Acquisition related benefits paid to CEOs of targeted companies as part of takeover deals are relatively prevalent and as such a US study sought to examine the bonuses paid to CEOs of targeted companies during acquisitions to better understand the implications for shareholders. Primarily the researchers looked to determine if merger bonuses paid to target CEOs facilitate a wealth transfer from shareholders of the target company to those of the acquiring company. The results found this not to be the case, and that bidders fair worse in deals with such bonuses, despite the finding that they pay lower acquisition premiums.
Key Topics: Mergers and acquisitions; Merger bonus
Title of Reviewed Article: Contractual revisions in compensation: Evidence from merger bonuses to target CEOs
Researchers: Eliezer M. Fich (Drexel University), Edward M. Rice (University of Washington), and Anh L. Tran (City University London).
Publication: Journal of Accounting and Economics, 2016, Vol. 61 No. 2–3, pp. 338–368.
Setting the Scene
Lambert and Larcker (1985) investigated if merger related payments made to the CEOs of targeted companies result in inefficient outcomes for the shareholder of the targeted company, and they referred to this possible outcome as the wealth transfer hypothesis. Under this hypothesis, Lambert and Larcker (1985) argued, wealth is transferred from the shareholders of the targeted company. The potential transfer of wealth through such payments has been further validated in more recent research (Moeller, 2005; Wulf, 2004).
As an alternative to this wealth transfer hypothesis, the researchers evaluate what they refer to as the contractual revision hypothesis, which asserts that with acquisition deals which are not expected to yield high takeover gains, a payment to the CEO which adjusts their merger related compensation may be necessary in order to align management and shareholder incentives. Such a payment can be seen as beneficial to the shareholders of the target company because in its absence the target CEO may be inclined to try to block the deal. The researchers thus suggest that these payments can circumvent potential conflicts of interests.
Both the wealth transfer hypothesis and contractual revision hypothesis suggest different causes and consequences relating to merger bonuses. In relation to the contractual revision hypothesis, as low synergies typically reduce the amount a buyer is willing to pay, the researchers expected that bonuses would be associated with deals with low premiums and low synergies. With the wealth transfer hypothesis, the researchers also expected lower premiums where merger bonuses were present, but here the lower premiums are a consequence of agency issues as opposed to low synergies. As such the researchers outlined three research hypotheses for examination:
Hypothesis 1 (contractual revision) - “Acquisitions with merger bonuses involve lower overall synergies.”
Hypothesis 2 (wealth transfer) - “An acquirer’s abnormal returns in bids associated with target merger bonuses are higher than the abnormal returns associated with other bids.”
Hypothesis 3 (wealth transfer) - “A target firm’s relative gains from a merger deal with target merger bonuses are lower than the relative gains associated with other deals.”
How the research was conducted
Data for this study was taken from 949 merger and acquisition bids, where the target company was a U.S. publicly traded company, logged by the Securities Data Company (SDC) on their M&A database between 1999 and 2009. The companies captured in this data came from a wide range of industries.
In order to be included in the analysis, the researchers required that target companies have data available in respect to stock market, accounting, governance, and deal background. This information was taken from the Center for Research in Security Prices (CRSP), Compustat, RiskMetrics, and proxy filings/Lexis Nexis search.
The researchers conducted statistical analysis on this data to investigate their research hypotheses.
Key Research Findings
Analysis found that, for the dataset reviewed, the average target company had a market capitalization of $3.3bl, and the average deal value was $4.6bl.
The results indicate that a significant proportion of bonus payments made to the target CEOs are related to the acquirer using the CEO in some manner or preventing them from acting against the merged firm. Approximately 23% of target CEOs (219 CEOs) were found to receive a merger bonus. These payments are categorized in various ways by the target companies’ boards, such as “consulting” fees (59 cases), “retention” (58 cases), and “noncompetition” agreements (41 cases).
Relatively speaking, these payments were modest in relation to the deals sizes, with average payment being $1.6m, and the maximum observed payment being $12m.
In relation to the shareholder wealth effects, the results found that in deals where the target CEO receives a merger bonus, target companies receive premiums which are approximately 4% lower. This finding is contrary to Hypothesis 2.
On average, the researchers did not find evidence of a wealth transfer from target shareholders to the bidding company shareholder, in fact the effect was in the opposite direction, with results showing that the effect of these bonuses on the performance of the acquiring company, as captured by short term stock return (-1.84%) and industry-adjusted post-merger return on assets (-1.63%). Given that it is the acquiring company that ultimately pays these bonuses there is a natural negative relationship between bonuses paid and the acquiring company’s return, although the size of the bonus paid does not account fully for this.
Consistent with Hypothesis 1, Synergies were also found to be lower, by approximately 1.58%, in deals where merger bonuses were paid to target CEOs. Additionally, for target companies whose CEO received a merger bonus, those companies typically received a larger proportion of the acquisition gains.
The results indicate that, on average, takeovers which include a merger bonus, do not transfer wealth to the shareholders of the acquiring company. This supports the contractual revision hypothesis. In relation to this, the findings indicate that with low synergy targets, merger bonuses can provide an important economic purpose by adjusting the takeover related compensation of a target CEO to align their incentives to those of their shareholders.
The researchers point out that the wealth transfer hypothesis should not be dismissed completely, as it may hold true in individual deals, despite the average findings not supporting it. For example, the findings show that wealth does appear to transfer to the acquiring company shareholders when target companies have high abnormal accruals or are subject to an SEC enforcement action. Therefore, the hypotheses are supported to some extent through subgroup analysis of the dataset, however the contractual revision position is the more dominant motivational factor for giving a merger bonus to a target CEO, it would appear.
The findings indicate that merger bonuses can be beneficial to target shareholders particularly when the two companies have low synergies. In this respect, the results suggest larger CEO compensation does not necessarily represent excessive compensation and may in fact encourage useful deals.
Overall, the findings in relation to the three hypotheses are in line with the contractual revision alternative, suggesting that the dominant effect of merger bonuses is the alignment of interests of the target company CEO and its shareholders.
Organizational and Reward Implications
The finding of this study that merger bonuses do not typically facilitate transfer of wealth from the target shareholders to acquiring shareholders is an important one and should serve as valuable guidance for various parties involved in M&A activity, and particularly those in decision making positions regarding merger bonuses. In light of the findings of this study careful consideration should be given to the awarding of such bonuses and whether they are having undesired consequences.
This study provides valuable insights into the role and cost of merger bonuses in merger and acquisition deals and the study’s development of an alternative hypothesis to the wealth transfer hypothesis, through the contractual revision hypothesis adds to the depth of understanding in this area.
Source Article: Fich, E. M., Rice, E. M., & Tran, A. L. (2016). Contractual revisions in compensation: Evidence from merger bonuses to target CEOs. Journal of Accounting and Economics, 61(2-3), 338-368.
Published by: Elsevier B.V.
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Lambert, R., & Larcker, D. (1985). Golden parachutes, executive decision-making, and shareholder wealth. Journal of Accounting and Economics 7(1),179–203.
Moeller, T. (2005). Let's make a deal! How shareholder control impacts merger payoffs. Journal of Financial Economics 76(1), 167–190.
Wulf, J. (2004). Do CEOs in mergers trade power for premium? Evidence from mergers of equals. Journal of Law, Economics, and Organization 20(1), 60–101.