Prior Target Valuations and Acquirer Returns: Risk or Perception?

Abstract

In a large sample of public-public acquisitions, target valuation changes between their 52-week highs and just prior to the acquisition announcements are positively related to acquirer announcement returns. I contend that prior target valuation changes are measures of target valuation uncertainty. Risk-averse acquirer managers likely require compensation when their firms take on valuation risk through the acquisition of hard-to-value targets. Diversified shareholders of public targets have little incentive to provide such compensation through lower acquisition prices because they do not benefit from offloading idiosyncratic risk. Without compensation for the acquirer in the form of lower acquisition prices, acquirer managers need to be motivated by other, likely private, benefits to undertake acquisitions of targets with uncertain valuations. In a competitive takeover market, the costs of the acquirer managers’ private benefits can only be borne by the acquiring firm. Therefore, the more uncertain a target’s valuation, the lower is the acquirer’s announcement return. I use various proxies for target valuation uncertainty and find that higher target valuation uncertainty is significantly related to lower acquirer announcement returns. As predicted, acquirer governance variables are related to this effect. Further, the target valuation uncertainty proxies have significant negative correlations with the prior target valuation changes and they dominate the prior target valuation changes in their effect on acquirer announcement returns. While behavioral biases based on prospect theory can explain the significant empirical relation of prior target valuation changes and acquirer announcement returns, my empirical results suggest that rational explanations based on target valuation uncertainty dominate the behavioral stories.