THE EFFECTS OF MUTUAL FUNDS ON M&A COMPENSATION

• DOI: http://doi.org/10.1111/jfir.12139
• Published date: 01 March 2018
• Date: 01 March 2018

THE EFFECTS OF MUTUAL FUNDS ON M&A COMPENSATION

Patty Bick and Matthew D. Crook

The University of Tulsa

Abstract

Motivated by shareholders’interest in combating executive wealth expropriation

through the merger and acqusition (M&A) process, we study how mutual funds

influence firm behavior around an acquisition through votes against management

proposals. We find that mutual funds reduce the chief executive officer’s ability to

extract rents during the M&A process by voting against management-sponsored

compensation proposals after the acquisition, thus lowering both excess compensation

and increasing pay-for-performance sensitivity. Furthermore, mutual fund voting

magnifies the impact on negatively performing firms and firms with a larger amount of

the mutual fund’s holdings in the firm.

JEL Classification: G34

I. Introduction

The prior literature finds that chief executive officers (CEOs) have incentives to pursue

mergers and acquisitions (M&As) even when the deal fails to benefit shareholders. In

general, acquiring firm CEOs obtain greater total compensation (Bliss and Rosen 2001),

higher bonuses (Grinstein and Hribar 2004), and flatter compensation sensitivities to

poor firm performance (Harford and Li 2007) after deals complete. Boards attribute

increases in compensation to managerial skill facilitating deal completion, but empirical

evidence suggests compensation increases result from growth in firm size postacqui-

sition and organizational complexity regardless of management skill (Anderson, Becher,

and Campbell 2004; Grinstein and Hribar 2004). Harford and Li (2007) find that the

median total compensation increases by 41% from the fiscal year before an acquisition

announcement to the fiscal year after deal completion, with more pronounced

compensation gains for CEOs when firms have poor governance. Moreover, Rosen

(2005) finds that CEOs who receive greater than expected compensation after one

acquisition are more likely to pursue additional acquisitions. As compensation tends to

be sticky, increases around acquisitions have a lasting effect on the efficacy of a CEO’s

compensation. Therefore, acquisitions serve as important events in which to study

factors that can curtail excessive compensation.

We are grateful for assistance and comments from Drew Winters (editor), Angela Morgan (reviewer), Laura

Field, Joel Harper, Michelle Lowry, Andrew Lynch, Fenghus Song, Brian Walkup, and seminar participants at the

Pennsylvania State University, University of Saskatchewan, and University of Tulsa. This research was supported

in part by a research grant from the Smeal College of Business. All errors and omissions are our own.

The Journal of Financial Research Vol. XLI, No. 1 Pages 67–89 Spring 2018

67

© 2018 The Southern Finance Association and the Southwestern Finance Association

Using a sample of acquisitions from 2003 to 2010, we examine whether mutual

funds, as large shareholders, affect CEO compensation after an acquisition through

shareholder activism. Although activist shareholders cannot directly control CEOs’

compensation, they can affect it. Chen, Harford, and Li (2007) examine the incentives of

independent long-term monitoring institutions (large blockholders) to monitor around an

acquisition. In the event of poor decisions, blockholders influence management to alter

such decisions. As large shareholders, mutual funds have incentives to pursue value-

increasing initiatives at shareholder meetings. Morgan et al. (2011) examine mutual fund

voting on shareholder proposals and find that funds tend to vote for shareholder proposals

to increase shareholder wealth. In contrast to Morgan et al., we examine votes on

management-endorsed proposals (compensation and director proposals). By voting

against management-endorsed proposals via proxy votes, mutual funds potentially

influence compensation outcomes after an acquisition announcement.

1

Results show that firms respond to mutual fund votes: votes against management

on compensation and director election issues reduce subsequent excess compensation.

Active monitors exert more effort to acquire information and act on information, and thus

have more impact on firm behavior (Almazan, Hartzell, and Starks 2005). We contend

that a monitoring fund, a fund holding a firm as one of its top 50 holdings, qualifies as an

active monitor. On average, we find that a 10 percentage point increase in votes by

monitoring funds against management in compensation and director election proposals

reduces excess compensation by 9.8% after deal completion. For firms with more than

20 monitoring funds, the excess compensation drops by 23.2% for a 10% increase in

monitoring votes against management.

In addition to compensation levels, we study pay sensitivity to postacquisition

performance changes. Although CEOs are paid for good performance, executive pay is

less sensitive to poor performance (Garvey and Milbourn 2006; Harford and Li 2007). In

our sample, we find that a 1% decrease in firm value in the fiscal year after M&A

completion decreases compensation by 0.26% in the same period if no mutual funds

voted against management after the deal announcement. Additionally, we find that

voting by monitoring funds increases pay for performance sensitivity (PPS) for poorly

performing firms. With average voting of 10% against management by monitoring

mutual funds, a 1% decrease in firm value decreases compensation by an additional

0.1%, raising the total sensitivity of pay due to a 1% loss in firm value to 0.37%. This

level of voting against management brings the executive’s pay sensitivity to negative

performance in line with those of positive performance. The results indicate that poorly

performing firms receiving votes against management by monitoring mutual funds

punish CEOs with slightly less pay after M&As. Voting insignificantly affects pay

sensitivity to good firm performance.

Our study contributes to two strands of literature: M&A compensation and

shareholder activism. Prior M&A studies show that CEOs have power over the board in

negotiating pay (Harford and Li 2007; Grinstein and Hribar 2004). We examine how

1

Although mutual funds can also initiate shareholder proposals, the ratio of shareholder-initiated proposals to

management-initiated proposals is roughly 2%. The infrequent nature of shareholder proposals would not have a

large impact on the majority of firms.

68 The Journal of Financial Research