exposure. The reason may be that such acquiring companies may be in a better position to negotiate the terms of the earnout contract with the target companies. Moreover, the target companies may be less circumspect about the financials and Table 4 Definitions and expected signs of the independent variables for the acquiring companies for cross sectional regression analysis. Variables

Definition of variables

Expected signs

Earn Stock Multiple LogmvA

Earnout offers = 1 and =0 otherwise (for stock and cash offers) Stock acquisition = 1 and =0 otherwise (for stock and earnout offers) Competitive bidding = 1 and =0 for single bidder Measured by the log of market value of the acquiring company

RelsizeT

Deal value as a proxy of target company0 s assets Deal valueþMarket value of acquiring company

+ +/− − −

LogDV Age HTSA HTST

Measured by the log of the absolute deal value Measured as the difference between the year of incorporation of the acquiring company and the year of acquisition by the acquiring company For acquiring companies in technology intensive and services sector = 1 and =0 otherwise For target companies in technology intensive and services sector = 1 and =0 otherwise

− − +/− + +

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Table 5 The results of the logistic regression measuring the likelihood of an earnout contract in outbound cross border acquisitions. Variables

Model 1

Model 2

Un-standardized coefficient

Probability

Un-standardized coefficient

Probability

Constant Hi-tech Common Private LogmvA LogDV RelsizeT Age International Age ∗ international LR statistic (6 df) Probability (LR stat) H–L statistic Prob. Chi-sq (8)

−4.62 2.20 −0.14 −0.11 0.010 −0.24 0.08 0.01 0.02 – 21.05 0.007 8.93 0.35

0.005 0.04 0.81 0.90 0.97 0.47 0.62 0.47 0.03 –

−2.18 1.81 0.27 −0.51 −0.04 −0.32 0.06 −0.06 −0.01 0.001 24.98 0.002 5.30 0.73

0.27 0.09 0.65 0.57 0.90 0.36 0.73 0.22 0.72 0.09

fundamentals of these companies (as already explained, skepticism arises on the part of the target companies especially when the acquiring companies belong to emerging economies and thus, suffer from the liability of emergingness) and may believe that such companies would be able to honor their earnout payment commitments when due. The other variables viz. ‘common’, ‘private’, ‘relsizeT’, ‘logDV’ and ‘LogassetsA’ have insignificant coefficients in both the models meaning thereby that these variables have no influence on the acquirer's choice of mode of payment in cross border acquisitions thus, rejecting Hypotheses 3, 4, 5a, 5b and 6. The overall model fit as measured in terms of LR statistics is significant meaning thereby that at least one of the variables is significantly related to the dependent variable. Further, the insignificant HL statistics states that there is no difference in the observed and expected values of the dependent variables thus implying the overall model fit. However, Gujarati (2006) opines that in probabilistic models the test of goodness of fit is of secondary importance, what matters is the signs and statistical significance of the coefficients of independent variables. Hence, from the signs and significance of the explanatory variables in both the models, we can infer that in India it is only the industry context and the international exposure on part of the older/mature acquiring companies that guide the choice of an acquirer regarding the use of an earnout. However, there is lesser support for the variables viz. ‘common’, ‘private’, ‘relsizeT’, ‘logDV’ and ‘LogassetsA’, that are proposed by extant researchers as the proxies for the information asymmetry and the resultant adverse selection problem that in turn motivates the acquirers to employ earnouts as a mode to hedge the adverse selection problem.

4.2. Analysis of announcement returns in cash, earnout and stock offers and comparisons thereof This section, at the outset, details the announcement returns of the acquiring company shareholders in cross border acquisitions for different modes of payment viz. cash, earnouts and stock offers. This is followed by a comparison of announcement returns across the modes of payment. From the above table it is clear that in case of cash offers, the rising trend of CAARs has picked up from 40th day before the announcement with a slight decline during the sub-period − 10 to − 1. However, significant positive returns have been earned by the shareholders of the acquiring companies from the sub-period − 5 to + 1 (2.18, 3.58). Besides, significant positive returns have been availed of on the day of actual announcement (1.19, 5.17) and during the sub-periods − 1 to 0 (1.26, 3.88) and 0 to + 1 (1.82, 5.58). Maximum returns have been attained during the sub-period − 5 to + 1 (2.18, 3.58) followed by three day event window (1.89, 4.75). Moreover, the rising trend of CAARs have sustained till the fifth day after the announcement as depicted in the announcement returns of the sub-period 0 to + 5 (1.29, 2.51). Afterwards, the trend of CAARs has declined till the sub-period + 21 to + 30 (− 0.63, − 0.87) with some recovery visible during the sub-period + 31 to + 40 (1.85, 2.54).

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Table 6 The announcement returns of the acquiring company in outbound cross border acquisitions segregated on the basis of mode of payment and comparison thereof. Days −50 to −41 −40 to −31 −30 to −21 −20 to −11 −10 to −1 −5 to +1 Day 0 −1 to 0 0 to +1 −1 to +1 0 to +5 +6 to +10 +11 to +20 +21 to +30 +31 to +40 +41 to +50

CARC 0.02 0.35 0.93 0.97 0.30 2.18⁎⁎ 1.19⁎⁎ 1.26⁎⁎ 1.82⁎⁎ 1.89⁎⁎ 1.29⁎ −0.10 −0.23 −0.63 1.85⁎ −0.41

CARE

CARS

CARC–E

CARC–S

CARE–S

−0.87 0.89 −2.21 1.03 1.66 5.75⁎⁎ 2.51⁎⁎ 3.46⁎⁎ 4.06⁎⁎ 5.01⁎⁎ 3.28⁎

−6.96 −2.70 −0.03 2.49 −0.19 3.07 2.18 4.16⁎ 0.83 2.82 −0.01 4.21 −5.83 −0.99 −2.71 −0.36

0.89 −0.54 3.14 −0.07 −1.36 −3.57⁎ −1.32† −2.20⁎ −2.24⁎ −3.12⁎⁎

6.97⁎ 3.05 0.96 −1.53 0.49 −0.89 −0.99 −2.90⁎ 0.98 −0.93 1.31 −4.30† 5.60⁎ 0.35 4.56 −0.05

6.09 3.59 −2.18 −1.46 1.85 2.68 0.33 −0.70 3.23† 2.20 3.30 −5.65 5.55⁎ −1.71 4.97 −3.87

−1.44 −0.29 −2.70 2.26 −4.24⁎

−1.99 1.34 0.05 2.07 −0.41 3.83⁎

† p value b0.10. ⁎ p value b0.05. ⁎⁎ p value b0.01.

Table 6 makes it evident from the trend of CAARs for earnout offers that the announcement returns have been fluctuating till the sub-period − 30 to − 21. The rising trend of CAARs has picked up from the sub-period − 20 to − 11 (1.03, 0.53) however, statistically significant CAARs have started flowing from the sub-period − 5 to + 1 (5.75, 3.50) and have continued till the fifth day after the announcement. Substantial returns have accrued to the shareholders on the day of actual announcement (2.51, 4.05) and during the sub-periods − 1 to 0 (3.46, 3.95) and 0 to + 1 (4.06, 4.63). Maximum returns have been earned during the sub-period − 5 to + 1 (5.75, 3.50) followed by the three day event window (5.01, 4.67). Moreover, the trend of significant positive returns has continued till the sub-period 0 to + 5 (3.28, 2.37) beyond which the trend has become random. Similarly, for the stock offers again the trend of significant positive returns has picked up from the sub-period − 5 to + 1 (3.07, 0.85). The positive trend has sustained during the actual announcement day (2.18, 1.60), during the sub-period 0 to + 1 (0.83, 0.43) and during the three day event window (2.82, 1.63). However, except for the event window − 1 to 0 (4.16, 2.16), the announcement returns across other sub periods are not statistically significant. Moreover, the trend of positive returns have sustained only till the announcement day beyond which the announcement returns have turned random. The insignificant positive market reaction to the stock offers in cross border acquisitions implies that unlike domestic acquisitions, negative signaling effect of stock offers does not persist in cross border acquisitions. From the above discussion it is clear that the acquiring company shareholders have received significant positive announcement returns only in case of earnouts and cash offers. However, in case of stock offers, except for the event window −1 to 0, the announcement returns across all other event windows are statistically insignificant. Keeping in view the trend of CAARs no concrete result can be drawn regarding whether earnouts have created higher wealth gains in outbound cross border acquisitions compared to those of cash and stock offers. Thus, a comparison of the announcement gains, across modes of payment, has been made by employing independent sample t-test to remove the ambiguity regarding wealth gains in outbound acquisitions and to know whether the announcement gains in earnout offers are significantly different from those of cash and stock offers. For this purpose, comparison of announcement gains for earnouts versus cash offers; earnouts versus stock offers; and cash versus stock offers has been performed, respectively. The results are given in Table 6 and are explained as follows. The results of independent sample t-test, clearly illustrate that earnouts have significantly outperformed the cash offers not only over immediate announcement windows viz. day 0 (−1.32, −1.85), −1 to 0 (−2.20,

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−2.38), 0 to +1 (−2.24, −2.46), and −1 to +1 (−3.12, −2.94) but over longer event window of −5 to +1 (−3.57, −2.15) too. The comparison of earnout offers with stock offers makes it evident that earnouts have outperformed stock offers over various event windows viz. day −10 to day −1 (1.85, 0.57), day −5 to day +1 (2.68, 0.95), day 0 (0.33, 0.24), day 0 to day +1 (3.23, 1.70), day −1 to day +1 (2.20, 0.91), and day 0 to day +5 (3.30, 1.07). However, the difference in the announcement returns is statistically insignificant except for the event window 0 to +1 (3.23, 1.70). From the comparison of announcement returns across cash and stock offers, it is clear that cash offers have underperformed the stock offers insignificantly except for the event window −1 to 0 (−2.90, −2.24). The reason may be that it is the event window −1 to 0, during which the stock offers have generated the significantly positive announcement returns. From the above discussion, it can be deduced that earnouts have outperformed cash offers significantly but not the stock offers. This may be due to the impact of other deal specific or company specific factors (besides mode of payment) that may have affected the announcement returns of the acquiring companies in cross border acquisitions. Thus, the cross sectional regression analysis is employed in the next section of the study to resolve the ambiguity regarding the announcement gains of the acquiring companies in cross border acquisitions.

4.3. Analyzing determinants of wealth gains In the final part of the analysis, cross sectional regression analysis has been conducted to explore the sources of value creation for the acquiring companies in outbound cross border acquisitions. The objective is to identify the factors, besides the mode of payment that may have influence on the announcement gains of the acquiring company shareholders in such acquisitions. The results of various regression models employing different independent variables are stated in Table 7 and are explained as follows. The significantly positive coefficient of the variable ‘earn’ in models 1–5 highlights that earnout offers have generated superior announcement gains to the shareholders in cross border acquisitions compared to the non-earnout offers. Other variables that are having significant positive impact on the announcement returns of the acquiring companies are ‘HTSA’ and ‘HTST’ in models 3 and 4, respectively. It means that cross border acquisitions generate significantly positive returns when these are pursued by the acquiring companies in technology intensive and services sector or in cases where these are pursued for the target companies in technology intensive and services sector. Researchers like Morck and Yeung (1991), Magee (1981), Buckley and Casson (1998) and Marr et al. (1993) propose that cross border acquisitions generate significantly positive wealth for the acquiring companies belonging to the technology intensive sector as such acquisitions enable these companies to internalize their intangible assets and resources, thus supporting the forward internalization hypothesis. However, the researchers like Eun et al. (1996), Seth et al. (2002), and Markides and Ittner (1994) support reverse internalization hypothesis stating that cross border acquisitions generate significant announcement gains to the acquirers when these are pursued for the target companies in technology intensive sector as such acquisitions provide an opportunity to the acquirer to access and internalize the target company's intangible resources and capabilities. Since in our study also, both variables (‘HTSA’ and ‘HTST’) measuring technology intensity of the acquiring and the target companies are significant in two different models, hence, an interaction variable ‘HTSA ∗ HTST’ has been introduced in model 5 to evaluate whether the source of wealth gains in cross border acquisitions lies in the intangible resources of the target company alone; or, it depends only upon the resources of the acquiring company; or else, it is realized when synergies accrue by combining and optimally utilizing the intangible assets of the target and the acquiring companies on a larger scale across new geographies. The significant positive sign of the interaction variable ‘HTSA ∗ HTST’ in model 5 makes it evident that cross border acquisitions generate significant positive wealth for the acquiring companies when these are pursued by one technology intensive company for another technology intensive target company so that the combined intangible resources and capabilities of both companies can be deployed on a broader scale across geographies. The results are consistent with the full internalization hypothesis encompassing both forward and reverse internalization as proposed by Kohli and Singh (2012).

Independent variables

Intercept Earn Stock Multiple LogmvA RelsizeT LogDV Age HTSA HTST HTSA ∗ HTST Earn ∗ HTST Earn ∗ relsizeT Earn ∗ logmvA Earn ∗ logDV Earn ∗ age F statistics R square Adjusted R square

Model 1

Model 2

Model 3

Model 4

Model 5

Model 6

Model 7

Model 8

Model 9

Estimate

Prob.

Estimate

Prob.

Estimate

Prob.

Estimate

Prob.

Estimate

Prob.

Estimate

Prob.

Estimate

Prob.

Estimate

Prob.

Estimate

Prob.

5.61 3.06 – −0.17 −0.12 −1.17 0.31 −0.02 – – – – – – – – 2.89 0.08 0.05

0.00 0.02 – 0.91 0.01 0.01 0.54 0.22 – – – – – – – – 0.01

5.58 3.07 0.13 −0.16 −0.12 −1.16 0.30 −0.01 – – – – – – – – 2.47 0.08 0.05

0.00 0.02 0.95 0.92 0.01 0.01 0.54 0.21 – – – – – – – – 0.02

4.63 2.59 – – −0.09 −1.27 0.35 −0.01 1.52 – – – – – – – 3.53 0.10 0.07

0.00 0.05 – – 0.05 0.01 0.45 0.64 0.05 – – – – – – – 0.00

4.60 2.53 – – −0.05 −1.16 – – – 1.58 – – – – – – 5.16 0.10 0.08

0.00 0.05 – – 0.22 0.01 – – – 0.03 – – – – – – 0.00

4.72 2.36 – – – −1.11 – – – – 1.25 – – 0.94 – – 4.72 0.09 0.07

0.00 0.09 – – – 0.01 – – – – 0.08 – – 0.76 – – 0.00

4.65 – – – −0.05 −1.17 – – – 1.50 – 2.77 – – – – 5.36 0.10 0.08

0.00 – – – 0.20 0.01 – – – 0.03 – 0.04 – – – – 0.00

4.64 – – – −0.06 −1.17 – – – 1.63 – – 0.52 1.93 – – 3.88 0.10 0.07

0.00 – – – 0.16 0.00 – – – 0.02 – – 0.14 0.53 – – 0.00

4.52 – – – −0.05 −1.13 – – – 1.68 – – – 1.03 1.07 – 3.77 0.09 0.06

0.00 – – – 0.16 0.01 – – – 0.02 – – – 0.76 0.31 – 0.00

4.83 – – – −0.10 −1.47 0.43 – – 1.77 – – –

0.00 – – – 0.03 0.00 0.34 – – 0.01 – – –

– 0.08 4.09 0.09 0.07

– 0.05 0.00

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Table 7 Ordinary least square regression analysis describing the impact of various bid specific factors on the acquiring company shareholders wealth in cross border acquisitions with CAAR3 (day −1 to day +1) as the dependent variable. Standard errors are corrected for heteroscedasticity by using White's heteroscedasticity consistent standard errors method.

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The significantly negative sign of the variable ‘relsizeT’ across various models highlights that the acquisitions of relatively larger target companies receive negative reaction from the market. The results are in consonance with those of extant literature where researchers like Kusewitt (1985), Danbolt (2004) and Hansen (1987) opine that acquiring a relatively larger target company increases the risk of performance in the post acquisition period and tend to be a case of biting off more than one can chew. The reason being, the acquisition of a target company larger than the relative size of the acquirer poses various managerial problems viz. problems in integrating the operations in the post acquisition period and also creates financial problems as the acquiring company generally has to raise debt to finance an acquisition larger than its own size. Moreover, insignificant positive sign of the interaction variable ‘earn ∗ relsizeT’ in model 7 highlights that the acquiring companies are not able to generate positive value even by employing earnout offers in cases where the relative size of the target company is larger than that of the acquiring company. It implies that earnouts are not able to hedge the risk of adverse selection arising out of the relatively large size of the target companies, though these offers are specially designed for this purpose. Another variable which has a significantly negative influence on the announcement returns of the acquiring companies is ‘logmvA’. The results are consistent with the findings of the researchers like Mandelker (1974) and Roman and Michael (2006) who suggest that the larger acquiring companies make value destroying mergers as the managers of such companies are more prone to hubris and also pursue acquisitions for their personal benefits. As regards the other interaction variables, the variables ‘earn ∗ age’ and ‘earn ∗ HTST’ have significantly influenced the announcement returns while the interaction variables ‘earn ∗ logmvA’ and ‘earn ∗ logDV’ have no influence on the announcement gains of the acquiring company shareholders. The variable ‘age’ has got insignificant negative sign in various models, however, the interaction variable ‘earn ∗ age’ has a significant positive coefficient. It implies that otherwise, market has given insignificant negative returns to the acquisitions announced by mature acquirers. However, they receive positive announcement gains when experienced acquirers finance their acquisition via earnout mechanism. Moreover, the positively significant coefficient of interaction variable ‘earn ∗ HTST’ also implies that earnouts have generated higher wealth gains for those acquisitions that are pursued for the target companies in technology intensive and services sector. From the above results it is clear that earnout offers have generated significant positive returns to the shareholders of the acquiring companies. Moreover, earnouts have outperformed non-earnout offers viz. cash and stock offers specifically in those cases where these are pursued by experienced acquirers and also in those cases where these are pursued for the target companies in hi-tech and services sector. It implies that had the other modes of payment been employed in these two cases, the acquiring companies would have been worse off in terms of shareholder wealth gains. Thus, it can be inferred that earnouts have yielded superior announcement returns compared to the non-earnout offers only in those cases where these are the preferred choices of the acquiring companies. 5. Conclusion and managerial implications From the above discussions, it can be concluded that, unlike in the developed markets, where earnout offers are driven by a combination of various deal specific and company specific factors, in India earnouts are employed as a mechanism to finance outbound cross border acquisitions only in two cases. Firstly, in those cases where the target company belongs to the hi-tech or services sector and secondly, in those cases where the acquirer is mature and has some international exposure. The reason being, earnout is a relatively new phenomenon in India and is being exercised by mid-sized companies only in the IT sector with a small number of such acquisitions being initiated by the acquiring companies in other technology intensive and services sectors viz. pharmaceuticals and healthcare, telecom, media and entertainment, logistics and hospitality. The results of event study highlight that earnout offers have generated significant positive announcement returns. However, a comparison of the announcement returns across the modes of payment makes it clear that earnouts have generated superior wealth gains compared to that of cash offers only and not stock offers. The regression results further highlight that earnouts outperform non-earnout offers when these are pursued for the target companies in technology intensive sector and when these are pursued by experienced acquirers. Further, besides earnout offers, other company specific

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features viz. size of the acquiring and the target companies and technology intensity of the target and the acquiring companies have significantly affected the announcement returns in cross border acquisitions in India. During the years 2005–2007, the IT companies in India were flush with cash, however, these companies, especially the mid-sized ones, were reluctant to employ cash for financing acquisitions of foreign target companies outside India. Hence, these companies, in order to save cash and also to acquire intangible resources and capabilities, started using earnout mechanism in financing their outbound deals. The results of the present study have shown that such acquiring companies have been rewarded with superior announcement gains by employing earnouts as a strategy to finance acquisitions of foreign target companies in hi-tech and services sector. Thus, the results offer important implications for the managers of the acquiring companies from emerging economies. There are two specific features of cross border acquisitions being pursued by the acquiring companies from the developing economies. Firstly, the acquiring companies from developing economies pursue cross border acquisitions to obtain strategic resources viz. brands, state-of-art technologies and managerial expertise so that these intangible resources and capabilities can be combined with their low cost manufacturing and service capabilities and enable these to create world class companies capable of competing in advanced and competitive global markets (Bhagat et al., 2011; Boateng et al., 2008; Sun et al., 2012). Thus, as put forward by Madhok and Keyhani (2012), such cross border acquisitions, by bestowing strategic resources, enable the companies from emerging markets overcome the ‘liability of emergingness’ that primarily arise due to the lack of such strategic resources. Secondly, in order to attain the first objective, these companies instead of integrating the operations of newly acquired foreign target company upfront, retain their separate identities, retain their management teams and provide them full autonomy in operations (Kale et al., 2009). One of the key factors for the successful implementation of the earnout offers is that the future performance of the acquired company to which part payment is linked must be easily and effectively measurable (Barbopoulos and Sudarsanam, 2012; Datar et al., 2001; Kohers and Ang, 2000; Reuer et al., 2004). Fabregat (2005) states that measurement of the future performance benchmarks is possible in cases where the target company is kept as a separate entity and its managers are provided full operational autonomy. Thus, keeping in view the motivations of cross border acquisitions of the acquiring companies from emerging economies, that are considered as the pre-requisites of an earnout strategy, and their integration strategies, that are essential for successful implementation of the earnout offers, earnouts can be suggested as a tailor made solution to hedge the risk of adverse selection in cross border acquisitions for the acquiring companies from the emerging economies. The study also offers important implications for the policy makers in India. One of the key drivers of the outbound acquisitions by Indian companies was availability of excess liquidity with Indian companies. It was mainly driven by the removal of restrictions on overseas investment and overseas borrowings on Indian companies by the Government of India in the year 2005 that has enabled these companies to obtain strategic resources to create world class companies. Thus, the study supports the overseas investment liberalization policy pursued by the Government of India. The study adds value to the existing literature by extending the findings on earnout offers to an emerging market like India. In fact, ours is the first study that has analyzed the likelihood of the earnout offers and has also tried to assess and compare the acquiring company shareholder gains in earnout offers in cross border acquisitions in India. Further, the study goes a long way in assisting managers in designing their mergers and acquisition strategies by highlighting the source of value creation in cross border acquisitions for an emerging economy like India. One of the limitations of the study is that the study has explored the issue of earnout offers for outbound cross border acquisitions of Indian companies only. Secondly, long term shareholder valuation effect of earnout offers has not been studied. Finally, besides earnouts, joint ventures (Mantecon, 2009) and prior strategic alliances (Chang and Tsai, 2013) have also been suggested as alternative modes by which an acquirer can hedge the risk of adverse selection while pursuing cross border acquisitions, however, these are not the focus of the present study. Hence, future research can try to fill the explicit gaps in the present study and can compare the announcement and long term shareholder wealth effect across emerging economies and also across the alternative modes of risk reduction viz. earnouts, joint ventures and strategic alliance.

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Appendix 1

CAR3 CAR3 Earn Stock Multiple LogmvA RelsizeT LogDV Age HTSA HTST HTSA ∗ HTST Earn ∗ HTST Earn ∗ relsizeT Earn ∗ logmvA Earn ∗ logDV Earn ∗ age ⁎ p value b0.05. ⁎⁎ p value b0.01.

1.00 0.19⁎⁎ 0.03 −0.03 −0.01 −0.19⁎⁎ −0.05 −0.14⁎ 0.18⁎ 0.19⁎⁎ 0.16⁎ 0.20⁎⁎ 0.13 0.15⁎ 0.16⁎ 0.14⁎

Earn

Stock

Multiple

LogmvA

1.00 −0.10 0.05 −0.02 0.01 −0.07 −0.06 0.23⁎⁎ 0.24⁎⁎ 0.26⁎⁎ 0.98⁎⁎ 0.94⁎⁎ 0.44⁎⁎ 0.90⁎⁎ 0.83⁎⁎

1.00 −0.06 0.02 −0.15⁎ 0.01 −0.10 0.06 0.11 0.08 −0.09 −0.09 −0.04 −0.09 −0.08

1.00 −0.01 0.16⁎ 0.22⁎⁎ 0.13 −0.01 −0.10 −0.08 0.05 0.03 −0.03 0.05 0.03

1.00 −0.15⁎ 0.24⁎⁎ −0.06 −0.10 −0.10 −0.09 −0.02 −0.03 0.05 −0.01 −0.03

RelsizeT

1.00 0.35⁎⁎ 0.34⁎⁎ 0.02 −0.01 0.00 0.01 0.15⁎ −0.21⁎⁎ 0.03 0.15⁎

LogDV

Age

HTSA

HTST

1.00 0.12 −0.09 −0.16⁎ −0.12 −0.05 −0.05 0.06 0.05 −0.03

1.00 −0.28⁎⁎ −0.33⁎⁎ −0.30⁎⁎ −0.06 −0.01 −0.09 −0.03 0.09

1.00 0.81⁎⁎ 0.91⁎⁎ 0.26⁎⁎ 0.22⁎⁎ 0.12 0.22⁎⁎ 0.20⁎

1.00 0.92 0.26 0.22 0.12 0.22 0.20

HTSA ∗ HTST

Earn ∗ HTST

Earn ∗ relsizeT

Earn ∗ logmvA

Earn ∗ logDV

1.00 0.28⁎⁎ 0.25⁎⁎ 0.13 0.25⁎⁎ 0.22⁎⁎

1.00 0.92⁎⁎ 0.45⁎⁎ 0.90⁎⁎ 0.81⁎⁎

1.00 0.24⁎⁎ 0.86⁎⁎ 0.89⁎⁎

1.00 0.55⁎⁎ 0.23⁎⁎

1.00 0.79⁎⁎

Earn ∗ age

1.00

R. Kohli, B.J.S. Mann / Emerging Markets Review 16 (2013) 203–222

Table 8 Correlation matrix.

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221

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