Target Information Asymmetry and Acquisition Price

• Author: Lin Li,Wilson H.S. Tong,Peter Cheng
• Published date: 01 July 2016
• DOI: http://doi.org/10.1111/jbfa.12202
• Date: 01 July 2016

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(7) & (8), 976–1016, July/August 2016, 0306-686X

doi: 10.1111/jbfa.12202

Target Information Asymmetry

and Acquisition Price

PETER CHENG,LIN LIANDWILSON H.S. TONG∗

Abstract: This study investigates the effects of target information asymmetry in a takeover

transaction. We find that a target with more information asymmetry receives a larger bid

premium from the acquirer. We examine the response of the acquirer’s investors to the bid to

clarify whether the larger bid premium is an overpayment by the acquirer. We observe that the

acquirer’s investors respond more positively to the acquisition of an opaque target, indicating

that the market recognizes the acquirer’s valuation of the opaque target and agrees with the

offer price. Our results indicate that corporate takeovers help to resolve asymmetric information

in the capital market.

Keywords: information asymmetry, price discount, bid premium, acquirer return

1. INTRODUCTION

The effects of information asymmetry on asset pricing have been widely examined

in both accounting and finance studies. An extensive body of literature shows that

equities with high information asymmetry are priced at discounts by investors (e.g.,

Glosten and Milgrom, 1985; Hertzel and Smith, 1993; and O’Hara, 2003). In the

takeover market, studies indicate that firms with low valuations often become desirable

takeover targets (e.g., Grossman and Hart, 1981; and Shleifer and Vishny, 2003).

Consequently, this suggests the possibility that firms with asymmetric information may

become targets for acquisition. Kraakman (1988) argues that certain firms are perma-

nently underpriced and that pricing discounts can only be corrected by transactions

that redeem shares for asset values, such as takeovers, privatization, or liquidation.

Draper and Paudyal (2008) propose that undervalued firms may announce takeover

∗The first author is at the Faculty of Management and Hospitality, Technological and Higher Education

Institute of Hong Kong. The second and third authors are at the School of Accounting and Finance, Faculty

of Business, Hong Kong Polytechnic University. This paper is part of Li’s dissertation at The Hong Kong

Polytechnic University under the guidance of the other authors. We gratefully acknowledge the helpful

comments from an anonymous referee and especially Ronan Powell (Associate Editor) whose insightful

suggestions have tremendously improved the paper. In addition, we thank Peter F. Chen, Ying Foon Chow,

Gang Li, Yong Zhang, seminar participants at The Hong Kong Polytechnic University, and conference

participants at the 2008 and 2009 European Financial Management Association (EFMA) Annual meetings,

and the 2013 Journal of Contemporary Accounting and Economics (JCAE) Symposium. (Paper received

March 2014, revised revision accepted March 2016).

Address for correspondence: Lin Li, School of Accounting and Finance, Faculty of Business, Hong Kong

Polytechnic University, Kowloon, Hong Kong.

e-mail: jack.li@polyu.edu.hk

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bids to attract the attention of investors, with a view to increasing the share price

through revaluation. As such, the takeover market can play a role in eliminating

valuation discounts due to information asymmetry that may not be corrected by the

target itself. The classic paper of Bradley et al. (1983) also discusses this issue and refers

to the target firms facing serious information asymmetry as ‘sitting on a gold mine’.

In this paper, we examine the role of takeovers in resolving asymmetric information

among participants in the capital market. We begin the analysis by considering a

situation in which the equity value of a target is discounted by the market due to

information asymmetry. An acquirer with more and better information about the

target than the market views the market discount as an opportunity for a bargain.

To avoid potential competitive bids and, in particular, to ensure the success of the

deal, the acquirer negotiates with the target by offering a price premium over the

target’s current market price. This ‘premium’ offer is attractive as the target may find

it difficult to credibly convey its true value to the market. Yet, the deal is also profitable

for the acquirer as the bid price will still be less than the true net value of the target,

let alone the possible gain from a merger synergy.

This simple framework generates a rich set of testable hypotheses. First, given that

greater information asymmetry increases the market discount, the bid premium can

appear to increase with the target’s information asymmetry. Second, the acquirer’s

announcement return also increases with the target’s information asymmetry as the

acquisition is viewed as a bargain to the acquirer due to the greater market discount.1

We conduct empirical tests of our predictions using a sample of 1,612 acquisitions

announced during the period 1986–2006. We define the bid premium received by the

target as the premium of the offer price relative to the market price of the target’s

shares four weeks prior to the bid announcement. We measure a target’s information

asymmetry, as perceived by market investors, using a set of proxies, including the bid–ask

spread, the number of analysts following the target, analyst forecast error, and forecast

dispersion.

The empirical results confirm our predictions. The proxies of the target’s infor-

mation asymmetry are positively associated with the bid premium and the acquirer’s

announcement returns, irrespective of the payment method. Furthermore, the acquir-

ers earn mildly positive returns when acquiring the most opaque targets. In contrast,

they realize significantly negative returns when acquiring the least opaque (most

transparent) targets.2Furthermore, we find greater post-takeover bidder operating

performance improvements for deals involving more opaque targets.

We conduct additional tests on the sensitivity of the bid premium on the target’s

information quality. First, we contrast the periods with and without merger waves.

Under a hot takeover market, we expect to, and do, observe an increase in the

bid premium sensitivity on target information asymmetry as acquirers tend to bid

more aggressively. Second, we contrast the periods before and after the enactment of

the Sarbanes–Oxley Act (SOX) in 2002. When investors are better protected under

SOX, the market may discount the opaque target less, leading to a decrease in

the bid premium sensitivity to target information asymmetry, and we do find the

corresponding supportive evidence. These two tests have high discriminatory power

1 This is consistent with Chang (1998), who reports larger abnormal returns to deals involving private

targets, which are presumably more opaque relative to public targets.

2 The stylized fact is that acquirers generally earn zero or mildly negative returns during the takeover

announcement period. See, for example, Jensen and Ruback (1983) and Andrade et al. (2001).

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because if the link between the bid premium and the target’s information asymmetry

is spurious, merger waves and SOX should affect the bid premium across the board

only, but not the bid premium sensitivity.

Taken together, our results show that the market recognizes the acquirer’s ability to

identify an undervalued opaque target and make the acquisition. The seemingly high

bid premium paid for the opaque target is not due to an overpayment by the acquirer

but rather to the market discount of the opaque target. Therefore, corporate takeovers

play a significant role in resolving asymmetric information in the capital market by

spotting and successfully acquiring opaque targets discounted by the market.3

Our study is closely related to several recent studies. Raman et al. (2013) examine

the impact of the target’s earnings quality on the bidder’s takeover decision. They

find that targets with low earnings quality, captured in the asymmetric information

component of the target’s accrual volatility, receive high bid premiums in negotiated

inter-industry acquisitions. Their study focuses on how the target’s earnings quality

affects the acquirer’s takeover decisions, the payment method, and takeover pre-

miums, whereas our study focuses on how corporate takeovers resolve the target’s

information asymmetry problem. To the extent that earnings quality captures only

one aspect of the information quality of a firm, our study takes a more general

and comprehensive perspective in addressing the role of the target’s information

asymmetry in the takeover market.4

Another subtle, but more important difference is that when Raman et al. (2013)

examine the target’s earnings quality, they implicitly define the target’s information

asymmetry from the acquirer’s perspective and examine how it affects the acquirer’s

takeover decisions.5In contrast, we define the target’s overall information quality

from the market’s perspective (necessitating that a more comprehensive set of market

information proxies be measured), and we suggest that the associations in question

hold even when the acquirer has perfect information about the target. This subtle

difference leads to our very different interpretations of the common finding that

the bid premium is higher for a target with lower information quality. For Raman

et al. (2013), the poor information (earnings) quality induces the acquirer to uncover

information on the target through negotiations. This information is likely to be value-

enhancing, and this value is reflected in a higher bid premium. As such, Raman et al.

(2013) implicitly assume away the possibility of overbidding, and thus do not carry out

bid announcement tests, as we have done in this paper.6

In contrast to Raman et al’.s (2013) focus on the acquirer’s perspective of the tar-

get’s information asymmetry, we make a standing assumption regarding the acquirer’s

3 Naturally, our analysis does not dispute the synergetic function of the takeover market but only focuses

on another function of the takeover market in resolving information asymmetry.

4 Ball and Shivakumar (2008) find that the average quarterly earnings announcement is associated with

only approximately 1–2% of the annual information that drives the stock price, suggesting that reported

earnings do not provide much timely new information to the stock market. Hu et al. (2014) find that

information asymmetry decreases for firms that cease to provide earnings guidance. As such, poor earnings

quality contributes as only one aspect among other factors in the information asymmetry problem of a firm.

5 In explaining the constructs of the information asymmetry proxies, they state in footnote 22 that ‘(the

proxies) will be insufficient to comprehensively capture aspects of information asymmetry between acquirers

and targets or of symmetric uncertainty’ (emphasis added).

6 A recent paper by McNichols and Stubben (2015) uses almost exactly the same measure of earnings quality

as Raman et al. and finds that the announcement returns are actually higher for the acquirer if the target

has a higher earnings quality. This finding seems to be inconsistent with the value-enhancing argument of

Raman et al. (2013).

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