Acquiring Innovation Under Information Frictions

Abstract

An active M&A market incentivizes many firms to specialize in innovation with the anticipation of being acquired in the future. Acquiring innovation, however, is subject to information frictions, because acquirers often find it challenging to assess the value and impact of innovative targets. Using data on US public firms, we document that (i) there is a robust inverted-U relationship between firm innovation and takeover exposure, (ii) equity usage increases with target innovation, and (iii) deal completion rate drops as targets become more innovative. Motivated by these findings, we develop and estimate a model of acquiring innovation under information frictions. We find that acquirers' due diligence reveals only 33% of private information possessed by targets, and eliminating the remaining information friction can increase firms' expected gains from the M&A market by 38%. This efficiency gain is achieved through a higher probability of mergers and a larger value creation in completed transactions. We also find that a more efficient M&A market encourages more firm innovation, resulting in a higher average firm growth rate.