How does the possibility of being taken over affect the disclosure of information by the management of the target firm? This has been a question of considerable interest in the accounting and finance literature because transparency is very important for a well-functioning takeover market. Whereas some argue that a target firm’s management will withhold information to increase the acquirer’s uncertainty about firm value and deter the takeover, others argue that the management will increase disclosures to inform existing shareholders about the firm’s fair value and prevent value-decreasing or opportunistic takeovers. The empirical evidence is mixed. In my recent article, I develop an analytical model to study the effect of takeovers on the voluntary disclosures made by the management of the target firm.
The success of a firm is driven by its prospects and its management’s competence. Bad investments or poor capital allocation can damage a good business. The market for corporate control, therefore, disciplines firm management by shifting good businesses into the hands of more able management. As noted activist investor Jeff Ubben puts it, “We try to focus on businesses that are so good that they are hard to screw up, but many times when management seems to be trying to do just that.”
Critical to the efficacy of the market for corporate control is information about the firm under existing management. In my model, I assume that the target firm’s management has some private information about the prospects of the business. The management, however, faces a potential acquirer who is more competent than the target firm’s management. Hence, the firm’s information complements the acquirer’s competence: A target firm with better business prospects is more valuable to a more competent acquirer, implying that it is more likely to be acquired by the potential acquirer. The question is, what are the incentives of the target firms’ management to voluntarily disclose information that could be potentially useful to the acquirer?
To motivate the target firm’s management to disclose, my model incorporates a few stylized facts about takeovers: first, takeovers are usually based around a management change at the target firm and hence, are viewed as a threat by the target firm’s management; and second, in light of the first fact, firms usually put in place severance packages to alleviate the incumbent management’s concern about being replaced. My model predicts that the possibility of a takeover induces the target firm’s management to disclose only mundane news about the firm’s business prospects and withhold extremely good or bad news. This happens due to the tradeoff for management between staying with the firm and getting acquired and receiving a severance package. If it has information that indicates business prospects are bad, the management would prefer that the firm be acquired and, hence, will hide any negative news from the acquirer. This induces the acquirer to believe the business is better than it actually is and makes the takeover more likely. If the target firm’s management has information that indicates business prospects are good, the management would prefer to stay with the firm rather than sell it to an acquirer and, hence, will hide the good news to make the firm look less attractive to the acquirer. This induces the acquirer to believe the business is worse than it actually is and makes the takeover less likely.
My analysis shows that increasing the severance payment does not always induce management to be more transparent. If the payment is not high enough, increasing it will, in fact, induce the target firm’s management to be less transparent. When the payment is low, an increase makes the prospect of a takeover more attractive to the management of firms with bad business prospects but not ones with good business prospects. Hence, the increase in severance pay induces the management of more firms with bad business prospects to withhold their information to make the firm more attractive to the acquirer. This results in an overall reduction in voluntary disclosures. However, if the severance pay is sufficiently high, an increase in severance pay also makes the takeover more attractive to firms with good business prospects. Hence, an increase in the severance payment now induces more firms with good business prospects to disclose information. This results in an overall increase in voluntary disclosures.
Given the widely acknowledged importance of firm-specific information for decision-making, and given that takeovers are considered a very important economic decision made by firms, what is the role of transparency in enabling takeovers. My model predicts that the relation between transparency and takeovers is not straightforward but depends on the severance payment to the target firm’s management. Among target firms with low severance packages for management, less transparent firms (i.e. firms that disclose less) are more likely to be taken over. Among firms with high severance packages, more transparent firms are more likely to be taken over. This suggests the need to interpret empirical evidence on the relation between transparency and takeovers with caution.
My study focuses on an important determinant of firms’ disclosure decision – the market for corporate control. My model predicts that the type of news disclosed by firms that face the threat of a takeover will neither be too good nor too bad. More important, I show that the strategic nature of firms’ disclosures results in a nuanced relation between firm transparency and the likelihood of a takeover. My model also highlights that higher severance packages for management does not always result in more transparency. The results of my study carry implications for board members responsible for designing severance contracts as well as policy makers interested in understanding the effects of transparency on the takeover market.
This post comes to us from Professor Rahul Menon at Purdue University. It is based on his recent article, “Takeovers and Voluntary Disclosures,” available here.