The starting point in their research was a 1984 paper by Stewart Myers and Nicolas Majluf. Those authors argued that firms typically prefer to issue debt rather than equity because debt features less “information asymmetry” – academic language for the gap between what sellers know and what buyers know about the item changing hands. In an ideal world, symmetry is perfect, and buyers and sellers have identical information. Where there is asymmetry – ie, the normal course of events – information is not the same.
Logic behind the theory that Myers and Majluf espoused lies chiefly in the notion that more information asymmetry breeds uncertainty, and uncertainty sabotages prices. Simply put, if investors do not know the true value of a company’s shares, they will only be willing to pay a low price for them. Companies want the best price; therefore in theory they should sell claims that have the least uncertainty and the least information asymmetry. Tax considerations aside, because debt is safer than equity, it has less information asymmetry, and so firms generally prefer to raise debt rather than equity.
Meyers and Majluf looked only at debt and equity, however. They did not consider asset sales. Applying their general principle to the asset sales decision, later observers assumed that firms should sell assets only when they exhibit less information asymmetry than equity.
Looking specifically at asset sales, Edmans and Mann determined that information asymmetry is not the primary driver of financing decisions. Peeling back the reasons that motivate the sale of assets versus stock shed light on the camouflage, correlation and certainty effects.
“While information asymmetry is indeed an important consideration,” they write, “our model identifies several new distinctions between asset sales and equity issuance that also drive the financing choice, and may swamp information asymmetry considerations.”
Lemons – or lemonade?
The camouflage effect marks the first departure from earlier theory. Myers and Majluf showed that when a firm issues equity, the market infers that it’s because the equity is overvalued. Experts liken this to consumer behavior in the used car market where buyers suppose that selling a car means something undisclosed is wrong with it (ie, it’s a lemon). That’s why used car buyers typically offer less than the asking price. Similarly, according to Myers and Majluf, firms are reluctant to issue equity. They don’t want to send a signal that casts doubt on their value.
A potential buyer for a factory, a plant, a division or any asset could draw a similar conclusion about an asset for sale: The seller is disposing of it because it’s a lemon. But companies also sell fundamentally sound assets that no longer fit strategic goals. Outsiders are seldom privy to real motives. Even ifthere is something fundamentally wrong with the asset, the seller might be able to avoid a low price by pretending that there’s nothing wrong with it, and it’s instead selling it because it no longer fits with the core business. Edmans and Mann call this potential to disguise the true motive for asset sales the “camouflage effect.”
Price discounts for sellers may not be all that significant at the e
