Debt, Information Acquisition, and the Takeover Threat
45 Pages Posted: 24 Jan 1999
Date Written: June 1998
In this paper we formalize the information acquisition process by a potential bidder and its relationship with the target firm's capital structure. We show that debt increases prior to an acquisition are negatively related to the precision of the bidder's information. Incumbent managers, by means of leverage, offset shareholders' losses derived from information acquisition about the firm's prospects by potential acquirors. This explanation for the use of capital structure to deter rivals for control complements the ones provided by the literature. We test our model with a sample of 739 U.S. targets of hostile tender offers, and show that informational variables (such as toehold size and nature of target and bidder industries) are significant determinants of the decision to adjust leverage. The paper shows that target firms display slightly higher debt levels than their industry peers, and that target firms significantly reduce leverage in the year prior to the tender offer announcement. The latter result indicates that leverage favors entrenchment prior to battles for control, although incumbent managers use gearing to benefit from the takeover when its announcement is imminent.
JEL Classification: G32, G34
Suggested Citation: Suggested Citation