Employee-Manager Alliances and Shareholder Returns from Acquisitions

Ronald Masulis is Scientia Professor of Finance at University of New South Wales Australian School of Business; Cong Wang is Professor of Finance at The Chinese University of Hong Kong, Shenzhen and the associate director of Shenzhen Finance Institute; and Fei Xie is Associate Professor of Finance at the Alfred Lerner College of Business & Economics at University of Delaware. This post is based on their recent article, forthcoming in the Journal of Financial and Quantitative Analysis.

In our recent article titled Employee-Manager Alliances and Shareholder Returns from Acquisitions, forthcoming in the Journal of Financial and Quantitative Analysis, we examine the potential for management-worker alliances when employees hold substantial voting rights due to their equity ownership, and how such alliances affect the agency relationship between managers and shareholders in the context of corporate acquisition decisions.

Employee equity ownership can provide workers with substantial cash flow and voting rights. The cash flow rights give workers residual claims to firm profits, partially aligning their interests with shareholders. Employee voting rights, on the other hand, can be a key factor in determining the likelihood of a firm becoming a takeover target as well as the outcome of such control contests (Gordon and Pound (1990), Chaplinsky and Niehaus (1994), and Rauh (2006)). Together, employee ownership of cash flow rights and voting rights makes them an important force that can affect corporate governance and firm policies.

We develop two competing hypotheses regarding the effect of employee equity ownership on managerial behavior in corporate acquisition decisions. On the one hand, employee equity ownership can enable managers to make ill-advised acquisitions. The theory of management-worker alliances developed by Pagano and Volpin (2005) suggests that when workers control substantial voting rights, they can use their power to protect managers from hostile takeover attempts, so long as management ensures that workers enjoy favorable wages, working conditions and job security. As managers form alliances with employees with major voting rights and become less concerned with the discipline of the market for corporate control, they are more likely to pursue unprofitable empire-building acquisitions that destroy shareholder value.

Another factor that aligns manager and worker interests is that they both hold undiversified portfolios and a large portion of their wealth (e.g., wage income, benefits, and human capital) is tied to the financial condition of their employer. Thus, they share a preference for acquisitions that reduce firm risk and increase employment security, even at the expense of shareholder value. Equity ownership in an employer makes employees more undiversified, enhancing their preferences for risk-reducing and diversifying acquisitions.

On the other hand, employee ownership may compel managers to eschew empire-building value-destroying acquisitions. The negative stock price impact of such transactions can result in large losses to employee shareholdings, which can lead to adverse consequences for firms and managers through several channels. For example, firms can experience declines in employee morale, reduced productivity, and increased voluntary employee turnover, all of which can lower a firm’s operating efficiency and performance. Also, as employee financial wealth is damaged by poor acquisitions, managers may find employees more demanding at times of contract renewals and renegotiations. More contentious labor relations can lead to temporary work stoppage or prolonged strikes and cause disruptions to a firm’s operations. Even absent any work stoppages, a strained relationship between employees and management can make employees unwilling to support incumbent managers and cost managers an important ally in the event of unsolicited takeover attempts. These considerations should discourage empire-building acquisitions that depress stock price and hurt the value of employee stock ownership. However, this mechanism can be rendered ineffective when employees receive large benefits from the labor-friendly policies of incumbent managers that outweigh the losses in their share value.

In a sample of 3,778 acquisitions made by large U.S. firms from 1996 to 2009, we find that acquirers with substantial employee equity ownership (at least 5% of shares outstanding) experience lower abnormal stock returns on acquisition announcements. This suggests that firms with sizable employee block ownership are more prone to engage in shareholder value reducing acquisitions. We further find that employee block ownership significantly reduces the likelihood that empire-building acquirers receive a potentially disciplinary takeover bid within three years following the acquisition. This is consistent with a white-squire role played by employee blockholders (Pagano and Volpin (2005)), where they insulate managers from the discipline of the market for corporate control, thereby encouraging empire-building behavior.

We next investigate employee incentives to use their voting rights to protect managers and allow them to make bad acquisitions with seeming impunity. The worker-management alliance theory of Pagano and Volpin (2005) argues that workers are motivated to support incumbent managers when they enjoy favorable employment policies, such as long-term contracts, high wages, generous benefits and infrequent layoffs. We expect employees to have stronger incentives to form alliances with empire-building managers when their employment status is more secure and less susceptible to adverse consequences of poor acquisitions. Under these conditions, managers have stronger incentives to pursue empire-building acquisitions without fear of market discipline. The results of our analysis confirm this prediction and lend direct support for the Pagano and Volpin (2005) theory. Specifically, the negative relation between employee block ownership and acquirer shareholder returns is concentrated in firms with better employee treatment, more unionized workforce, abnormally high employee wages, and in diversifying acquisitions. These findings highlight a key difference between employee ownership and other takeover defenses such as staggered boards and poison pills in that support for management is conditional on whether employees receive sufficient quid pro quo benefits in their alliance with management.

Our study contributes to a growing body of research examining the influence of labor on major corporate policies and outcomes. Studies in this literature generally focus on employee rights arising from unionization or legal protection and explore the implications of these rights in creating employee-shareholder conflicts. In contrast, we emphasize employee power derived from equity ownership and how it can exacerbate manager-shareholder conflicts. As a result of this shift in focus, our investigation differs from most prior research by explicitly accounting for both manager and employee incentives and then exploring the conditions under which manager-worker alliances are likely to arise. Our evidence suggests that substantial employee voting rights can provide a catalyst for managers and workers to form implicit alliances to realize reciprocal benefits at shareholder expense. This reciprocal relationship between managers and employees is consistent with the worker-manager alliance theory of Pagano and Volpin (2005), and portrays a more complex and nuanced picture of the interactions among managers, workers, and shareholders. Our results raise concerns about the potential for large employee ownership positions to undercut shareholder value, rather than aligning employee interests with those of outside shareholders.

The complete article is available here.

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