Published February 15, 2013
Shareholders tend to groan when their CEO receives a fat merger bonus just for agreeing to a takeover, fearing it's a sign the deal was done on the cheap.
To support that conflict-of-interest thinking, studies have found that when a merger bonus is awarded, the transaction typically carries a lower takeover premium when compared with agreements where no bonus is paid.
However, new research suggests that the payouts may not be all that shady. Instead, bonuses tend to be paid only in low-synergy transactions involving less-desirable companies that may not otherwise be sold or to compensate CEOs for the fact they're likely to lose their current job.
“This is not nefarious behavior here. These guys are actually doing right by their shareholders,” said Eliezer Fich, a professor at Drexel University in Philadelphia who co-authored the paper along with Edward Rice of the University of Washington and Ahn Tran at the City University London.
Backing up this reasoning, the authors discovered that acquiring companies in these bonus deals do not enjoy outsized stock returns after the transaction is announced and the CEOs who receive a bonus don’t have trouble finding employment soon afterwards.
“There is always this cynical view of CEOs and CEO compensation. We’re actually coming at it from a different side of the” equation, said Fich.
Bonus Deals Carry Lower Premiums
According to the paper, which was first released in December, the CEO of an acquired firm receives a merger bonus about 25% of the time, averaging $1.6 million and reaching as high as $12 million.
The authors found that transactions that include a merger bonus carry a takeover premium that is 3.87 percentage points lower, implying an average drop of about $186 million in terms of the deal value.
A takeover premium is defined by the difference between the takeover bid and the target company’s last trading price before the deal was announced.
For example, this week Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) and 3G Capital agreed to pay $72.50 a share to acquire iconic ketchup maker H.J. Heinz (HNZ), representing a 20% takeover premium on the company’s close of $60.48 the previous trading day.
The research also revealed that there is an inverse relationship between the size of merger bonuses and the premium: every $1 increase in the bonus lowers the deal value by about $11.
“Our first reaction was: Oh, no. The merger bonus is another vehicle that CEOs are able to use to extract more rents from their own shareholders. But we really took a step back and looked at things more carefully,” said Fich.
Benign Reasons for Bonus?
By digging through almost 1,000 proxy statements filed with the Securities and Exchange Commission, the authors found that bonuses tend to be handed out when so-called synergies (financial upside created by the merger) are low.
This suggests that the target company is less desirable and may be tougher to sell.
“Bidders pay less to acquire the targets but they also buy less in the form of low synergies,” authors wrote.
There is another benign reason to pay out a merger bonus: to compensate the CEO, who is often left without a job and needs to promise not to compete against the company in the future. The paper found that more than 45% of all merger bonuses given to target CEOs are linked to consulting or non-competition contracts.
“It’s well deserved from a human resources point of view. You’re compensating the CEO for not only selling the firm but also for giving up potential future employment,” said Fich.
Others believe merger bonuses should still be scrutinized despite these findings.
“I’m skeptical. I don’t think you should pay someone extra to do their fiduciary duty,” said Charles Elson, a corporate governance professor at the University of Delaware. “I’ve always thought the solution is to make the executive a significant shareholder: link their interest to everyone else’s.”
Because this research only tracks agreements that have been made public, the authors acknowledged they “cannot decisively assess whether” merger bonuses “are beneficial to target shareholders.”
M&A Fallout Eyed
Still, the research found that even though lower premiums tend to be paid when target CEOs receive merger bonuses, the acquiring companies don’t typically see large stock returns following the transaction announcement.
Instead, the acquiring companies often saw negative returns, though not significantly.
The results suggest “there is no additional transfer of wealth” from the target shareholders to the acquirer shareholders beyond what is spelled out in the deal, said Fich.
Likewise, the authors said that target CEOs who are awarded merger bonuses “are not punished” in the managerial labor market following the deal.
“This finding casts doubt on the idea that these CEOs neglected their shareholders’ wealth prior to (and during) the acquisitions,” they wrote.
After all, what board wants to hire a CEO who just sold his or her company on the cheap?
"Merger bonuses seem to mitigate rather than exacerbate" conflict-of-interest "problems in low synergy targets, and seem to be at worst benign on average," the paper concluded.