The Asymmetric Private Information Mask: Informed Trading in Takeovers

The U.S. Securities and Exchange Commission (SEC) has increased the regulation of asymmetric information-based trading, aiming to mitigate disclosure of material private information to select market participants. These efforts have not been fully successful, raising questions about the impact of asymmetric information on private equity trades, informed trades, and expected gains. The integrity of competing market structures and market makers’ rent has heightened the need to understand and measure the cost components of the market maker bid-ask spread. Whether the existence of private information in takeovers through selective disclosure is harmful to financial markets is still uncertain. Inside information is a particularly valuable in the takeover market, especially around private equity bids. Nevertheless, without information asymmetries, private equity would not exist, forcing firms to raise capital from banks and other sources of debt financing. Stock prices thereby include information leakage, evidencing how superior information can lead to superior returns.

My paper, “The Asymmetric Private Information Mask: A Comparative Analysis of Private Equity Bids and Tender/Merger Offers,“ empirically examines whether private equity targets exhibit differences in adverse selection costs due to informed trading, pre- and post-announcement, relative to tender or merger target firms.

Private information may result in increased insider trading as investors seek to maximize profits. Yet the anticipated profit from insider trading may be negated by the time necessary to convert private information into monetizable assets. Given the increased number and frequency of market transactions, and the technological advances that make sharing information easier, over the last 30 years, the risk of market makers encountering informed traders has also increased.  I predict that the expected monetary gain from inside information will increase the permanent spread component of the bid-ask spread, which compensates dealers for losses to informed traders, otherwise known as adverse selection costs. Adverse selection costs thereby represent price protection to buyers who expect to pay less if they believe there is an informed trader and information asymmetries.

Using the deconstructed model presented in Bollen et al. (2004), I evaluate minimum tick size, the inverse of trading volume, and expected inventory-holding premium, isolating the market maker’s order-processing costs and inventory price risk and adverse selection costs as a measure of informed trading. Changes in the bid-ask spread have been commonly used as estimates for information asymmetry, assuming market makers adjust for asymmetric trading risk of holding inventory of stock. I find a significant decrease in the probability of informed trading in the post-announcement period for private equity bid targets relative to tender or merger offer targets. Results provide support for decreased information asymmetry post-announcement for private equity bid targets relative to tender or merger offer targets and offer evidence that information asymmetry declines by a greater amount for private equity bids paralleled by a greater decline in the probability of informed trading for private equity bids.

The significant decrease in the probability of informed trading found in the post-announcement period for private equity bid targets relative to tender or merger offer targets is good news and an advantage for small investors. These investors are less likely to suffer losses after a private equity announcement due to the lower probability of informed trading. Nonetheless, this does not necessarily negate the need for increased regulation: Where multiple insiders receive identical information, any action to trade on the information would reduce its expected payoff towards zero. Information asymmetries can create the perception of unfairness that investors, market makers, and regulators such as the SEC are concerned will lead to reduced investment and higher bid-ask spreads. This research is significant in providing insight to support greater regulation of private equity transactions where information is protected from regulatory oversight.

This post comes to us from Sarah Osborne, a lecturer at Queensland University of Technology. It is based on her recent article, “The Asymmetric Private Information Mask: A Comparative Analysis of Private Equity Bids and Tender/Merger Offers,” available here.

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