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«This version: November 2009 Abstract We present evidence of the impact of asymmetric information on firms’ likelihood to issue equity and to be ...»

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Does Asymmetric Information Affect SEOs and

M&A? Evidence from Corporate Pension Plans

João F. Cocco∗ Paolo F. Volpin†

This version: November 2009


We present evidence of the impact of asymmetric information on firms’ likelihood to issue

equity and to be acquired. We argue that the existence of corporate sponsored defined

benefit pension liabilities, and their magnitude, are a source of risk for buyers of the firm’s

shares. We show that firms that sponsor DB pension plans and have a large pension deficit relative to their market capitalization are less likely: (i) to raise equity through SEOs; (ii) to be the target in an acquisition and to be taken over; and (iii) to use stock when they acquire other companies or assets.

JEL classification: G32, G34, J32.

Keywords: asymmetric information, SEOs, M&A, corporate pensions.

Acknowledgments: We are grateful to Henri Servaes for comments and the ESRC through the Corporate Governance Centre at London Business School for financial support.

∗ London Business School, CEPR, and Netspar, Regent’s Park, London NW1 4SA, E-mail: jcocco@london.edu † London Business School, CEPR, and ECGI, Regent’s Park, London NW1 4SA, E-mail: pvolpin@london.edu 1 Introduction There is a vast theoretical literature emphasizing the importance of asymmetric information for corporate financial decisions, with perhaps the most famous contribution being the pecking order theory of capital structure proposed by Myers and Majluf (1984) and Myers (1984).1 The basic idea behind these papers is Akerlof (1970)’s lemons principle: in the presence of information asymmetries between the firm and the market it is costly for firms to sell equity to outsiders. As in Akerlof’s used car market, adverse selection in the market for equity may lead to a market breakdown.

In contrast to the vast theoretical literature, evidence on the impact of asymmetric information on firms’ financial decisions has been harder to obtain. This is to some extent due to the difficulty in measuring asymmetric information across a large group of firms. Our idea is to use company-sponsored defined benefit (DB) pension plans as a source of asymmetric information for the value of the shares of the companies that sponsor such plans.

The deficit in DB pension plans (that is the difference between pension liabilities and pension assets) is a liability for the sponsoring company. The size of this deficit is difficult to determine since its value is very sensitive to the assumptions, which are not always made explicit, regarding discount rates, pension plan members longevity, employee mobility, among others. Naturally, uncertainty withrespect to the value of the pension deficit translates into uncertainty with respect to the value of the sponsoring firm’s equity. Furthermore, the management of the companies that sponsor such plans have more information on the assumptions used and on the value of the deficit than outsiders do. This may make it difficult for firms that sponsor a DB pension plan to sell equity to outsiders: potential acquirers of the company shares may be worried that they are buying a lemon.

We investigate whether this is the case in two different situations in which firms sell equity to outsiders: Seasoned Equity Offerings (SEOs) and Mergers and Acquisitions (M&A). More precisely we investigate whether firms that sponsor DB pension plans, and in particular those that sponsor plans with large deficits, are less likely to issue equity in a SEO, to be taken over, and to use equity as a means of payment in acquisitions.

Early contributions in this literature include Ross (1977) on the signaling role of debt, Leland and Pyle (1977) on the informational content of inside ownership, and Bhattacharya (1979) on the signaling role of dividends.

In our study we use United Kingdom (UK) data for the 2002-2008 period. The universe of firms in our sample are the Footsie 350 companies in 2002, the first year in our dataset. Our choice of large companies is motivated by the fact that we would like a sample with variation with respect to the significance of company sponsored DB pension plans. About two-thirds of these companies sponsor DB pension plans, and among the latter there is significant variation in the value of the pension deficit relative to the market value of the firms’ equity, ranging from 49 percent to −13 percent. We have hand-collected the value of the deficits and other pension data from the footnotes to the companies’ annual reports. In addition, we use firm-level data from Worldscope, and SEOs and M&A activity data from SDC Platinum.

To assess whether firms that sponsor DB pension plans, and particularly those that sponsor plans with large deficits relative to market capitalization, are less likely to issue equity, we estimate probit regressions of the decision to issue as a function of pension plan variables.

We control for several firm characteristics, including size, profitability, leverage, among others.

Interestingly, we find that firms with a large pension deficit relative to the market value of their equity are less likely to issue and to raise a significant amount of equity. It is important to note that we obtain this result controlling for a measure of firm leverage, that treats the pension deficit as debt for the sponsoring company. That is: our results are not due to the fact that companies that sponsor DB pension plans tend to be more highly leveraged (Shivdasani and Stefanescu, 2009). Hence, our result is consistent with the view that DB pension plans are a source of asymmetric information for the sponsoring firm.

In addition, we find that the sponsoring of DB pension plans has an impact on M&A activity which is consistent with the asymmetric information theory. More precisely, we find that firms which sponsor DB pension plans are less likely to be targeted in M&A acquisitions, particularly when they have a large pension deficit relative to the market value of their equity.

And conditional on being attempted, acquisitions that target firms which sponsor DB pension plans are less likely to be completed. These findings lend support to the idea that DB pension plans act as an implicit poison pill that discourages potential (and actual) bidders from acquiring the sponsoring companies.

Although our result that company sponsored pension plans act as a takeover defense resembles the results in Rauh (2006b), it is important to note that the economic mechanism at work in our paper is different. Rauh shows that US companies that sponsor pension plans that invest in the shares of the sponsoring company are less likely to be taken over. The mechanism at work in his paper is an agency one, with the employees and the management of the sponsoring company using shares owned by the pension plan to prevent a takeover.2 In contrast, in the UK pension plans are not allowed to invest their assets in the shares of the sponsoring company, nor own assets that are related to the sponsoring company (e.g. the pension plan cannot own property that is rented out to the sponsoring company). Therefore, in our paper another mechanism is at work. Namely, the presence of a DB pension plan, particularly when running a large deficit, represents a source of risk for potential acquirers of the sponsoring firm’s equity.

We also find an effect of pension plan variables on the means of payment in M&A activity. The theoretical work of Hansen (1987) and Fishman (1988) predicts that acquiring firms for which there are information asymmetries should use cash as the means of payment when acquiring other firms. This is because target firms will be reluctant to accept the shares of the acquirer as a means of payment. Consistent with this prediction, we find that firms that sponsor DB pension plans with larger deficits are more likely to use cash when they acquire other companies. This result lends support to the idea that information asymmetries related to company sponsored DB pension plans affect firms financial decisions.3 The remainder of the paper is structured as follows. In the remainder of this section we discuss related literature and we motivate our use of DB pension plans as a source of information asymmetries, and their implications for equity sales. We do so using an illustrative example that describes recent events related to a company in our sample. Section 2 describes the data that we use for our study, and it also includes a description of the methods used to determine the pension deficit. Our main results are presented and discussed in Section 3. Robustness checks are in Section 4. Section 5 concludes.

1.1 An Illustrative Example

The idea that we wish to investigate in this paper is simple but, we believe, important. The value of the equity of a firm that sponsors a DB pension plan depends on the value of its corporate The employees may be against a takeover since as Pontiff, Shleifer and Weisbach (1990) show DB pension plans are more likely to be terminated following hostile rather than friendly takeovers.

It also complements the early evidence on the relation between means of payment and information asymmetries in Travlos (1987), Eckbo, Giammarino, and Heinkel (1990) and Franks, Harris and Titman (1991), and the more recent evidence provided by Moeller, Schlingemann and Stulz (2004), Officer (2007), and Raman, Shivakumar, and Tamayo (2008).

pension deficit (pension liabilities net of pension assets) relative to its market capitalization.

Because of the complexity in evaluating the assets and liabilities in a pension plan, corporate insiders (managers and large shareholders) may have more information than the market about the true value of the pension deficit. As a consequence, investors may be reluctant to buy the firm’s shares. This will affect the firm’s ability to sell its equity, either in seasoned equity offerings or in M&A activity.

As an example of the relevance of corporate sponsored DB pension plans for SEOs and M&A activity we discuss recent events related to British Airways, which is one of the firms in our sample. In July 2008, British Airways (BA) and Iberia of Spain announced that they were planning to merge their operations, creating a $3.8 billion company that would benefit from Iberia’s presence in Latin America and BA’s market share in North America and Asia.

Industry analysts believed the two companies to be a good “strategic fit,” since there would be considerable cost savings generated by bringing their operations together.

However, in the months following the announcement of the all-share merger, discussions stalled on concerns about the size of BA’s pension deficit and on stakes valuation. In March 2008, BA’s pension deficit was $437 million, while BA’s market capitalization had declined to $2 billion pounds. Later that year, BA admitted that on September 18 the trustees of the pension plan had calculated the deficit to be equal to $1.74 billion. Industry experts believed that the deficit might be even larger.

The size of the BA pension scheme deficit, and the large fluctuations in its value were a concern to Iberia, which by December 2008, after months of struggling to understand it, had hired Mercer, a pension consulting firm, to review BA’s pension schemes. Fernando Conte, Iberia Chairman, said that unless Iberia could protect itself from the BA scheme, it would be “bonkers” to enter into a transaction where it was “on the hook” for it (The Daily Telegraph, 28 December 2008).

By February 2009 signs of difficulty in reaching a deal were apparent. Nick van den Brull, an analyst with BNP Paribas, said “I don’t see anything happening before the pension deficit is known. Directors [at Iberia] would wish to know the maximum extent of the liabilities before proceeding.” (The New York Times, 8 February 2009). It was this uncertainty, and the worry that it may be buying a lemon, that led Iberia, three months later, to propose that the merger contains a post-deal adjustment to account for BA’s pension deficit. More precisely, Iberia proposed an all-share merger ratio that would be adjusted if the deficit widens because of such things as increased longevity assumptions. However, BA fiercely resisted demands for such adjustment mechanism, believing it would be impossible to sell such an open-ended deal to its shareholders (The Daily Telegraph, 22 May 2009).

At the same time, British Airways’ Chairman Martin Broughton was blaming the firm’s spiralling pension scheme deficit on the processes employed by actuaries and accountants. “It’s little wonder that the Spanish have such difficulty understanding [our pensions]. It’s clearly time that the actuarial and the accounting world got together and recognized the folly of having mechanical processes in place that produce such divergent results, neither of which really seem in touch with reality.” At the same time he called for an overhaul of the system to help BA shareholders and Iberia understand the situation (Pensions Week, 25 June 2009).

One month later BA acknowledged that due to the crisis it needed to increase liquidity, but at the same time its Chairman Martin Broughton ruled out a rights issue, arguing that it was not a good time for the firm to carry it out. This happened amid questions about the sustainability of the firm’s business model, geared towards premium travelers, and the firm’s pension deficit (Dow Jones Market Watch, 14 July 2009).

On November 12, after many months of discussions, BA and Iberia announced that they had reached a preliminary agreement for a merger expected to be completed in late 2010. Under its terms Iberia would take a 45% stake and BA a 55% stake. However, Iberia said it can pull out if BA fails to resolve its pension deficit problem (BBC news, 12 November 2009).

The BA example illustrates how concerns about the value of the company sponsored pension deficit, and information asymmetries regarding the value of this deficit, can affect M&A activity and the decision to issue equity. Although the events described suggest that there is such an effect for BA, the purpose of this paper is to find out how relevant such considerations are for a wider sample of firms. For that reason we have collected data for a large sample of UK firms.

1.2 Related Literature

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