Due Diligence Failure as a Signal Detection Problem

Abstract

In conducting due diligence during corporate acquisitions, acquirers obtain new and usually negative information regarding targets' values. Because such information is noisy, acquirers must balance the risk of withdrawing from a value-enhancing acquisition against the risk of persisting with a value-destroying acquisition. Drawing on signal detection theory - a rational choice theory of decision making under uncertainty - we propose that the relative importance acquirers place on these two risks affects how they utilize information obtained during due diligence. To assess this proposition, we undertook an experimental study of decision making in due diligence. The results are consistent with the assertion that the initial value acquirers attach to the acquisition opportunity affects 1) the impact that negative information from due diligence has on their valuations of targets and 2) their final acquisition decision.

Keywords: corporate acquisitions, due diligence, escalation of commitment, signal detection theory

JEL Classification: D8, M21, M10