Feedback Effect of Disclosure Spillovers

Prior research has documented the existence of disclosure externalities, or information spillovers, between firms in a number of different settings. The idea is that when two firms are economically related, public disclosures by one firm can affect the stock price of the other firm. In a recent paper, we extend this idea by asking whether firms make disclosure decisions with the intention of affecting other firms’ stock prices. That is, we examine whether the presence of information spillovers influences firms’ disclosure decisions.

We investigate our question in the context of cash-based mergers and acquisitions. We test whether bidders disclose information designed to depress the target’s stock price during merger negotiations, when the takeover price is being determined. Cash-based acquisitions provide a uniquely powerful setting to test whether firms exploit their disclosure externalities for several reasons. First, merger negotiations resemble a zero-sum game in which the acquirer gains from a lower target stock price (i.e., the acquirer has a clear motivation to reduce the target’s stock price if possible). Second, using cash (as opposed to its own stock) to finance the transaction ensures that the acquirer remains relatively insensitive to any temporary decline in its own price. Third, the merger period is relatively short-lived (on average, beginning 60 trading days prior to the acquisition announcement), providing a limited window during which the acquirer must strategically disclose information. Last, market participants apart from the bidder and target firms are generally unaware of the merger negotiations while they are taking place, so the market likely perceives the disclosures as credible.

Our primary empirical strategy is to examine how bidders’ disclosures change from the merger pre-negotiation period to the negotiation period, conditional on the nature of the information spillovers between the bidder and target firms. We posit that information spillovers between firms can be either positive or negative, depending on the nature of the economic relationship between the two firms. To highlight the opposing incentives created by positive and negative spillovers, we partition our sample of cash deals into three groups: (i) firms with positive spillovers in which good news for the acquirer is also good news for the target, (ii) firms with negative spillovers in which good news for the acquirer is bad news for the target, and (iii) firms with little or no spillover in which the news for the acquirer is irrelevant to the target (control firms). We use as a proxy for information spillovers between the bidder and target firms their historical returns and earnings correlations.

Using deals in the zero spillover group as a benchmark, we find that acquirers with positive spillovers generate an additional 3.4 negatively biased news articles during merger negotiations. In contrast, acquirers with negative spillovers generate an additional 6.8 positively biased articles during negotiations. Both results provide initial evidence consistent with our hypothesis that acquirers alter their disclosure during the period when the firms are negotiating their takeover price. In addition, we find that in the period following the merger’s completion date, bidder firms’ disclosure largely reverts back to its pre-negotiation levels. This result suggests that bidders’ disclosure during merger negotiations is strategic and not being driven by a missing factor (say, a change in performance).

Next we investigate the valuation implications of the acquirers’ disclosure choices. Our results suggest that strategic disclosures by acquirers with strong spillovers depress the target’s cumulative returns in the run up to the merger announcement. Compared with acquisition premiums in deals with zero spillovers, bidders with strong (positive or negative) spillovers appear to acquire the target at a 5.4 percent to 10.6 percent lower premium, which translates into mean (median) dollar savings of approximately $30 million to $60 million ($12 million to $24 million) in the acquisition price.

In additional analysis, we examine the target’s (as opposed to the acquirer’s) disclosure during the negotiation period. While the transaction is the same for the acquirer and the target, the nature of the spillover incentives is quite different. The target’s incentive is to maximize its own stock price during negotiations, independent of the acquirer’s stock price. Hence, the target firm is inclined to disclose more favorable information regardless of the nature of the spillover between the two firms. Consistent with this argument, we find that during merger negotiations, target firms uniformly disclose more positive news, independent of the nature of the information spillovers with the acquiring firm. Taken together, these results suggest that the disclosure decisions of the target and the acquirer are game-theoretic – whereas targets positively bias their disclosures to inflate their own stock price, acquirers counteract these effects by exploiting information spillovers to reduce the target’s stock price.

Finally, we investigate a potential cost of exploiting information spillovers by examining the likelihood that an announced deal fails before it is completed. We predict that when bidding firms attempt to reduce the takeover price by exploiting information spillovers, target firm shareholders become incrementally less likely to accept the takeover bid. Consistent with this argument, we find that announced deals are more likely to fail before completion when information spillovers are strong. This result suggests that one cost to bidders of exploiting disclosure externalities to obtain a lower takeover price is a higher risk of losing the deal entirely.

Our findings are important, because they provide evidence that firms understand that their disclosures have the potential to affect the value of other firms, and they exploit that fact when doing so is beneficial. In particular, our evidence suggests that bidder firms take advantage of information spillovers to reduce the acquisition premium paid to the target.

This post comes to us from Jinhwan Kim, a PhD candidate at MIT’s Sloan School of Management; Rodrigo S. Verdi, a professor at MIT’s Sloan School of Management; and Benjamin Yost, a professor at Boston College’s Carroll School of Management. It is based on their recent paper, “The Feedback Effect of Disclosure Externalities,” available here.