Mandatory Financial Disclosure and Merger and Acquisition Activity
Paolo Volpin, Stratakis Professor in Corporate Governance and Accountability at Drexel University’s LeBow College of Business, and coauthors show that mandatory disclosure of financial information facilitates the identification of new deal opportunities, leading to more merger and acquisition (M&A) activity and better performing acquisitions.
- The 2003 Accounting Directive by the European Union (EU) aimed to establish common rules for requiring private limited liability firms to report financial information. The adoption of the directive by the EU member states led to an increase of between 2.8 and 14.3 percent in the number of M&A deals, suggesting that mandatory financial reporting for private firms can alleviate information frictions in the market for corporate control.
- The directive was applied to firms with asset values above certain thresholds. Firms just above the threshold have become twice more likely to be acquired than firms just below the threshold. In Germany, where financial disclosure was very low before the directive, each 10 percentage-point increase in reporting by private firms has led to an increase of 10.2 percent in the number of M&A deals and of 23.7 percent in the total value of assets acquired.
- The positive impact of mandatory financial reporting on M&A activity is stronger in sectors that face more severe information frictions (innovative sectors), where the lack of information can lead to costly mistakes (sectors with assets that cannot be redeployed), and where it is helpful to have information about peers (sectors where firms are more similar in size and age). It is also stronger when the disclosure requirement is specific to the target firms rather than industry-level information.
Summary of Complete Findings
Acquisitions are typically large investments for firms. Therefore, access to reliable information about M&A targets is a first order concern for acquirers. To screen potential targets, a firm would need information about their profitability, growth, standalone asset value, and the value of any synergies associated with the deal. Asymmetries of information between acquirer and the current owners are likely to be severe when the target is a private firm. Mandatory financial reporting can improve the quality of information available to assess targets and, therefore, it can enable more M&A activity.
This study analyzes a sample of over 40,000 M&A deals across 12 countries, and investigates the impact of a 2003 European Union (EU) Accounting Directive which enhanced the coverage and electronic dissemination of private firms’ financial statements. The directive was implemented by EU member states using country-specific legislative processes, resulting in different adoption dates, disclosure requirements, and enforcement levels. Overall, it led to a large increase in the amount of accounting information that is publicly available for private firms.
Consistent with the view that more extensive disclosure of financial information reduces the information frictions faced by the potential acquirers, the researchers find that mandatory reporting is associated with greater M&A activity. In economic terms, a one-standard-deviation increase in mandatory reporting is associated with an increase in the number of M&A deals of 3.1 percent with respect to the average. The same result holds when M&A activity is measured in terms of the total assets of the acquired firms. The researchers use different approaches to corroborate this main finding.
First, they show that the directive adoption has led to an increase of M&A deals of between 2.8 and 14.3 percent with respect to the average (depending on the model specification). Second, they study firms whose asset values was close to the threshold established by the directive in order for the disclosure obligations to apply. The researchers estimate the probability of becoming an M&A target for firms above and below the thresholds. They find that the firms just above the threshold are twice more likely to be acquired, supporting the view that disclosure requirements increase the exposure of potential targets and expand opportunities in the market for corporate control.
As a third approach, the researchers use Germany as a case study. In the early 2000s, the compliance rate for financial disclosure among German private firms was very low at between 5 and 10 percent. This situation changed drastically in 2006 when an enforcement reform was enacted, known as EHUG, which centralized compliance monitoring and increased the penalties for non-compliance. As a result of this change, the compliance rate for financial disclosure among German private firms rose above 90 percent. By investigating the German experience, the researchers find that industries with a higher fraction of regulated firms are associated with more M&A activity after the reform, both in terms of number and size of the deals. Specifically, their estimates imply that a 10 percentage-point increase in the share of private firms that are subject to the enforcement reform is associated with an increase of 10.2 in the number of deals and 23.7 percent in size of the deal (measured as total assets acquired).
The study further investigates the mechanisms at work by undertaking three deeper tests of the hypothesis that mandatory reporting reduces the information frictions that hold back potential acquirers of private firms from bidding. First, the authors consider that information frictions are likely to be more severe in innovative sectors due to their complexity, and therefore mandatory reporting is likely to be more impactful for those sectors. Second, they use asset re-deployability as a measure of the cost of making acquisitions with limited information. The acquisitions of firms with specialized assets are less reversible and more dependent on the quality of information available. Therefore, mandated reporting should increase M&A activity particularly in sectors with low asset redeployability. Finally, the authors look at firms’ similarities at the country-industry-year level, using firm size and age. Similar firms are more likely to have correlated values, and therefore investors can more effectively use information reported by one firm in valuing another. If so, the positive effect of mandated reporting on M&A activity should be greater in sectors were firms are more similar. Across all three tests, the study shows support for the information mechanism: mandatory reporting has a greater effect on the M&A activity of private firms in sectors that are likely to face more severe information frictions (more innovative sectors), where the lack of information can lead to more costly mistakes (sectors with assets that are less redeployable), and where there are more benefits from peers’ information (sectors with lower heterogeneity across firms).
The effect of mandated reporting on M&A activity is not linear: the marginal effects of reporting on M&A activity decreases as the intensity of mandatory financial disclosure increases. However, the impact remains positive. This finding suggests that too much information in the market might also discourage certain acquisitions after an optimal level of financial reporting is reached.
Finally, the study finds that more mandatory financial disclosures in an industry lead to higher growth rates (measured by total assets) in the target after the acquisition, but do not necessarily bring better firm performance. Conversely, an increase in firm-specific disclosure requirements is associated with both post-deal greater growth and improved performance of the target firm. This suggests that firm-specific information is the key driver of synergistic deals, while industry-specific information may not necessarily help achieve the best match between acquirer and target. Consistent with this result, target-level reporting is shown to increase deal value while industry-level reporting does not.
In conclusion, mandatory financial reporting for private firms can resolve information failures in the market for corporate control, improving the efficiency and intensity of M&A activities.
“Mandatory Financial Disclosure and M&A Activity” by Marcelo Ortiz (Universitat Pompeu Fabra), Caspar David Peter (Erasmus University), Francisco Urzúa (City University of London), Paolo Volpin (Drexel University).