- Top of page
- I. Sample Description
- II. Empirical Results
- III. Conclusions
We examine whether corporate governance mechanisms, especially the market for corporate control, affect the profitability of firm acquisitions. We find that acquirers with more antitakeover provisions experience significantly lower announcement-period abnormal stock returns. This supports the hypothesis that managers at firms protected by more antitakeover provisions are less subject to the disciplinary power of the market for corporate control and thus are more likely to indulge in empire-building acquisitions that destroy shareholder value. We also find that acquirers operating in more competitive industries or separating the positions of CEO and chairman of the board experience higher abnormal announcement returns.
Following a string of corporate scandals in the United States, legislators and regulators rushed to enact corporate governance reforms, which resulted in the passage of the Sarbanes-Oxley Act of 2002. Yet, these reforms were instituted with little scientific evidence to support their purported benefits. As the impact of these reforms continues to be strongly felt, with further reforms likely in the future, it is of great economic import to understand how major corporate governance mechanisms affect shareholder wealth. A series of recent studies by Gompers, Ishii, and Metrick (GIM, 2003), Bebchuk, Cohen, and Ferrell (BCF, 2004), Bebchuk and Cohen (2005), and Cremers and Nair (2005) examine one important dimension of corporate governance, namely, the market for corporate control. They document negative relations between various indices of antitakeover provisions (ATPs) and both firm value and long-run stock return performance.1,2 However, it remains unclear exactly how or through what channels antitakeover provisions negatively affect shareholder value. GIM hypothesize that antitakeover provisions cause higher agency costs “through some combination of inefficient investment, reduced operational efficiency, or self-dealing,” though they do not provide direct evidence to support their conjecture.3 In this study, we directly examine the impact of a firm's antitakeover provisions on its investment efficiency, and in particular, the shareholder wealth effects of its acquisitions.
Acquisitions are among the largest and most readily observable forms of corporate investment. These investments also tend to intensify the inherent conflicts of interest between managers and shareholders in large public corporations (Berle and Means (1933) and Jensen and Meckling (1976)). As a result, academic researchers have extensively studied merger and acquisition activity.4 It is also well recognized that managers do not always make shareholder value-maximizing acquisitions; sometimes they extract private benefits at the expense of shareholders. Jensen's (1986) free cash flow hypothesis argues that managers realize large personal gains from empire building and predicts that firms with abundant cash flows but few profitable investment opportunities are more likely to make value-destroying acquisitions than to return the excess cash flows to shareholders. Lang, Stulz, and Walkling (1991) test this hypothesis and report supportive evidence. Morck, Shleifer, and Vishny (1990) identify several types of acquisitions (including diversifying acquisitions and acquisitions of high growth targets) that can yield substantial benefits to managers, while at the same time hurting shareholders.
Fortunately, a number of corporate control mechanisms exist that help mitigate the manager–shareholder conflict of interest. In this paper, we focus primarily on one important component of corporate governance, the market for corporate control. Mitchell and Lehn (1990) find that the market for corporate control can discourage corporate empire building in that firms that make bad acquisitions have a higher likelihood of being acquired later. However, by substantially delaying the process and thereby raising the expected costs of a hostile acquisition, antitakeover provisions reduce the probability of a successful takeover and hence the incentives of potential acquirers to launch a bid (Bebchuk, Coates, and Subramanian (2002, 2003) and Field and Karpoff (2002)).5 In other words, ATPs undermine the ability of the market for corporate control to perform its ex post settling up function and to provide managers with the proper incentives to maximize current shareholder wealth. Therefore, ceteris paribus, the conflict of interest between managers and shareholders is more severe at firms with more ATPs, or equivalently, firms less vulnerable to takeovers. This leads to the following ATP value destruction hypothesis: Managers protected by more ATPs are more likely to indulge in value-destroying acquisitions since they are less likely to be disciplined for taking such actions by the market for corporate control.6,7
Using a sample of 3,333 completed acquisitions during the period between 1990 and 2003, we find strong support for the ATP value destruction hypothesis. More specifically, acquisition announcements made by firms with more ATPs in place generate lower abnormal bidder returns than those made by firms with fewer ATPs, and the difference is significant both statistically and economically. This result holds for all the corporate governance indices or subsets of ATPs we consider and is robust to controlling for an array of other key corporate governance mechanisms, including product market competition, leverage, CEO equity incentives, institutional ownership, and board of director characteristics.
In further analysis, we address the causality issue by examining two endogeneity-related alternative explanations for our empirical findings, namely, reverse causality and spurious correlation. To investigate the first possibility, we limit our attention to acquiring firms that go public prior to 1990. This ensures that most of their takeover defenses are adopted prior to our acquisition sample period, since shareholder support of further ATP adoptions, especially staggered boards, was uncommon in the 1990s (Gompers, Ishii, and Metrick (2003) and Bebchuk and Cohen (2005)). The significant time gap between ATP adoption and acquisition makes it highly unlikely that these firms adopt ATPs immediately before or in anticipation of making bad acquisitions. We find that our full-sample results continue to hold in this subsample.
The negative effect of ATPs on bidder returns can also be attributed to CEO quality in that bad CEOs can adopt takeover defenses for entrenchment purposes and make bad acquisitions.8 In other words, the relation between ATPs and bidder returns could be spurious. We address this omitted variable problem by controlling for bidder CEO quality proxied by pre-acquisition operating performance. We find that higher quality CEOs indeed make better acquisitions for their shareholders. However, we continue to find that takeover defenses have significantly negative effects on bidder announcement returns.
We also uncover evidence regarding the value of several other corporate governance mechanisms. We find that firms operating in more competitive industries make better acquisitions, as do firms that separate the positions of CEO and chairman of the board. The first piece of evidence supports product market competition acting as an important corporate governance device that discourages management from wasting corporate resources, while the second piece of evidence lends support to the recent call for the elimination of CEO/Chairman duality.
Our study makes two valuable contributions to the literature. First, we identify a clear and important channel through which takeover defenses destroy shareholder value. Our evidence suggests that antitakeover provisions allow managers to make unprofitable acquisitions without facing a serious threat of losing corporate control. This is consistent with the agency-based interpretation GIM provide for why ATPs are related to shareholder wealth: ATPs generate shareholder–manager agency costs. In addition, our short-term event-study approach is not subject to the critiques levied on long-run event studies.9
We also substantially expand the set of governance mechanisms studied. This addition can be important since the negative correlation between ATPs and shareholder value could be spurious if alternative corporate control mechanisms are not independently chosen. We find that after introducing a wide range of other governance mechanisms, the marginal effect of ATPs on acquirer returns remains negative and significant.
Second, we contribute to the extensive literature on corporate governance by highlighting the role played by the market for corporate control in providing managerial incentives to increase shareholder wealth. Previous studies focus on the effects of takeover defenses on executive compensation (Borokhovich, Brunarski, and Parrino (1997), Bertrand and Mullainathan (1999), and Fahlenbrach (2004)), firm leverage (Garvey and Hanka (1999)), the cost of debt (Cremers, Nair, and Wei (2007) and Klock, Mansi, and Maxwell (2005)), and R&D expenditures (Meulbroek et al. (1990)), in addition to firm value and long-term stock performance. Our evidence suggests that the market for corporate control has a strong and material impact on managers' efforts to make value-enhancing investments, and in particular profitable acquisitions. Our study is also related to Bebchuk and Cohen (2005), Bebchuk, Cohen, and Ferrell (2004), and Cremers and Nair (2005) in that we examine different subsets of the 24 antitakeover provisions in the GIM index. Bebchuk, Cohen, and Ferrell document that some takeover defenses are more important than others. Our investigation of bidder returns reveals similar patterns.
The remainder of the paper is organized as follows. Section I describes our data sources and acquisition sample. Section II presents the empirical results on the impacts of corporate governance on the profitability of acquisitions. Section III concludes the paper.
I. Sample Description
- Top of page
- I. Sample Description
- II. Empirical Results
- III. Conclusions
We extract our acquisition sample from the Securities Data Corporation's (SDC) U.S. Mergers and Acquisitions database. We identify 3,333 acquisitions made by 1,268 firms between January 1, 1990 and December 31, 2003 that meet the following criteria:
The acquisition is completed.
The acquirer controls less than 50% of the target's shares prior to the announcement and owns 100% of the target's shares after the transaction.
The deal value disclosed in SDC is more than $1 million and is at least 1% of the acquirer's market value of equity measured on the 11th trading day prior to the announcement date.
The acquirer has annual financial statement information available from Compustat and stock return data (210 trading days prior to acquisition announcements) from the University of Chicago's Center for Research in Security Prices (CRSP) Daily Stock Price and Returns file.
The acquirer is included in the Investor Responsibility Research Center's (IRRC) database of antitakeover provisions.10
The IRRC published six volumes in years 1990, 1993, 1995, 1998, 2000, and 2002. They include detailed information on antitakeover provisions at approximately 1,500 firms during each of the 6 publication years, with more firms covered in the more recent volumes. As GIM point out, these firms comprise members of the S&P 500 index and the annual lists of the largest corporations published by Fortune, Forbes, and BusinessWeek. The IRRC expanded the sample in 1998 to include smaller firms and firms with high levels of institutional ownership. In each of the 6 years, firms in the IRRC database represent more than 90% of the U.S. stock market capitalization (Bebchuk, Cohen, and Ferrell (2004)). Following GIM, we assume that during the years between two consecutive publications, firms have the same governance provisions as in the previous publication year. We obtain very similar results (unreported, but available upon request) if we assume that firms have the same governance provisions as in the next publication year or if we restrict our sample to the 6 years with IRRC volumes.
In Table I, we present summary statistics of our sample acquisitions by announcement year. Beginning in 1991, the number of acquisitions in each year increases annually until it reaches its highest level in 1998. Then it drops off significantly before rebounding in 2002. The trend is very similar to that documented by Moeller, Schlingemann, and Stulz (2004). Table I also reports annual mean and median bidder market value of equity (measured 11 trading days before the announcement), deal value, and relative deal size, defined as the ratio of deal value to bidder market value of equity. Both deal value and bidder market value of equity appear to peak around the “bubble” period from 1999 to 2000, when bidders also make acquisitions of greater relative size.
Table I. Sample Distribution by Announcement Year The sample consists of 3,333 completed U.S. mergers and acquisitions (listed in SDC) between 1990 and 2003 made by firms covered by the IRRC antitakeover provision database. Variable definitions are in the Appendix.
|Year||Number of Acquisitions||Percentage of Sample||Mean Acquirer Market Value of Equity ($mil) (Median)||Mean Deal Value ($mil) (Median)||Mean Relative Size (Median)|
|1990|| 119|| 3.6||1,793||177||0.12|
|1991|| 110|| 3.3||1,954||207||0.17|
|1992|| 120|| 3.6||1,755||108||0.09|
|1993|| 213|| 6.4||1,725||148||0.12|
|1994|| 226|| 6.8||2,576||231||0.13|
|1995|| 238|| 7.1||2,447||316||0.15|
|1996|| 241|| 7.2||3,954||576||0.16|
|1997|| 247|| 7.4||5,302||516||0.16|
|1998|| 409|| 12.3||5,580||825||0.16|
|1999|| 321|| 9.6||10,597||1,200||0.20|
|2000|| 265|| 8.0||12,733||1,396||0.22|
|2001|| 250|| 7.5||7,385||797||0.15|
|2002|| 306|| 9.2||5,785||454||0.13|
|2003|| 268|| 8.0||5,731||647||0.15|
- Top of page
- I. Sample Description
- II. Empirical Results
- III. Conclusions
The market for corporate control is an important corporate governance mechanism that provides managers with the proper incentives to maximize shareholder value by performing an ex-post settling up function (Mitchell and Lehn (1990)). Due to the cross-sectional differences in the adoption of antitakeover provisions, managers at different firms are subject to varying levels of discipline from the takeover market. Those at firms with more antitakeover provisions are more insulated from the discipline imposed by the market for corporate control and thus are more likely to display self-serving behavior.
Focusing on corporate acquisition decisions, we find that bidders with more antitakeover provisions experience significantly lower abnormal returns around acquisition announcements. This result is robust to controlling for bidder characteristics, deal features, and other corporate governance mechanisms, and is stronger when we focus on the subset of antitakeover provisions that Bebchuk, Cohen, and Ferrell (2004) distill from the corporate governance index constructed by Gompers, Ishii, and Metrick (2003). Our evidence suggests that managers facing more pressure from the market for corporate control tend to make better acquisition decisions.
By incorporating bidder vulnerability to takeovers, product market competition, and CEO/Chairman duality into the analysis along with other corporate control mechanisms, this study represents the most complete investigation to date of the effect of corporate governance on acquirer announcement returns. It establishes a causal link that goes from antitakeover provisions to shareholder value, and provides a partial explanation for the findings in Gompers, Ishii, and Metrick (2003) and several subsequent studies that firms with more takeover defenses are associated with lower shareholder value.