Authors: Lucian A. Bebchuk (Harvard Law School), Alma Cohen (Tel Aviv University), and Charles C.Y. Wang (Harvard Business School)
Publisher: Harvard Law School John M. Olin Center Discussion Paper No. 683
Date Published: October 2012
Golden parachutes have been the subject of considerable debate since their widespread adoption in the late 1970s and early 1980s. This study will only add fire to that debate, giving investors reasons to both cheer and jeer these lucrative severance packages.
Proponents argue that the parachutes, which guarantee cash bonuses, stock options, or other benefits if upper-level managers lose their job in a merger or takeover, help attract and retain top talent. Without such protection, executives could be motivated to stick with a “sinking ship” and refuse to accept reasonable takeover offers.
But critics contend that the packages are too costly to shareholders and could lead to declines in management performance because executives who have a parachute are no longer fearful of a takeover. Congress has approved tax regulations seeking to curb large payouts, and the 2010 Dodd–Frank Act requires advisory shareholder votes on public firms’ implementation of golden-parachute policies.
This study provides empirical evidence that the presence of golden parachutes does have a beneficial effect on deals: Companies with golden-parachute policies are more likely to receive bids and be acquired by other firms. But the study also shows that companies with parachutes were underperformers on average, relative to their industry counterparts, before they adopted the packages — and that they continue to lag their peers in the years after implementing them.
Although investors may eventually benefit from a sale thanks to golden parachutes, they may find in the meantime that a company’s performance, in terms of firm valuation and stock returns, remains mired. Indeed, although golden parachutes are intended to ensure that executives act with their shareholders’ best interests in mind, the evidence shows that guaranteeing top managers a soft landing in the event of a takeover weakens the long-term value of their firms, the researchers contend.
The authors analyzed all companies in the Investor Responsibility Research Center (IRRC) reports issued from September 1990 to January 2006; the reports are released every two to three years. The IRRC reports cover firms in the S&P 500 and more than 90 percent of the combined market capitalization of the AMEX, Nasdaq, and NYSE stock exchanges. The final sample included 10,856 announced takeover bids from the 1990 to 2006 period, covering 9,277 target firms.
This data was merged with financial information from the Center for Research in Security Prices and Compustat databases. The authors used Tobin’s Q ratio, which is the market value of assets divided by book value, to measure firm valuation, as is standard in financial research. They controlled for variables including firm size, leverage, and industry.
The analysis showed that the number of firms offering golden-parachute policies has increased significantly. About 50 percent of the companies in the sample had golden-parachute agreements in 1990, but more than 77 percent offered them in 2006.
Firms with golden parachutes were much more likely to be takeover targets. On average, 6.68 percent of the firms in the sample that offered golden parachutes received a takeover bid or were acquired within the following year, compared with 4.67 percent of firms without such policies, a 43 percent higher likelihood.
The authors found that the presence of a golden-parachute policy reduces acquisition premiums — or the difference between a firm’s estimated purchase price and what it actually sells for — by 12.8 percent at the one-week mark and 19.2 percent at the four-week mark (two time periods were considered because M&A deals typically drag on for a bit). The authors attribute these lower prices to the incentives that golden parachutes carry for executives to complete deals.
Golden parachutes “can be expected to affect premiums by lowering the premium threshold above which an acquisition would be in executives’ private interests,” the authors write. “In addition, some lower-premium transactions that would not be in the interest of executives in the absence of a [golden-parachute policy] might become worthwhile” once such a policy is introduced.
But shareholders still benefit from the deals, the authors note, because the lower acquisition premiums are offset by the fact that these firms are more likely to be sold in the first place.
Investors may not be as pleased, however, by the relationship between golden parachutes and overall firm value. The authors found that in the two to three years between publication of IRRC reports, the implementation of a golden-parachute policy led to an average decrease of about 4.5 percent in a company’s Tobin’s Q ratio.
They found a similar effect when comparing stock returns. The stock of companies that adopted golden parachutes underperformed the stock of non-parachute firms by about 4.35 percent annually during the period around adoption and several years following adoption. “Results on the stock returns of long-term adopters versus long-term non-adopters suggest that firm performance tends to deteriorate in the presence of a [golden parachute],” the authors write, inferring that they “provide corporate executives disincentives to manage the firm efficiently.”
“This pattern does not provide support for theoretical predictions that [golden parachutes] improve performance by encouraging long-term planning and investments in firm-specific human capital,” the authors conclude. “Instead, our findings are consistent with the possibility that, by reducing the disciplinary force of the market for corporate control, [golden parachutes] lead to increased managerial slack.”
Companies that use golden parachutes to reward their ousted executives in the event of a takeover are targeted and acquired more often, and their shareholders benefit from those buyouts. But these firms also have lower value and subpar stock returns, on average, before adopting the parachutes, and they tend to continue to underperform with the parachutes.