Ever since economist George Akerlof offered his “market for lemons” insight, many studies have examined the role of asymmetric information in the market for sale and purchase of corporate assets.[1] They have typically focused on buyer-side information asymmetry about a firm’s stock price and the associated wealth transfer between buying and selling shareholders. In a new paper, we focus instead on seller-side information asymmetry and its effect on the likelihood of selling the firm in part or in whole. In addition, we highlight the role of private acquirers in mitigating the effects of higher information asymmetry about the value of sold assets.

We first propose a new measure of asymmetric information. We argue that information asymmetry about a firm’s value is best measured by the market reaction to periodic earnings announcements. Earnings determine that value, and insiders have superior information about earnings, as shown by a sharp market reaction to occasional earnings guidance provided by them. In fact, to protect investors against potential expropriation by insiders of superior information, most firms prohibit insider trading over a long window starting two to four weeks before the end of a fiscal quarter and ending one or two days after the earnings release date.[2]

We therefore measure asymmetric information about seller value by the average absolute value of cumulative abnormal returns surrounding all earnings announcements over a year, which we call ACARE. This is a better measure than analyst forecast error, or AFE, which is earnings surprise relative to analyst consensus forecast scaled by the stock price. ACARE combines the earnings surprise and its riskiness and persistence with other performance information that together determine the new market value. Further, by definition, ACARE measures the market-value effects of earnings surprise relative to the market consensus forecast, whereas analyst forecast is known to be a downward biased estimate of the market-consensus forecast.[3]

Using a comprehensive sample of 140,902 firm-years from 1985-2022, we find that ACARE calculated during the previous year is negatively related to the likelihood of asset sales by a firm during the current year, but positively related to the likelihood of its being acquired in whole. This result seems anomalous at first given that both asset sales and mergers and acquisitions involve the sale of corporate assets, but we explain it by referring to, among other things, adverse selection.

We argue that asymmetric information should matter more when a firm sells some rather than all its assets. Adverse selection can be reduced if audited statements are available, which may be the case for assets in a subsidiary. However, even then the audited statements would be less informative than ones for whole firms. The reasons are, first, that the financials reflect the subsidiary’s value as part of a firm rather than a standalone entity, and second, there may have been transactions with other parts of the firm that were priced opportunistically. In addition, asset sales are already done deals when announced by managers and escape the scrutiny of capital markets that is common for whole-firm acquisitions and adds a layer of market discipline.

Among other reasons, firms characterized by greater information asymmetry often have unique and evolving technologies that may be more valuable in whole than in part, which would decrease the prospects for a partial-firm sale and increase the prospects for a whole-firm sale. The managers of firms with higher information asymmetry are also more likely to be compensated with illiquid stock and options of their firms that become vested upon a change in control after a merger or an acquisition but not after an asset sale.[4] That would increase their acquisition prospects as a whole firm compared with the prospects of a partial asset sale. Finally, there may be a substitution effect as some financially distressed firms facing greater adverse selection and unable to do an asset sale choose to be acquired in whole.

We validate our primary results using a quasi-natural experiment: firms affected by natural disasters from 1985-2022. Natural disasters create a sudden exogenous shock, raising firms’ need for external financing while increasing information asymmetry between insiders and the market. We show that their ACARE value increases significantly more than for unaffected control firms over a period of up to eight quarters after disasters. Previous literature also shows that asset sales are an important source of external financing for firms, so one would expect more frequent asset sales after natural disasters.[5] However, we find the opposite: a significant decrease in the frequency of asset sales for treatment firms relative to that for the same firms before disasters as well as control firms after disasters. This finding is consistent with our argument that partial asset sales are less likely when information asymmetry increases. Our difference-in-difference analysis shows that this decrease for treatment firms is partly explained by the increased asymmetric information after natural disasters. We also find an increase in mergers and acquisitions for treatment firms compared with control firms after natural disasters.

We examine the relation between asymmetric information about the seller value and acquirer type, which we categorize into public firms and private firms. For both asset sales and mergers and acquisitions, we find that the proportion of private-firm acquirers increases steadily from the lowest to the highest ACARE quintile. Previous literature has reasoned, without supporting evidence, that private equity firms have an advantage in undertaking long term strategic investments in “inscrutable” assets, i.e., assets whose unique, specialized, and uncertain nature makes it challenging for public equity markets to value them correctly.[6] We further argue that operating outside the scrutiny of the public markets gives private firms at least some advantage over publicly traded firms. Our evidence thus shows that private firms add value by acquiring assets that suffer from greater information asymmetry.

ENDNOTES

[1] Akerlof, G.A. (1970). The market for “lemons”: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84(3), 488-500.

[2] Based on a joint survey by NASPP (National Association of Stock Plan Professionals) and Deloitte, available on https://www.naspp.com/blog/4-Trends-in-Trading-Blackout-Periods.

[3] Keung, E., Lin, Z.X., Shih, M. (2010). Does the stock market see a zero or small positive earnings surprise as a red flag? Journal of Accounting Research, 48(1), 105-135.

[4] Cai, J., Vijh, A.M. (2007). Incentive effects of stock and option holdings of target and acquirer CEOs. The Journal of Finance, 62(4), 1891-1933.

[5] Edmans, A., Mann, W. (2019). Financing through asset sales. Management Science, 65(7), 3043-3060.

[6] Nary, P., Kaul, A. (2023). Private equity as an intermediary in the market for corporate assets. Academy of Management Review, 48(4), 719-748.

This post comes to us from professors Anand Vijh at the University of Iowa’s Tippie College of Business and Jiawei Wang at Miami University of Ohio’s Farmer School of Business, It is based on their recent paper, “Asymmetric Information and Asset Sales versus Mergers and Acquisitions,” available here.