An Examination of Pre-Merger Executive Compensation Structure in Merging Firms *

Lynch, Luann J., Perry, Susan E., Journal of Managerial Issues

In recent years, growth through acquisition has been an important strategy for many firms. While considerable attention has been devoted to merger valuation analysis, less consideration has been paid to successful integration of merging firms (Carey, 2000; Anonymous, 1999). Differences in culture, corporate philosophy, management style, corporate structure, and compensation are just a few of the important subjects to be reconciled. Much media attention has been given to the difficult issues of combining management and structuring executive compensation packages (Schellhardt, 1999). DeVoge and Shiraki (2000) suggest that issues involving employees are often the most poorly handled in mergers and acquisitions, and that this poor handling can create problems that may undermine the success of the merger. Yet, at the executive level, mergers can create problems due to uncertainties about job responsibilities, power sharing, and compensation. This study focuses on one of these important issues, namely compensation issues.

Recent merger activity has motivated considerable discussion of executive pay. In some cases, significant differences in pre-merger compensation structure and magnitude have raised interesting questions of firm compatibility. One recent example is the merger between Citicorp and Travelers Insurance. John S. Reed, CEO of Citicorp, and Sanford I.

Weill, CEO of Travelers, agreed to act as Co-Chairmen and Co-Chief Executive Officers for the new firm, Citigroup. Prior to the merger, Weill had substantially higher compensation than Reed. Media reports raised doubts that Weill and Reed could successfully integrate the two firms and predicted turf battles in the future (Dwyer, 1998). Anecdotal evidence suggests that retention issues may arise during acquisitions. In our sample, of the 1,612 executives listed in the proxy statement as top-five executives of the pre-merger acquiring firms, only 1,112 appear as one of the top-five executives after the merger. Furthermore, target-firm executives seldom appear in the top-five list after the merger. (1) Assuming the desire to retain top executives from both firms, at least in the short term to facilitate post-merger integration, large differences in total compensation may create challenges for the integration process. These challenges may be particularly important when the merger is outside the acquiring firms' c ore competencies and there is a critical need to retain target-firm executives for their expertise. In fact, Walsh (1988) suggests that a merger may be attractive due to the acquisition of target-firm management.

Acquiring and target firms can exhibit pre-merger differences in either levels of compensation or in compensation mix, including salary and performance-based components such as bonuses, restricted stock, long-term incentive plans, and stock options. The compensation disparities can be particularly troublesome if they impede integration of the two firms after the merger. Closing large pay gaps can begin to chip away at the merger's proposed savings. Alternatively, allowing large differences in compensation to continue after the merger can result in morale problems among members of the lower-paid executive team. Equity theory (Adams, 1963, 1965) suggests that when individuals perceive that large inequities in relationships with others exist, individuals feel distress and use various techniques to reduce that distress, including but not limited to, altering or terminating the relationship.

While research on executive compensation has increased dramatically in recent years, (2) research examining the relation between merger activity and compensation structure is limited. Two studies examine whether post-merger executive compensation is associated with post-merger firm financial performance. These studies find mixed results. Schmidt and Fowler (1990) find that post-merger compensation for acquiring firm executives does not relate to post-merger firm financial performance. However, Lambert and Larcker (1987) find that post-merger increases in executive compensation are associated with post-merger increases in shareholder wealth. Both studies limit their analysis to cash compensation. In contrast to these studies, our study, which includes both cash and equity-based compensation and is motivated by concerns that differences in those structures may affect successful integration of the merging firms, focuses on the pre-merger compensation structures of acquiring and target firms.

Successful merger integration requires an awareness of compensation disparities and thoughtful reconciliation of the pre-merger compensation structures of the merging firms. This study facilitates our understanding of these issues. In this study, we untangle the nuances of pre-merger compensation structure for a sample of firms involved in merger activity. Specifically, we examine and provide potential explanations for the pre-merger differences in acquiring- and target-firm compensation structures. Using executive compensation data from a sample of 321 mergers occurring from 1994 to 1996, we examine pre-merger executive compensation structures of acquiring and target firms. We document significant differences in executive compensation structures between acquiring and target firms before the merger. On average, executives in acquiring firms earn significantly greater total compensation than executives in target firms. In part, this difference is explained by pre-merger differences in firm size and growth oppo rtunities between acquiring and target firms. Prior to the merger, acquiring firms, on average, pay significantly higher salaries and award significantly higher annual bonuses, restricted stock, and other long-term incentive compensation, and grant stock options with significantly greater value than do target firms. Further, more acquiring firms than target firms award annual bonuses, restricted stock, other long-term incentive compensation, and stock options. While salary accounts for a larger proportion of the average executive's compensation in target firms, performance-based compensation such as bonuses and stock options account for a larger proportion of compensation in acquiring firms. In part, these differences are explained by pre-merger differences between acquiring and target firms in size and performance.

Notably, our models relating pre-merger differences in compensation to pre-merger differences in these well-documented determinants of compensation structure (i.e., size, growth opportunities, and performance) leave a significant portion of the difference in pre-merger compensation unexplained. Executives likely may understand pay differences attributable to these well-known factors. However, since these factors explain only a portion of the pre-merger compensation differences, it may well be the less obvious factors that create the greatest perceived inequities and thus the greatest integration challenges.

The remainder of this article is organized as follows. In the next section, we discuss …

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Publication information: Article title: An Examination of Pre-Merger Executive Compensation Structure in Merging Firms *. Contributors: Lynch, Luann J. - Author, Perry, Susan E. - Author. Journal title: Journal of Managerial Issues. Volume: 14. Issue: 3 Publication date: Fall 2002. Page number: 279+. © 1999 Pittsburg State University - Department of Economics. COPYRIGHT 2002 Gale Group.

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