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This paper investigates the relationship between a firm "s corporate governance structure and the abnormal returns associated with acquisition announcements. Based on a sample of 294 acquisitions occurring from 1994 through 1998, it is found that acquiring firms have significant two-day abnormal returns of-2.71%. A multiple regression model that includes corporate governance variables has an Adjusted R-squared of 14.2% with board size, the sensitivity of the CEO's wealth to changes in share price, method of payment, and acquiring firm size all being significant explanatory variables.
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The modern corporation is a complex organization of interlocking relationships. For publicly held companies, one of the most important relationships is between the owners and managers of the firm. This relationship is a classic example of the principal-agent relationship and is characterized by a potential misalignment of goals where the agent may behave in his own interest instead of acting in the principal's interest. A firm's corporate governance structure can be used to reduce the total agency costs of a firm through the monitoring of management actions and by aligning the managers' self-interests with those of shareholders.
The board of directors has the responsibility to represent shareholders by monitoring top management. They do this by hiring and firing management, designing the executive compensation contract, and voting on major firm decisions. However, recent events from Enron to WorldCom indicate that the board may not always adequately monitor management. These events have stirred calls for board reform and the effect of board structure on corporate decision making is an important and widely debated topic.
A firm's compensation policy should be designed to attract and retain quality managers and also to align the managers' incentives with shareholders. Executive compensation is primarily composed of a base salary, a bonus often tied to accounting returns, and equity-based incentives. Stock option grants are an increasingly important component of compensation and can align interests by making compensation and overall wealth more sensitive to shareholder performance.
This study investigates the relationship between corporate governance and agency costs by examining the abnormal returns to acquisition announcements. While there are a variety of explanations for acquisitions that increase shareholder wealth, many acquisitions actually reduce shareholder wealth in both the short-run and the long-run. One explanation is that shareholder wealth reducing acquisitions are the result of the failure of corporate governance mechanisms to properly align managers' interests with those of shareholders.
The following section of this paper reviews the literature on corporate governance and mergers. The third section presents the data and methodology, followed by the empirical results in the fourth section. The final section summarizes the findings with suggestions for further research.
Literature Review
The existing literature investigating the relationship between managers' interests and mergers examines the issue from varying perspectives. Morck, Shleifer, and Vishny (1990) test managerial self-interest indirectly by arguing that self-interested managers will either diversify or buy growth firms. Since these types of acquisitions were found to be more likely to reduce shareholder wealth, they concluded that they were driven by self-interest. Kroll, Simmons, and Wright (1990) found that CEO compensation increased following acquisitions due in part to the increased size of the firm. CEO shareholdings and incentive plans were found to be positively related to announcement cumulative abnormal returns (CARs) by Travlos and Waegelein (1992). Ueng (1998) also found that managers with large stockholdings relative to salary are more likely to make acquisitions that increase shareholder wealth. Datta, Iskandar-Datta, and Raman (2001) find that the proportion of equity-based compensation (EBC) leads to higher abnormal returns in mergers. All of these papers support the idea that managers may behave in their own interest in merger decisions as opposed to focusing on shareholders' interest.
This paper differs in that it tries to take a broader perspective of corporate governance. If the corporate governance structure is effective, then the manager is less likely to make shareholder-wealth reducing decisions, including acquisitions. However, the question arises as to what factors affect governance effectiveness. The variables used in this study include the proportion of the board represented by independent outsiders, the size of the board of directors, and the sensitivity of the CEO's equity-based wealth to stock price.
The role of the board of directors in modern corporations has become increasingly important in recent years. Critics have pointed to scandals at Enron, WorldCom, and Tyco (just to name a few) as evidence that boards have become too lax in their duties and simply rubberstamp the actions of CEOs. These failures of corporate governance have opened the door to government involvement such as Sarbanes-Oxley or Eliot Spitzer. While there have been many suggestions for board reform, reducing board size and increasing board independence are two of the most common and tested recommendations.
Fama (1980) and Fama and Jensen (1983) recommend the use of independent outsiders on the board of directors. As support, Weisbach (1988) finds that the relationship between executive turnover and performance is stronger for outsider dominated boards. Byrd and Hickman (1992) find that tender offer bidders are best served when outsider representation is close to 60% of the board. Rosenstein and Wyatt (1990,1997) find that the share price response was positive to announcements of outside directors and insignificantly negative to the addition of inside directors. Thus, there is some empirical evidence that supports the argument that outside representation on the board might result in better monitoring. This leads to the first hypothesis of this paper stated in null form.
Hypothesis 1 : Acquisition abnormal returns are unrelated to the proportion of outside directors.
Board size has also been suggested as a possible factor affecting monitoring quality by Lipton and Lorsch (1992) and Jensen (1993). Yermack (1996) finds that the log of board size is negatively related to Tobin's Q. Core, Holthausen, and Larcker (1999) find that CEOs are able to extract greater pay from larger boards. However, there is also evidence that large boards do a better job. Grinstein and Hribar (2004) find that larger boards tend to pay smaller M&A bonuses to managers. The effect of board size then becomes an empirical question tested in the second hypothesis.
Hypothesis 2: Acquisition abnormal returns are unrelated to board size.
While the structure of the board is part of corporate governance, one must also examine what the board does. One of the most important functions of the board is determining the compensation of executives and the degree to which a manager's wealth is tied to shareholder wealth. While setting compensation is not the only monitoring function of the board, it is a function that has been criticized as an example of CEOs having excess influence over the board. Other monitoring functions might involve the threat of firing managers for inferior performance and the level of effort put forth by outside directors in evaluating firm decisions, including mergers; however, these functions cannot be observed and measured as easily as the compensation sensitivity.
Jensen and Murphy (1990), among others, argue that compensation is not effectively related to share performance for many firms. Baker, Jensen, and Murphy (1988) and Rose and Shepard (1997) show that factors such as firm size and degree of diversification also affect compensation levels. Thus, a manager might be better off if an acquisition increases size and/or diversification even if shareholder wealth is reduced.
Since compensation structure may change dramatically from year to year, the use of a single year's compensation may not capture the true alignment between the manager's wealth and shareholder wealth. To better capture this, a measure of the sensitivity of the CEO's total firm-related wealth to changes in share price is included. If abnormal returns to acquisitions are positively related to the sensitivity of the CEO's total wealth to changes in share price, then this would provide evidence that greater wealth sensitivity results in better alignment between managers and shareholders as tested in the third hypothesis.
Hypothesis 3: Acquisition abnormal returns are unrelated to the sensitivity of the CEO's total wealth to changes in share price.
These hypotheses investigate agency conflict within firms by examining its effect on acquisition decisions. In addition to the above variables, control variables representing whether the acquisition was made with cash and the size of the acquiring firm are also included. These variables have been found to be related to merger returns and are included to isolate the effects of the tested variables.
Data and Methodology
This study basically involves a two-step procedure. First, an event study on acquisition announcements is used to determine the acquiring firm's abnormal returns. Second, these abnormal returns are used as the dependent variable in regression models in order to explain the cross-sectional variation in abnormal returns.
The sample includes 294 acquisitions that were completed from 1994 to 1998. In order to be included in the sample, the acquisition could not involve regulated utility or financial firms, foreign firms, or privately-held firms. Sufficient data for the companies also had to be available from CRSP, Compustat, and proxy statements. In order to reduce the level of noise in the findings, the target firm had to have a market value of at least 10% of the acquiring firm, there could not be a preexisting relationship between the firms, the acquiring firm could not have made an earlier acquisitions in the same fiscal year, and there could be no confounding events around the two-day event window. Table 1 summarizes the sample selection process and reasons for exclusion.
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