Does Target Firm Insider Trading Signal the Target’s Synergy Potential in Mergers and Acquisitions?

In our paper forthcoming in the Journal of Financial Economics, we raise a question: can a firm looking for a takeover target use a target firm’s net insider buying as a signal of the potential worthiness of this acquisition? Prior studies have not examined the implication of insider trading for the outcomes of corporate mergers and acquisitions (M&As), possibly due to target insiders’ uncertain foreknowledge about acquisition outcomes and the stringent insider trading regulations prior to M&As. Our study fills this void by investigating whether target firm insider trading helps to reduce the “lemons” problem in the M&A market.

Corporate insiders’ trading activities are often used as a way to sign various potential firm-level events (e.g., dividend policy changes, seasoned equity offerings, open market share repurchases, corporate disclosures, etc.) as good or bad. However, it is not ex ante clear whether target insider trading can be used to infer the success of future M&As because the informational implications of target insider trading for acquisition outcomes are quite different from those of insider trading for the outcomes of other corporate events. In particular, prior to M&As, (1) target insiders are often uncertain about the bidder’s synergy potential, sometimes even lacking the knowledge of a potential acquisition, and (2) the Short Swing rule (i.e., SEC rule Section 16b), which requires any profits earned by insiders on round trip trades within any six-month period to be paid back to the firm, curbs target insiders’ trading prior to takeovers more severely than insider trading prior to other corporate events because takeover completion forces the sale of the target stock. (Facing any upcoming corporate events other than M&As, however, insiders can avoid the violation of the Short Swing rule simply by holding the stock over six months. If the limited target insider trading prior to M&As is unlikely to reflect target insiders’ private information, it would not be informative of M&A outcomes.) Due to these dissimilarities in the information structure and the regulatory environment of insider trading between M&As and other firm-level events, it is a discrete and important empirical issue to test whether target firm insider trading helps to reduce the adverse selection problem in the M&A setting.

Suppose target insiders have some private information that can be used by the acquirer to infer the target firm’s potential for generating acquisition benefits, whether or not target insiders are aware of a potential acquisition. Prior to takeovers, the Short Swing rule mainly discourages target insider trades pursuing short-term profits, so that target insider trades are more likely to pursue long-term profits and thus contain a signal that reveals target insiders’ private information on their firms’ long-term prospect. Under such circumstances, target insiders’ pre-M&A trades can be used by the acquirer as an information source in inferring the target’s potential for generating acquisition gains and synergies, regardless of whether target insiders intend to reveal targets’ synergy potential. We examine this “signaling” or “informativeness” hypothesis and find that the observable equity transactions undertaken by target insiders prior to M&As help acquirers make more efficient acquisitions.

Specifically, we use 5,313 acquisitions occurred among U.S. public firms from January 01, 1987 to December 31, 2016 and insider trades made within a one-year period prior to public announcements of these acquisitions and construct net purchase ratios for each acquisition by aggregating target firm insider trades made during a one-year period before the M&A announcement. We find that both the abnormal acquirer returns (measured as the acquirer’s (1) abnormal returns at the M&A announcement and (2) long-term abnormal returns after the acquisition completion) and acquisition synergies (measured as (1) acquirer-target combined cumulative abnormal returns at the M&A announcement and (2) the change in three-year operating income and sales after the acquisition completion) increase with target firm insiders’ net purchase ratios. These results suggest that the information reflected in target insider trading prior to the M&A announcement serves as a credible signal for acquisition outcomes. We also find that both the offer price paid by the acquirer, relative to the target’s stock price, and the target’s abnormal stock returns at the M&A announcement increase with target insiders’ net purchase ratios. Overall, the findings indicate that the acquirer enjoys higher returns and synergies from acquiring a target with higher insider purchases although it pays a higher takeover premium to the target. A number of sensitivity analyses (e.g., alternative aggregation windows for insider trading further, a conventional instrumental variable approach, non-routine insider trading only, or separate samples of insider purchases and sales) rule out the potential omitted correlated variable bias (e.g., the acquirer abnormal return could be affected by outsiders’ reactions to any events rather than insiders’ foreknowledge) or reverse causality (e.g., target insider trading could be made to induce an acquisition) and ensure that our findings are robust to alternative specifications.

We then extend our analysis in several ways to lend additional credence to the signaling hypothesis. The cross-sectional analysis reveals that the signaling role of target insider trading prior to the M&A announcement is more pronounced when target information environment is opaque. We further find that the probability of an announced acquisition being completed and the likelihood of a firm being targeted increase with target net insider purchase ratios. Finally, we examine pre-M&A short-run returns following insider trading and find that target firms’ pre-M&A insider net buying has weaker predictability of short-run abnormal returns in the pre-M&A year than matched non-target firms’ insider net buying during the same period. Overall, our findings suggest that target insider trading has predictability for future acquisition outcomes, in support of the signaling hypothesis.

This paper highlights an indirect effect of insider trading, i.e., the use of target insider trading to forecast the acquirer’s future returns as well as acquisition synergies and shows that target firm insider trading helps to reduce the “lemons” problem in the M&A market. It also adds to the literature examining the implications of insider trading for numerous corporate events and provides nuanced insights into the longstanding debate on insider trading regulations. Our evidence insinuates that pre-M&A target insider trading, even under strong regulations, increases the M&A market efficiency by signaling the target’s potential for generating acquisition benefits. Finally, our findings have implications for how the uncertainty about the target’s potential for producing acquisition benefits affects acquisition decisions and consequences.

The full paper is available for download here.