Charles A. Dice Center for Research in Financial Economics Are Acquisition Premiums Lower because of Target CEOs’ Conflicts of Interest?

CEOs have a conflict of interest when their company is the target of an acquisition attempt: They can bargain for private benefits, such as retention by the acquirer, rather than for a higher premium to be paid to their shareholders. We find that target CEO retention by the bidder does not appear to be driven by the CEO bargaining for his own interests at the expense of shareholders. Retention is not associated with a lower premium. Retention is more likely when it is more valuable to the bidder in running the merged firm, in that the CEO is more likely to be retained when she has skills and knowledge that bidder executives do not have and when the incentives of target insiders are well aligned with those of target shareholders. Regardless of retention, shareholders of acquired firms whose CEO is at retirement age receive lower premiums than shareholders of acquired firms with younger CEOs. This lower premium seems to be explained by the apparent reduced acquisition value of firms led by retirement age CEOs rather than by the target CEO conflict of interest. * Leonce L. Bargeron is at the Katz Graduate School of Business, University of Pittsburgh. Frederik P. Schlingemann is at the Katz Graduate School of Business, University of Pittsburgh and the Rotterdam School of Management, Erasmus University. René M. Stulz is at the Fisher College of Business, The Ohio State University and the National Bureau of Economic Research. Chad J. Zutter is at the Katz Graduate School of Business, University of Pittsburgh. We thank Yakov Amihud, Tom Boulton, Alexander Ljungqvist, Scott Smart, and seminar participants at the Rotterdam School of Management for valuable comments. We also thank Jesse Ellis, Manoj Kulchania, and Ahmet Kurt for excellent research assistance. René M. Stulz is the corresponding author: tel. : +614292-1970; fax: +614-292-2359; email: stulz@cob.osu. edu. 2 The CEO of a firm faces a conflict of interest when that firm becomes an acquisition target. The CEO can fight the bid and, if successful, keep her job, but the shareholders lose the acquisition premium. She can work hard to drive up the premium offered by the acquirer but, as she does so, she is more likely to have to find a new job if the acquisition takes place. Finally, she can bargain less vigorously for a higher premium in the hope of or even in exchange for keeping her job and/or receiving other private benefits, such as the acceleration of the vesting of options and retirement benefits. In this paper, we investigate whether the target CEO is more likely to be retained and whether the premium received by target shareholders is lower when the conflict of interest between shareholders and the CEO is stronger using both acquisitions by public firms and acquisitions by private firms, including private equity firms. We find that CEO retention takes place when the retained CEO has skills and knowledge that make her valuable to the bidder for the operation of the merged entity and when the conflict of interest is lower because target insiders have a larger stake in the target’s equity; further, target shareholders do not receive a lower premium when the CEO is retained. Everything else equal, we would expect the conflict of interest to be worse for CEOs of retirement age since they have little reason to worry about their reputation in the labor market (see, e.g., Graham, Harvey, and Rajogopal (2005) for evidence on the importance of career concerns of top executives). Shareholders of firms led by CEOs of retirement age receive significantly lower premiums. However, this lower premium seems more likely to be due to a lower acquisition value of firms led by CEOs of retirement age than to the target CEO conflict of interest. Courts and the press have recognized the conflict of interest of target CEOs. For instance, in a recent decision, a judge concludes that a CEO “had powerful interests to agree to a price and terms suboptimal for public investors so long as the resulting deal” gave him some benefits including “the chance to continue his managerial positions for a reasonable time. ” 1 This conflict of interest is even more serious when target managers are allied with the acquirer as is common in acquisitions made by private equity firms. Incumbent management’s heightened conflict of interest in such acquisitions has been the subject of much attention in the press. For instance, an article in the Financial Times notes that “[t]here are 1 In Re: Lear Corporation Shareholder Litigation, Opinion, Court of Chancery, Delaware, June 15, 2007. 3 always conflicts of interest between shareholders and managers of public companies, but they escalate when private equity firms hove into view. Take Justin King, chief executive of Sainsbury’s, the supermarket chain. We are told that Kohlberg Kravis Roberts, CVC Capital Partners and Blackstone want him to stay if they buy the business and will no doubt give him a stake. Whose side is Mr. King now on? ” 2 We call the hypothesis that shareholders receive a lower premium because target CEOs put their interests ahead of those of the shareholders the “CEO conflict of interest” hypothesis. With this hypothesis, we expect that CEOs are less likely to trade retention for a lower premium if the incentives of insiders are well aligned with those of shareholders because they have a large stake in the target and thus would bear more of the costs of a lower premium. We also expect that CEOs are more likely to trade retention for a lower premium if their compensation is unusually high compared to other firms since it would be harder for them to replicate such compensation elsewhere unless it reflects unusually high ability. Hence, everything else equal, with the conflict of interest hypothesis we expect retention to be more likely for targets where insiders have a low stake in the target and more likely for CEOs with abnormally high compensation. Of course, a CEO could be willing to have the firm taken over for a lower premium even when she is not retained in exchange for other private benefits, such as retirement benefits, the vesting of options, or guarantees that her legacy projects will be kept intact. An acquisition could also provide liquidity to the CEO by allowing her to exchange her shares for cash, a benefit that might have no value for diversified shareholders. Many of these private benefits from acquisitions not associated with retention would appear to be more important for retirement age CEOs and some of these benefits would be especially valuable for CEOs who do not have confidence in potential successors and/or do not have confidence in the future prospects of their firm as a stand-alone firm. Though much attention has been paid to the view that the conflict of interest between target CEOs and their shareholders can be costly for shareholders, an acquirer might instead find the acquisition to be 2 “Sleepwalking into a new insider scandal,” by John Gapper, The Financial Times, February 5, 2007. 4 more valuable precisely because of the anticipated retention of the target’s CEO and might therefore pay less for the acquisition if the CEO were to exit at or shortly after the completion of the merger. For instance, part of the attraction of acquiring Bank One for JP Morgan Chase was the fact that the CEO of Bank One, Jamie Dimon, was viewed as a likely future CEO of the acquirer. 3 We call this hypothesis the “valuable CEO” hypothesis. We expect a CEO to be more valuable to the acquirer if the target firm has good performance, if it is specialized so that the CEO is less likely to be a more easily replaceable generalist, and if the bidder is making a diversifying acquisition, so that bidder management has limited skills in the industry of the target. We find strong evidence that CEO retention does not typically take place because it benefits the target CEO at the expense of shareholders. A CEO is more likely to be retained when the interests of insiders are better aligned with those of shareholders, which contrasts with the prediction of the conflict of interest hypothesis. We also show that the CEO is more likely to be retained when the target firm is a specialized firm rather than a diversified firm and when the target has good performance. We find no evidence that target CEO retention is associated with a lower premium. In contrast to the absence of a relation between retention and the gains to target shareholders, we find a negative relation between the premium paid and whether the CEO is at or approaching retirement age (age 60 or more). The premium paid by the bidder is lower by about 6 percentage points when the CEO is of retirement age. However, a CEO of retirement age is neither more nor less likely to be retained by the bidder. We examine various extensions and alternative specifications of our regression models. First, we use a sample for which compensation data for the CEO is available. We find evidence that CEOs with higher abnormal compensation are less likely to be retained, which is inconsistent with the conflict of interest hypothesis since such CEOs would value retention more as long as the higher abnormal compensation is not compensation for higher unmeasured skills. Note that if the higher abnormal compensation were compensation for unmeasured skills, we would expect CEOs to be more likely to be retained with the 3 The New York Times article “Banking Giant: The Overview; $58 Billion Deal to Unite 2 Giants of U.S. Banking” dated January 15, 2004 states, “[Dimon] is to take over as chief executive in two years from J. P. Morgan’s leader, William B. Harrison, settling the persistent question of succession. ” 5 valuable CEO hypothesis. Second, we extend our sample to include cases where the target CEO is not retained but non-CEO target managers are retained. We find that our results are robust when this extended sample is used and gain further insight as to why shareholders of firms with retirement age CEOs receiv