MASTER THESIS
Executive compensation of the “good” and the “bad”
acquirers in Europe
By
Vu Thi Phuong Thao
S1705148
Supervisor: Dr. A.B. Kibriscikli-Ozcandarli
Co-referent: Nathan Lillie
University of Groningen
Faculty of Management and Organization
Msc. International Business and Management
Executive compensation of the “good” and the “bad”
acquirers in Europe
ABSTRACT1
The paper investigates the impacts of merger quality and firm value changes associated with mergers and acquisitions on executive compensation growth in European firms in the period from 2005 up to 2007. We find that the changes in firm size and firm performance both defined by accounting figures and stock market do not show a clear relationship with executive remuneration. However, there is evidence that the “bad” mergers, as perceived by stock market, lower the compensation growth rather than the “good” mergers. Combined with other literatures, this result suggests that executives may involve in a merger in pursuit of seeking prestige and higher positions in the ladder of power instead of gaining more. Keywords: executive compensation, mergers and acquisitions, M&A, Europe
TABLE OF CONTENTS
1. INTRODUCTION 4
1.1 Problem Statement and Research Question 6 1.2 Significance of the Research 9
1.3 Research Outline 10
2. THEORETICAL BACKGROUND 11
2.1 Alternatives approaches on executive compensation in the context of M&As 11
2.2 Hypotheses 13
2.2.1 Whether quality of M&A affects executive compensation 13 2.2.2 Whether firm size affects executive compensation 16 2.2.3 Whether firm performance affects executive compensation 17 2.2.4 Whether nationality of firm affects executive compensation 18
3. METHODOLOGY & DATA 20
3.1 Variables and Measures 20
3.1.1 Dependent variables 20 3.1.2 Independent variables 21 3.1.3 Control variables 24 3.2 Conceptual framework 24 3.3 Sample data 25 3.4 Data description 27 4. RESULTS 30 5. DISCUSSIONS 33
6. CONCLUSION & LIMITATION 37
1 INTRODUCTION
The globalization trend in business has called a search for competitive advantages that spread out all over the world (Finkelstein, 1999). In order to follow customers who are getting more global themselves, firms have to respond to pressures of obtaining economic of scale in a rapidly consolidating global economy. In combination with other trends such as increased deregulation, privatization, and corporate restructuring, globalization has encouraged an unprecedented surge in cross-border merger and acquisition activity (ibid).
Mergers and acquisitions are very common way through which a firm can accomplish its vertical integration and diversification objectives (Barney & Hesterly, 2006, pg 310). The terms are often used interchangeably as we have done in this study, even though they are not synonyms. A firm engages in an acquisition when it purchases a second firm. An acquiring firm can use cash or its own equity or a mix of these mechanisms in order to purchase a target firm. It can purchase all of a target firm’s assets or a majority of those assets or a controlling share of those assets (ibid).
Mergers with, or acquisitions of, domestic firms by international firms are defined as cross-border Mergers and Acquisitions (M&As). As a matter of fact, all challenges that acquiring and/or acquired firms must face with will become much more complicated in cross-border M&As because of various fundamental differences existing across countries. Thus, cross-border mergers and acquisitions are considered much more difficult to implement (Finkelstein, 1999).
Cross-border mergers & acquisitions and executive compensation
misunderstanding and disagreement. Hence, such differences can influence the pay design of both acquiring and acquired firms in the context of post mergers.
According to Finkelstein (1999) the basic principles for successful cross-border mergers can be interpreted into several questions that need comprehensive answers: (1) What is the strategic logic for the acquisition? and (2) How will the two companies be integrated? These questions are so difficult that they may require a careful pre-acquisition and objective analysis (ibid).
On the one hand, finding solutions for such questions only lies in the responsibility of the top management team or executive managers. As a result, they should be compensated more in order to successfully solve these complicated questions mentioned above. On the other hand, Certo et al (2007) argue that when facing with complicated strategic decisions, such as in the context of M&As, managers may not consider only shareholders’ benefits whose they are legally bound to represent, but also their own interests. The ultimate reason is that M&As can lead to an enormous increase in director remuneration. In the view of agency theory, Wright et al (2002) also contend that acquisitions may occur because they enhance managerial compensation rather than because they benefit shareholders.
In line with existing economic studies, this paper aims at making an empirical research on the differences in executive compensation growth of “good” and “bad” M&As and whether these pay divergences really come from what managers really do to make the firm grow for the sake of shareholders.
Summary
acquisitions has influenced executive remuneration is an interesting question calling for an answer.
1.1 Problem Statement and Research Question
Executive compensation is a hot topic which lies at the heart of corporate governance and management interest (Ferrarini and Moloney, 2005). Moreover, executive compensation has been at the centre of heated corporate governance issues in the U.S. due to substantial increase in the CEO pay in the last two decades (Paligorova, 2007). Recently, executive compensation has also been a controversial debate in European corporate governance reform (Perkins and Hendry, 2005). It is considered the source of interest conflicts between the principle and agent, especially when EU corporate governance is in its reforming process.
Executive compensation in the context of cross-border M&As
Acquisitions are so complex that even professionals have difficulty assessing and understanding them. Although so far there have been quite a lot of researches on mergers and acquisitions, most are event studies on acquisition announcement (Ebneth and Theuvsen, 2007). Existing studies on executive compensation are quite rich (Oxelheim and Randoy, 2005). However, executive compensation associated with the effects of M&As, especially in Europe is not often chosen field to be studied, even though it has attracted a lot of attention in the continent (Perkins and Hendry, 2005).
As a matter of fact, the role of executives in a successful cross-border M&A is considered more and more crucial. In such case, gathering two hot issues in one study makes our research become critical. It will be a contribution to the existing empirical literature that investigates the relationship between executive compensation and M&A deals.
Falato (2006) researches top executive remuneration of U.S. corporations with the effects of excess pay on the profitability of corporate acquisitions. He finds that excess pay has a positive impact on shareholder value, in that the more executives involved in M&As are rewarded, the higher returns the firm gains. His results are considered strongly consistent with the model of executive pay based on talent rather than power. Previously, Girma et al (2006) examined the impact of mergers and acquisitions on the executive remuneration in the UK for the period from 1981 to 1996. Their results indicate that CEO pay is not strongly correlated to firm performance. But it is related to increases in firm size, described by firm sales and acquired sales. From the findings of these two studies, the answer for the question ‘whether executives are remunerated basing on firm performance’ seems contradictory. However, Girma et al’s result suggests that executives who engaged in ‘wealth-reducing’ acquisitions were rewarded lower than their counterparts who involved in ‘wealth-increasing’.
In the same period, Bliss and Rosen (2001) observed major mergers from 1986 to 1995, but only in US banking industry. The study is based on the data consisting of two-year pre M&A together with two-year post M&A. According to their research, mergers have a net positive effect on executive compensation, primarily because of an increase in firm size even if mergers cause the acquirer’s stock price to decline.
Lambert and Larcker (1987) formerly inspected among the largest acquisitions over the period 1976-1980 to find out whether changes in executive compensation associated with an acquisition are related to acquisition's effect on the stock price of the acquiring firm. They find that there is a positive correlation between increases in compensation and increases in shareholders’ wealth.
Besides, the quality of merger and acquisition has been rarely mentioned in prior researches on the relationship between M&As and executive compensation. Among these, Girma et al (2006) discuss about whether “wealth enhancing” and “wealth reducing” acquisitions equally rewarded involved managers. They reckon that the success or otherwise of the acquisition, as shown in stock markets, may be considered a signal of executive ability and results in different treatments toward CEO pay. In order to determine whether CEOs were soundly rewarded for acquisitions approved by stock market or punished for those disapproved, a set of 195 completed mergers during the period from 1985 to 1996 in UK was chosen for study.
It was once studied by earlier research of Khorana and Zenner (1998) which contended that ‘wealth-enhancing’ acquisitions positively influenced US CEO compensation. In this research, in order to examine the impact of mergers and acquisitions on the compensation of executives in acquiring firms they used a sample of 46 top executives of 27 US large acquisitions over the 1982–1986 period.
values perceived by stock market and by accounting figures. Thus, due to the limited studies in such topic, we choose European, particularly Western EU countries as the new playing field to implement our research. Although the disclosure policies of executive compensation historically were quite transparent in US, those of European Union’s corporations have not made known to outside public. However, Western European has been considered more progressive in remuneration disclosure. Moreover, in the reform of EU Corporate Governance, recently executive compensation has been widely disclosed as the requirements for public-traded firms even though the level of disclosure is quite different across countries. In this paper, we only look at the impact of mergers and acquisitions on compensation of executives in acquiring firms who are reckoned to be responsible for initiating the merger (Bliss and Rosen, 2001).
Research question
In line with this, the research question will be “Whether and to what extent do the change in firm characteristics and performance associated with mergers and acquisitions have an impact on executive remuneration in European acquiring companies? How does executive compensation in “good” mergers and acquisitions of these firms differ from “bad” ones?”
In order to answer this research question the first step is to build a theoretical framework basing on possible determinants that may have relationships with executive compensation using literature. Based on the literature found we have used several variables with a relation towards executive compensation. These variables are firm size, firm performance, and quality of mergers and acquisitions. We identify mergers or acquisitions in the Europe from 2005 to 2007 from ZEPHYR database on mergers and acquisitions. Data on stock price performance will be obtained from Thompson Datastream. Annual Reports published in companies’ websites will make use to retrieve other information on executive compensation, executive characteristics and firm performance.
1.2 Significance of the Research
contract with executives. This is also practical for lawmakers in the field of corporate governance to implement the EU reforms.
Most research to date has been performed on US or UK mergers and acquisitions and only bank mergers of banking industries and never on multiple industries. European countries (except UK) seem not often to be chosen as countries of research on executive compensation even though executive remuneration continues to attract lots of controversy, despite the structural changes in corporate governance arrangements over the past decade (Perkins and Hendry, 2005). Therefore, in order to fill this research gap we have selected European countries to be our focal point for this research.
1.3 Research Outline
2 THEORETICAL BACKGROUND
2.1 Alternatives approaches on executive compensation in the context of M&As In order to obtain a full understanding of executive compensation in the context of M&A, it is necessary to have a look at several alternative approaches to executive compensation and possible ways that executive compensation can theoretically be influenced by M&As. Thus, the analysis in this part is aimed at exploiting the relationship between executive compensation and corporate acquisitions which are explained in the light of different alternative approaches as managerial-power and managerial-talent.
Mergers and acquisitions are among the largest and the most important investment decision undertaken by top management team, thus, they can deepen the potential agency problem between managers and shareholders in public corporations (Falato, 2006).
In the light of the managerial-power view, Bebchuk and Fried (2003) hold that executives have substantial influence over their own pay. So executive compensation is not only viewed as a potential instrument for addressing agency problem but also as a part of the agency problem itself. Supporting this approach, several researchers recognize that some features of pay arrangements seem to reflect managerial rent-seeking than the provision of efficient incentives (Bebchuk and Fried, 2003). Grinstein and Hribar (2004) also contend that acquiring firms’ executives who have more power can receive considerably larger bonuses from M&As.
According to Falato (2006), the straightforward prediction of this view is that CEOs who have more power should have higher levels of cash compensation, since they are expected to be able to extract more resources from the firm. Moreover, these entrenched managers are more likely to extract private benefits at the expense of shareholders than to maximize shareholder’s value. Therefore, the agency problem should result in both higher levels of executive compensation and higher likelihood of risky acquisitions. This raise a possibility that executives who have higher pay levels will decide to undertake mergers and acquisitions without caring much to shareholders’ returns.
important question comes up “Why do managers of bidding firms continue to engage in M&A strategies?” They discuss some possible explanations; these are 1) to ensure survival, 2) free cash flow, 3) agency problems, 4) managerial hubris, and 5) potential for economic profits. According to agency theory, although M&As possibly do not generate profits for bidding firms they can benefit managers directly at least in two ways. Firstly, executives use M&As to diversify their human capital investments because M&As can help them to enlarge the range of businesses. Secondly, executives can use M&As to quickly increase firm size, measured in either sales or assets. Of all the way to quickly increase firm size, growth through M&A is perhaps the easiest. Acquiring firm will grow by the size of the target or at even faster rate depending on whether there are economies of scale or not, even though M&As do not benefits the owners of the acquiring firms (ibid).
compensation schemes that can offer managers enough incentives to act in maximizing shareholders’ benefits.
The sharply contrasting view is that executive compensation is the result of competitive forces in the top management market, thus it makes up an appropriate reward for the scarcity of managerial talent (Falato, 2006). A straightforward proposition of this view is that more talented executives should have higher levels of compensation. It also has direct implications to the link between managerial talent and corporate acquisitions (ibid). Smaller pool of executives involved in M&As, who are able to handle challenging tasks of executing successful M&As, possibly pushes the compensation level of these executives up. This view is known as managerial-talent approach.
This is also supported by Harris and Helfat (1997) who suggest the human capital theory that any job requirements which limit the supply of CEO candidates would increase CEO pay. It means if the managers with necessary skills and competences to manage complicated situations as M&As are scarce in the supply market the compensation level will be higher. This theory focuses on the supply-side of competent CEO in labor market. In the light of opposite side, the managerial discretion theory emphasizes the demand-side effects which is the firms are probably willing to pay a higher salary for the services of competent CEO to handle more complex situation. As presented above, Finkelstein (1999) contend that how to succeed in cross-border mergers is a hard issue responsible for top management team. As a result, for completing M&A deals the Board can possibly pay an incredible compensation level to its top management team.
Moreover, relating to managerial-power approach the organizational power theory argues that the labor market for CEOs can deviate from competitive labor markets. That is CEO pay can increase above the level that supply factors (human capital theory) and demand factors (managerial discretion theory) would suggest (Oxelheim and Randoy, 2005). 2.2 Hypotheses
2.2.1 Whether quality of M&A affects executive compensation
increasing shareholder value, has been vigilantly implemented despite its high failure rates in the past (MacDonald, Coulthard and de Lange, 2005). In this study, authors try to identify steps to achieve M&A success through finding the link between corporate strategic planning and M&A strategy; examining the due diligence process in screening a merger or acquisition and evaluating previous experience. CEOs and company boards are the ones who have to shoulder the entire responsibility to implement these key planning steps. As the complexity of mergers and acquisitions has increased, the effectiveness of executives is critical to the success of M&As.
The quality of M&As is an interesting topic inviting more closely research. MacDonald, Coulthard and de Lange (2005) contend that M&A activity had been increasing sharply despite the fact that approximately half of all mergers and acquisitions have proven unsuccessful. They express many studies as their examples such as those of Covin, Kolenko, Sightler & Tudor (1997); Gadiesh & Ormiston (2002); Gadiesh, Ormiston & Rovit (2003); Kaplan (2002); Stanwick & Stanwick (2001); Weber, Shenkar & Raveh (1996); Schneider (2003). However, there was a contradiction that KPMG (2003) found the shareholder value was increased more than reduced as a result of mergers and acquisitions (cited by MacDonald, Coulthard and de Lange, 2005). In another study, Bliss and Rosen (2001) show that even though their stock price falls down after M&A announcement, top management team’s compensation and wealth increases after large bank mergers.
Thus, whether M&As have been successfully implemented recently in order to reach the growth target and increase stakeholders’ value is still a question. Our research will focus on the quality of M&As as a determinant to organisational growth and ultimately to executive compensation. Given the inconsistent results above and in light of the booming of mergers and acquisitions activity, it appears worthy of review.
business media. In line with this, the Board of Management or Remuneration Committee may react by additional pay for the involved executives if acquisitions are considered successful. And vice versa, if the executive is deemed to have mishandled the deal, such as overbidding as well as any anticipated loss of profitability, his perceived value will be reduced. As a consequence, this may prevent his compensation increasing this year. Also, in their research on UK, Girma et al (2002) find the evidence that depending on the quality of acquisitions, CEOs will experience different levels of remuneration. For example, it can be seen that ‘wealth-reducing’ mergers do indeed appear to reduce executive pay growth at the same period of mergers and after their completion. Khorana and Zenner (1998) also separate “good” from “bad” acquisitions when studying the impact of merger quality on executive compensation in US. They find that good acquisitions result in net positive effects on compensation which do not appear to be true for bad acquisitions. That also means bad acquisitions do not enhance compensation. In line with this research, we come up with the first hypothesis which is the more successful of M&As, the higher compensation that managers in Western European firms may receive.
H1: The change in compensations of executives involving the “good” M&As is higher than those relating to the “bad” acquisition
Moreover, an acquisition is clearly a great corporate event which is easily observed by public investors. As a result, it may cause a significant reaction in stock market (Falato, 2006). Thus we take advantage of market reaction to measure the quality of M&As. The quality of mergers and acquisitions mentioned here is referred to the reaction of the stock market to the merger and acquisition announcement (see Girma et al, 2006 and Khorana & Zenner, 1998). Thus, whether an M&A is successful or not is defined as the approval or disapproval of the stock market toward M&A event. The stock performance around the announcement date will be taken into account.
2.2.2 Whether firm size affects executive compensation
In existing literature, firm size is mentioned the most often as a determinant influencing executive compensation. Barney & Hesterly (2006) suggest that executives can use M&A as the fastest way to increase the size of a firm. It is clear that firms can take advantage of M&As in order to quickly increase their sales or market shares. Even if there are no economies of scale, an acquisition will ensure that the acquiring firm will be expanded by the size of the target firm. When there is an economic of scale it will grow at even faster rate, although M&A do not actually generate wealth for the owner of the acquiring firms (ibid).
Jensen and Murphy (1990) contend that executives of larger firms probably earn more. Moreover, Girma et al (2002) argue that there are two stylized facts, one of which suggests that there exists a strong, positive and statistically robust relationship between executive compensation and firm size. Researching US bank mergers from 1986 to 1995, Bliss and Rosen (2001) also contend that acquisitions increased executive compensation, largely through the impact of M&As on size.
According to Schmidt and Fowler (1990), acquisition theory draws two hypotheses of executive motivation behind M&As. The former is usually referred to the shareholder wealth-maximization while the latter focuses on gains accruing in hands of top managers in acquiring firms. This theory proposes that executives involve in M&A activity in order to get more wealth. For instance, managers may gain more power through controlling a larger empire. Simpler, they will get higher compensation typically related to the increase in organization scale. This increase will lead to the increase in complexity of management and executives ultimately have to be responsible for this. So it is not surprising that executive will receive higher level of compensation due to the higher level of responsibility.
H2: There is a positive relation between the change in firm size after M&As and the change in executive compensation.
2.2.3 Whether firm performance affects executive compensation
The relatively weak link between executive compensation and firm performance has attracted much attention of researchers because it conflicts with the principal–agent approach which is considered the primary theory used to explain corporate pay determination (Girma et al, 2006).
Schmidt and Fowler (1990) reckon that academic studies on the relationship between executive pay and firm performance have mixed results. Studying the executive remuneration of mergers and acquisitions UK firms, Girma et al (2002) find that CEO pay is not strongly related to company performance. Their study is in line with “managerial power theory” in which executives have such a great power that they can substantially influence their own compensation so their pays do not go together with their performance (Bebchuk and Fried, 2003). Girma et al (2002) also report that the statistical relationship between executive compensation and firm performance, in contrast to the size effect, is less robust and has a smaller scale.
Falato (2006) empirically evaluates the merit of the two main existing answers to the question “why top executives are paid so much”: (1) because of their talent; and (2) because of their power. By measuring short term excess pay of top executives, their results are strongly consistent with the model of executive pay based on talent rather than power. This means executives are remunerated basing on how much their performance benefits the firm. That means executive compensation should go in line with firm performance.
Considering the robustness of findings from these existing researches, we come up with the third hypothesis. However, we expect an increase in firm performance due to M&As will lead to a rise in executive compensation.
H3: There is a positive relation between the change in firm performance after M&As and the change in executive compensation.
Following Bliss and Rosen (2001), we measure firm performance using both stock performance and accounting data over the studied period of acquiring firms as explained further in methodology part of this study.
2.2.4 Whether nationality of firm affects executive compensation
The nationality of acquiring firms also can affect levels of executive compensation. It has been proved by previous researches. Becht and Mayer (2004) contend that UK system of corporate governance is believed clearer and closer to US market system than the insider systems of continental Europe. Heidrick & Struggle (2005) show that UK Corporate Governance Rule (Combined Code) has the strictest regulations relating to disclosure levels of executive compensation among EU countries. Baird, J & Stowasser, P (2002) also reckon that Corporate Governance Rules do not attempt to regulate the amount of compensation payable to executives or directors. However, they also argue that the detail disclosure ultimately results in a rise in compensation level, not limit executive compensation as expected. For instances, in the case of US firms, despite the relatively inclusive and long-standing disclosure requirements, the pay level of American executives is the highest in the world.
H4: The change in executive compensation of UK acquiring firms is higher than that of non-UK acquiring firms.
3 DATA & METHODOLOGY 3.1 Variables and Measures
3.1.1 Dependent variable
The dependent variable in this research is the change of executive compensation between the year that the firm completed the M&A and the previous year. The compensation schedules of the top managers in listed companies can be very complicated. Generally, the components include salary, annual bonus, benefits and long-term compensation. The fixed packet as base wage can be distinguished from flexible (performance-based) payments and additional compensation component such as pension, insurance payments, and other benefits (Abowd and Kaplan, 1999).
According to Khorana and Zenner (1998), we use two measures of managerial remuneration. The former is ‘total compensation’ which includes (1) cash compensation including salary plus bonus, (2) insurance and personal benefits, (3) grants of restricted stock, phantom shares, and performance shares, (4) stock options and stock appreciation rights and (5) deferred compensation (refer to Glossary for definitions). The latter is ‘cash compensation’ that includes salary, bonus and other cash benefits.
However, each method of compensation measurement has its strength and weaknesses. While the former measure is more comprehensive, the latter can be calculated with more accuracy and is less reckless. The valuation of total compensation may be not precise because sometimes the information on stock options and other long term incentives such as stock option grants, restricted stock and share appreciation rights is not completely disclosed in the Annual reports which lead to the difficulties in valuing both stock options and stock appreciation rights.
Kroner (NOK), or USD (United State Dollar), ect as their currencies in financial reports. Thus we use exchange rate as at 31 December each year of X-rates website in order to transfer them into euro amount.
3.1.2 Independent variables
The independent variables are the change in firm size (annual sales, total assets), the change in firm performance both in accounting (ROE change) and stock returns of this year toward previous year, and the quality of the M&As. The control variable is the nationality of the firm.
Quality of M&A
‘What is the best way to evaluate the success of an acquisition’ is still a question calling for an answer. In Kaplan’s study (2006), several different criteria used by financial economics perspective are recommended to evaluate merger success. He researches on stock return studies, accounting-based studies, and clinical studies. From the empirical evidence he finds that each method has its own strengths and drawbacks. However, he suggests that the most popular way to evaluate quality of success is to use acquisition announcement returns (ibid).
According to Khorana and Zenner (1998), if announcement abnormal returns of the acquirer are negative and significant, then the firm is classified as a ‘bad’ acquirer, other wise its M&A is consider ‘good’ acquisition. Kaplan (2006) also recommends using acquisition announcement returns to evaluate the quality of M&A.
Wright et al (2002) calculated acquisition announcement returns with event study methodology of Brown and Warner. They estimated cumulative abnormal returns (CARs) for two event windows: - 1 to 0 days and - 3 to +3 days. However, Girma et al (2006) evaluated mergers and acquisitions basing on the stock market’s response over a much longer interval: 30 days (from –10 to + 20) surrounding the successful acquisition announcement.
the actual return on this stock. This method is often used to evaluate the impact of important event on a stock price (ibid).
To measure the cumulative abnormal returns (CARs), the market adjusted returns (MARs) will be calculated as well. MARs will be calculated for the announcement acquisition date and the period before and after this date. Here we choose to use the longer interval of Girma et al (2006) because it always takes time for the market to fully response to an important event.
In particular, first of all adjusted daily stock prices were obtained from Datastream for every single sample firm for 30-days-interval (10 days prior to the announcement date, the announcement day itself and 20 days after the announcement date). Then we calculate the daily raw returns and adjust them by the market returns. Different firms are quoted in various stock exchange markets. Moreover, each firm can be listed in many different markets at the same time. Thus, in order to adjust these daily returns the EURONEXT was used as a proxy for the market index which could take advantage of the harmonization of the European Union financial markets.
Following Girma et al (2006), the abnormal return was computed by comparing the return on the acquiring firm with the corresponding return on the market index. In this context, they argue that underlying intention was to capture the impact of the executive’s action on the benefits of shareholders who would ultimately have impact on executive’s remuneration.
To determine CARs, firstly abnormal return (AR) for day t of stock i for can be calculated as follows:
AR
i,t= R
i,t- R
m,tWhere: R i,t is the actual return for the European firm’s stock i on day t R m,t is the market return on the EU market for day t.
(*)
As discussed above, this study only considers the success of M&As in the perspective of acquiring firm’s shareholders not in terms of acquired firm and focuses on executive compensation of acquiring firms.
Firm size
Firm sales and number of employees are commonly used as firm size. For instance, Khorana and Zenner (1998), when studying executive compensation of large acquirers in 1980s, used firm sale as the measurement of firm size. Wright et al (2002) indicate pre- and post-acquisition changes in firm size by the percentage changes of sales. These values are determined as the percentage changes in the acquiring firms' sales in the year following the merger versus the year of the merger announcement. Barney & Hesterly (2006) argue that executives can use M&A to quickly enlarge firm size, measured in either sales or assets, in order to be highly perceived by both board of management and remuneration committee. In line with these researches, we measure the change in firm size by the change in annual sales and total assets between the studied year t and the previous year t-1.
Firm performance
t-1. For abnormal stock return of acquiring firm as the firm performance indicator, the cumulative average abnormal return (CAAR) will be calculated based on formula (*) but for the period over two year [t-1, t] which is from the first day of previous year to the last day of completion year.
3.1.3 Control variables
To define nationalities of acquiring firms we divide our sample into two categories according to its head quarter’s location which are UK and other countries in Western Europe (UK). We use dummy variables and nominate UK acquiring firms and non-UK acquiring firms as 0 and 1, respectively.
3.2 Conceptual model
In order to investigate the existence of a connection between executive compensation and mergers and acquisitions, a relationship is built basing on various determinants which are expected to have impacts on remuneration of top team management.
In order to examine the impacts of M&A quality on executive compensation, we add M&A quality variable in our equation. Such factors as changes in firm size and firm performance are indicated in existing literature as important determinants to executive pay. Thus, this basic relationship is represented in Equation (1) as follow:
∆ Executive pay i,t = α + β1 ∆ Annual sale i,t + β2 ∆ Total assets i,t + β3 ∆ ROE i,t + β4 ∆ CAAR i,t
+ β5 M&A quality dummy i,t + ε i,t (1)
∆ Executive pay i,t = α + β1 ∆ Annual sale i,t + β2 ∆ Total assets i,t + β3 ∆ ROE i,t + β4 ∆ CAAR i,t + β5 M&A quality dummy i,t
+ β6 nationality i + ε i,t (2)
The effect of inflation on executive pay will not be considered due to the limited period of studied time.
Estimation Methods
For models with continuous variables (Hypotheses 1, 2,…) we used ordinary least squares (OLS) regression. From the results of multiple regressions, all the sub questions raised in the hypotheses above will be answered. After conducting regression, if β is statistically significant which means there is a relationship between firm size or firm performance with executive compensation associated with M&A context, the test outcome will determine the type of relationship: positive or negative. In that way, it can be clearly indicated whether and to what extent the change in firm characteristics and performance associated with mergers and acquisitions have an impact on executive remuneration in European acquiring companies and how executive compensation in “good” mergers and acquisitions of these firms differs from “bad” ones.
3.3 Sample data
This research will base on the data of M&A transactions obtained from Zephyr database of Bureau van Dijk Electronic Publishing. In addition, stock price information of each firm as well as EURONEXT index is available at Financial Thompson Datastream which contains historical stock data on most publicly traded and big firms.
Figure 1 Theoretical framework Quality of Acquisition
Dummy variable (good-0, bad-1) Change in Firm Size - Annual sales - Total assets Change in Firm Performance - ROE - ROA Executive compensation - Cash compensation - Total compensation Firm Nationality Dummy variables (UK-0, Non UK-1)
In order to narrow the topic down, we will focus on only mergers and acquisitions with estimation value larger than 100 million Euros. Our research is limited to large transactions because they represent economically significant events and are more likely to directly affect managerial compensation (Grinstein & Hribar, 2003). Bliss and Rosen (2001) also focus on large mergers as they argue that those most likely to impact executive compensation and therefore influence the top management team’s decision. Then both acquiring firms and target firms have to be Western European companies as classified in the company location of Zephyr. Because disclosure level of executive compensation is quite different from countries to countries, we assume that this information is available to access in Western Europe rather than in Eastern and Central Europe.
Appendix 1). Due to the unavailability of needed information from companies’ websites (no Annual report at the studied year, no information in English) and Datastream (no data on stock performance), 88 M&As were left for analysis, consisting a total of 82 different acquiring companies (some companies involved more than one deal in the studied period). Maybe there is a case that firms have undertaken more than one merger and acquisition in studied year and the qualities of these mergers and acquisitions are conflicting. In fact, “good” and “bad” mergers together can have reverse influences on compensation at the same time. The fluctuation of compensation at the end of studied years will be a result of assessments on both “good” and “bad” mergers by the Board. That means executive compensation will be influenced by mixed effects from these conflicting mergers. Thus it is not appropriate to consider two contradictory M&As of a firm as two separate observations. In order to avoid it, we leave them out of the sample data. These firms conducting more than one merger and acquisition in studied year of which quality is consistent, we consider them as one observation. This results in 84 mergers and acquisitions (78 firms in total) as showed in Appendix 2. Moreover, in our sample we only include executives that appear in Remuneration Reports of two consecutive years and exclude excluding executives’ first year in office and those who do not show up for either studied year or previous year. This results in 238 executives in three years and all regressions have 238 observations.
3.4 Data description
Table 1 shows the number of mergers and acquisitions that took place in each year of the analysis period. It also illustrates the number of firms that undertook at least an acquisition during the studied period.
Table 1 Sample Data during Analysis Period (2005-2007)
Period 2005 2006 2007 Total
Number of M&A transactions 29 35 20 84
Number of firms 25 33 20 78
de Lange (2005) and Bliss and Rosen (2001) who contend that the stock price has fallen down after most mergers and acquisitions.
Table 2 Dummy Variables
Dummy variables
Quality of mergers and acquisitions Good Bad Total
- In number 31 47 78
- In percentage 39.7% 60.3% 100%
Firm nationality UK Non-UK Total
- In number 21 57 78
- In percentage 27% 73% 100%
Table 3 provides descriptive statistics. Cash compensation is defined as salary plus bonus and other cash benefits. Total compensation is defined as cash compensation plus the value of stock options and restricted stock granted during prior years which are valued using the Black-Scholes formula. Murphy (1998) show that in a sample of firms 95% of the options were granted with an exercise price equal to the stock price at the time of the grants. We do not include changes in the value of existing shares in total compensation, only the value of new share-based compensation.
Table 3 Descriptive Statistic
Mean Median Minimum Maximum
Total compensation
year t (in Euro) 2,320,587 968,293 20,586 25,268,060 Total compensation
year t-1 (in Euro) 1,902,497 792,094 13,595 6,100,637 Cash compensation
year t (in Euro) 873,163 598,624 10,307 7,060,922 Cash compensation
year t-1 (in Euro) 752,845 473,496 13,595 6,100,637 Annual sales year t
(in million Euro) 29,733 3,868 0.11 1,426,475
Annual sales year t-1
(in million Euro) 17,035 2,680 0.01 386,643
Total assets year t
(in million Euro) 71,183 6,086 102.75 2,979,951
Total assets year t-1
(in million Euro) 48,468 4,358 34.20 1,278,977
Returns on equity
year t (%) 14.55% 17.76% -70.94% 42.46% Returns on equity
year t-1 (%) 14.91% 14.56% -176.88% 77.12%
Table 4 Compensation and M&A activity
In percentage (%) Mean Median Minimum Maximum
Change in total compensation 111.98 16.88 -74.68 5,497.09 Change in cash compensation 98.07 14.43 -96.42 5,497.09 Change in firm sales 412.20 17.10 -35.13 28,340 Change in firm assets 90.04 19.66 -24.03 2,396.47 Change in ROE -47.40 -4.98 -2,687.85 380.72 Change in stock returns to
4 RESULTS
Before all the hypotheses testing is implemented, it is essential to notice that α in all the tests will be set at 0.05. As we mentioned earlier, multiple regression analyses would be used to find whether and how mergers and acquisitions affect executive compensation in terms of cash compensation and total compensation.
In order to find the answer for our hypotheses we perform multiple regression analyses in which alternate variables are taken into account. We alternately choose cash executive compensation and total executive compensation as the dependent variable. We have two variables (change in annual sales and change in total assets) to define the change in firm size. Similarly, both change in ROE and stock return change are used to describe the change in firm performance. Each variable denoting firm size was chosen along with each variable indicating firm performance to use in the analysis.
Table 5 presents the regression of (2) using cash executive compensation (Table 5.1) and total executive compensation (Table 5.2) as dependent variables. It shows regressions of compensation changes against the quality of mergers, changes in firm value due to firm sales, changes in asset size and returns to equity, stock return changes and firm nationality as a control variable. Years are not taken into account. For all coefficients, p values are shown in parentheses. All regressions have 238 observations. The detail results are present in Appendix 3 (from 3.1 to 3.8).
Table 5.1 Regression results (1) – Impact on cash compensation change
Dependent variable:
Cash compensation change (1) (2) (3) (4)
Annual sales change 0.003
(0.815)
0.003
(0.779)
Total assets change 0.039
(0.733)
0.036
(0.766)
ROE change (0.898) -0.013 -0.012
(0.909)
Stock return change 0.072
(0.958) 0.076 (0.955) Quality of mergers -1.312 (0.055) -1.300 (0.056) -1.276 (0.061) -1.289 (0.060) Native country 0.446 (0.560) 0.440 (0.576) 0.437 (0.576) 0.445 (0.558) Adjust A2 0.003 0.003 0.003 0.003
Table 5.2 Regression results (2) – Impact on total compensation change
Dependent variable:
Total compensation change (5) (6) (7) (8)
Annual sales change 0.003
(0.779)
0.003 (0.752)
Change in total assets 0.081
(0.492) 0.082 (0.503) ROE change -0.007 (0.944) 0.004 (0.971)
Stock return change -0.016
Examining Table 5.2 which represents multiple regression tests between the change in total compensation of executives and the change in firm value coupled with mergers and acquisitions and the quality of mergers themselves. The outcomes of multiple regressions only show a significant relation between total compensation and quality of mergers. The p-values (0.021; 0.021; 0.024 and 0.025) are much smaller than the requirement for being significant (0.05). In addition, we found that the coefficient is negative for both measures of cash compensation and total compensation although it is significant in case of total compensation (Table 5.1 and Table 5.2). As mentioned above, we assigned “good” as 0 and “bad” as 1 for dummy variable denoting the quality of mergers. Hence, we can conclude that executive compensation increase larger if the quality is “good” and lesser if the quality is “bad”.
For other variables, although regression coefficients of each variable in different cases are not substantial different, the results show no significance and the p-values are too high (from 0.434 to 0.991).
Regarding relationships between the change in firm size and change in executive compensation which is either total compensation or cash compensation, the coefficients are positive. This means the change in firm size has positive correlation with the growth of executive compensation. However, these results are not significant. The relationship between change in executive compensation and firm performance is trivial. The coefficients are either positive or negative and the possibilities are not significant. So it cannot be concluded from these results that there is a relation between change in total compensation of executives and change in firm values of acquiring companies since the multiple regression showed no significant relation.
5 DISCUSSIONS
In the globalization trend of the world economy, mergers and acquisitions are one of the most favoured tactics which top managers usually choose to implement, in order to quickly achieve growth targets and new competitive advantages. However, the real benefit that executives associated with mergers and acquisitions can bring to shareholders is still a question. Moreover, there have been only few researchers seek for this answer in Europe comparing to a number of studies on United States and United Kingdom. The objective of this thesis is to examine the impacts of quality of mergers and acquisition as well as the change in firm values associated with mergers and acquisitions on executive compensation. Although there is a significant evidence of the relationship between the change in executive compensation and firm values associated with mergers and acquisitions, the received results are trivial.
Regression results show that the quality of mergers and acquisition has a great impact on total executive compensation (Table 5.2). The coefficients are negative and significant which means the change in remuneration of executives associated with “good” or “wealth-enhancing” mergers is greater than that of executives involving “bad” or “wealth-reducing” mergers. In line with our previous discussion, the role of executives is critical to a successful merger and acquisitions so ideally executives are remunerated based on their efforts and skills contributed to the success of merger. In line with Girma et al (2002) and Khorana and Zenner (1998), our research also finds that ‘wealth-reducing’ mergers lessen executive pay growth in the year that firms complete mergers and acquisitions.
involved to unsuccessful M&As. It is significantly confirmed in case of total compensation. For cash compensation, although lower than in the case of total compensation, significance levels are still quite high (very close to 5%). So we can conclude that the first hypothesis ‘The change in compensations of executives involving the “good” mergers is higher than those relating to the “bad” ones’ can be proved.
It is noticeable that quality of mergers cannot have a great impact on cash compensation as it does on total compensation. Total compensation includes both cash and non-cash compensation. Cash compensation consists of fixed salary, annual bonus and other cash benefits. It is understandable that quality of mergers may not remarkably affects fixed salary and other cash benefits as in most cases they must be complied with remuneration policies. It seems strange that bonus at year-end is not significantly correlated with the success of mergers. However, our results suggest that the success of mergers may not play an important role in determining M&A bonuses. Grinstein and Hribar (2003) contend that except for deal size, executive’s efforts and skills in M&A do not explain a large amount of the change in the bonus. In particular, they cannot find clear information in remuneration report relating to why firms give the deal bonuses in about 50% of their cases. In the rest of their cases, main arguments for bonuses of these firms rely on the growth of firm size rather than on the growth of firm value after M&As. Thus, in this case whether it is a “wealth-enhancing” or “wealth-reducing” merger executive bonus may not show a remarkable change.
the acquirer. Hence, due to the brunt of stock-based compensation, the quality of mergers shows greater impacts on total compensation than it does on cash compensation.
Our result seems challenging Bliss and Rosen’s study (2001) which shows that top management team’s compensation and wealth increases after large bank mergers even though their stock price falls down after M&A announcement. However, what we found does not have the same meaning with the decrease in executive compensation in “bad” mergers. It can increase but not as much as that of “good” mergers.
Moreover, we notice that none of acquiring firms in our sample belong to banking industry, but manufacturing and telecommunication industries. Studying differences and similarities in the characteristics of regulated bank holding companies and unregulated manufacturing firms, Adams and Mehran (2003) find that different characteristics of industries can lead to different governance structures and different firm behaviors (including pay practices). It suggests that industry differences may result in the divergence of remuneration practices. Moreover, John and Qian (2003) reckon that banks differ from manufacturing firms in several key respects and these differences interacting with corporate governance and managerial alignment leads to divergence in pay practices in general and to remuneration for executives in particular. They also argue that banks should have lower pay-performance sensitivity than manufacturing firms. That may constitute to such differences if there is any between our findings and Bliss and Rosen (2001).
complexity. Moreover, the quality of large mergers has always invited lots of attention in stock market and business press. Avery et al (1998) also examine the possibility that managers may decide to carry out mergers and acquisitions to gain more power, prestige, and position in the business community. They find evidences suggesting that CEOs can improve their prestige and standing in the business community by undertaking acquisitions. Moreover, they find no evidence that top managers can increase his salary or bonus by pursuing an acquisition.
6 CONCLUSION & LIMITATION
Our research has contributed to the deepness of the existing literature on the impact of mergers and acquisitions on executive compensation, especially in term of M&A quality by examining a bundle of sample firms in Western European Union that undertook mergers and acquisition from 2005 to 2007.
Theoretical and empirical evidence from our study proves that there exist differences between total compensation growth of executives associated with “good” mergers and those involved in “bad” mergers. The results have shown that the “wealth-reducing” mergers lessen executive remuneration growth rather than “wealth-enhancing” ones. The result has shown no correlation between the change in firm values due to mergers and acquisition and executive compensation growth.
The discussion made some interesting relations to explain the divergence between executive compensation in “good” and “bad” mergers. The reason seemed to be responsible for that is executive’ value perceived by board of director, shareholders and public is higher if he can well handle a complicated task as M&A. When he is higher evaluated, his remuneration does certainly experience a great growth. Ultimately, executives involved in mergers and acquisitions may not look for more salary and incentives, but they seek for more reputation, skills and experience. Since they focus on achieving more prestige, it is possible that growth in firm values does not have a relationship with growth in executive compensation.
In the previous stage of building this thesis, data was selected in a longer period of time for a broader sample which might give us a better result. Unfortunately, all research is determined by the availability of data. Therefore, due to the fact that executive compensation data completely relies on how much the company discloses in their websites, only firms with fully disclosed information in a very short period of time (from 2005 to 2007) could be chosen. Moreover, because we only focus on executives who are considered to initiate mergers and acquisitions, remuneration of executives in acquired firms was not included in this study.
However, concluding that an acquisition is a good one if the acquired loses value is inappropriate for shareholders of both acquirer and acquired firm as a whole (Kaplan, 2006).
Further Research
Based on the remarks above, further research should consider not only executive compensation in acquiring firms but also in acquired ones. The time frame also should be extended in order to test the influence of mergers and acquisitions on executive compensation more thoroughly.
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GLOSSARY
Phantom stock An employee benefit plan that gives selected employees (senior
management) many of the benefits of stock ownership without actually giving them any company stock. Sometimes referred to as "shadow stock”. Rather than getting physical stock, the employee receives "pretend" stock. Even though it's not real, the phantom stock follows the price movement of the company's actual stock, paying out any resulting profits.
Performance share In the case of stock compensation, shares of company stock given to
managers only if certain company wide performance criteria are met, such as earnings per share targets. The goal of performance shares is to tie managers to the interests of shareholders. Their goal is similar to employee stock-option plans, as they provide an explicit incentive for management to focus their efforts on maximizing shareholder value. Note that in the case of performance shares, the manager receives the shares as compensation for meeting targets, as opposed to stock-option plans where employees receive stock options as part of their usual compensation package.
Stock/Share option A privilege, sold by one party to another, that gives the buyer the right, but
not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.
Options can be exercised anytime between the date of purchase and the expiration date.
Restricted stock Insider holdings that are under some other kind of sales restriction.
Restricted stock must be traded in compliance with special SEC
regulations. Insiders are given restricted stock after merger and acquisition activity, underwriting activity, and affiliate ownership in order to prevent premature selling that might adversely affect the company. Restricted stock cannot be sold without registration with the SEC (under the Securities Act of 1933) or some other special exemption.
Stock Appreciation Right A right, usually granted to an employee, to receive a bonus equal to the appreciation in the company’s stock over a specified period. Like employee stock options, SARs benefit the holder with an increase in stock price; the difference is that the employee is not required to pay the exercise price (as with an employee stock option), but rather just receives the amount of the increase in cash or stock.
ROE A measure of a company’s profitability that reveals how much profit a company generates with the money shareholders have invested. It can be calculated as follows:
ROE = Net Income Common Equity
