The Change in Information Uncertainty and Acquirer Wealth Losses

In this paper, The Change in Information Uncertainty and Acquirer Wealth Losses, forthcoming in the Review of Accounting Studies, we examine the possibility that the change in the acquiring firm’s information uncertainty is a factor contributing to acquiring firms’ long-term post-acquisition stock underperformance. By information uncertainty, we mean investors’ perceived uncertainty about a firm’s fundamentals, which captures the second moment of fundamentals. Prior literature focuses on the first moment of acquirer fundamentals. Uncertainty affects the discount rate (the cost of capital), which in turn influences stock price. Our discount rate theory offers an alternative explanation to the market’s mispricing of the acquirers’ fundamentals as a source of acquirers’ long-term underperformance. As suggested by standard finance theory, stock price responds to changes in either fundamentals or the discount rate. The prolonged integration process of M&As and complicated financial reporting issues are not fully anticipated ex ante and are likely to increase the uncertainty of the combined entity. An increase in acquirer’s uncertainty causes investors to demand a higher premium (higher cost of capital) to compensate for the rise in uncertainty/risk, which in turn results in acquirer stock price declines.

Investors’ perceived uncertainty about a firm’s fundamentals (e.g., cash flows and earnings) is likely to come from two sources: fundamental volatility and information precision/asymmetry. In the M&A setting, the former is the result of combining two separate streams of fundamentals (i.e., acquirer and target) in the acquisition and the uncertainty associated with the integration process. The latter is related to uncertainty associated with information disclosure and the expected information loss resulting from the disappearance of the target. These factors aggravate information asymmetry and raise uncertainty in the post-merger period for the combined entity. While some prior studies use the term “information asymmetry,” we use the term “information uncertainty” because it captures both the volatility of a firm’s fundamentals, such as earning streams, and the information asymmetry between managers and outsiders.

Prior research has documented the effect of change in information uncertainty on a firm’s value in a non-acquisition context. Specifically, Krishnaswami and Subramaniam (1999), examine the effect of spin-offs on a firm’s information uncertainty. They suggest that information uncertainty leads to undervaluation of the firm and, thus, a reduction in information uncertainty resulting from a spin-off will reduce such undervaluation. Acquisitions are the inverse of spin-offs. If spin-offs reduce information uncertainty, we expect that on average acquisitions will increase information uncertainty. As discussed above, the expected increase in information uncertainty in turn is likely to increase the acquirer’s cost of capital, and that in turn has a negative effect on the acquirer’s stock performance.

To investigate the association between acquirer stock performance and changes in information uncertainty resulting from acquisitions, we use the dispersion in analysts’ forecasts as a proxy for information uncertainty. For a sample of 1,915 acquisitions announced between 1985 and 2003, we find that on average acquisitions lead to an increase in information uncertainty for acquirers. Specifically, we find that analyst earnings forecast dispersion increases by about 15 percent on average in the post-acquisition period. Moreover, we find that, after controlling for fundamental news such as firm’s performance (e.g., cash flows), growth, etc., the change in information uncertainty is negatively related to the acquirer’s post-acquisition stock performance. An inter-quartile increase in the change in information uncertainty corresponds to a 19.6 percent decrease in stock returns in the 36-month period after the acquisition. In addition, when the sample is partitioned based on whether there is an increase or decrease in information uncertainty after the acquisition, post-acquisition stock returns are found to be positive for acquirers with a decrease in information uncertainty and negative for acquirers with an increase in information uncertainty.

Because our objective is to investigate an additional explanation for the previously observed acquirer post-acquisition stock performance, it is important to ensure that our information uncertainty measure does not capture a firm’s post-acquisition fundamentals (e.g., cash flows). We include a number of ex-post fundamental variables (e.g., change in return on equity) in our model to control for ex post operating performance. In addition, dispersion which represents the second moment of firm fundamentals is unlikely to be correlated with the first moment. However, to alleviate concerns that our dispersion measure is capturing changes in fundamental performance, we also conduct a matched-design test. Specifically, for each acquirer, we select a matched non-acquiring firm with the closest size and analyst forecast dispersion within the same industry. Then we assign the acquirer’s event date as the pseudo-event date for the matched firm. For the matched firms, we do not find that information uncertainty increases after the pseudo-event. Moreover, for the matched sample firms, we do not find a negative relation between changes in information uncertainty and post-event returns. The matched-design test results taken together with the statistically significant relationship between the post-acquisition change in information uncertainty and acquirer’s post-acquisition stock performance support the conclusion that a portion of previously observed acquirer wealth losses are associated with the change in the acquirer’s cost of capital.

Our paper complements Moeller, Schlingemann, and Stulz (2007) with different theories, hypotheses, and research designs. Moeller et al. follow the theory of diversity of opinion and focus on the level of analyst dispersion and the acquirer’s announcement returns. They find that the level of analyst dispersion is negatively related to acquirers’ announcement returns. In contrast, we focus on the channel of information uncertainty affecting a firm’s stock price via the discount rate. We are interested in whether information uncertainty changes after the acquisition and whether this change affects the acquirer’s post-acquisition returns. We find that the post-acquisition change in analyst forecast dispersion is negatively related to acquirers’ post-acquisition returns.

This paper makes two significant contributions to the literature. First, we propose and test an economics-based theory predicting that acquirers’ post-acquisition stock returns are related to a cost of capital (discount rate) effect. Similar to prior studies of changes in fundamentals post-acquisition, this study analyzes acquirer discount rate changes resulting from M&As. Simply put, the acquirer is not the same company after a large acquisition (the deal’s value must be equivalent to at least 10% of the acquirer’s pre-deal market value to be in our sample). Two key features of this discount rate explanation distinguish this study from prior research: 1) we provide evidence on the discount rate as an alternative explanation for the well documented acquirer long-term stock under performance, and 2) our theory accommodates market rationality as opposed to the irrationality suggested by mispricing in the literature. As acquisition related uncertainty becomes apparent gradually over time in the post-acquisition period, our analyses also provide an explanation for why acquirer underperformance persists long after acquisitions.

Second, the evidence in the paper has important implications to the broader asset pricing literature. Information uncertainty is often modeled as the critical component of the cost of capital or estimation risk, but empirical results have provided mixed evidence on the pricing of uncertainty by the market. Acquisitions potentially have a pronounced effect on information uncertainty due to the magnitude of the transaction. The magnitude of the shift in information uncertainty in this institutional setting is significant enough to allow a more powerful test of the pricing effect of information uncertainty. Furthermore, changes in information uncertainty and the cost of capital are easier to isolate and analyze around significant corporate events than in a steady state setting. Because we use ex post dispersion measures in our research design, our test is an ex post analysis of the role of information uncertainty in explaining post-acquisition stock performance. For that reason, our analysis does not suggest an implementable trading strategy. Furthermore, our analysis and results do not speak to market efficiency.

The full paper is available for download here.