Target information asymmetry and takeover strategy: Insights from a new perspective

Published date01 January 2019
Date01 January 2019
DOI: 10.1111/eufm.12199
Target information asymmetry and takeover
strategy: Insights from a new perspective
Paul Borochin
Chinmoy Ghosh
Di Huang
Department of Finance, University of
Connecticut, Storrs, Connecticut
Department of Business, Alma College,
Alma, Michigan
We examine the relation between information asymmetry
and firm value around a merger and acquisition (M&A).
Owing to the due diligence and intense scrutiny around
M&A announcements, acquisitions are significant shocks
to a target's information asymmetry. We find that M&A
announcement-period wealth gains are significantly related
to a target's information asymmetry and the relationship is
concentrated in same-state or same-industry mergers. Our
difference-in-difference analysis shows that the wealth
effects become weaker when the overall information
environment improves. Furthermore, we document that
information asymmetry is an important factor in target
selection and the likelihood of diversifying deals, deal size,
and deal closure time.
acquisitions, firm valuation, information asymmetry
G14, G34
We thank two anonymous referees, John Doukas, the editor, Daniel Hoechle, discussant at the 2016 European Financial
Management Association Meetings, Professor Jaideep Shenoy and the participants at the 2015 Indian Finance Conference
at the IIM Calcutta, India, for their detailed and insightful comments that have helped to improve the quality of the paper.
All remaining errors are our own.
© 2018 John Wiley & Sons, Ltd. Eur Financ Manag. 2019;25:3879.
We analyze the relation between information asymmetry and firm value in the context of mergers and
acquisitions (M&As). Information asymmetry restricts the flow of information about a firm's strategies
and activities, which renders it easier for entrenched managers to consume excess private benefits of
control and causes difficulties in firm valuation. Consistent with this notion, prior literature documents
that information asymmetry is positively related to cost of capital and negatively related to firm value
(Anderson, Duru, & Reeb, 2009; Barth, Konchitchki, & Landsman, 2013; Fu, Kraft, & Zhang, 2012;
Shroff, Sun, White, & Zhang, 2013). M&A is an ideal identification strategy to examine the effect of
information asymmetry on corporate decisions for several reasons. First, an M&A announcement
triggers a drastic change in the merging firmsinformation environment. The acquirer conducts a
thorough analysis of the target firm's financials as part of the due diligence (DD) to gather both public
and private information about that firm (Lajoux & Elson, 2000). Simultaneously, the announcement
triggers intense public interest in the merging firms, which creates the incentive for investors to gather
new information about these firms. The scrutiny by the bidder and market participants releases new,
material information about the target. In essence, an M&A alleviates the information asymmetry about
the target without materially impacting its fundamental value. If information asymmetry depresses
firm value as demonstrated in prior studies, then the acquisition announcement should lead to
significant value gains that reflect the information asymmetry discount in the target's value. As such,
the announcement effect provides a direct measure of a target firm's valuation discount due to
information asymmetry.
Recent studies (Bena & Li, 2014; Ben-David, Drake, & Roulstone, 2015; Chemmanur, Paeglis, &
Simonyan, 2009; Cheng, Li, & Tong, 2016; Dionne, La Haye, & Bergeres, 2015; Golubov, Petmezas,
& Travlos, 2016; Marquardt & Zur, 2014; Martin & Shalev, 2016; McNichols & Stubben, 2015;
Moeller, Schlingemann, & Stulz, 2007; Officer, Poulsen, & Stegemoller, 2009) use various proxies for
information asymmetry to examine its impact on the deal structure, characteristics, and valuation effect
of mergers. Despite extensive research, several issues remain unresolved. First, while there is general
agreement that superior information about the merging firms improves the efficiency of the acquisition
process, there is significant divergence in the findings of individual studies. Second, the interpretation
and reconciliation of the disparate findings is difficult because these studies use different proxies for
information asymmetry and focus on different aspects of the acquisition process such that the findings
are not directly comparable. Finally, most of the previous studies analyze the impact of target
information asymmetry on acquisition characteristics, but ignore acquirer information asymmetry.
Chemmanur et al. (2009) and Moeller et al. (2007) show that acquirer information asymmetry also has
a significant impact on merger-related effects.
A potential reason for the divergent findings of studies on information asymmetry is that the true
level of information asymmetry is unobservable. Although the standard approach is to use proxies to
measure information asymmetry, there is lack of consensus over which proxy best captures this
asymmetry. To obviate this problem, Karpoff, Lee, and Masulis (2013) construct an aggregate
information asymmetry factor by employing factor analysis to construct an aggregate factor with eight
proxies for information asymmetry identified by previous studies. This approach avoids the potential
bias that arises from arbitrarily choosing and assigning weights to the proxy variables. Similar to
Karpoff et al. (2013), we use 10 variables to construct a factor to proxy for firm-specific information
asymmetry. Consistent with the existence of an information asymmetry discount, our information
asymmetry factor is positively related to the cost of capital and negatively related to Tobin's Q.
Our central premise is that the DD and scrutiny of a target firm surrounding M&A announcements
helps attenuate that target's information asymmetry. In our first set of tests, we focus on the impact of
information asymmetry on the stra tegic aspects of the acquisition pro cess. Based on prior literature
(Bena & Li, 2014; Betton, Eckb o, & Thorburn, 2008), we predict that the opportunity to capture the
information asymmetry disco unt induces acquirers to purs ue targets with high information
asymmetry. Our tests reveal that acr oss three separate control sample s, firms with high information
asymmetry are more likely to become targets. Our analy ses also reveal that greate r information
asymmetry is associated with a lower likelihood of diversifying ac quisitions (acquisition s between
acquirers and targets in di fferent industries).
Further, we find a significa ntly negative relation
between target information as ymmetry and relative deal size, which suggests that hi gh information
asymmetry targets are small f irms. Finally, we find that hi gher target information asy mmetry is
associated with a shorter dea l closure time, similar to the findings by Bick, Crook, Lync h, and
Walkup (2017).
Our second set of tests focus on the contention that the attenuation of target information asymmetry
during an M&A generates significant wealth gains, which stem from the revaluation of the target.
Acquirers that identify undervalued targets with information asymmetry offer a premium that is below
their reservation price, which results in gains for both the target and the acquirer. Consistent with this
notion, we find that the announcement-period returns of the target, the acquirer, a combined target
acquirer value-weighted portfolio, and the premium, increase significantly with the target firm's
information asymmetry. Finally, we find that the target's relative gains are significantly smaller when
its information asymmetry is high, but increase in the acquirer's information asymmetry. These results
imply that the party with high information asymmetry is at a relative disadvantage when negotiating a
Finally, in corroboration of the notion that mitigation of information asymmetry is indeed a
potential source of value, we find that the significant relation between target information asymmetry
and the target's and acquirer's announcement-period returns exists only in deals in which target and
acquiring firms are in the same state or in the same industry. This result suggests that the information
advantage possessed by the acquirer about the target firm either due to proximity of location or industry
constitutes the major channels through which target information asymmetry yields wealth gains during
the acquisition announcements.
Two potential sources of bias in our tests are the endogeneity between the target firm's information
asymmetry and the acquisition outcome, and the self-selection of target firms (Denis, 2015; Roberts &
Whited, 2013). To alleviate the endogeneity concern, we investigate the impact of information
asymmetry around the 2005 passage of the Security Offering Reform (SOR) Act. Intended to enhance
the amount and quality of information prior to a seasoned equity offering (SEO), SOR induced a rich
pre-SEO information environment (Clinton, While, & Woidtke, 2014; Shroff et al., 2013). As SEO is a
frequent and closely monitored corporate decision, the information released during the issuance
potentially improves the overall information environment in the market; hence, the passage of SOR
provides a natural experiment to test the impact of an exogenous change in the information
environment. We use the passage of SOR in 2005 to perform a difference-in-difference test of the
impact of target information asymmetry on acquirer's and target's wealth effects during the acquisition
announcements before and after 2005 (Denis, 2015; Seru, 2014). Our analyses reveal that compared to
a matched control sample, target firmsinformation asymmetry yields significant wealth gains.
However, after 2005, the wealth effect associated with target information asymmetry becomes weaker.
This result is consistent with the notion that the target information asymmetry is a significant
determinant of wealth gains induced by an acquisition.
Throughout the paper, we define mergers between two firms in different industries as diversifying.

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT