CEO Preferences and Acquisitions

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday June 25, 2012 at 9:44 am
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Editor’s Note: The following post comes to us from Dirk Jenter of the Department of Finance at Stanford University and Katharina Lewellen of the Tuck School of Business.

In our recent NBER working paper, CEO Preferences and Acquisitions, we test whether target CEOs’ retirement preferences affect the incidence, the pricing, and the outcomes of takeover bids. If mergers force target CEOs to retire early, then the CEOs’ private merger costs are the forgone benefits of staying employed until the planned retirement date. Though retirement plans differ across individuals, research in labor economics shows that a disproportional fraction of workers retires at the age of 65 (we observe the same phenomenon for CEOs). This age-65 effect cannot be fully explained by monetary incentives, including social security benefits or Medicare, which suggests behavioral explanations related to customs or social norms. If CEOs similarly favor 65 as retirement age, this preference should be reflected in their private merger costs, and – provided that these costs affect merger decisions – in the observed merger patterns. Specifically, one should observe an increase in merger activity as CEOs approach 65, or a discrete jump in this activity at the age-65 threshold.

We find strong evidence that target CEOs’ retirement preferences affect merger patterns. In data on U.S. public firms from 1992 to 2008, the likelihood of a takeover bid increases sharply when the target CEO reaches age 65. Controlling for CEO and firm characteristics, the implied probability that a firm receives a takeover bid is close to 4% per year for CEOs below the retirement age (e.g., in age groups 56-60 and 61-65), but it increases to 6% for the retirement-age group (above age 65). This corresponds to a 50% increase in the odds of receiving a bid, and the effect is statistically significant at the 1% level. The increase in takeover activity appears abruptly at the age-65 threshold, with no gradual increase as CEOs approach retirement age. The effect is similar whether all bids or only successful bids are included, and it remains economically large and significant even when CEO age and age squared are included separately as controls. These results show that bidders are more likely to target firms with retirement-age CEOs, possibly due to these CEOs’ weaker expected resistance against takeover bids.

We next examine the effect of CEOs’ retirement preferences on target shareholders’ gains from acquisitions. A target CEO’s attitude towards a merger bid is likely to be influenced by both the CEO’s private costs and by the expected impact of the merger on target shareholder value. CEOs pay attention to shareholder value because they themselves hold equity in their firms, and because of pressure from boards to maximize shareholder wealth. This implies that a CEO with lower private costs will require a smaller gain for shareholders to approve a merger deal. Thus, if retirement-age CEOs face lower private costs, then they should allow more mergers to go through (as we document), and the incremental deals should generate lower shareholder gains on average.

Consistent with this prediction, observed takeover premiums and target announcement returns are significantly lower when target CEOs are above 65. Controlling for firm, CEO, and deal characteristics, the takeover premium measured from one month before the first bid announcement to the final offer price is eight to ten percentage points lower when the target has a retirement-age CEO. This effect is both statistically significant and economically large. There is no difference in the pre-announcement stock price run-ups between targets with above- and below-65 CEOs, though we cannot rule out that some of the difference in takeover premiums is caused by differences in investors’ expectations about the likelihood of a bid. Interestingly, acquirer announcement returns are on average zero in both the retirement-age and the below-65 samples, suggesting that the bargaining power in merger negotiations remains with the target firm regardless of the age of its CEO.

Finally, the discrete increase in the likelihood of receiving a bid at age 65 is not limited to full takeover bids. We discover a similar pattern in a sample of bids for partial stakes, which are bids for less than 50% of the target’s equity. Some of these transactions are likely to be a direct consequence of the more active takeover market in the retirement-age sample. For example, investors may purchase target shares in anticipation of a takeover bid, or potential acquirers may accumulate toeholds to reduce future acquisition costs. Consistent with the first motive, we find that most partial acquisitions in the retirement-age sample are open-market purchases by passive investors, probably betting that the target share price will rise due to a takeover bid.

We evaluate several alternative explanations for the change in merger patterns as target CEOs reach retirement age. We find little support for the alternative hypotheses in the data. For example, retirement-age CEOs appear to be no more frequent targets of disciplinary takeovers than younger CEOs. There is also no evidence that the more frequent takeovers of firms with above-65 CEOs are due to CEOs’ desire to cash out their stock and option holdings, or that they are caused by old interim CEOs who were hired to sell their firms. We also examine the possibility that retirement-age CEOs sell their firms more frequently in order to solve succession problems. While it is difficult to rule out this explanation, there is no evidence that the retirement-age effect on takeover frequencies is larger in firms or industries in which we expect succession problems to be more severe.

This paper merges two strands of literature: the literature on managerial career concerns and horizon problems, and the literature on agency conflicts in mergers and acquisitions. While the associations between target CEO incentives and mergers documented in prior studies are interesting, they are difficult to interpret. Both equity holdings and offers of post- merger employment are choice variables, are determined jointly with other merger decisions, and can be adjusted quickly by boards. As a result, both variables are likely to be correlated with prior performance, CEO quality, CEO power, and many other unobservable factors that are themselves likely to affect merger patterns.

In comparison, using the presence of a retirement-age CEO as a proxy for low career costs is attractive. The age of the target CEO is not the result of immediate choices by the parties negotiating the merger deal, and changing CEO age requires replacing the CEO. Moreover, as we argue in more detail in the next section, preferences are likely to change for at least some CEOs around age 65, making CEO age a useful proxy for otherwise unobservable preferences. Finally, the fact that merger patterns change abruptly at age 65 suggests that we are in fact capturing an effect of CEO preferences: any other determinants of mergers that are correlated with CEO age are unlikely to change discretely just because a CEO reaches retirement age.

The effects of retirement-age CEOs on mergers documented in this paper should nevertheless not be interpreted as the true causal effects. Instead, what we observe is the combined effect of changing CEO preferences and of boards’ reactions to them. There are at least two mechanisms likely to be at work that render retirement-age CEOs endogenous: First, boards make the decision to have a retirement-age CEO. CEOs are bundles of many attributes, making it impossible to have CEOs who are optimal on all dimensions at all times, but CEO age is one of the attributes boards are likely to consider. Second, boards can adjust the terms of CEO compensation contracts, and especially of golden parachutes, to offset CEO preferences that change with CEO age. If career concerns cause younger CEOs to be too reluctant to sell their firms, then boards can mitigate this problem through explicit monetary incentives. If golden parachutes tied to a successful sale of the firm perfectly compensated CEOs for the loss of future income (and loss of other benefits) associated with being acquired, then one should see no effect of CEO age on mergers. Our empirical evidence shows that golden parachutes, despite being a standard element of CEO compensation contracts, do not eliminate the effect of CEOs’ retirement preferences on merger outcomes. However, the observed effects of CEO age on mergers would arguably be even larger without the countervailing effects of golden parachutes.

The full paper is available for download here.

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