In corporate takeovers, firm specific equity holdings of target and acquirer managers provide two different incentives that may affect the takeover wealth effects for firms’ shareholders. First, managers stand to share the benefit from the takeover wealth gains via any increase in the value of their firm-specific equity portfolio which induces them to undertake value-maximizing investment decisions.
Second, they can use the takeover transaction as an opportunity to obtain liquidity (target managers) or increase the diversification level of the firm (acquirer managers) to reduce or eliminate the risk of holding an undiversified firm-specific equity portfolio. In pursuit of liquidity or portfolio diversification, managers may take acquisition decisions at the expense of firms’ shareholders. Prior research has examined this issue largely from the standpoint of effectiveness of equity-based compensation in corporate takeovers. In this study, I extend the extant literature and identify two competing hypotheses that potentially explain the effect of target and acquirer CEOs’ equity incentives on takeover wealth gains.
Both target and acquirer CEOs share the benefit from takeover wealth gains via an increase in the value of their equity portfolio invested in the firm’s stock. Thus higher equity based incentives (or more aligned) for managers will induce them to act in the interests of their shareholders. Based on this, the Incentive Alignment hypothesis predicts that both target and acquiring firm shareholders’ wealth gains from takeovers are positively related to the equity-based incentives of target and acquiring firm managers, respectively.
On the other hand, a target manager, whose ability to diversify his equity portfolio is constrained by trading limitations, may sacrifice takeover premiums in order to benefit from the opportunity of liquidating his equity portfolio through the takeover transaction. The benefits from portfolio liquidation is likely to increase as more of the manager’s wealth is linked to the firm’s wealth, thus at higher levels of manager’s equity incentives. Consequently, the Diversification driven-liquidity hypothesis predicts that target wealth gains are decreasing in the level of target CEO’s equity incentives. I expect this hypothesis to be more dominant for target managers in undiversified firms relative to the target managers in diversified firms.
From the acquiring CEO’s perspective, in addition to the incentive alignment, diversification objectives may also play a role in determining the relation between equity incentives and acquirer wealth gains. Since acquirer CEO’s equity portfolio is not fully diversified, he may undertake value-destroying diversifying acquisitions in order to decrease the risk of his portfolio. Therefore, according to the Diversification hypothesis for acquirer CEOs, acquirer firm returns are expected to decrease in the equity incentives of the acquiring CEO, if the acquirer firm is undertaking a diversifying acquisition.
I use a sample of 760 public U.S. target firms, consisting of 656 completed and 104 failed takeovers and examine these competing hypotheses to explain the relationship between managerial incentives and takeover wealth gains in target and acquiring firms. The sample period is from January 1, 1994, to December 31, 2003. I define equity-based incentives (EBI) of the manager as the dollar change in the value of stock and stock options that the CEO holds, for every $100 change in the total shareholders’ wealth in the year prior to the acquisition announcement. This measure aims to capture the degree of alignment of CEOs with their firms’ shareholders.
Download
PDF Ebook Managerial Incentives And Takeover Wealth Gains
