Downside Risk Similarity and M&As
59 Pages Posted: 8 Apr 2022 Last revised: 2 Sep 2022
Date Written: March 30, 2022
This paper examines the role of downside risk similarity between acquirers and targets in M&As. We introduce a measure of downside risk similarity between two firms based on the degree of overlap between their risk factor descriptions. In validity tests, we show that the measure is distinct from the existing similarity measures, can predict the co-occurrence of extremely negative returns of firm pairs, and is negatively associated with acquirers’ change in risk factors during M&As. In the main analyses, we document that the market reacts more positively to deals when merger pairs have more similar downside risks after controlling for similarity measures from the literature. Cross-sectional tests show the effect to be driven primarily by deals in which acquirers have a weaker risk management capacity or face greater uncertainty about targets. We find corroborating evidence using alternative measures of deal quality, including deal-specific goodwill impairment and combined firms’ profitability. Finally, we show that downside risk similarity also influences the M&A process, including the target selection, due diligence, deal completion likelihood, and payment method.
Keywords: Downside risks; M&A quality; risk management; information asymmetry; risk factor descriptions; textual analysis
JEL Classification: G34, M40
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