In stock-for-stock mergers, a lock-up period can be a sign of confidence
When a company acquires another by paying with its own shares, shareholders of the target company face a difficult choice. They can hold onto the new shares and bet on the future of the merged company. Or they can sell them, protecting themselves from the risk that they might lose value.
In many cases, however, this second option is ruled out for a period of time. Some shareholders of the acquired company enter into a stock lockup: an agreement that prevents them from selling the shares they received for a predetermined period, typically around six months.
Why accept such a burdensome restriction? This is the question addressed in “The Role of Lockups in Stock Mergers,” a study published in Management Science by Stefano Rossi, of the Department of Finance at Bocconi University and a member of the Baffi research center, together with Zhong Chen of King’s College London and Yi Liu of Southwestern University of Finance and Economics.
The researchers analyzed 1,128 mergers and acquisitions among U.S. companies, announced between 1996 and 2018 and paid for entirely in stock. The starting point is a well-known risk: a company can use highly valued shares to finance an acquisition, thereby transferring part of the risk to new shareholders. In the sample, the average abnormal return on the acquirer’s shares in the six months following the completion of the transaction was -10.3%.
Yet, in nearly one out of every four transactions, the affected shareholders do not sell the shares they received for months. This gives rise to the paradox at the heart of the study.
A costly commitment. And precisely for this reason, an informative one
The authors hypothesize that the lockup functions as a signal. By agreeing not to sell, the shareholders of the acquired company demonstrate their belief in the prospects of the merged entity. The signal is credible precisely because it entails a cost: it exposes the sender to the potential loss of share value and prevents them from liquidating their shares in case of need.
“Only shareholders of target companies involved in transactions with solid long-term prospects can afford to accept a lockup.”
The mechanism is hard to imitate. Those who doubt the quality of the transaction might try to reassure the market by agreeing to the restriction anyway, but they would risk being stuck with shares destined to underperform. A false signal could therefore backfire.
For the mechanism to work, it is not necessary for all investors to be perfectly rational or for the market to always value companies correctly. It is sufficient for a portion of market participants to recognize the incentives of those who accept the restriction. If these shareholders have better information about the merger’s prospects, their willingness to wait takes on particular informational value.
The lock-up is therefore most telling when the acquirer’s shares are highly valued: precisely where the market would have the most reason to fear that shares were purchased at too high a price, the decision not to sell them constitutes a demonstration of confidence that is harder to ignore.
One in four agreements, and higher returns
These agreements are far from rare: they appear in 276 transactions, accounting for 24.5% of the sample. On average, they cover 14.8% of the shares of the merged company and last approximately five months and three weeks—very close to the most common duration of six months. They are particularly common when the acquired company is unlisted and when the acquirer’s market valuation is high.
During the 11-day window surrounding the announcement, transactions with lock-up agreements are associated, for the acquirer, with an abnormal return that is 5.3 percentage points higher than in transactions without such restrictions. This association is stronger if the lock-up period is longer, covers a larger share of the stock, or occurs when the acquirer’s valuation is particularly high.
The results extend beyond the immediate market reaction. Over the following two years, transactions with lock-up provisions outperform comparable transactions without such restrictions by 6.8%. Two-year stock returns are also higher.
These associations do not prove that the lockup itself produces better results. Rather, the authors interpret this to mean that the lockup is chosen in transactions with more promising fundamentals and helps to highlight their quality through the behavior of those who have inside information and something to lose.
Higher probability of deal success
The data also show that the presence of a lockup is associated with a higher probability of deal completion and shorter time frames between announcement and closing. This result is consistent with the proposed mechanism: a negative market reaction increases the risk that a merger will be abandoned, so shareholders of the target company who believe in the synergies have an incentive to reassure the market.
The hypothesis that shareholders accept the lockup only in exchange for a higher price is not supported, in the sample of listed target companies, by tests on the acquisition premium. The premium does not show a statistically significant relationship with the presence, duration, or scope of the lockup. The authors note, however, that this test has a smaller sample size and does not account for any agreements with selected shareholders of private targets.
Nor does the expiration of the lock-up trigger the wave of selling that one might expect. Abnormal trading volume increases by 27%, but prices do not fall; if anything, they are higher. Furthermore, in the two years following the expiration, Rule 144 filings reveal insider sales in only 53 of the 262 completed deals. Even in these cases, the quantities sold are modest on average. Subsequent behavior is therefore consistent with the idea that the initial commitment was not merely a tactical move.
