Risk Allocation and Material Adverse Events in Merger Deals: A Discussion with Professor David J. Denis

In a paper published previously in the Journal of Financial and Quantitative Analysis, Analysis Group affiliate David J. Denis and his colleague, Antonio J. Macias, examined material adverse change (MAC) clauses and their impact on acquisition dynamics. Now, MAC clauses and material adverse events (MAEs) are making headlines in light of the far-reaching financial effects attributable to the global COVID-19 pandemic and governmental responses to it.

Managing Principal Gaurav Jetley and Vice President Yuxiao Huang spoke with Professor Denis about his most recent updates to this research, and what implications the increasing prevalence of MAC clauses in merger agreements may have. Professor Denis is the Roger S. Ahlbrandt, Sr. Chair and Professor of Finance at the University of Pittsburgh Joseph M. Katz Graduate School of Business.

What are MAC clauses, and what is their purpose in merger agreements?

David J. Denis: Roger S. Ahlbrandt, Sr. Chair and Professor of Finance, University of Pittsburgh Joseph M. Katz Graduate School of Business

There is often a lengthy period between the initial announcement of a merger agreement and the completion (or termination) of the merger (a period of 4.5 months, on average, in our sample). During this period, a material adverse event (or MAE) may occur that alters the value of the target company and therefore the wealth gains to each party from the acquisition. Examples of MAEs include economic or industry shocks that affect a company disproportionately, financial misreporting, and regulatory changes.

Merger agreements thus often contain contractual mechanisms that allocate the risks between the target and the acquirer over this time period. A MAC clause is one such mechanism, and functions as an abandonment option in which the acquirer has the right to walk away from the acquisition, without penalty, if an MAE occurs between the announcement and the expected completion of the acquisition.

How prevalent are the use of MAC clauses and the occurrence of MAEs in M&A deals?

MAC clauses are a ubiquitous and intensely negotiated feature of M&A deals. More than 99% of the merger agreements in our sample contain MAC clauses. This is not surprising given how often MAEs occur.

Approximately 9% of the sample acquisitions experience an MAE between the initial announcement of the acquisition and the completion of the acquisition period. MAEs are the underlying cause for 69% of acquisition terminations and 80% of acquisition renegotiations.

Moreover, MAEs ultimately lead to large changes in the price offered to shareholders. In our sample, acquirers negotiate a 15% reduction in offer price, on average, when the target experiences an MAE. Most recently, MAEs related to the pandemic have prompted an increasing number of renegotiations, leading to a 10.1% reduction in deal price, on average.

Gaurav Jetley: Managing Principal, Analysis Group

Your paper examines the structure and variations of MAC clauses across merger agreements. How are MAC clauses typically structured, and how do they vary across deals?

MACs are primarily geared toward providing walk-away rights to acquiring firms. However, in recent years, MACs have been increasingly restricted by sets of MAE exclusions that limit the scenarios in which an acquirer can walk away. For example, while a MAC clause allows the acquirer to freely walk away when an MAE occurs, the exclusions may further specify that the acquirer cannot walk away if the MAE is due to market-wide economic conditions or changes as a result of the pending transaction. In other words, the MAE exclusions allocate certain MAE risks back to the acquirers.

MAC clauses vary from deal to deal in terms of the number of MAE exclusions and the types of MAEs being excluded. Over time, we observe that more MAC clauses contain MAE exclusions and the average number of MAE exclusions has also increased. In our sample, 60% of deals in 1998 included MAE exclusions, and the average number of exclusions was 2.8. These figures increased to 98% and 7.2, respectively, in 2005. [See Table 1 Panel A.]

The trend continued beyond 2005 – when we extended the analysis by reviewing another sample of deals through 2019, we found that all deals in this recent sample included MAE exclusions and the average number of MAE exclusions increased to 10.5. [See Table 1 Panel B.]

One way to interpret the increasing presence of MAE exclusions in merger agreements is that more risks are allocated to acquirers and/or the categorization of an MAE has become increasingly refined. For example, a recent study documents that pandemic-related provisions became more common after the H1N1 crisis in 2009 and spiked again in late 2019 and early 2020 due to COVID-19.

Yuxiao Huang: Vice President, Analysis Group

How do variations in MAC clauses affect acquisition dynamics?

The MAC clauses, combined with MAE exclusions, are a mechanism for allocating risks that stem from the lengthy period between the signing and the closing of an acquisition transaction. In particular, a greater number of MAE exclusions increases the risk borne by the acquirer by making it more difficult for the acquirer to back out of a transaction. When it’s harder for the acquirer to back out, one would expect the acquirer to offer a lower deal price, but in that case there will be a higher probability that the deal will be completed at the originally agreed-upon price.

Consistent with these predictions, we documented that MACs with a greater number of exclusions are associated with lower offer premium, fewer terminations, fewer renegotiations, and narrower arbitrage spreads. Collectively, these findings support the view that MACs have an economically important impact on the dynamics of the acquisition process.

In the recent decision in AB Stable v. Maps Hotels, the Delaware Court of Chancery ruled that the pandemic was not an MAE based on definitions in the merger agreement, but the acquirer could nonetheless freely walk away because the target company’s responses to the pandemic constituted a breach of the ordinary course covenant. How do you think the ruling will affect future acquisition dynamics?

It seems likely that the ruling will prompt deal parties to further refine MAE definitions and ordinary course covenants in merger agreements. In terms of acquisition dynamics, from an economic perspective, any clauses in merger agreements (or interpretation of such clauses) that strengthen the walk-away rights of acquirers and thus allocate more deal risk to the target should motivate the acquirers to offer higher deal premium, but at the same time, will also lead to more terminations, more renegotiations, and wider arbitrage spreads. ■

Table 1. Time Profile of MAC Clauses and MAE Exclusions