Faculty Guest Post: Acquisitions and the Lemon Problem

What do business acquisitions have in common with buying used cars?

The markets for used cars are riddled with information asymmetry between buyers and sellers.  This lack of symmetry arises because sellers know much more about the car than buyers do and in particular they know whether it is a “lemon.”

A similar asymmetry often arises in business acquisitions. Acquirers have to rely on information provided by target company managers to assess synergies, but they cannot tell whether these managers are well-meaning or opportunistic when selling their companies.    

Like consumers, acquirers have developed mechanisms to overcome these problems.  Beyond conducting thorough research on the company, some acquirers have chosen to form an alliance or a joint venture with the target. Think of it is a test drive, except it is much more involved.  By buying a partial stake in the target, the acquirer can operate it jointly with the target’s management and get a much better sense of its true worth.

After a certain period, if the acquirer’s management is convinced, they can then buy the remaining stake in the target and consummate the acquisition. If not, they can sell back the partial stake at a price that was negotiated at the time of the original deal. The process takes many of the uncertainties out of the acquisition process and has helped companies create value which often tends to be elusive in these deals.

Shyam Kumar is an associate professor at the Rensselaer Lally School of Management.