DOES EQUITY‐BASED COMPENSATION MAKE CEOS MORE ACQUISITIVE?

• Author: Marcus V. Braga‐Alves,Frederik P. Schlingemann,Thomas J. Boulton
• Published date: 01 September 2014
• DOI: http://doi.org/10.1111/jfir.12037
• Date: 01 September 2014

DOES EQUITY‐BASED COMPENSATION MAKE

CEOS MORE ACQUISITIVE?

Thomas J. Boulton

Miami University

Marcus V. Braga‐Alves

The University of Akron

Frederik P. Schlingemann

University of Pittsburgh, Rotterdam School of Management

Abstract

Theory is conflicted on the impact of equity‐based compensation on managerial risk

taking. We explore this issue by studying the relation between equity‐based

compensation and firms’propensity to make acquisitions. Consistent with the notion

that equity‐based compensation encourages managerial risk taking, we report a positive

relation between equity‐based compensation and CEO acquisitiveness. Additionally, we

find that the number of acquisitions, acquisition size, use of equity as payment, and

propensity to acquire private firms are all positively associated with equity‐based

compensation. Abnormal returns around acquisition announcements suggest that the

impact of equity‐based compensation is not uniformly positive for acquiring‐firm

shareholders.

JEL Classification: G34, J33

I. Introduction

The exposure of CEO wealth to their firms’stock price has increased dramatically in

recent years (see, e.g., Hall and Liebman 1998; Core, Guay, and Larcker 2003). Bebchuk

and Grinstein (2005) show that for a large sample of firms, equity‐based compensation

increased more than 400% from 1993 to 2000 and, despite a drop in later years, is still

approximately 150% larger in 2003 than in 1993. In contrast, cash‐based compensation

has increased approximately 40% during the same period and has never grown more than

50% relative to 1993. Kaplan (2008) also documents that CEO pay has decreased

substantially since 2000 but emphasizes that pay‐for‐performance remains very high.

Some argue that managerial wealth that is highly sensitive to firm performance

better aligns the interests of managers with outside shareholders. For example, Smith and

Stulz (1985) and Hirshleifer and Suh (1992) contend that properly constructed

We thank Randy Heron (associate editor), Jay Cai (referee), Bradley Benson, Nont Dhiensiri, Shawn Thomas,

Evangelos Vagenas‐Nanos, and seminar participants at the 2013 Financial Management Association meetings

(Chicago), 2014 Midwest Finance Association meetings (Orlando), and the University of Pittsburgh for valuable

comments. Any remaining errors or omissions remain the responsibility of the authors.

The Journal of Financial Research Vol. XXXVII, No. 3 Pages 267–293 Fall 2014

267

© 2014 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

compensation contracts can increase the likelihood that a firm’s managers pursue valuable

risky investment projects. Others, including Amihud and Lev (1981), suggest that

compensation plans that closely link managerial wealth to share prices might instead

induce risk‐averse behavior on the part of managers seeking to avoid the downside

possibilities of undertaking risky investments. At the other extreme, a recent survey by the

Institute of International Finance finds that a striking 98% of respondents from major

financial institutions “believe that compensation structures in the financial services

industry were a factor underlying the crisis”because of excessive risk taking by the CEO.

1

Mergers and acquisitions (M&A) provide a unique backdrop for studying the

incentive effects of executive compensation as they are often the largest, and the riskiest,

investments made by a firm. Although many acquisitions add value for acquiring firm

shareholders, including managers with equity‐based compensation, a significant fraction

turn out poorly. In fact, Andrade, Mitchell, and Stafford (2001) find that from 1973 to

1998, based on 4,256 deals, acquirer shareholder wealth declined on average 3.8%

between the deal announcement and completion. However, Harford and Li (2007)

document that CEOs are better off in three‐fourths of the cases where shareholder value is

actually destroyed as their pay becomes insensitive to negative stock performance, but

remains sensitive to positive stock performance. This raises interesting questions: (1)

Does equity‐based compensation affect the likelihood of announcing an acquisition? and

(2) Conditional on making an acquisition, does equity‐based compensation affect deal

characteristics and target selection?

Datta, Iskandar‐Datta, and Raman (2001) find that equity‐based compensation is

positively correlated with stock price performance around and following acquisitions.

2

Overall, their results tend to support Morck, Shleifer, and Vishny’s (1988) contention that

equity‐based compensation reduces misalignment of incentives between managers and

shareholders. In contrast, the results in Harford and Li (2007) are inconsistent with the

incentive alignment hypothesis.

We address the question of whether and how equity‐based compensation affects

the likelihood that a firm is an acquirer. The findings of Datta, Iskandar‐Datta, and Raman

(2001) might indicate that equity‐based compensation leads firms to consider only those

opportunities they view as “can’t miss,”leading to fewer, albeit generally better,

acquisitions. Alternatively, equity‐based compensation might motivate management to

pursue takeovers equally or more actively while executing greater due diligence and

under more favorable terms. We investigate the relation between equity‐based

compensation and firms’propensity to pursue acquisitions.

We consider competing hypotheses regarding the relation between equity‐based

compensation and firms’acquisition activities. Our risk seeking hypothesis, which is

motivated by studies such as Jensen and Meckling (1976) and Smith and Stulz (1985),

predicts a positive relation between equity‐based compensation and firms’propensity to

acquire and willingness to take risk through these transactions. Specifically, the risk

1

Institute of International Finance, 2009, “Compensation in financial services: Industry progress and the

agenda for change.”

2

Masulis, Wang, and Xie (2007) fail to find a positive relation between equity‐based compensation and

acquisition returns. We also explore this issue in detail.

268 The Journal of Financial Research