Takeovers and (Excess) CEO Compensation

Isabel Feito-Ruiz is Assistant Professor in Corporate Finance at University of Leon (Spain); and Luc Renneboog is Professor of Corporate Finance at Tilburg University. This post is based on their recent paperRelated research from the Program on Corporate Governance includes Golden Parachutes and the Wealth of Shareholders by Lucian Bebchuk, Alma Cohen, and Charles C. Y. Wang (discussed on the Forum here).

An executive compensation contract, especially when it comprises equity-based remuneration, ought to align the managerial objectives with those of shareholders. In our paper Takeovers and (Excess) CEO Compensation, we study if a CEO’s equity-based compensation—especially when it seems excessive—affects the choice and expected value generation in takeovers announced by European firms.

According to the optimal contracting theory, equity-based compensation of top executives may be effective in shaping long-term corporate investment policies and encourage managers to make decisions that do not hurt the return required by shareholders. Giving shareholder-oriented incentives to top management leads to better takeover decisions (this is at least what the market seems to believe). Managers pay lower premiums for target firms in takeovers and undertake more risky investments when they receive high levels of equity-compensation. Therefore, stock option-based compensation motivate managers to take on projects that maximize shareholders’ value (even in the absence of active ownership).

In our paper, we ask the following questions: (i) does CEO equity-compensation (LTIPs and stock options) have a positive effect on the bidder’s expected shareholder valuation at an M&A announcement?; (ii) how does CEO equity-compensation interact with other monitoring mechanisms (such as concentrated ownership) in the context of takeovers?; and (iii) does excessive top executive remuneration affect the takeover decision and the transaction value?

Examining the takeover transaction at the announcement, we first find that bidders’ shareholders put a higher expected value (higher expected synergies) on these deals for firms of which CEOs receive a higher level of equity-based compensation. This suggests that the shareholders have more faith in takeover decisions when the proceeds/losses will also be shared with the top management (through their equity claims when the options and restricted stock vest).

Whereas in widely-held firms, the decision power is with the management, in firms with concentrated ownership, the decision power may be with the major blockholders which may entail that ownership concentration and equity-based pay are substitutes. Given that we work with a sample of European acquisitions and that a large subsample of bidders have concentrated ownership, we also focus on the role of large shareholders as monitors and decision makers, as well as a detailed analysis of ownership involving the distinction between who holds the dominant share blocks (families, corporations, financial institutions) along with minority share blocks. Our findings contribute to the view that the effectiveness of a corporate governance mechanism depends on the corporate context such as corporate ownership, which is more concentrated in Continental Europe than Anglo-American countries. Agency problems between shareholders and managers are in general lower in the Continental European countries because blockholders have more incentives to monitor managers and they can force the managers to carefully ponder on value-creating acquisition strategies in order to avoid suboptimal risk investment decisions. Still, in these countries, another type of agency problem may arise: that between the majority shareholder and minority blockholders. Given that our dataset covers continental Europa and the UK, both types of agency costs may arise. The dichotomy between shareholder-management and majority-minority shareholders does not perfectly coincide with regional borders (market- based versus blockholder-based governance systems). Specifically, not all UK firms are widely-held: a minority of listed UK firms (about 10–15% and mostly firms in the trade and logistics industry) have larger blocks amounting to more than 25% of the equity. The average of the largest share block of listed UK firms amounts to 14.5%; whether or not this share stake is powerful enough to trigger majority-minority agency problems depends on the concentration of shares in minority blocks held. Even in a country with strong ownership concentration such as Germany, about one fifth of German listed firms do not have a blockholder owning 20% or more of the shares. Consequently, both types of agency problems may arise to some extent both in the UK and in Continental European countries. For these reasons, we study different degrees of ownership concentration, ownership by type of shareholder, and the presence of a dominant shareholder of a specific type in addition to minority shareholders (by type). Our findings show that the major blockholders do not have an impact on the relation between the CEOs’ equity-based compensation and the M&A announcement with exception of the dominant corporate blockholders whose presence erodes the relation between the bidder’s shareholder value at announcement and the equity-based pay. The latter result is consistent with a substitute effect between the monitoring role of concentrated ownership (held by corporations) and the self-regulatory role of equity-based compensation.

While equity-based pay turns management into co-owners and should make their decision making more value-oriented, it is possible that powerful CEOs in companies with weak boards and lack of actively monitoring shareholders manage to set their own pay (and pay-for-performance structure) which could lead to excesses. We therefore estimate a “normal” or expected remuneration for the CEO considering some of his traits (such as age, and tenure or experience), firm attributes (such as size and financial performance), industry, country (e.g. the degree of investor protection), and the year of pay. We then obtain excess pay by subtracting expected from actual pay. We demonstrate that excess compensation negatively affects the acquirer’s stock valuation at a takeover announcement. Public concerns about the excess remuneration of top managers have shown that CEOs’ compensation could blur fair managerial corporate investment judgments and be regarded as an agency problem (managerial power theory).

The complete paper is available here.

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