Inside Debt and Mergers and Acquisitions

In my paper Inside Debt and Mergers and Acquisitions, forthcoming in the Journal of Financial and Quantitative Analysis, I examine the link between CEO inside debt holdings and corporate risk-taking in M&A activities and its implications for bondholder, shareholder, and firm value. M&As are among the largest and most readily observable forms of corporate investment, which tend to intensify the inherent conflict of interests among shareholders, bondholders, and managers. Manager’s pension benefits and deferred compensation are debt-like compensation since they represent fixed obligations by the company to make future payments to corporate insiders/managers (hence, these are usually referred to as “inside debt”). Inside debt is expected to align manager interests with those of external debtholders and alleviate managers’ risk-taking incentive since inside debt is typically unsecured and unfunded, and if the firms go bankrupt, managers have equal claims as those of other unsecured creditors. Therefore, M&As provide a unique ground for testing the potential effects of debt-like compensation on corporate investment and financing strategies and the implications of the stakeholders’ interests.

In my research, I use relative CEO leverage, which is measured as the ratio of CEO’s debt-to-equity scaled by the firm’s debt-to-equity ratio, and relative CEO incentive, which is the ratio of the marginal change in the value of CEO inside debt holdings to the marginal change in CEO inside equity holdings given the change in firm value, all scaled by the firm’s respective ratio, to test the effects of CEO’s inside debt holdings on M&A propensity, the selection of M&A target, the choice of financial leverage, payment consideration, and their implications for the acquirer’s operating performance and shareholder and bondholder wealth.

Using a panel of 2,822 firm-year observations of 891 unique firms that had positive CEO inside debt holdings over the period from 2006 to 2009, I find that CEO inside debt holdings are negatively correlated with firms’ M&A propensity. My analysis of a subsample of 296 unique firms that pursue 581 M&A deals over the period from 2007 to 2010 indicates that large CEO inside debt holdings are associated with industry diversification, smaller proportion of cash payment for the targets, lower financial leverage, and smaller increase in firm risks post merger. Further investigation indicates that CEO inside debt holdings are positively correlated with short-term M&A announcement abnormal bond returns and long-term operating performance, but negatively correlated with M&A announcement abnormal stock returns. In addition, I find that acquiring firms restructure CEO compensation packages post merger to mirror their capital structure. Overall, my evidence suggests that CEO inside debt holdings motivate risk-decreasing M&As which benefits the acquirer bondholders at the expense of shareholders in the short term; however, acquiring firms restructure CEO compensation packages post merger to mitigate CEOs’ incentive to pursue corporate activities that lead to wealth transfer from shareholders to bondholders or vice versa in the long term.

Besides contributing to the financial economics literature, my research adds to the ongoing debate on the efficiency of inside debt as a form of compensation, which has significant implications for improving executive compensation efficiency as well as M&A outcomes. It was widely believed that excessive risk taking, motivated by the overwhelming equity compensation to CEOs, was one of the main drivers of the most recent economic recession. My research suggests that compensating CEOs with inside debt could mitigate CEOs’ risk-taking incentive in corporate financing and investment. Furthermore, setting the CEO inside leverage that resembles corporate financial leverage would alleviate the risk of wealth transfer from bondholders to shareholders or vice versa.

The full paper is available for download here.