Aurora Borealis
1 June 2017 CFA Institute Journal Review

Friends in the Right Places: The Effect of Political Connections on Corporate Merger Activity (Digest Summary)

  1. Biharilal Deora, CFA, CIPM

Firms often work with politicians and former regulators to navigate the corporate world—in particular, mergers and acquisitions. The authors aim to explore and establish the nexus between political connectedness and heightened merger activity. The critical issues are whether the political connectedness of firms (i.e., having former politicians and regulators on boards of directors or management teams) influences the frequency, deal size, and success rate of mergers that undergo regulatory scrutiny and whether acquirers exhibit better operating performance after the merger.

How Is This Research Useful to Practitioners?

Most analysts (whether equity or fixed income) have a hard time predicting the growth of companies, especially when that growth is led by a merger or an acquisition. Analysts and portfolio managers need clarity on the size of the merger, the likely premium paid, the regulatory outcome of antitrust and other laws, and most importantly, whether the post-merger performance justifies the capital allocation. For portfolio managers and fixed-income investors, acquisition events often trigger a debt repayment, a default, or a need to rebalance the portfolio because of credit-rating changes. The authors’ results can help analysts understand that politically connected bidders are more likely to acquire targets than are bidders that are not politically connected.
The targets of connected firms are also larger than those of nonconnected acquirers and are likely to have superior post-merger financial and accounting performance. The authors provide evidence that connected acquirers receive higher five-year abnormal returns as well as industry-adjusted returns on assets than do nonconnected acquirers. This performance could be attributed to the firms’ ability to use private information about the regulatory landscape and/or the lobbying access that politicians and former regulators can offer them. Practitioners should be wary of potential merger activity when there are board-level changes involving connected people.

How Did the Authors Conduct This Research?

The authors use the CRSP and Compustat databases for US public companies (both target and acquirer) over 1997–2013 for deals of more than $1 million. Using a filter for their sample, they require that the acquirer own less than 50% of the outstanding shares of the target six months before the bid announcement and seek to acquire more than 90% after the deal. The relative value of the deal is at least 1% of the bidder’s size. The authors obtain regulatory data from both the Federal Trade Commission and the Antitrust Division of the Department of Justice.
Three indicator variables are used to measure the bidder’s political connectedness—that is, whether the bidder has on its board or management team or as an employee such types of individuals as a former politician, an industry regulator, a general or admiral, or a noncounsel lawyer. Using descriptive and comparative sample statistics to examine their data, the authors showcase their results on the amount of merger activity by both connected and nonconnected firms. This phenomenon is more evident in industry sectors where the regulations are more complex—for example, telecommunications, heavily regulated utilities, and financial services. They then estimate the success of mergers and political connectedness on the basis of probit models using regression and correlation. In estimating takeover premiums, the authors use three measures: PREMMOEL (Harford, Journal of Financial Economics 2005), PREMISM (Ismail, Financial Management 2011), and PREMBET (Betton, Review of Financial Studies 2000). To address endogeneity and the omitted-variables effect, they use an instrumental-variable approach and a difference-in-differences framework.

Abstractor’s Viewpoint

Most businesses engage in some form of advocacy or lobbying with regulators. This engagement can be in the form of political donations or the appointment of a former regulator or politician to the management team or board in the hope that the firm will sail through any regulatory scrutiny. Firms may use either option to enhance their reputation, gain attention from investors, or obtain guidance in setting up new businesses or in navigating the licensing process.
Although the authors conclusively demonstrate the relationship between (1) political connectedness and (2) merger success and operating performance, they are unclear about the exact quantitative factors that lead to these results. Some industry sectors—including telecommunications, financial services, and utilities—often have monopolistic or oligopolistic characteristics and thus have stronger, more stable cash flows that are bound to strengthen operating performance regardless of political connectedness. The authors fail to identify clearly how political connectedness helps the acquirer generate higher post-merger returns. Because the authors’ dataset is limited to the United States, their results may be less applicable to the fragmented economies in Europe and Asia.

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