(originally published by Booz & Company)

How CEO Compensation Affects M&A

Stock options lead to more deals, but not to better performance.

Title: Do Acquirer CEO Incentives Impact Mergers?

Authors: David A. Becher, Jennifer L. Juergens, and Jack R. Vogel (all Drexel University)

Publisher: Social Science Research Network

Date Published: July 2012

How CEOs receive stakes in their company has a significant impact on the frequency with which their firms move to acquire other companies and on the quality of the deals that result, according to this paper. The authors found that CEOs who receive large blocks of their company’s stock as part of their compensation package tend to spearhead fewer but superior deals that maximize shareholder value and produce better returns. By contrast, CEOs with higher levels of stock options strike more deals, and are more likely to employ costly outside advisors and pay higher premiums—often reducing shareholder value and crimping postmerger performance.

The difference, the authors say, can be traced to how each form of compensation shapes CEO incentives. CEOs with more actual stock seem to align with other shareholders and are cautious in pursuing mergers and acquisitions, whereas those with a large number of options may have a conflicted view of M&A that puts a bigger focus on their own interests. Although prior studies have indicated that mergers, on average, don’t create value for acquiring shareholders, compensation for the purchasing firm’s CEO tends to increase, the authors of this paper note, adding that the CEO’s “overall wealth and compensation appear relatively insensitive to poor post-merger performance.”

Prior studies on the broad effect of different forms of stock compensation on company performance have produced contradictory conclusions. Some studies have found that CEOs who are paid in actual shares lead better-performing companies, but others contend that such CEOs become “entrenched” and unwilling to roll the dice on risky but potentially lucrative projects. As for stock options, which give the holder the right to buy shares in the future at a set price, some researchers say that they encourage managers to boost firm performance, thereby increasing the value of their options when exercised. Others, however, see options as prodding CEOs to undertake overly risky short-term projects, to the long-term detriment of shareholders.

But little research has been done on how CEOs’ incentives might specifically affect M&A deals. The authors, who analyzed a large sample of mergers in the United States between 1996 and 2008, say this paper is the first to prove that “the mechanism by which the acquirer CEO is incentivized” prior to a merger affects both the merger structure and ultimately the success of the deal.

The authors combined several databases on large firms, their CEO and transaction characteristics, and the companies’ postmerger performance. Overall, the sample encompassed more than 3,000 firms, with an average market capitalization of US$6.54 billion; 36 percent of the companies announced at least one public or private merger during the period studied. Deals valued below the 25th percentile in the sample (around $106 million for public firms) were eliminated from the study, as were spin-offs, leveraged buyouts, and liquidations.

The authors first investigated whether the award of stock or options to a CEO affected a company’s decision to launch a merger bid the following year. Using regression analysis, and controlling for numerous firm and CEO variables, the authors found that the likelihood that a company would undertake a merger declined the more stock its CEO owned. (A 1 percent increase in stock ownership reduced merger activity by 17.2 percent.) The opposite was true for option-based compensation: A firm’s probability of launching a merger bid was increased by 1.33 times if its CEO received a 1 percent boost in options.

Although CEOs who owned more stock were less likely to undertake deals, they put them together in better ways for their shareholders when they did, according to the authors. For example, outside advisors have been shown to have potential conflicts of interest because their fees are highly contingent on sealing the deal rather than extracting maximum value for shareholders. After controlling for size and other deal variables, the authors found that a 1 percent increase in CEO ownership reduced the firm’s decision to hire an advisor by between 45 and 64 percent. On the other hand, a 1 percent increase in stock options for a CEO made it at least three times as likely the company would use an advisor.

Firms whose CEOs had high ownership stakes prior to a merger were also more likely to finance the deals using cash instead of stock. Previous research has shown that returns to acquiring companies are higher, on average, for cash-financed mergers and lower for stock-funded deals. Companies with stock-owning CEOs also paid lower premiums, on average, for the firms they acquired.

Finally, the authors examined the acquiring firms’ performance following the merger, tracking their stock returns for two years after the completion of the deal. “We find that performance of firms where CEOs had large ownership stakes pre-merger is significantly higher than at firms where CEOs had low ownership stakes,” the authors write.

The form of compensation awarded to CEOs thus has statistically and financially significant repercussions on the decisions surrounding merger deals, the authors say, and ultimately helps determine whether the deals are successful. “The broader implication of our study is that CEO ownership and option holdings are not interchangeable mechanisms when it comes to incentivizing CEOs, at least around mergers,” the authors conclude. “Separating the two, therefore, allows us to better isolate whether either mechanism aligns incentives with shareholders and may add to the debate on how to best compensate CEOs.”

Bottom Line:
The structure of CEOs’ incentive packages helps determine the likelihood and success of their firm’s acquiring another company. CEOs with larger ownership stakes in their companies are less likely to oversee an acquisition, compared with CEOs whose compensation is tied more to stock options. But when they act, stock-owning CEOs generally strike better deals for their shareholders and see improved postmerger performance.

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