Academic journal article Review of Business

Manager Incentive Ad Returns to Shareholders of Acquiring Firms

Academic journal article Review of Business

Manager Incentive Ad Returns to Shareholders of Acquiring Firms

Article excerpt

In acquisition activities, the impact of manager incentive on returns to shareholders is based on the proposition that shareholder wealth maximization is a function of the "personal objectives" of the managers of the acquiring firm. A two-part model of the manager's incentive ratio details the relationship between relative size of equity ownership held by managers of the acquiring firm and the wealth effects resulting from increased firm size. Their compensation packages affect investment decisions in a substantial way, and the value of the manager's incentive ratio has a significant impact on returns to shareholders of acquiring firms.

Introduction

Evidence of stock returns to shareholders of acquiring firms in acquisition activities remains inconclusive. While some studies document that shareholders of acquiring firms generally benefit from acquisitions, others conclude that the shareholders experience decreases in wealth as a result of an acquisition [1,3,5,13,15]. The fact that stock returns to shareholders of acquiring firms may be negative can be explained by:

* Proposition I. A mistaken belief on the part of a manager that the acquiring firm has the ability to successfully operate the target firm

* Proposition II. The pursuit of personal objectives on the part of a manager of the acquiring firm rather than an objective of shareholder wealth maximization.

Proposition II implies that a manager may knowingly undertake an acquisition that results in personal gain at the expense of the shareholders of the acquiring firm. This view is consistent with standard agency theory that the interests of managers and shareholders are not necessarily consistent in acquisition decisions.

Previous studies that examined the "personal objectives" of managers of acquiring firms were inadequate because they considered only one part of a two-part relationship. The relative size of equity ownership help by managers of an acquiring firm explains their incentive - an important variable and thus a necessary condition - but that is not sufficient. The wealth effects experienced by managers as a consequence of increased firm size and the associated reduction in unsystematic risk faced by managers following an acquisition also need to be considered.

The Manager's Incentive Ratio

Proposition I is consistent with the Roll's hubris hypothesis [13]. Roll theorized that management hubris, excessive pride, conceit and arrogance, was a strong explanatory variable associated with negative returns found in prior acquisition studies [4]. Proposition I is not examined further here; instead, a model is developed to test both parts of a two-part relationship associated with Proposition If. The modal will examine the interaction between a manager's personal wealth maximization goals and the goal of shareholder wealth maximization.

If the manager is a shareholder, an acquisition may reduce his personal wealth if shareholder returns are negative. In which case, the manager's wealth reduction is a function of the proportion of outstanding shares he holds. However, the wealth effects experienced by managers as a consequence of increased firm size and an associated reduction in risk that can be diversified through a portfolio may be positive.

A manager's incentive ratio is used to investigate the impact of these two effects on a manager's incentive to maximize shareholder's wealth. The numerator of this ratio is the dollar market value of shares held in the firm by the manager on a specified date prior to the acquisition. The denominator is total compensation, both salary and bonuses, received by the manager on the same date. A large ratio means that market value of shares owned by the manager was substantial relative to total compensation. In this case, share value is a major portion of a manager's compensation. A rational manager seeks to engage in acquisitions that maintain or improve this ratio; thus, the manager's incentive would be consistent with the interest of the public shareholders. …

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