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9 August 2018 CFA Institute Journal Review

Managerial Risk-Taking Incentives and Merger Decisions (Digest Summary)

  1. Butt Man-Kit, CFA

Because mergers and acquisitions are a possible way to reduce firm risk, CEOs with higher deferred compensation and defined benefit pensions, who would suffer more if their firms fail, have a higher chance of engaging in mergers that reduce firm risk, even when the mergers are not beneficial to shareholders.

How Is This Research Useful to Practitioners?

According to agency theory, managers might not maximize shareholders’ value when their interests are not aligned. Therefore, CEOs who have higher “inside debt,” such as deferred compensation and defined benefit pensions in their compensation package, have a higher incentive to lower their firms’ risk, even when the decision is not beneficial to shareholders. In this regard, these CEOs should be more likely to choose vertical mergers, where the acquirer and target have a supply chain relationship as supplier and customer, to effectively reduce firms’ risk. The authors find evidence to support this argument and show that a one-standard-deviation increase in a CEO’s inside debt variable leads to a 17.4% probability increase of conducting a vertical merger versus not engaging in a merger at all.

These vertical mergers and acquisitions (M&As) conducted by CEOs with high inside debt incentives also generate lower returns to shareholders. The sample shows that a one-standard-deviation increase in a CEO’s inside debt variable leads to a reduction of 93 bps in the five-day cumulative abnormal returns (CARs) for vertical mergers. This reduction is huge considering the in-sample average CAR is around 40 bps. Clearly, the higher inside debt provides larger incentive for CEOs to make selfish decisions at the expense of shareholders’ value.

The authors also explore factors that influence the relationship between CEO inside debt incentives and vertical acquisition announcement returns. As expected, agency problems are more pronounced when corporate governance and internal control are weak. Empirical results show that when acquirers manipulate earnings more frequently, have fewer institutional investors, have less industry competition, and hold excess cash, the negative effect of high inside debt incentive on a vertical acquisition’s CAR is more obvious.

Finally, these risk-averse CEOs also tend to pay a higher premium to acquire their targets. A one-standard-deviation increase in a CEO’s relative inside debt measures is associated with a 16-percentage-point increase in the acquisition premium.

This research helps practitioners to better assess the announcement returns of M&As to acquirers’ shareholders by considering managerial risk-taking incentives as well as types of M&As.

How Did the Authors Conduct This Research?

The authors construct their sample of M&As using the database from Securities Data Company (SDC) and obtain CEO compensation data from Compustat’s ExecuComp database. The base sample consists of 5,562 firm-year observations with relevant inside debt data between 2006 and 2011. Among the base sample, there are 1,405 completed M&As.

The authors construct the managerial risk-taking incentive as CEO’s inside debt/equity ratio scaled by the firm’s debt/equity ratio. The rationale is that, if the CEO’s inside debt/equity ratio (measured by CEO’s inside debt/CEO’s equity holdings) equals the firm’s debt/equity ratio, then the interests of the CEO and shareholders are aligned and the agency conflict is eliminated. On the contrary, if the CEO’s inside debt/equity ratio is much higher than the firm’s debt/equity ratio, there would be high incentive for the CEO to reduce the firm’s risk for self-benefit.

In the empirical test, the authors show that vertical M&As have the largest risk reduction effect compared with other types of mergers. Then, the authors use regression analysis to show that higher inside debt incentive leads to higher chance of vertical merger decisions, lower five-day CAR, and higher acquisition premiums. Finally, the factors strengthening these effects are analyzed.

The authors’ research is rigorous in the sense that potential endogeneity is ruled out by changing regressions, using instrumental variables, and employing the Heckman selection model. The results are also shown to be robust by the authors’ use of a tighter definition of vertical acquisitions and different control variables.

Abstractor’s Viewpoint

The structure of a CEO’s compensation package must be carefully designed. Previous researchers have showed that when CEO remunerations are linked with firm size, CEOs may recklessly target larger firms for acquisition even when those transactions result in negative net present values.

In addition, poor corporate governance may lead to value-destroying M&A decisions. An earlier researcher suggested that CEOs with more power tend to acquire larger firms but generate inferior CARs.

Investors should be alert when investing in these firms and at least require a high risk premium. In the long term, investors should participate actively in corporate governance and insist on board transparency and accountability.

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