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

• Published date: 01 January 2019
• Author: Di Huang,Chinmoy Ghosh,Paul Borochin
• DOI: http://doi.org/10.1111/eufm.12199
• Date: 01 January 2019

DOI: 10.1111/eufm.12199

ORIGINAL ARTICLE

Target information asymmetry and takeover

strategy: Insights from a new perspective

Paul Borochin

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Chinmoy Ghosh

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Di Huang

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Department of Finance, University of

Connecticut, Storrs, Connecticut

Emails:

paul.borochin@business.uconn.edu;

chinmoy.ghosh@business.uconn.edu

2

Department of Business, Alma College,

Alma, Michigan

Email: huangd@alma.edu

Abstract

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.

KEYWORDS

acquisitions, firm valuation, information asymmetry

JEL CLASSIFICATION

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.

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© 2018 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/eufm Eur Financ Manag. 2019;25:38–79.

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INTRODUCTION

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 firms’information 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

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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).

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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

deal.

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 firms’information 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.

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Throughout the paper, we define mergers between two firms in different industries as diversifying.

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