When Do Targets Benefit From Negotiations? Evidence from Auctions and Negotiations

Recent research suggests that target shareholders’ wealth effects from auctions do not differ from their wealth effects in single-bidder negotiations (Boone and Mulherin, 2007b). We find this result puzzling and contend that an analysis of the method of sale decision and the wealth effects outcome must address the self-selection bias resulting from target management’s private information inherent in the decision. Using a self-selection framework, we hypothesize that adverse selection risk (i.e., an anticipated risk) and the uncertainty of future cash flows (i.e., an unknown risk) impact the target’s decision to sell through an auction, as well as the wealth accruing to target shareholders. We find that when target managers initiate the sale of the firm, they are more likely to choose an auction as the method of sale. Our results suggest that the method of sale (i.e., selling the firm through an auction or negotiating with a single bidder) is not random and has a significant impact on the wealth of target shareholders. Specifically, both under a self-selection framework and in deal initiator subsample analysis, we find that adverse selection risk, including a lack of transparency in financial reporting and the uncertainty of future cash flows, impacts the target’s decision to sell through an auction as well as the wealth accrued to target shareholders. Auctions are associated with both higher target cumulative abnormal returns and offer premiums than negotiations, but only if the transaction is not initiated by the target. The target can self-select itself and choose an auction (vs. negotiation) to increase target wealth effects. We also show that controlling for both simultaneity and self-selection biases enriches our understanding of the corporate takeover process.