Mitigating Acquisition Risk: The Critical Role of Indemnification during Merger Contracting

Failing to adequately uncover, assess, and manage uncertainties and risks in M&As can lead to large financial losses for acquirers. Two key avenues to mitigate acquisition risk are (i) due diligence, processes that identify potential risks prior to consummating the deal, and (ii) indemnification, contractual clauses that allow acquirers to recuperate some of their losses from key risks after consummating the deal. Using an extensive database of merger contracts, we show that mergers with higher information asymmetry between the acquirer and target are more likely to utilize indemnification. We also provide evidence consistent with a substitution effect of due diligence effort with indemnification. Specifically, on average, acquirers have shorter post-contract periods when they obtain indemnification. Moreover, we find segments absorbing indemnified targets are significantly more likely to experience future goodwill impairments, consistent with a substitution effect and the notion that lower due diligence is detrimental to appropriately valuing targets. As such, our findings provide new evidence of how this understudied contracting feature plays a role in deal valuation and wealth gains.