Value creation around merger waves: The role of managerial compensation

• Author: Athanasios Tsekeris,David Hillier,Patrick McColgan
• Date: 01 January 2020
• Published date: 01 January 2020
• DOI: http://doi.org/10.1111/jbfa.12419

DOI: 10.1111/jbfa.12419

Value creation around merger waves: The role of

managerial compensation

David Hillier1Patrick McColgan2Athanasios Tsekeris3

1StrathclydeBusiness School, University of

Strathclyde,Glasgow, UK

2Department of Accounting and Finance,

University of Strathclyde,Glasgow, UK

3Department of Accounting and Finance,

Nottingham TrentUniversity, Nottingham, UK

Correspondence

AthanasiosTsekeris, Department of Account-

ingand Finance, Nottingham Trent University,

NottinghamNG1 4BU, UK.

Email:athanasios.tsekeris@ntu.ac.uk

Abstract

This paper examines the relation between executive compensation

and value creation in merger waves.The sensitivity of CEO wealth to

firm risk increases the likelihoodof out-of-wave merger transactions

but has no influence on in-wave merger frequency.CEOs with com-

pensation linked to firm risk have better out-of-wave merger per-

formance in comparison to in-wave mergers. We also present evi-

dence that cross-sectional acquirer return dispersion is greater for

in-waveacquisitions. Our results suggest that the underperformance

of acquiring firms during merger waves can be attributed in part

to ineffective compensation incentives, and appropriate managerial

incentives can create value, particularly in non-waveperiods.

KEYWORDS

deal performance, delta, incentive compensation, merger waves,

vega

JEL CLASSIFICATION

G31, G34, M12

1INTRODUCTION

Merger waves cluster across time and industry (Moeller, Schlingemann, & Stulz, 2005; Powell & Yawson, 2005).

Mitchell and Mulherin (1996) propose that exogenousshocks to the cost and revenue structure of industries, including

changes in technology and government regulations, drive merger waves.Shleifer and Vishny (2003) argue that waves

are driven by the relativevaluations of acquiring and target firms, and Garfinkel and Hankins (2011) show that merger

activity is positively related to uncertainty about future cash flows. The value impact of merger waves is overwhelm-

ingly negative with significant post-merger acquirer underperformance reported by many authors (Bouwman, Fuller,

& Nain, 2009; Moeller et al., 2005).

Duchin and Schmidt (2013) find monitoring quality is poorer and information asymmetry higher during merger

waves, which they attribute to weak acquirer corporate governance.In this paper, we directly test this hypothesis by

asking whether CEO compensation incentives influence merger value creation around merger waves. Given its likely

impact on CEO behaviour (Croci & Petmezas, 2015; Lahlou & Navatte,2017), remuneration incentive structure (Delta

and Vega ) will affect corporate merger performance, conditional on levelsof merger activity.

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2019 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2020;47:132–162.

HILLIER ET AL.133

In non-wave periods, when information asymmetries are low (Duchin & Schmidt, 2013), we predict that CEOs will

respond positively to ex-ante compensation incentives that reward risky projects (Coles, Daniel, & Naveen, 2006). For

all merger decisions, managers receiveprivate benefits of control including ex-post increases in CEO compensation (Fu,

Lin, & Officer,2013; Goel & Thakor, 2010). During merger waves, weak monitoring conditions mean private benefits of

control dominate ex-ante compensation incentives, and this will minimize the link between CEO incentives and (a) the

propensity to acquire, and (b) acquiring firm performance.

Consistent with our expectations, we find that ex-ante CEO cash compensation is higher and pay-risk sen-

sitivity, Vega, is lower for acquiring firm executives during merger waves compared to CEOs who lead out-of-

wave mergers. We find no evidence that CEO compensation incentives are related to acquisition activity dur-

ing merger waves, suggesting sub-optimal compensation design. In contrast, the relationship between Vega and

the likelihood of initiating an acquisition is positive during out-of-wave periods. This is consistent with the view

that higher pay-risk sensitivity reduces managerial risk aversion (Billett, Mauer, & Zhang, 2010; Coles et al.,

2006).

If in-wave acquisitions destroy value for the acquirer (e.g. Moeller et al., 2005), they should not be among

the investment choices of CEOs whose interests are closely aligned to stockholders. We propose that the supe-

rior performance of out-of-wave deals can be partially explained by stronger compensation incentives and our

empirical evidence supports this proposition. While Delta and Vega are positively related to short- and long-term

stock price returns for out-of-wave acquisitions, no consistent relation is found for mergers initiated during a

wave.

We also examine the standard deviation of cross-sectional post-acquisition abnormal returns for in-waveand out-

of-wave acquiring firms. During merger waves, companies that make low-quality acquisitions can more easily pool

their performance with other acquiring firms and avoidinvestor scrutiny (Duchin & Schmidt, 2013). The larger number

of merger events and performance variability leads to greater dispersion in post-acquisition returns (Yung, Colak, &

Wang, 2008). Wefind that firms engaging in merger activity during in-wave periods experience a higher dispersion of

abnormal returns post-acquisition. In contrast,during out-of-wave periods, high Ve ga CEOs makeacquisition decisions

characterizedby a lower dispersion in cross-sectional post-acquisition returns. This supports our proposition that CEO

compensation during out-of-wave periods incentivizes acquiring firm CEOs to avoid low-quality acquisitions. On the

other hand, we observe no difference in the dispersion of cross-sectional post-acquisition returns between high and

low incentive compensation CEOs during in-waveperiods.

Our paper makes a number of contributions to the literature. We extend the findings of Duchin and Schmidt

(2013), who show that adverse selection costs and inefficient monitoring of firm management can explain the acquir-

ing firm underperformance during merger waves. This is driven, in part, by weakercompensation incentives provided

to acquiring firm CEOs. Outside of merger waves, executivesrespond to pay-risk compensation incentives by making

a larger number of acquisitions that create value for shareholders and display greater consistency in post-acquisition

performance. During merger waves, compensation incentives are unrelated to deal performance and propensity to

acquire.

Our results have implications for the optimal design of CEO compensation contracts. We show that the effec-

tiveness of risk-seeking compensation incentives (see Cohen, Dey, & Lys, 2013; Coles et al., 2006) is contingent on

takeover market activity.Outside of merger waves, CEO risk-taking incentives increase the likelihood of managers

undertaking mergers and the performance of acquiring firms, whereas such incentives are ineffective during merger

waves. Our findings are robust to endogeneity testing (3SLS, PSM, predicted incentives) and a number of sub-sample

analyses.

The paper is organized as follows. Section 2 surveys the literature on merger waves, executive compen-

sation and merger performance, and develops our empirical hypotheses. Section 3 outlines the construction

of the sample and identification of merger waves. Section 4 presents our empirical results and Section 5

concludes.