The joint determination of the payment method and the bid premium in M&As: What is the role of firm opacity?

• Published date: 01 September 2024
• Author: Pierpaolo Battigalli,Carlo Chiarella,Stefano Gatti,Tommaso Orlando
• Date: 01 September 2024
• DOI: http://doi.org/10.1111/eufm.12474

DOI: 10.1111/eufm.12474

ORIGINAL ARTICLE

The joint determination of the payment

method and the bid premium in M&As: What is

the role of firm opacity?

Pierpaolo Battigalli

1

|Carlo Chiarella

2

|Stefano Gatti

3

|

Tommaso Orlando

4

1

Department of Decision Sciences,

Bocconi University, Milan, Italy

2

Department of Finance and Accounting,

CUNEF Universidad, Madrid, Spain

3

Department of Finance, Bocconi

University, Milan, Italy

4

Anti‐Money Laundering Supervision

and Regulation Unit, Bank of Italy,

Rome, Italy

Correspondence

Stefano Gatti, Department of Finance,

Bocconi University, Milan, Italy.

Email: stefano.gatti@unibocconi.it

Abstract

This paper investigates how private information affects

the joint determination of the payment method and the

bid premium in M&As. The focus is on the uncertainty

of the stand‐alone valuations of the firms involved in

the transaction induced by their opacity. First, we

model M&A negotiations as a signalling game with

two‐sided private information and derive correlations

between firm opacity and bid characteristics from

equilibrium analysis. Then, we analyze a sample of

U.S. deals, using an index based on market measures of

adverse selection to quantify firm opacity. We find that

the likelihood of stock offers and the bid premium

increase with the target's opacity, while more opaque

Eur Financ Manag. 2024;30:2195–2241. wileyonlinelibrary.com/journal/eufm

|

2195

EUROPEAN

FINANCIAL MANAGEMENT

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

© 2023 The Authors. European Financial Management published by John Wiley & Sons Ltd.

We would like to thank John A. Doukas and anonymous referees of the European Financial Management for timely

and helpful feedback. We are also grateful to our colleagues Renée Adams, Yakov Amihud, Anna Battauz, Laura

Bottazzi, Paolo Colla, Francesco Corielli, Carlo Cusumano, Nicodemo De Vito, Alberta Di Giuli, Francesco Fabbri,

Carlo Favero, Vidhan Goyal, Giacomo Lanzani, Kai Li, Julien Manili, Nadia Massoud, Marco Ottaviani, Annette

Poulsen, Michele Pellizzari, Annalisa Prencipe, Stefano Sacchetto, and Roberto Steri for their helpful comments. Thank

you as well to the participants at the 2017 RES Annual Conference, the 2017 EEA Annual Congress, the 2017 FMA

Annual Meeting, the 2017 Australasian Finance and Banking Conference, and seminars at IE University and CUNEF

Universidad. We acknowledge the generous financial support of Baffi Carefin and Fondazione Cariplo. Carlo Chiarella

also acknowledges financial support from the Spanish Ministry of Science and Innovation, Project PID2021‐128994NA‐

I00 and Project TED2021‐132896A‐I00. This paper has circulated as IGIER Working Paper n. 596.

The views expressed in this paper are of the authors only and do not necessarily reflect those of the Bank of Italy.

bidders are associated with fewer stock offers and

smaller bid premiums.

KEYWORDS

asymmetric information, bid premium, mergers and

acquisitions, method of payment, signalling games

JEL CLASSIFICATION

G34, G14

1|INTRODUCTION

A rich collection of anecdotal evidence suggests that mergers and acquisitions (M&A) can

result in substantial transfers of value between the parties involved in the transaction, if the

offer price and the method of payment are not selected properly. On multiple occasions, bidders

eventually regret overpaid cash acquisitions that result in large goodwill impairments. It was

the case, for example, of Microsoft recording between 2012 and 2015 a combined $13.9 billion

in writedowns from its cash acquisitions of aQuantive ($6.3 billion) in 2007 and Nokia ($8.5

billion) in 2014, or the acquisition of Alstom by General Electric in 2015, which had been fully

written off by 2018 ($23.2 billion). There is also evidence that shareholders of targets accepting

a stock payment can experience large losses. In this respect, AOL's acquisition of Time Warner

at the peak of the dot.com bubble in 2000 is considered the perfect example of the risk involved

in the valuation of stock bids. The market value of the merged firm eventually dropped by more

than $100 billion (or almost 90%) in the 2 years following the merger agreement.

Indeed, bidders and targets face a complex task when undertaking a possible transaction.

On the one hand, the bidder needs to decide on the value of its offer to the target and on the

method of payment. From its point of view, the offer needs to be sufficiently attractive to avoid

rejection by the target, while increasing or at least preserving value for its shareholders if it is

accepted. On the other hand, the target needs to assess how much the offer is worth, if all or

part of the payment is not in the form of cash, and understand if it can increase value for its

shareholders. The complexity of these tasks stems from the fact that each party negotiates

without full knowledge of the true value of the other. Indeed, regardless of how much

information is disclosed during negotiations, typically each firm remains to some extent hard to

value for the counterparty, because opacity exposes valuations to some degree of uncertainty.

Against this backdrop, theory has shown that the choice of the method of payment can

address adverse selection concerns related with asymmetric information taking on a signalling or

sorting function. However, in mostof the previous empirical studiesin the M&A literature on the

topic no further distinction is made between scarcity of information and uncertainty about

fundamentals. This leads to inadequate support in the data for the asymmetric information

explanation of the choice of the method of payment. Indeed, evidence on the contingent pricing

or preemptive bidding hypotheses from the classical models of Hansen (1987), Fishman (1989),

Berkovitch and Narayanan (1990), Eckbo et al. (1990), and Gorbenko and Malenko (2018)is

mixed and indecisive (Chemmanur et al., 2009; Faccio & Masulis, 2005; Luypaert & Van

Caneghem, 2017). Similarly, empirical analyses based on the behavioural models of Shleifer and

Vishny (2003) and Rhodes‐Kropf and Viswanathan (2004) find only limited evidence of

2196

|

EUROPEAN

FINANCIAL MANAGEMENT

BATTIGALLI ET AL.

opportunistic behaviour by overvalued bidders (Di Giuli, 2013; Eckbo et al., 2018;Lietal.,2018),

or overpricing due to divergence of opinion (Chatterjee et al., 2012; Cheng et al., 2016).

In this paper, we analyze the adverse selection explanation under an alternative empirical

setup that focuses specifically on the degree of uncertainty about the value of the firms involved

in the transaction, as this appears to the potential counterparties, and its role in the joint

determination of the method of payment and of the bid premium (i.e., the difference between

the offer price and the value of the target). More precisely, our focus is on firm opacity, defined

as the uncertainty about the stand‐alone valuations of the firms involved in a transaction

besides and independent of the information that is publicly available or is effectively disclosed

during the negotiation. Indeed, such information is only imperfectly informative. True values

depend to a different extent on partly unobservable firm‐specific characteristics as well as on

the uncertainty about the firms' underlying fundamentals.

1

This notion of firm opacity has the

advantage of being firm‐specific, symmetrical across market participants (in the sense that all

potential counterparties face the same degree of opacity when evaluating a specific firm), and

isolated from endogenously determined information disclosure in the private negotiation

phase, which is hard to track down or quantify in an empirical setting (Boone et al., 2014).

Analyzing a sample of M&A bids by and for U.S. publicly listed nonfinancial firms between

1986 and 2019 and using an index of market measures of adverse selection to quantify firm

opacity, we find evidence suggesting that firm opacity can shape the outcome of negotiations

between bidders and targets in multiple ways. Bidders select stock bids to benefit from

contingent pricing and risk sharing when targets are more opaque, which also leads to higher

bid premiums. In contrast, more opaque bidders are associated with a smaller propensity to

offer stock, as the concern of adverse selection on the target side of the deal induces more

valuable bidders to offer cash, and with smaller bid premiums, consistent with opportunistic

behaviour by overvalued bidders.

These findings are generally consistent with specific pieces of the existing empirical

literature. Still, an important innovation of our paper is that the correlations that we observe

from the study of firm opacity and bid characteristics in the data are sustained by a model‐

based equilibrium analysis. Compared to most prior empirical works, this approach allows us

to provide a unified explanation to a variety of empirical results in the context of a theoretical

argumentation and to obtain a better understanding of the alternative channels through which

firm opacity affects bid characteristics.

Indeed, together with the new empirical setup we propose a simple theoretical framework

for the analysis of the strategic interactions between a bidder and a target. The model does not

aim to provide a new theoretical explanation of the correlations in the data. Instead, it is

designed to help identify the forces at play and the economic mechanism behind the observed

empirical patterns. It builds on the seminal work of Hansen (1987) and extends the existing

literature by adopting a signalling game perspective instead of the typical adverse selection

1

A similar view is common in the banking literature where opacity and uncertainty are used interchangeably to refer to

ahard‐to‐value quality caused by the underlying nature of an asset (Flannery et al., 2004; Iannotta, 2006;

Morgan, 2002). This is, for instance, the case of a tech firm with many growth options, whose prospects are intrinsically

more uncertain than those of firms active in more traditional sectors. Even if information about them is fully disclosed

during the negotiation phase, valuing the company with any degree of precision remains anyway a difficult task,

making the company opaque. This goes beyond and is independent of pure asymmetric information resulting from the

lack of transparency or distrust of disclosures that can affect, for instance, the valuation of a mining company, whose

mining reserves can be accurately estimated.

BATTIGALLI ET AL.EUROPEAN

FINANCIAL MANAGEMENT

|

2197