Inside Debt and Mergers and Acquisitions (Digest Summary)

CEO inside debt—senior managers’ pension and deferred compensation benefits—influences the degree to which the company that he or she stewards takes risks in the merger and acquisition (M&A) process. This interrelationship carries implications for the interests of bondholders and shareholders and figures importantly in the company’s operating performance and value.

The author considers how inside debt aligns management’s interests with those of external bondholders and reduces risk-taking M&A activity to avoid bankruptcy and protect the company’s fixed obligations to corporate insiders. But the disclosure of such information may shift value to debt from equity, decrease both securities’ volatility, and depress company value. M&As are a rich forum for evaluating how such compensation arrangements affect the wealth of shareholders, bondholders, and senior management because they exemplify discretionary risk taking and the interplay of conflicts of interest that arise between these three groups.

The author makes several contributions to the body of literature on the subject. The focus expands beyond equity-based compensation to include debt-like remuneration. He illustrates the effect of inside debt on M&As and company stock and bond performance and sheds light on how this form of executive payment can improve compensation efficiency and M&A results.

The research sample covers a broad dataset of CEO pension and deferred compensation arrangements from 2007 to 2010 sorted to include only those involving M&As. The composition of the remuneration package tends to govern the management style with respect to the relative interests of the holders of the various classes of security in that arrangement. The sample reveals that CEO inside debt forms a sizable portion of the compensation package and is behind more conservative M&A activity that is more diversified and likely to mitigate senior management’s exposure to company-specific risks. Such an approach leads to improved operating performance in the aftermath of the acquisition.

Syndication teams and corporate finance strategists will find the author’s conclusions worthy inputs in the M&A strategy and valuation process. Securities analysts, industry seers, and trade buyers will also find it interesting.

The author’s research expands on the existing body of literature on the subject. The Compustat Executive Compensation database contains numerous compensation items on more than 12,500 executives in several Standard & Poor’s company indexes. But a US SEC disclosure reform allows for executive pension data only from 2006. These include pension and deferred compensation data, which proxy for CEO inside debt holdings. The dataset used also includes Compustat accounting data, stock and bond price return data from CRSP and Trade Reporting and Compliance Engine, and M&A data from Thomson ONE Banker. The author filters out deals with a value of less than $1 million. The full sample includes more than 2,800 company-year observations of 891 unique companies with CEO inside debt holdings from 2006 to 2009. The M&A subsample covers 296 companies involved in 581 deals from 2007 to 2010.

Prior research informs the proxies for the author’s empirical tests. These measure CEO leverage relative to company leverage or the ratio of debt to equity and CEO incentive, which relates the marginal change in the value of CEO inside debt holdings to the marginal change in the value of CEO inside equity holdings when a change in company value occurs pursuant to an M&A transaction. In the sample, CEO inside debt constitutes a meaningful share of total compensation.

These tests examine the interrelationship between CEO inside debt holdings and the company’s proclivity to engage in acquisition functions of varying risk levels. CEO inside debt holdings often lead to M&A activity that decreases risk because such deals tend to reduce leverage and use equities as acquisition currency. In the immediate post-announcement environment, the acquirer experiences positive abnormal bond returns but negative abnormal stock performance. In this same environment, companies restructure CEO remuneration to mirror the acquirer’s capital structure to neutralize corporate behavior that transfers wealth to either equity- or debtholders. The results of additional tests for robustness—which include (1) salary and bonus along with inside debt, (2) control for potential bias from serial M&As, and (3) control for bias because of the inclusion of the recent recession in the sample period by expanding the M&A sample—for the most part confirm the author’s findings.

A CEO’s remuneration motivates corporate actions—in this case, M&A activity. Because inside debt holdings form a large part of CEO compensation, such activity tends to be more conservative, which may be viewed as enhancing or reducing value in the wake of a corporate tie-up. Expanding innovative research to extend the scope of debt-like compensation beyond pensions and deferred compensation and to consider similar practices in other economies with well-developed security markets would be interesting areas for future inquiry.