In M&A, information about target companies is usually allocated asymmetrically. Buyers mitigate the risks arising from incomplete information through various means.
Economics goes legal – information asymmetry in M&A
Companies grow not only organically, but to a large extent through mergers & acquisitions (“M&A“). Even though empirical data shows a certain cyclicality of M&A activity (“M&A waves”) – the last peak being at the outbreak of the financial crisis in 2007 – M&A is a phenomenon in the modern business world. Many legal and other advisors are kept occupied analysing M&A opportunities, evaluating targets and implementing transactions.
One driving element in M&A deals is the price paid for the target (company). Whereas neoclassical finance theory implies efficient capital markets and completely informed players, in practice, we typically see information asymmetry detrimental to the buyer. At the outset of a transaction, the buyer (bidder) has only limited insight into the qualities of the target determining its value; thus, the buyer cannot reliably establish the price it should pay. The seller may, on the one hand, have no concrete information regarding the target. Explanations for limited seller information, besides practical information barriers (eg insufficient reporting tools/mechanisms), include, among other things, the confidentiality obligations of the target’s management, and the concept of equal treatment of shareholders. On the other hand, the seller has few incentives to disclose any information to the buyer.
As with any meeting regarding supply and demand, the players in M&A transactions also form a market; in terms of economic theory, this is called the market for corporate control. When Akerlof introduced his concept of a market for “lemons” (adverse selection problem) in 1970, he came up with the infamous example of used cars.1 Likewise, the theory could be translated into the market for corporate control, and would predict that the problem of adverse selection would result in a collapse of the M&A market. Fortunately, this is not observed in reality.
So, how are information asymmetries in the M&A market overcome in practice? What is the legal context for this?
The first intuitive solution is for the buyer to seek missing information. This process is widely known as a due diligence process. Legally, the concept stems from the fact that the management of the buyer may be liable to the company (or creditors) if it harms the company through making uninformed decisions. Therefore, virtually any M&A deal is preceded by a more or less thorough due diligence exercise. The buyer would thereby not only review publicly available information, such as published annual accounts, registers, capital market information, etc, but would request specific information to be disclosed in a “data room”. The limitations of this approach are obvious: First, the buyer would always have to rely on the completeness and correctness of the pieces of information disclosed by the seller. Secondly, implicit knowledge (eg cultural values and organisational processes) can hardly be ascertained from a due diligence exercise.
Another approach originates from the economic concepts of signalling and self-selection. Capital markets are highly regulated. Publicly listed companies are on the one hand bound by strict and comprehensive disclosure obligations (eg regular reporting, ad-hoc reporting) or even disclose information voluntarily (eg at road shows); on the other hand, a company that chooses to launch an IPO (ie going public) is less likely to be a “lemon”. Hence, if a buyer selects a publicly listed company as a target, it can be assured that there are much smaller information gaps than with a private company.
Risk mitigation cannot only be achieved through the reduction of information asymmetry, but also by limiting one’s exposure; this is what economists refer to as ownership solutions. A buyer can opt not to buy a 100 % stake in a company, but to enter into a joint venture with the seller or the target company. This can be implemented either contractually (through a cooperation agreement) or by the acquisition of a minority or majority equity stake. That way, both parties share the risk of incomplete information.
Options are a useful tool to be combined with a joint venture structure. After gaining further insights over time, the new partner may exercise a put option (if the opportunity did not turn out well) or a call option (in case of a success story) and thus either divest its stake or fully utilise its investment.
Lawyers find contractual solutions particularly interesting. Just like structural ones, contractual solutions do not aim at decreasing information gaps presigning, but at allocating the risk of asymmetric information (partially) to the seller.
By way of an earn-out, the buyer pays and the seller receives an additional purchase price if certain qualities (usually measured by certain key performance indicators) of the target materialise within a certain period after the closing of the transaction. A seller offering an earn-out scheme also signals the target’s qualities.
Warranties, representations and guarantees work the other way round. If, ex post facto, a certain quality of the target turns out to be untrue or missing, the seller is obliged either to “repair” the defect (restitution in kind) or to compensate the buyer financially (damages). Both remedies cure the overpayment.
These ways of mitigating the risks arising from information asymmetry are not exhaustive. Experience shows that markets (including the M&A market) tend to develop mechanisms to tackle friction arising from such asymmetry. Legislation provides a framework for incentivising or forcing market players to reduce information gaps. Moreover, there are efficient ways to control such risks through legal solutions.
Information asymmetry is a common phenomenon in any market. M&A markets deal with this issue in different ways that can broadly be categorised into due diligence, and market, structural and contractual solutions.