In principle, a potential acquirer may use private information to initiate a deal and offer to pay for the target with temporary overpriced shares. Analogous to insider trading in secondary equity markets, and irrespective of how the deal plays out, initiating a transaction increases the chances of success. The potential problem with this strategy, however, is that the most overvalued rather than the most efficient bid may win. Also, undervalued and financially constrained firms may avoid a costly bidding contest, despite offering the most synergies. All of these effects might distort the disciplinary role of the market for corporate control.

In  a new paper, we perform an empirical analysis to test whether bidder opportunism is important in takeovers. We find that buyers initiate deals for U.S. public targets only about half of the time, with the other half initiated by the seller. This classification, which is based on 2,968 acquisitions of public U.S.-domiciled targets from 2000 through 2020, is based on reading the “background of the merger” filed with the Securities and Exchange Commission by bidders (e.g., S-4) and targets (e.g. DEFM 41a) and which allows identification of the party that initiated the deal.

Our main alternative to the bidder-opportunism hypothesis is that bidders prefer to use their shares as acquisition currency to hedge against adverse selection on the target side of the deal. As first illustrated by Nobel Laureate George Akerlof in his seminal paper entitled “The Market for Lemons.” suppose you are privately interested in buying an asset (in his case a used car) that the market currently values at X dollars. The asset owner, however, may have private information that the asset’s true value is different higher or lower than X. If you offer to pay X in cash for the asset, the seller will accept only if her private information indicates that the asset is worth X or less (i.e., if the car is a “lemon”). A rational buyer understands this and realizes that offering X in cash implies an expected overpayment (X minus the asset’s true value conditional on the seller accepting the deal for X in cash). In the case of a takeover, the buyer finances this expected overpayment from the expected takeover synergies.

However, a publicly traded bidder in a corporate takeover has the choice to pay for the target using the bidder’s own traded stock instead of cash. Again, suppose the bidder offers to exchange bidder shares for target shares in an amount that equals X when valued at the bidder’s current stock price. The key implication is that stock payment mitigates the “lemons” problem described above. A target that would otherwise have accepted an all-cash deal may now reject the stock-swap offer. The reason is simply that, if the target knows that it is overvalued at X, the same overvaluation lowers the value of the shares it would receive in the merged firm. From the bidder’s perspective, however, this potential rejection by highly overvalued targets effectively lowers the expected overpayment of the deal relative to the same deal paid in cash. In other words, stock payment is a screening mechanism that helps address adverse selection on the target side.

Suppose also that the target knows that the bidder may have private information that the shares offered are overvalued by the market. In that case, the proposed stock swap is akin to buying a used car while paying with another used car so that both sides of the deal are now worried about the true value of the other party’s shares (two-sided information asymmetry).  As a result, the bidder prefers to use its own shares as acquisition currency as long as the target does not significantly undervalue those shares. We refer to this hypothesis as rational payment design.

The importance of rational payment design is that, in contrast to bidder opportunism, it can explain a bidder’s preference for paying for the target in its own shares even when those shares are correctly priced by both parties to the deal. Empirical tests of bidder opportunism versus rational payment design therefore comes down to tests of whether a bidder is more likely to pay with shares when the target is relatively uninformed about true bidder values: It is, of course, harder for a potential opportunistic bidder to fool a precisely informed target. Moreover, since private information about market mispricing arrives randomly, a bidder that initiates a deal is also more likely to possess such private information. We test whether we are more likely to observe stock financing in bidder-initiated than in target-initiated deals. Our test shows instead that, regardless of which party initiates the deal, stock financing is more likely the more informed the target is about the bidder. Moreover, this likelihood is independent of the deal initiation decision. In other words, there is no evidence that otherwise synergistic bidders initiate the deal to trade on inside information about its stock being overvalued.

While the above regression test is broadly applicable, we also perform a structural estimate of bidder opportunism in a competitive auction model where the counterfactual auction outcome assumes a zero probability of bidder mispricing. Interestingly, we find that sorting the data on deal initiations does not increase the fraction of the cases where opportunistic bidders crowd out higher-synergy bidders, which occurs in only 6% of the sample.  Moreover, this fraction is the same whether the target or the bidder initiates the deal. Again, this runs counter to the proposition that bidders tend to time the market when they initiate a deal process.

Finally, we perform multitude market valuation estimates  that also sort the data on the party that initiates the deal. We find that bidder-initiated and stock-financed deals tend to increase the market value of the bidder’s close industry peers. This runs counter to the notion that bidder shares offered in the deal reflect sector-specific overpricing, which predicts a reduction in peer values. If anything, it suggests that the bidder’s self-selection to initiate a takeover instead signals that the peers themselves may have a higher value.

Our transaction-based evidence fails to support the notion that information asymmetries between the trading parties cause bidder opportunism to be a concern in takeovers between publicly traded U.S. firms. Rather, the explanation most consistent with the evidence is that the takeover process itself deters bidders from timing the deal so as to swap overpriced bidder shares for the target. This deterrent effect is most likely the result of regulatory, disclosure-related constraints, contractual issues, and the nature of the source of synergy gains, all of which help the target to substantially reverse-engineer any bidder mispricing during the deal process.

B. Espen Eckbo is the Tuck Centennial Professor of Finance at Dartmouth’s Tuck School of Business, Tanakorn Makaew is an adjunct professor of finance and business economics at the University of Southern California, and Karin S. Thorburn is a professor at the NHH Norwegian School of Economics. This post is based on their recent article, “Are Bidder-Initiated Takeovers Opportunistic?” available here.