Board Composition and Shareholder Wealth: The Case of Management Buyouts

Article excerpt

* The role of the board of directors (BOD) in the corporate governance process had received considerable research attention in recent years. Although the board is legally authorized to ratify monitor managerial decisions, critics have argued strongly that management generally dominates the board by its influence on the selection of outside directors, and by its control over the agenda of board meetings and the information provided to outside board members. Hence, the issue of BOD effectiveness is an empirical question.

A growing body of recent empirical research appears to support the notion that outside directors are important in monitoring managerial actions. However, only a limited number of studies focus directly on the issue of the BOD's impact on shareholders' wealth (Byrd and Hickman [4], Rosenstein and Wyatt [25], and Shivdasani [26]). This study contributes to the evolving empirical literature by focusing on the narrow, but yet unexplored, issue of the role of the BOD in management buyouts. It examines whether wealth gains in MBOs are affected by the composition of the board of directors (the proportion of independent outsiders), and if so, whether the BOD helps to mitigate the agency issues inherent in these transactions.

In a management buyout (MBO), an investor group that includes management makes a bid for all or part of a publicly held corporation. The nature of these transactions inherently provides for conflicts of interest. While management, as potential owners of the privatized firm, has the fiduciary obligation to obtain the highest price for shareholders, it also has an incentive to make the acquisition at the lowest possible price. This conflict is more pronounced when the entire firm is taken private, because the firm's top management is generally part of the buyout group. Although the courts and regulatory agencies play a role in helping to ensure that shareholder interests are served, the primary responsibility for maximizing shareholder wealth rests with those corporate directors who are independent of management.

While the CEO and other top executives control the board of directors under normal circumstances, the role of outside directors assumes greater importance when serious agency problems surface between inside managers and shareholders, for example, in response to financial distress, an incompetent CEO, or takeover bid (see Lorsch [22]). In going-private transactions, independent outside directors are specifically charged with protecting shareholder interests (see Lederman and Bryer [19]).

Although a considerable body of empirical research has evolved on the operating characteristics and shareholder wealth effects of management buyouts (see [11], [14], [15] and [23]), the role of the BOD in such transactions has not been examined. Our empirical results indicate that for bids where the entire firm is to be taken private, the increase in shareholder wealth is substantially higher when the board is numerically dominated by independent outside directors than when insiders and nonindependent outsiders control the board. For transactions in which management takes only a segment (business unit) of the firm private, the results are inconclusive. A comparison of these results indicates that independent directors play an important role in going-private transactions, where serious agency problems exist between top managers and shareholders. However, independent directors appear to be less important in unit management buyouts, where top management often negotiates at arm's length with the purchasing group. Additionally, in going-private transactions, high levels of inside ownership, which mitigate the agency problem between managers and shareholders, have a positive impact on abnormal returns.

The paper is organized as follows: Section I discusses conflicts of interest for manager and the role of the board of directors, and then presents research questions. …