The Relationship between M&A Activity and Executive Compensation in the Netherlands

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The Relationship between M&A Activity and

Executive Compensation in the Netherlands

By Haobo Ye

Rijksuniversiteit Groningen

MSc in International Economics and Business

University of Groningen, Groningen, the Netherlands

Supervised by Dr. Padma Rao Sahib

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Abstract

This paper examines the relationship between M&A1 activity and executive compensation in the Netherlands over the period 2002-2006. When we consider only whether or not the executives engage in M&A deals, we find that this relationship is not significant, indicating that there is no apparent difference in compensation between executives who carried out M&A deals and those who did not. However, we indeed find that compensation increase is relatively higher when executives take more M&A deals. With one more M&A deal undertook, there is a 3% increase in total compensation and 1% increase in cash-based compensation in the contemporaneous year while there is a 12% increase in stock-based compensation 2 years after the M&A activity. Cross-border deals and 100% takeovers create relatively higher compensation increase for executives than domestic deals and non-100% M&A deals. Meanwhile, executives achieve greater compensation after the completion of mergers and acquisitions. CEOs are rewarded with higher compensation than the other executives (CFOs and other board members). However, there is no significant difference in compensation between CEOs and the other executives as a result of M&A deals. The impact of executive compensation on M&A propensity is significantly positive. The probability is higher for executives to engage in M&A activities and they tend to carry out more M&A deals if they have been well rewarded in the past. Firm size and performance are not strongly associated with executive compensation in our sample firms. However, shareholders’ interests play an important role in the determinants on compensation. Executive compensation is significantly positive related to relative total share return.

Key words: Mergers; Acquisitions; Executive Total Compensation; Cash-based Compensation; Stock-based Compensation; Panel Data; Logit Model Regression; Tobit Model Regression

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1. Introduction

This paper aims at providing a systematic analysis of the association between M&A activity and executive compensation in the Netherlands. The impact of mergers and acquisitions on executive compensation have been widely investigated in the US and UK. However, to the best of our knowledge, there are not many studies which are based on a detailed dataset of Dutch firms.

Mergers and acquisitions are defined as an important industry and corporate restructuring method (Garcia and Torre-Enciso, 1996). Looking over the global economic, the volume of M&A activity is significantly larger in advanced countries with better accounting standards and stronger shareholder protection (Rossi and Volpin, 2004). The utilization of M&As throughout the European Union countries is increasing and seem to be dramatic and widespread since the 1990s. The significant volume transactions in M&As in Europe are carried out in the UK while the US is the largest M&A country in the world. The Netherlands has been listed as the 4th largest M&A country in Europe over the period of 1993-19942. M&A activity continued to boom in the Netherlands since 19983.

Many investigations report that the failure rate for M&A deals is relatively high, around 50%. Thus there is a question makes us to ponder: “Why do firms engage in mergers and acquisitions? What kind of benefits do firms gain from M&A deals making?”

According to empire building theory, firms engage in M&As in order to achieve economies and market power by enlarging firm size and expanding operating regions. Thus firms’ productivity grows and their costs reduce subsequent to the achievement of economies of scale or economies of scope following mergers and acquisitions.

2_{See table 1.}

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Synergistic mergers theory suggests that firms achieve efficiency gains through combining an efficient target with their business and therefore result in improving the target’s performance. Acquirers usually recognize specific complementarities between their business and that of the target, such as technology, brand, market knowledge, distribution channels and network relationships. Therefore, both of the acquiring firms and target firms perform better when they are combined with their complementary counterpart.

Disciplinary mergers theory suggests that M&As discipline target firms’ executives who pursue objectives rather than profit maximization. Executives may focus more on goals rather than profitability. In this case, firms may suffer from goals achievement at the expense of operating efficiency. However, firms which are poorly performed may contain good assets. Therefore as these firms are merged or taken over by other firms, their performance would be improved if the acquiring companies realize the potential of the targets’ assets.

Economists stated that mergers occur in waves and within a wave mergers strongly cluster by industry (Mitchell and Mulherin, 1996). Table 3 reports the distribution of corporate mergers and acquisitions across industries for Dutch firms over the period of 1998-2006. From table 3, the merger wave in the Netherlands over the period of 1998-2006 is clustered and highly concentrated in 5 industries which are business services, food, electronics, industrial machinery and publishing. The companies from these 5 industries account for 33% (35/107) of our sample firms and the M&A deals made by those 35 firms account for 40% (608/1549) of total. The highly concentrated mergers and acquisitions result in effective utilization of resources (natural, capital and human resources) and may further promote technological innovation. Firms from the highly concentrated industries also benefit from higher competitive power and stronger negotiations or bargain ability.

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waves are caused by shocks, such as industrial, regulatory and technological shocks, low interest rates, deregulation, foreign competition, price changes etc. These factors affect some industries more than the others during a particular period of time.

According to theories and empirical evidence, mergers and acquisitions are driven by both industry-level and firm-level motivations stated above. Empirical studies from the US and UK argue that executive compensation is one of the important factors for driving mergers and acquisitions. Meanwhile, mergers and acquisitions lead to an increase in executive compensation according to many previous studies (Firth, 1991; Grinstein and Hribar, 2004; Girma, Thompson and Wright, 2006). Thus, in this study, we focus on analyzing the relationship between M&A activity and executive compensation in the Netherlands.

To analyze the impact of mergers and acquisitions on executive compensation, this study employs an unbalanced panel dataset which includes 107 listed Dutch firms over the period of 2002-2006. Executive compensation is separately measured as total compensation (fixed salary plus cash bonus plus shares plus options), cash-based compensation (fixed salary plus cash bonus) and stock-based compensation (shares plus options). M&A activity is measured as M&A dummy and M&A total number. Executives in this research include CEOs, CFOs and other board members. Panel data allows both period-fixed and board-member-fixed to be controlled for in this study.

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an acquisition, but the deal may be announced as a merger to the public, or vice versa. The employment of dynamic panel estimation permits an examination of the adjustment path adopted as well as that of the immediate impact effects. Based on the detailed dataset and dynamic panel estimation, this study is going to examine whether executive compensation increase result in M&A activities. We are also going to test whether executives are rewarded differentially for taking cross-border deals, 100% takeovers comparing with domestic and non-100% M&A deals; whether executives are rewarded differentially after the completion of the M&A deals relative to non-completed M&A deals (such as announced, rumor or pending). Further we are going to test whether executives are well rewarded in the past leads to higher M&A propensity. Moreover, this study is going to explore whether there is an incentive for executives to do M&As which are in line with shareholders’ interests; whether executive compensation is strongly related to firm size and firm performance; whether there is a difference in compensation between CEOs and the other executives (CFOs and other board members) result in M&A deals.

The paper is organized as follows: Section 2 provides literature review and hypotheses. Section 3 describes the econometric methodology and the dataset. Section 4 presents the empirical results. Section 5 reports the robustness tests and additional analyses. Section 6 states the limitations and the suggestions for further research. Section 7 provides the conclusions.

2. Literature Review and Hypotheses

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2.1 An overview of the literature on incentives and compensation

Economists argued that there are many conflicts of interests between firm owners and managers as a result of the separation of ownership and control, whether or not to take an M&A is one of the prominent conflicts. Theorists argued that mergers and acquisitions are driven by top executives’ self-serving incentives rather than by economic considerations. Empirical evidence from the research on UK firms revealed that shareholders’ wealth maximization appears to be a weak motivation in many acquisitions. Instead, increasing in executive rewards appears to be a strong motivating factor for acquisitions (Firth, 1991).

However, executives might have many different incentives to undertake mergers and acquisitions which might not be in the best interests of the shareholders, or even destroy the shareholders’ wealth. There are two main important motivations for executives to undertake mergers and acquisitions. One of them is that executives aim at improving their prestige or standing in the business community by acquiring other firms. The other motivating factor is that executives seek to increase their compensation by enlarging the sizes of their firms.

The argument for the personal prestige and social standing we can see as Jensen (1989:66) argued: "Corporate growth enhances the social prominence, public prestige, and political power of senior executives. Rare is the CEO who wants to be remembered as presiding over an enterprise that makes fewer products in fewer plants in fewer countries that when he or she took office-event when such a course increases productivity and adds hundreds of millions of dollars of shareholder value."

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acquisitions for their career security, because managers who complete acquisitions are less likely to be replaced.

Reich (1983:166) made argument for the executive compensation, he claimed that: "when professional managers plunge their companies deeply into debt in order to acquire totally unrelated businesses, they are apt to be motivated by the fact that their personal salaries and bonuses are tied to the volume of business, their newly enlarged enterprise will generate rather than to any potential for any added returns to shareholders."

2.2 Firm size, performance and executive compensation

Shareholders, or the boards, evaluate the executive compensation through the firm size and performance following mergers and acquisitions. As the firm size increases, the organizations become more complex and place greater demands on the executives’ management skill and experience. Labor market theory suggests "size-pay relation is the outcome of matching more talented executives with larger firms in which their managerial product is maximized"(Guest, 2005). These explanations imply that executive compensation increases in response to larger firm size following acquisitions, regardless of whether the acquisitions create value or not. Numerous empirical studies support the statement above, arguing that there is a strong and positive relationship between executive compensation and firm size.

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from 1986 to 1995, Bliss and Rosen (2001) reported that CEO compensation increase subsequent to acquisitions and largely through the impact on size.

Growth in firm size via mergers and acquisitions is a simple but important way for executives. If executive compensation is closely tied to firm size, then mergers and acquisitions which will result in an expansion of the firm is an attractive option for executives. Thus we offer the following hypothesis:

Hypothesis1: Executive compensation is significantly positive related to firm size.

Compared with firm size, firm performance has a much smaller, or even no significant influence on executive compensation according to the empirical evidence. Jensen and Murphy (1990) concluded that the compensation of top executives is virtually independent of performance. Empirical studies in UK in the 1990s demonstrated that there is a weak, or even no relationship between executives pay and firm performance (Gregg et al. 1993; Conyon and Leech, 1994). According to Conyon and Gregg (1994), executives pay is at best merely marginally influenced by firm performance.

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Similar statements were made by some other scholars, like Lambert and Larcker (1987), Khorana and Zenner (1998). They found that there is no significant increase in executive compensation result in wealth destroying acquisitions while wealth enhancing acquisitions lead to an increase in compensation. However, Anderson et al. (2000) showed that both types of acquisitions cause a significant increase in compensation, but wealth enhancing acquisitions lead to a larger increase. Similarly, Firth (1991), Avery, Chevalier and Schaefer (1998), Bliss and Rosen (2001) found that both types result in a significantly positive impact on compensation, but there is no significant difference between the wealth destroying and wealth enhancing acquisitions. Therefore we propose:

Hypothesis2: Executive compensation is significantly positive related to firm performance.

2.3 Shareholders' wealth and executive compensation

When executives engage in business activities, does their incentive align with shareholders' interests? Is there any difference in executive compensation growth between the wealth-reducing and wealth-enhancing business for shareholders? Many studies state that acquisitions, as one of the main business activities, are motivated more by managerial desires for increased firm size which increase their compensation, and less motivated by considerations of shareholders’ value. These statements are supported by some empirical evidence that acquisitions, on average, are detrimental to the shareholders’ profitability.

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et al., 1990; Hoskisson and Johnson, 1992). Avery, Chevalier and Schaefer (1998) argued that the effect of acquisitions on executive compensation does not depend on whether the acquisition improved shareholders’ wealth. There is no difference in compensation growth between managers who undertook shareholder-value- increasing acquisitions and those who undertook shareholder-value-reducing acquisitions.

However, some other scholars argued that the interests of senior managers are served when they enhance shareholders’ wealth. Top managers may try to enhance their firms’ value because of the influence of capital market signals, pressures from managerial labor markets, or the threat of hostile takeovers (Fama, 1980; Rozeff, 1982; Easterbrook, 1984; Martin and McConnell, 1991). Moreover, many senior managers are good stewards, they do businesses not only in order to increase their own rewards, but also enhance the wealth of shareholders (Kroll, Wright, Toombs and Leavell, 1997).

If executive compensation is significantly associated with shareholders’ wealth, executives would consider shareholders’ interests when they carry out business activities. Therefore we propose:

Hypothesis3: Executive compensation is significantly positive related to shareholder’s wealth.

2.4 M&A activity and executive compensation

The components of executive compensation comprise different parts. The total compensation is usually divided into cash-based and stock-based compensation. From the previous studies we found that the influence of M&A deals varies depending on different components of compensation.

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2.4.1 M&A activity and executive total compensation:

Whether executive compensation increases via making mergers and acquisitions, different results were demonstrated in different previous studies. The studies in 1980s and 1990s in the US explored that there is no significant relationship between M&A activity and executive compensation. Avery, Chevalier and Schaefer (1998) found that there is no significant difference on compensation growth between CEOs who undertook acquisitions and who did not. They argued that CEOs have an incentive to pursue acquisitions to improve their social prestige and their position in the business community, but they have no incentive to pursue acquisitions in order to increase their own compensation. Moreover, their study suggested that there is a decrease in compensation following small acquisitions. Lambert and Larcker (1987) reported that the changes in executive compensation in response to acquisitions are small by examining 37 large US acquisitions.

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empirical results as well via studying 167 UK companies. They argued that executives of companies carrying out acquisitions attain a significant pay premium.

Similar results were also found in the US in recent years. Grinstein and Hribar (2004) did a research on 327 large M&A deals in the US and reported that 39% of the acquiring firms cite the completion of the deal as a reason for rewarding their CEOs. Furthermore, bonuses were larger when the deals were larger and took longer time to complete. CEOs receive an additional $1.408 million on average for deal completion, and an additional $1.447 million for CEOs who are also heads of their boards. Therefore we predict:

Hypothesis4a: Executives who engaged in M&A activity experience higher total compensation than those who did not.

Hypothesis4b: The greater the number of M&As an executive engaged in, the higher his/her total compensation is.

2.4.2 M&A activity and executive cash-based compensation

Cash-based compensation, which is without shares, may cause managers do business for their own interests. They may wish to empire building, in this case they may not select targets carefully. They are not willing to take on much risk and they do not care whether they pay too much because they would not gain much from success and they would not lose much from failure. Therefore, executive cash-based compensation may not be related to M&A activity. Lambert and Larcker (1987) support the argument because they found that there is no significant relationship between acquisitions and executives’ salaries and cash bonuses.

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reported that in the UK executive compensation increases, especially cash compensation, following mergers and acquisitions. Therefore we predict:

Hypothesis5a: Executives who engaged in M&A activity experience higher cash-based compensation than those who did not.

Hypothesis5b: The greater the number of M&As an executive engaged in, the higher his/her cash-based compensation is.

2.4.3 M&A activity and executive stock-based compensation

For managers, large grants of company stock and stock-option pay have become more common. Executive stock ownership and stock options are regarded as the major incentives that support the alignment of interests between top managers and firm owners. Lambert and Larcker support the alignment assumption in their research in 1987. They found that managers who receive big amounts of stock-based compensation avoid acquisitions which do not increase the wealth of shareholders. With stock ownership, managers benefit from rising stock price but suffer reduction in their current wealth if the firm’s stock price declines. Their empirical results were consistent with the arguments made by Amihud and Lev (1981), Jensen and Murphy (1990). They suggested that executives who own big amounts of stock are more reluctant to engage in acquisitions. This is because share-holding executives avoid investments that do not increase the wealth of shareholders. Share-holding executives will lose something as the value of their stock decreases and thus they will be somewhat risk averse. It is very difficult for executives to predict which acquisitions will add value and which will reduce value. Therefore, stock ownership, as a form of compensation, is likely to cause executives to be more conservative and try to avoid acquisitions.

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negative stock performance but completely sensitive to positive stock performance. CEOs of the underperforming firms experience a net wealth increase of 46%, while the shareholders from the same corporations experience an average 10% reduction in their wealth.

Some other economists provided similar results as well. Haspeslagh & Jemison (1991) stated that some acquisitions produce very large outcomes when they are announced. Executives are more likely to predict that their acquisitions will have positive outcomes (Hayward & Hambrick, 1997). Outcomes mean that Companies become more potentially powerful subsequent to the potential increase in firm size or industrial diversification. Price of the stock may increases. Thus, executives have an opportunity to benefit from gains in stock price associated with some acquisitions. Therefore, stock options encourage a motivation for executives to seek for large gains from acquisitions because option pay does not destroy executives’ wealth even the acquisitions fail. Stock-option pay leads executives to take risks.

In Harford and Li's research (2007), CEOs are granted with high percentage of stock and stock option of their compensation. CEOs' total pay and wealth increase following the year of acquisitions, and about one-third of the growth are from stock and stock-option grants. Therefore we predict:

Hypothesis6a: Executives who engaged in M&A activity experience higher stock-based compensation than those who did not.

Hypothesis6b: The greater the number of M&As an executive engaged in, the higher his/her stock-based compensation is.

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the M&A deals is completed or not (announced, rumor etc.)?

a) Cross-border M&A deals and executive compensation:

In the race for global competitiveness, M&A is one of the most important corporate-level strategies to achieve economies and market power abroad. M&A is an attractive entry mode for managers to enter the foreign market because comparing with another entry mode, Greenfield, M&As consume less time and undertake less risk. Therefore, cross-border M&A deals have been commonly employed by firms.

Cross-border M&As may cause higher increase in executive compensation relative to domestic M&A deals. Cross-border M&A deals, by expanding the scope of the firms internationally, may result in more complex organizations than domestic deals. Due to physical, cultural and language distances, multiple currencies, different legal systems, multinationals face informational complexities (Duru and Reeb, 2002). In this case, the integration process is more complex and requires more work for executives. Furthermore, Murphy (1999), Cheffins (2003), Cheffins and Thomas (2004) stated that as the acquired firms are from countries in which the pay systems are higher may result in higher compensation gains for executives. Thus we suggest:

Hypothesis7a: The impact of cross-border M&A deals on compensation is significantly higher than domestic deals.

b) 100% takeovers and executive compensation

By carrying out 100% takeovers, executives might have more responsibilities for the management. Executives might also take more risks in making strategic decisions in the future. Therefore, executives may achieve higher compensation via carrying out 100% takeovers relative to the non-100% M&A deals. Thus we suggest:

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c) The completion of the M&A deals and executive compensation

In our M&A deals data, 65% of the deals are stated as completed while 35% are stated as not completed on average at the end of a particular year. Grinstein and Hribar (2004) reported that in the US, there are 39% of the acquiring firms cite the completion of the deal as a reason for rewarding their CEOs. In our study, we take non-completed M&A deals into account because in the real world, an announcement or a rumor of an M&A also affects executive compensation, especially their stock-based compensation via the changes in stock price. However, considering the completion of the M&A deals, executives must consume more time and energy on the procedure of completing the deals comparing to the other deals which are announced but not completed in that year. Thus we suggest:

Hypothesis7c: The impact of completed M&A deals on compensation is significantly higher than non-completed deals.

2.5 The impact of executive compensation on M&A propensity

Considering the endogenous nature of executive compensation and M&As, we now explain M&A activity as a function of executive past compensation.

Some scholars stated above that even wealth destructive acquisitions can lead to an increase in executive compensation and wealth, therefore there might be a significant influence of compensation on acquisition propensity. Sanders (2001) demonstrated that higher levels of executive compensation promote more acquisition activities. Therefore, compensation level and structure might affect executives’ motivation for future acquisitions. Meanwhile, Guest (2005) explored that executives are more likely to carry out future acquisitions if they have been well rewarded for previous acquisitions.

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resulting from the post-acquisition performance. CEOs from acquiring firms are barely punished by carrying poor-acquisitions, but generously rewarded for positive performance Harford and Li (2007). With the downside protection4, such as stock option grants, which the shareholders provide to discourage managerial risk aversion, eliminates the downside risk from acquisitions, executives might tend to carry out more mergers and acquisitions in order to achieve greater compensation. Therefore we predict:

Hypothesis8: Executives are more likely to engage in M&A activity if their past compensation is high.

Hypothesis9: The number of mergers and acquisitions executives engage in is positively related to their past compensation.

3. Methodology

3.1 Model, variables and estimation method

3.1.1 Model

To test the impact of mergers and acquisitions on executive compensation we build on a basic relationship between executive compensation and the various determinants which have been identified as important in the literature review on executive remuneration (see Girma, Thompson and Wright, 2006; Harford and Li, 2007; van Ees, van der Laan, and Witteloostuijn, 2008). This basic relationship can be written as follows:

LnCompensation it = β0 + β1Sales it + β2Employees it + β3Profit it + β4EPS it +

β5RTSR it + β6M&A it + β7M&A it-1 + β8M&A it-2+ β9M&A it-3 +β10M&A it-4 + e it (1)

3.1.2 Variables

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Dependent variables: We examine three types of distinct executive compensation:

total compensation, cash-based compensation and stock-based compensation.

Compensation it is defined as the compensation for executive i (i=1, 2,……501) in year t (t=2002-2006). We study compensation in natural logarithm since this ensures linearity controls. Furthermore, some previous study also measured compensation in logarithm (see Avery, Chevalier and Schaefer, 1998; Girma, Thompson and Wright, 2006; van Ees, van der Laan, and Witteloostuijn, 2008).

Independent variables: In keeping with our hypothesis, M&A it is measured as a set of dummy variables and total number variables (respectively measured in separated regressions) of mergers and acquisitions for the years surrounding (from 1998 to 2006). M&A dummy variables measure the direct effect of mergers and acquisitions on compensation. M&A total number variables measure the effect of the deals number on compensation. According to the previous studies, it takes time for the effects of M&A activity on executive compensation to be observable, therefore separate M&A variables are defined for the year following M&A activities and then for each of the following four years to capture lagged effects. We measured the effects of M&As for lagged four years because 1998 is the year in which M&A activity boom started in the Netherlands. Furthermore, Guest (2005) reported the offsetting decline happens two years after acquisitions in the UK while Girma, Thompson and Wright (2006) found that the impact of M&As on compensation in the UK starts to decrease in the third year after M&A activities. Therefore, we are going to test in which year the impact would be negative after examining the impact for every four years in the Netherlands.

Control variables: Sales represents firm sales and is the measure of the company size

in this study. Most previous studies have found that there is a positive significant relationship between compensation and firm size; therefore Sales is necessary to be controlled for. The Employees (fte5) is included as a control variable, which also

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measures firm size. Profitis used to evaluate firm performance here. Some studies show firm performance is positively correlated with executive compensation while others show there is no significant relationship between firm performance and executive compensation. RTSR is the relative total shareholder return. TSR, total shareholder return, was computed for each company in the sample, and RTSR is defined as the deviation of company TSR from the cluster mean (van Ees, van der Laan, and Witteloostuijn, 2008). RTSR is used to analyze the shareholders’ interests, to evaluate wealth-enhancing or wealth-destroying performance, so RTSR is also necessary to be controlled for. We are going to test if there is a significant relationship between shareholder’s wealth and executive compensation so that we can see whether the alignment of interests between managers and shareholders is supported in the Netherlands. EPS is the earnings per share (net earnings divided by the number of outstanding shares), which represents the potential performance of each company. EPS is controlled for because when the earnings per share is higher, indicating that firms have better potential performance in the future. Therefore, executives might be rewarded with higher compensation.

3.1.3 Estimation method

Panel fixed effects estimation was adopted by many previous studies on the relationship between executive compensation and M&A activity (see Grinstein and Hribar, 2004; Girma, Thompson and Wright, 2006; Harford and Li, 2007). The panel design adoption allows us to circumvent some of the usual difficulties associated with isolating the impact of the M&A of economic outcomes (Girma, Thompson and Wright, 2006). We employ Hausman test6 and found that the random effects estimation is inappropriate in our study. Therefore we adopt fixed effects estimation. With panel fixed effects estimation, we are able to control for board member-specific

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fixed effects and period-fixed effects. Furthermore, we can also allow for the possible endogeneity of M&A activity in the compensation process.

The correlation coefficients among the independent variables are quite low implying that multicollinearity is not a problematic issue here. Both board member and period fixed effects have been included in all the models. Fixed effects estimation has been found to be most robust against contemporaneous correlation and heteroskedasticity (Certo and Semadeni, 2006). Serial correlation has been tested for and we found that this is no longer a problem as we adopt period fixed effects. However, endogeneity of some of the independent variables may be an issue here, equation (1) does not control for endogeneity.

3.2 Data description

The data used in this analysis is derived from two separate sources. The first source is the database used in the paper written by van Ees, van der Laan, and van Witteloostuijn (Pay-performance Relationships in the Netherlands. An analysis of Dutch executive compensation, 2002-2006.) From this paper, executives (CEOs, CFOs and other board members) Compensation, Sales, Profit, RTSR and EPS for 501 executives in 107 stock-listed Dutch firms over the period of 2002-2006 are derived. In this paper, it stated that information on executive compensation, which includes fixed salary and cash bonus, stock ownership and stock option, are derived from the annual reports of these firms. Firm performance data, include Sales, Profit, RTSR and EPS, was collected from the Thompson Financial’s DataStream database. Our compensation model is estimated from 2002 to 2006. Our final sample consists of an unbalanced panel of 107 firms between 2002 and 2006 for which we have 1498 observations on 501 executives. The balance of the panel is show in table 2.

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January 1st, 1998 to December 31st, 2006. Nine successive years of M&A data are required because the regression model described in equation (1) requires 4 years of lagged data. Our compensation model is estimated from 2002 to 2006, but for 2002 observations we require M&A data going back to 1998. We take the data on M&As over this period of time because it is coincidence with the merger wave in the Netherlands. In 1997, there are only 59 M&A deals made by the sample firms. However, since 1998, mergers and acquisitions started to boom. M&A deals are defined that the acquiring companies are the 107 stock-listed firms in the Netherlands, the target companies are in both domestic and foreign countries. Deal type includes both 100% takeovers and others non-100% deals, deal status involve completed, announced, rumor or pending. We consider a deal as completed in year t if it was stated as completed in that year.

The final sample consists of 1549 M&A deals (see table 4), carried out by the 107 firms. The sample consists of 749 100% takeovers, and the other 800 deals are not 100%. There are 1007 cross-board deals while the domestic deals are 542. 1012 deals among the total of 1549 are completed, while the other 537 are announced, rumor or pending etc.

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shares and option (stock-based compensation). For the variable M&A we employ both dummy variable and total number variable of mergers and acquisitions for each analysis of compensation. Furthermore, we are also going to test if there is difference on executive compensation between different features of M&A deals, such as cross-border and domestic deals, 100% takeovers and non-100% M&A deals, completed deals and non-completed deals. Moreover, we are also interested to estimate if there is a difference in compensation and M&A rewards (compensation following mergers and acquisitions) between CEOs and other board members in our sample firms.

4. Empirical Results

4.1 The impact of M&A activity on total compensation

Table 7 reports the impact of mergers and acquisitions on executive total compensation. Column (1) reports the effects of the control variables on total compensation without considering M&A variables. The results show that both of the coefficients for sales and employees are positive but statistically insignificant at high levels, implying that there is no significant influence of firm size on executive compensation. We fail to support the hypothesis1 which suggested that executive compensation is significantly positive related to firm size. Likewise, the coefficient for profit is positive but not statistically significant as well. Hypothesis2 is also failed to be supported. However, the coefficient for RTSR is positive and significant at 1% level. Therefore, hypothesis3 is accepted, executive total compensation is found to be significantly positive related to relative total share return. There is a strong relationship between executive total compensation and shareholders’ wealth. Earnings per share are negatively associated with executive total compensation but not significant.

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statistically significant at high levels. We fail to accept hypothesis4a which suggested executives who engaged in M&A activity experience higher total compensation than those who did not. The coefficient for M&A dummyit is positive, while the

coefficients for M&A dummyit-1 and M&A dummyit-2 are negative, implying that

executive total compensation increases in the contemporaneous year but declines one and two years following the mergers and acquisitions.

Column (3) reports the impact of the number of mergers and acquisitions on executive total compensation. The results of column (3) support hypothesis4b. The coefficient for M&A total numberit is positive and statistically significant at 1% level, implying

that an additional M&A carried out would results in 3% increase in executive total compensation in the contemporaneous year. The coefficient for M&A total numberit-2

is positive as well and statistically significant at 10% level, indicating that one more M&A made would lead to 2% increase in executive total compensation two years after the M&A activity.

Column (4) reports whether there are differential impacts on executive total compensation between cross-border and domestic deals, 100% takeovers and non-100% deals, completed and non-completed deals. We adopt additional sets of dummy variables (M&A cross-borderit, 100% takeoverit and M&A completedit) which

are set equal to one if the M&A is cross-border, 100% takeover or completed, zero if the M&A is domestic, non-100% or non-completed. The coefficient for M&A cross-border it is positive and statistically significant at 1% level, indicating that the

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is significantly higher than domestic deals. The coefficients for 100% takeovers are positive and the coefficient for the year t-2 is statistically significant at 10% level. Hypothesis7b is accepted. The coefficient for M&A completed is positive and statistically significant at 5% level in the year t-1 and the significantly positive impact lasts till the year t-2; the coefficient is positive and significant at 1% level. Hypothesis 7c is accepted as well that the impact of completed M&As on executive compensation is positive and statistically higher than non-completed deals.

In summary, the difference in the effects between cross-border and domestic M&As is significant. The increase in the contemporaneous year and the decline in the 4th year following M&A activities are significantly greater for cross-border deals compared to domestic deals. The only significant difference between 100% takeovers and non-100% deals is that the increase in the 2nd year following M&A activities is significantly higher for 100% deals relative to non-100% ones. The difference between completed and non-completed M&A is that the increase in the 1st and 2nd year following the M&A activities is significantly greater for completed deals compared to non-completed ones.

Column (5) reports the differential compensation for CEOs and other board members. CEO dummy variable is set equal to one if the executive is a CEO and zero if he or she is not a CEO. The coefficient for CEO dummy is significantly positive at 1% level. This implies that CEOs’ compensation is significantly higher than the other border members following M&A activities.

In column (6) we include dummy variables for CEO*M&A dummy, enabling us to examine the differential impact of CEO whilst controlling for any differential impact of mergers and acquisitions, and vice versa. However, there is no significant impact on compensation in our results

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4.2 The impact of M&A activity on cash-based compensation

Table 8 reports the impact of mergers and acquisitions on executive cash-based compensation. From the results in column (1), we found that the coefficient for sales is positive and statistically significant at 1% level. Therefore, executive cash-based compensation is significantly positive related to firm-size. The coefficient for profit is positive as well and statistically significant at 5% level, implying that executive cash-based compensation is significantly positive related to firm performance. The coefficients for RTSR and EPS are the same as we reported in table 7. Executive cash-based compensation is significantly positive related to relative total share return but negatively insignificant to earnings per share.

Turning to the effects of M&A activity, column (2) of table 8 reports the impact of M&A dummy variables on executive cash-based compensation. All the coefficients for M&A dummy variables are statistically insignificant, indicating that there is no significant influence of mergers and acquisitions on executive cash-based compensation. Hence we reject hypothesis5a which predicted executives who engaged in M&A activity experience higher cash-based compensation than those who did not.

Column (3) reports the total number of M&A variables on executive cash-based compensation. The results are inline with hypothesis5b therefore we fail to reject hypthesis5b. The coefficients for M&A total number it and it-1 is positive and significant at 5% level and 10% level respectively. This result implies that in the contemporaneous year and the 1st year following M&A activities, the total number of M&A is significantly positive associated with cash-based compensation. The coefficients for M&A total number it-2, it-3 and it-4 are not different from zero.

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for all M&A cross-border dummy variables are statistically insignificant at high level. However, the coefficients for both 100% takeovers it and it-1 are positive and statistically significant at 5% level, implying that the positive impact on cash-based compensation is significantly higher for 100% takeovers than it is for non-100% deals in the contemporaneous year and in the 1st year following the M&A activities. For completed M&A dummy variables, the coefficients for it and it-1 are statistically significant at 1% and 5% level respectively. Therefore, the positive impact is significantly higher for completed M&A than it is for non-completed M&A in the contemporaneous year and one year after the M&A deals.

Column (5) reports that there is a significant difference in cash-based compensation between CEOs and other board members. In column (6), we find that the coefficients for CEO*M&A dummy it and CEO*M&A dummy it-3 are negative and significantly at

10% level. Therefore, CEOs who carried out M&A deals achieve lower cash-based compensation than the other executives who did not engage in M&A deals in the contemporaneous year and three years after the M&A activity.

INSERT TABLE 8 HERE

4.3 The impact of M&A activity on stock-based compensation

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significance level. Comparing to the total compensation and cash-based compensation, stock-based compensation is positive related to earnings per share, but the relationship is insignificant as well.

Column (2) of table 9 shows that there is no significant relationship between M&A dummy variables and executive stock-based compensation, which is consistent with the impact of M&A dummy variables on executive total compensation and cash-based compensation. Therefore hypothesis6a should be rejected. Column (3) reports the impact of the total number of M&A deals on executive stock-based compensation. The results partially support hypothesis6b. The coefficient for M&A total numberit is

negative but not significant at high level. However, the coefficient for M&A total numberit-2 is positive and statistically significant at 1% level, while the coefficient for

M&A total numberit-3 is positive and statistically significant at 5% level. This result

implies that executive stock-based compensation increases two years following the mergers and acquisitions. The increase persists in the 3rd year following the deals but an offsetting decline occurs in the 4th year. However, the offsetting decline is not statistically significant. Comparing with the total compensation and cash-based compensation, the effect of mergers and acquisitions number on stock-based compensation takes longer time.

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for completed deals than it is for non-completed deals.

Column (5) and column (6) reports that there is no difference between CEOs’ stock-based compensation and the other executives’ stock-based compensation. The impact of CEOs who carried out mergers and acquisitions on stock-based compensation is positive but statistically insignificant.

INSERT TABLE 9 HERE

In summary, sales, employees, profit and EPS have no significant influence on executive total compensation while relative total share return has significantly positive impact on total compensation. Hence, total compensation is not significantly related to firm size and firm performance, this result is not inline with most of the previous statements (see Jensen, 1986; Girma, Thompson and Wright, 2006). However, sales and profit play an important role in the influence on cash-based compensation while employees and profit are significantly positive associated with stock-based compensation. Therefore, the influences of these variables on executive compensation are mixed while relative total share returns is always an influential variable for all compensation.

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following M&A activities. Girma, Thompson and Wright (2006) stated that the impact of acquisitions on executive compensation is positive in the period 2 years after the event but it starts to be negative since the 3rd year after the acquisition events. Our findings are not inline with their statements. In our study, the impact of all the M&A total number variables (from the year t to t-4) on executive total compensation and cash-based compensation are positive while the impact on stock-based compensation is negative in the contemporaneous year and the 4th year following the M&A deals. However, Girma, Thompson and Wright (2006) did not measure M&A as total number variable; they only measured M&A as dummy variable. Hence the results are not definitely comparable.

Executives are rewarded with significantly higher total and stock-based compensation for taking cross-border M&A deals in the contemporaneous while they are rewarded with significantly lower total and stock-based compensation in the 4th year after taking cross-border deals. Total compensation is only rewarded higher in the 2nd year for taking 100% takeovers while cash-based compensation is higher rewarded in the first 2 years. Stock-based compensation is not rewarded differently for taking 100% takeovers and non-100% deals. Executives are rewarded with higher total and cash-based compensation after the completion of M&A deals. Their total rewarding is significantly higher in the 1st and 2nd years while their cash-based rewarding is significantly higher in the first 2 years. The significant higher rewards for executive stock-based compensation happened in the 2nd and 3rd year after the completion of M&A deals.

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4.4 The impact of executive compensation on M&A propensity

In this section we turn to examine whether executive past compensation reward affect M&A activity decisions. If executives carry out M&A deals in order to increase compensation, then executives who have been most highly compensated in the past are more likely to make M&A deals.

Modeling the probability of M&A activity:

In order to examine the relationship between M&A probability and compensation, we employ Logit7 model regression estimation because the error terms are not standard normally distributed.

Modeling the number of M&A deals:

As we are going to examine the association between the number of M&A deals and executive past compensation, M&A total number is defined as the dependent variable. In this case, there are 626 observations are zero while the other 397 observations are positive. The OLS estimator is biased and inconsistent for model using censored data8. An appropriate estimation procedure is Tobit9. Therefore the Tobit model regression estimation is used to examine whether the executives carry out more M&A deals as they achieve higher compensation in the past.

Variables and estimation model:

Previous studies show that Sales, Profit and EPS have positive impact on M&A activity propensity (Hughes, 1989); hence we employ these variables for the Logit model estimation. Shareholders’ return may reflect the quality of previous M&A deals which may affect the probability of M&A activities. The quality of previous M&A

7

Logit Model depends on the assumption that the random errors follow a logistic distribution instead of normal distribution. Hill, Griffiths and Lim (2007)

8_{Censored data means that a substantial fraction of the observations on the dependent variable take a} limit values which is zero.

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deals may affect the probability of acquisitions because it may indicate whether firm owners benefit from the M&A activities or not. Therefore I also employ RTSR in the regression. The variable of Employees is also controlled for here, as a measure of the firm size. The equation we therefore run is as follows:

M&A it = β0 + β1LnCompensation it-1 + β2Sales it-1 + β3 Employees it-1 + β4 Profit it-1 +

β5 EPS it-1 + β6 RTSR it-1 + e it (2)

In case of the M&A it as the dummy variables, the dependent variable M&A is one if a

firm carries out an M&A in year t, zero if the firm does not. The above equation is just the z-value equation of Logit model. The Logit model function is as follows:

P = F (β0+β1LnCompensationit-1+ β2Salesit-1+ β3 Employeesit-1+ β4 Profit it-1+ β5 EPSit-1 + β6 RTSR it-1)=1/(1+e–(β0+β1LnCompensation it-1 + β2Salesit-1+ β3 Employeesit-1+ β4 Profit it-1+ β5 EPSit-1+ β6 RTSR it-1)

)

F is the cumulative standard logistic distribution function.

In case of the M&A it as the total number variable, it is a censored data, therefore I

employ Tobit model regression estimation for equation (2).

Empirical results:

The results of the Logit model regression are reported in Column (1), (3) and (5) of table 10. All the coefficients for LnCompensation it-1 are statistically significant at 1%

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interests show a significant impact on most M&A deals, but not all, because the coefficient for RTSR is insignificant in column (5).

Column (2), (4) and (6) measures the relation between the number of M&A deals and executive compensation. The results of the Tobit regression model are reported, all the coefficients for lagged compensation are statistically significant positive at 1% level, indicating that the total number of M&A deals for firms are strongly positive related to prior executive compensation. Hypothesis9 is accepted. One more M&A deal would be carried out as the executive past total compensation increased by 62% (1/1.62). The impact of cash-based compensation is similar as total compensation does. However, the impact of stock-based compensation is weaker relative to cash-based and total compensation. One additional M&A deal carried out subsequent to 175% (1/0.57) increase in stock-based compensation. The coefficients for profit are significantly positive at 1% level while the coefficients for RTSR are significantly positive at 5% and 1% level in column (2) and (4). Therefore, firm performance and shareholders’ interests are significantly positive associated with most of the M&A activities.

INSERT TABLE 10 HERE

5. Robustness Tests and Additional Analyses

5.1 Robustness tests

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0.63, 0.61 respectively, in table 6a and 6b), but they are still lower than 0.8.10 The White tests show that heteroskedasticity is an issue in our model. Heteroskedasticity does not cause coefficient estimates to be biased. However, ignoring heterokedasticity leads to standard errors incorrect and therefore the confidence intervals and hypothesis tests will be misleading. Therefore, we adopt White Heteroskedasticity-Consistent Standard Errors & Covariance to correct the standard errors (in table 7, 8 and 9). There is no longer a problem for autocorrelation as I employed panel fixed effects estimation since all the Durbin-Watson Stat. values are close to 2. However, when we employ panel fixed effects estimation, the endogeneity may be an issue, we do not control for this problem in our above estimation.

5.2 Additional analyses: Instrumental Variables (IV) Estimation

Many previous studies show that lagged compensation is an important factor in the determinants of compensation since there is a significant persistence in executive compensation (Girma, Thompson and Wright, 2006; Harford and Li, 2007). Therefore we are going to make a new equation to test the persistent impact.

We take the first difference transformation of equation (1) and adopt instrumental variables (IV) estimation instead of least squares estimation to correct endogeneity issue. Endogeneity problem exists when an explanatory variable and the error terms are correlated. Endogenous variables are variables which are determined within the system. When we measure the relationship between M&A deals and executive compensation, we find that executive compensation is higher when he or she engages in more M&A deals. Meanwhile, executives have higher propensity to carry out M&A deals if their past compensation is higher. Therefore, carrying out M&As results in higher executive compensation and higher compensation leads to higher M&A activity propensity. The variable M&A and compensation are endogenous variables.

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Considering the variable Employees is also measured as firm size we remove it from the equation. The new model is as follows:

∆LnCompensation it = β0 + β1∆LnCompensation it-1 + β2∆LnSales it + β3∆Profit it +

β4∆RTSR it + β5∆EPS it + β6 M&A it + β7 M&A it-1 + β8 M&A it-2 + β9 M&A it-3 +

β10 M&A it-4 +e it (3)

The operator ∆ here on any variable is the current value minus last period value, for example, ∆LnCompensation it =LnCompensation it – LnCompensation it-1.

The variables M&A are only measured as M&A dummy variables here.

Taking the first differences as in equation (3) leads to an MA (1) error term11, the lagged dependent variable will be correlated with the equation disturbance term, consequently the estimation of this dynamic panel data model by least squares results in biased estimates on the coefficient of lagged dependent variable, β1 (Nickell, 1981).

We employ LM test to test this problem. The results show that the coefficient for eit-1 is statistically significant at 1% level. Therefore the null hypothesis of no autocorrelation is rejected. This indicates that the error term is correlated with the lagged dependent variable. Therefore an instrumental variable estimation technique must be adopted to avoid such problem. The MA (1) error structure suggests that under the null hypothesis of no serial correlation, valid instruments are those dated t-2 and earlier. Here we instrument ΔLnCompensation it-1 with lags of compensation in

logarithm (Lncompensation it-2). This approach has been employed by previous empirical

executive pay studies in the UK (Conyon, 1997; Girma, Thompson and Wright, 2006).

Table 11 reports the results for equation (3). The period of samples adjusted to

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2005-2006, therefore the observations are very small with only 331 for total compensation and cash-based compensation, 104 for stock-based compensation. With this short period of time and small observations, the results might not be able to reflect the relationship between M&A activity and executive compensation precisely. The results show that the persistence of lagged compensation is insignificant which is inconsistent with the empirical evidence from UK. The link between firm size and executive compensation is weak. Firm performance only has strong positive relations with executive cash-based compensation. The coefficient for profit is positive and statistically significant at 1% level. However, there is a very significant positive relation between shareholder’s wealth and executive compensation. This is in line with the estimation results for equation (1).

M&A dummy variables have no significant influence on executive total compensation and cash-based compensation, but have significant negative impact on stock-based compensation in the contemporaneous year.

INSERT TABLE 11 HERE

6. Limitations and Suggestions for Further Research

Although this study employed detailed data and different methodologies, it is also has limitations like most researches. First, the time period of the samples is only for 5 years, from 2002 to 2006. It is fairly short comparing with the previous studies. Therefore as we adopt the instrumental variable estimation to correct the problem of endogeneity, the results are not proper enough to explain the relationship between the variables.

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this case, sales of part of these firms could also affect executive compensation. However, we did not measure this impact because of lacking of this part of data.

Third, in our study, we did not classify the M&A deals by industries. We did not measure whether there is a difference in executive compensation between related industry M&A deals and unrelated industry M&A deals. Further, since we did not acquire the data for Herfindahl index12, we did not analyze whether the industries in the Netherlands become more concentrated after the merger wave in 2007 relative to 1997.

Fourth, since the data for corporate governance, like executive tenure, outside directors’ proportion and compensation are not available in our study, we did not explore whether the impact on executive compensation is different between firms with different governance systems. We did not explore whether the propensity of M&A activity is different between corporations with various governance levels as well. Therefore, in the further research, the variable of corporate governance is possible to take into account.

Empirical evidence shows that the level and structure of top management compensation packages is heavily influenced by corporate governance response to various cultures in different countries. In the US, the corporate governance system is characterized by dispersed ownership, an efficient market for corporate control, little political intervention, and a focus on shareholder concerns. On the other hand, in Germany, the corporate governance system is concentrated ownership, strong political intervention, and an internal control of management through powerful owners and worker co-determination. Tuschke (2003) showed that the US executives receive

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higher compensation than German managers in the same corporations following acquisitions.

Wright et al. (2002) found that firms with a high percentage of independent directors experience less acquisitions driven by CEOs’ self-serving motives. Outside directors are more likely to concern with their reputation while managers are concerned with their employment security. The effect on firm’s strategy of outside directors depends on the relative power of the board members in relation to the top management team. Outside directors are more effective in influencing a firm’s decision making than inside director, especially when a firm has high proportion of outside directors (Peng, 2004).

7. Conclusions

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First, this study demonstrates that firm size and firm performance is completely insignificant related to executive total compensation. When we consider the total compensation, the size-compensation relation is inconsistent with most previous studies while the performance-compensation relation is inline with many previous evidence from the US and UK. However, the impact of Sales and Profit on cash-based compensation turns up significant and positive while Employees and Profit have a significantly positive effect on stock-based compensation. An additional measurement of the impact of Profit following M&As (Profit*M&A) on compensation was employed and the result shows that the impact is insignificant, indicating that Dutch executive compensation do not differ significantly between whether M&A deals create values or not.

Second, in contrast to many arguments that managers may do business which benefits their own self-interests than those of the shareholders, the relationship between executive compensation and RTSR is significant and positive in our study. This result indicates that shareholders’ interests play an important role in the determinants on executive compensation in the Netherlands. Economists argued that executive stock ownership and stock options are regarded as the major incentives that support the alignment of interests between top managers and firm owners. Our findings support this alignment assumption. The compensation structure with substantial stock shares and options grants (accounts for 17% of total compensation on average) in Dutch firms are aligned with the interests between executives and shareholders.

From the results and comparisons stated above, we conclude that firms in the US and UK reward managers more based on firm size while firms in the Netherlands reward executives more based on shareholders’ interests. This is because of the differences in culture, business environment and management systems etc. across countries.

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Perrin (2000) stated that, in the US, the stock-based compensation of CEOs amounts to an average of 110% of their base salary. In contrast, German CEOs receive, on average, around 20% of their base salary. Based on this various percentage of stock-based compensation, Tuschke (2003) reported that according to the German managers, managers in the US put too much emphasis on short-term success. Further, the US managers overly focus on shareholders’ interests and have a comparatively high risk exposure, but tend to neglect the interests of other stake-holder groups. Contrary, the US managers claimed that German managers pay too little attention to market requirements, less innovative but more risk-averse. This is because German executive compensation is too little performance-oriented with relatively low grants of stock-based compensation. However, in the Netherlands, we find that the stock-based compensation of executives amounts to an average of 45% of their cash-based compensation. As an approximate comparison, we find that the percentage of stock-based compensation in the Netherlands is between the US and Germany. Based on the findings in our result, we can say that with a relatively substantial stock-based payment, executives may consider to keep their own interests, shareholders’ interests and stake-holder groups’ interests in a balance.

Third, we indeed find that there is no significant difference in executive compensation between executives who carried out M&A activities and those who did not. The impact of M&A dummy variables on compensation turns up insignificant. The reason for this phenomenon might be that most of the sample firms in our study carried out M&A deals over the period 1998-2006. This result is inconsistent with many previous studies (Khorana and Zenner, 1998; Firth, 1991; Conyon and Gregg, 1994; Girma, Thompson Wright, 2006). However, the results in our study demonstrate that executives achieve greater compensation as they carry out more M&A deals. The increase in stock-based compensation takes longer time than that in cash-based compensation.

The Relationship between M&A Activity and Executive Compensation in the Netherlands