Contrary to common belief, M&A transactions are not overwhelmingly initiated by acquirers. Target managers frequently put their firms up for sale before receiving any unsolicited bids. In fact, in our sample of U.S. domestic M&A deals completed between 1997 and 2012, target firms approached potential bidders more than one third of the time. One well known example of this is the transaction involved in the landmark decision of the Delaware Supreme Court in Smith v. Van Gorkom, where the boundaries of corporate-director protections under the Business Judgement Rule were re-drawn. Given the large proportion of target-initiated deals, we decided to investigate the causes and consequences of such transactions and to explore how they differ in their economic characteristics from the more common bidder-initiated deals.
The first step in this analysis is identifying the deal-initiating party in each merger transaction. This information is reported in the merger documents filed with the SEC, such as forms DEFM14A, TO-T, and S4. These documents typically include a “background of the merger” section that includes a history of the events leading up to the initiation of merger negotiations and prior to the document filing date. These filings show that if a target is interested in selling itself, then it usually considers strategic alternatives to operating as an independent firm and it typically hires an investment bank to evaluate its options. In these circumstances, target firm management, or its investment bankers, solicits potential acquirers. In this type of deal, target firms intend to sell themselves prior to any offer from a bidder. We designate these deals target-initiated.
In contrast, for a typical bidder-initiated deal, the target firm is not seeking to sell its business. Instead, a bidder or its investment banker approaches the target’s senior management to express an interest in exploring a strategic combination of the two firms. Target management takes this offer to its board and later conveys to the bidder the board’s decision. While not all transactions have a clear deal initiator (mainly because of complicated negotiation histories, lack of SEC filings, or unclear statements about deal initiation), we are nevertheless able to extract the deal initiating party in over three quarters of the observations in our sample period.
Having identified the deal initiating party from the SEC filings, we first compare the wealth effects of target-initiated deals with that of bidder-initiated deals. Target firms are paid an average 48 percent bid premium in target-initiated deals, whereas they are paid an average 58 percent bid premium in bidder-initiated deals. The stock market reactions to merger announcements also differ between the two deal initiation groups. The cumulative abnormal returns (CARs) of target firms from two trading days before a merger announcement through two trading days after the announcement averages 22 percent for target-initiated deals and 30 percent for bidder-initiated deals. Target shareholders therefore receive significantly lower premia in target-initiated deals than in bidder-initiated deals.
One might expect targets to receive lower premia in target-initiated deals, because managers of a bidder with no prior intention of merging with a target have less incentive to make an aggressive bid. However, given the active M&A market in the U.S., should it really matter who initiates a deal? If a bidder fails to meet the target firm’s reservation price, then the target can always start negotiations with another potential bidder. An important question is whether target-initiated deals have features that distinguish them from bidder-initiated deals and might help explain the differences in bid premia and announcement returns.
To address these questions, we examine whether the observable financial characteristics of merging firms, combined with macroeconomic conditions at the time of the offer, can explain the deal-initiating decisions of target firms. We consider two factors. First, targets with financial or competitive weaknesses or financial constraints can have strong motives to search for potential buyers. Targets can face financial distress that might lead to significant losses for shareholders and managers if the firms go bankrupt. Thus, being acquired can be quite attractive. Second, industry-specific or economy-wide shocks, such as technological innovations, deregulation, or changes in key input prices, may necessitate a reallocation of assets among firms within an industry. During this consolidation process, managers and owners of weaker, less efficient firms can find it optimal to be acquired by larger, more efficient firms, rather than attempt to survive on their own and risk further loss of market share and financial distress.
We find empirical support for the importance of both of these factors. Based on a wide range of proxies, targets are indeed financially weaker in target-initiated deals than in bidder-initiated deals. There were also more target-initiated deals than bidder-initiated deals during the 2001 economic recession. Yet, the lower bid premia and target CARs found in target-initiated deals cannot be easily explained by these factors. In fact, the effect of target initiation on bid premia does not diminish when we control for these factors in our analysis. This led us to investigate another possible explanation for the bid premia difference across the two deal initiation groups. What we uncovered was that the information asymmetry about target firm quality between targets and acquirers is a key concern of bidder firms.
Target firm managers possess valuable and undisclosed information about their firms such as sales and profit forecasts, R&D projects and outcomes, financing issues, legal liabilities, and indications of financial difficulties. This information is not generally available to bidder firm managers, even after thorough due diligence. Rational managers of bidders recognize this information disadvantage. Hence, the information asymmetry between merger partners presents acquirers with an adverse selection problem, causing rational acquirers to offer lower acquisition prices as the risk of purchasing an overvalued target rises.
Using a self-selection model, which addresses potential endogeneity, we show that the private information held by target managers is a significant cause of low bid premia in target-initiated deals. We find that the adverse effect of target private information on bid premia becomes stronger for harder to value targets. In other words, because the information asymmetry between merging firms increases for hard-to-value target firms, bidders have greater concerns about overpaying, leading them to discount their offer price. In contrast, for easy-to-value target firms, the effect of target private information on bid premia is much weaker.
If the adverse selection problem between merging firms has a negative impact on bid premia, then target firm managers and shareholders with more positive information should want to share their private information with bidders. We consider two ways this might happen.
First, if target shareholders are willing to accept acquirer firm stock as payment, then they would be adversely affected by post-merger valuation declines of overvalued target assets. Thus, a target’s willingness to accept bidder stock signals a target manager’s willingness to share the deal risk with the bidder. This indicates that target managers have no seriously negative information about the target’s asset values since they know that, when this information eventually becomes public, the market will immediately discount the acquirer’s stock price for the purchase of these overvalued target assets.
Second, targets can retain highly reputable due diligence advisers (auditors) to certify the accuracy of their financials, operations, and other business characteristics. Although acquiring firms have their own due diligence advisers, they can still benefit from the opinions of the target firm’s due diligence advisers, especially when those advisers have greater access to target information. Our results suggest that target firms can use these two signaling methods to significantly reduce bid premia discounts in target-initiated deals, especially when information asymmetry is severe.
Our study raises several interesting questions. Should managers refrain from initiating deals with potential bidders since target-initiated deals lead to low bid premia? We do not see this as a necessarily attractive approach. First, we cannot observe the economic consequences of the counterfactual event of a target firm not initiating a deal. If the target firm is experiencing financial problems, and its survival is at stake, not initiating a deal with a potential bidder may lead to bankruptcy, which is typically more painful for the shareholders and managers than being acquired. Nevertheless, if deal initiation is the optimal course of action, target managers may want to consider signaling their private information to bidders during negotiations. Bidders should seek to be convinced about the primary reasons target managers are motivated to initiate a sale. As our research shows, willingness to accept stock payments is an effective signaling device, because target shareholders continue to share in the gains or losses associated with the long-term success or failure of the deal. Likewise, targets offering greater access to their proprietary information can again reassure bidders as to the value of target assets.
Our investigation of deal initiating parties, the economic factors that drive them, and the resulting wealth effects can also have important implications for M&A litigation, where target managers’ and directors’ sale decisions are closely scrutinized.
This post comes to us from professors Ronald W. Masulis at the University of New South Wales and Serif Aziz Simsir at Sabanci University. It is based on their recent article, “Deal Initiation in Mergers and Acquisitions,” available here