In our paper, The Sources of Value Destruction in Acquisitions by Entrenched Managers, forthcoming in the Journal of Financial Economics, we identify how acquisitions by entrenched managers destroy value. Managerial entrenchment is often seen as worsening corporate governance and facilitating agency-motivated investments. We analyze the role of entrenchment in acquisitions by (not for) entrenched firms. We focus on acquisitions by entrenched managers in order to examine the impact of entrenchment on managerial investments. We find that value-destruction in acquisitions by entrenched acquirers arises for several reasons:
- Entrenched acquirers disproportionately avoid private targets, which have been shown to be associated with value-creation.
- If entrenched acquirers do buy an unlisted target (or a public target with a blockholder), they tend not to pay with stock, thereby avoiding the governance benefits that would otherwise accrue from creating a blockholder in the bidder.
- Entrenched bidders tend to both overpay and acquire low-synergy targets, which manifest in lower combined bidder/target announcement returns and lower post-acquisition operating performance.
It is well known that one particularly costly manifestation of the agency conflict between shareholders and managers is a bad acquisition (see, for example, Jensen, 1986). Recently, Masulis, Wang and Xie (2007) present evidence that acquisitions that destroy the most bidder value are made by managers who can be considered partly entrenched. In this paper, we ask how partly-entrenched managers destroy value in their acquisitions. Specifically, we study the types of acquisitions they make with respect to the target’s attributes, the method of payment, and the synergies created.
We examine a sample of 3,935 acquisitions make by publicly listed US acquirers for public, private, and subsidiary targets between 1990 and 2005. We use this sample to examine the acquirer, target, and combined returns that accrue around takeover announcements and to analyze the types of targets that entrenched bidders prefer, as compared with non-entrenched bidders. We specifically focus on the likelihood that entrenched acquirers use stock to acquire an unlisted target or a publicly listed target with a blockholder, which would have the effect of grand-fathering a blockholder into the merged entity and improving corporate governance. We use data on combined bidder/target returns and post-acquisition operating performance to examine takeover synergies, and we use data on takeover premiums to identify the nature of overpayment by entrenched acquirers.
We find that a significant portion of value-destruction comes from entrenched managers’ avoidance of private targets, and from their attempts to preserve their position of entrenchment. Prior research, such as Chang (1998) and Fuller, Netter and Stegemoller (2002), has shown that acquisitions of private targets are generally value-increasing, while those of public targets are more likely to be value-decreasing. Most evidence points to the capture of the illiquidity discount (see Officer, 2007) and to the creation of a monitoring blockholder in an equity-based transaction, as discussed in Chang (1998) and Fuller, et al. (2002). Additionally, an equity offer for a private company is effectively a large private placement, and carries similar scrutiny and certification effects (Moeller, Schlingemann and Stulz, 2007). We find that when entrenched managers do target private companies, they are more likely to use cash. While we can never perfectly assign motivation, paying cash has the effect of avoiding both scrutiny and the potential creation of a blockholder. We also find that entrenched managers prefer not to use stock when acquiring public firms with large blockholders. Nonetheless, even controlling for the form of the target, entrenched managers make worse acquisitions, so target form is not the whole explanation.
We next examine synergies and overpayment across acquisitions. All value destruction involves overpayment. The question we ask is whether entrenched managers select low synergy targets in the first place, or select high or normal synergy targets, but simply pay too much for them. The post-merger operating performance for acquisitions by entrenched managers is worse than for others, suggesting that poor target selection, as opposed to simply overpaying for good targets, explains the value destruction. We also examine premiums paid by entrenched and non-entrenched managers. Notably, on average, entrenched managers pay lower premiums than non-entrenched managers. Thus, the net effect of paying somewhat lower premiums for much worse targets is value destruction. Some evidence suggests that the higher premiums paid by non-entrenched managers are justified by greater synergy creation.
The full paper is available for download here.