Gestión de correspondencia e información Actividad propuesta 7

The firm is a separation of ownership and control, in which shareholders are the owners of the

firm (i.e. the principal) and managers are the agent hired by shareholders to manage the firm

(i.e. the agency). According to Jensen and Meckling (1976), this principal-agency relationship

is a financing contract between shareholders and managers, in which managers are committed

to maximising the wealth of shareholders. However, such a contract is violated when managers

pursue their own interests at the expenses of their shareholders (i.e. agency problems).

M&A studies have found evidence of agency problems in firms with sizable free cash flows.

Jensen (1986) suggests in the free cash flow hypothesis that managers of cash-rich firms tend

to distribute the excess of cash in unnecessary investment projects rather than paying out to

their shareholders. Harford (1999) provided empirical evidence in support of Jensen’s view.

Studying a large sample of U.S. M&As from 1950 to 1994, Harford found that managers of

cash-rich firms engaging in M&As due to low managerial ownership is where agency problems

are likely to occur. Cash-rich bidders receive negative market reactions and experience declines

in operating performance following M&As.

Contrary to the free cash flow hypothesis, Gregory (2005), focusing on the long-term

Chapter 2. Literature Review: M&A Motives

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those possessing low free cash flows. The author argued that firms with low free cash flows

are more likely to be financially constrained in the long term, and have difficulty in boosting

its performance following a merger. Managers who hold large free cash flows and whose firms

have a low Q ratio are likely to create value for the firm, in that the initial undervaluation tends

to be corrected by the market in the long term. Likewise, Lin and Lin (2014), using a sample

of Australia takeovers and measuring free cash flows with two proxies: excess cash holding

and excess accounting cash flow5, found that managers of cash-rich firms do not undertake value-destroying M&As.

Morck et al. (1990) found “bad managers”6 who raise severe agency conflicts in M&As. Using a sample of 326 U.S. M&As from 1975 to 1987, the authors found evidence of agency problems

through three types of value-destroying deals. First, agency problems are raised when managers

act for the purposes of job security and risk reduction of their own stock holdings. As such,

managers tend to undertake diversifying M&As associated with negative market reactions due

to unfamiliarity with an unrelated industry. Further, it is also suggested that bidders are likely

to overpay for high-growth targets to increase their personal benefits. Finally, firms performing

poorly in the past are likely to initiate bad deals. Harford et al. (2012) found entrenched

managers were less likely to pay for acquisitions with all-equity offers, avoiding creating larger

block-holders that diminish their power in the firm. Their M&A selection avoids acquiring

private targets that could create value for the firm7, and more importantly, they overpay for targets whose synergy-generating ability is low.

5 _{Excess accounting cash flow was defined as the ratio of earnings after interest paid, tax paid and dividend paid}

before depreciation to total assets.

6 _{“Bad managers” here refers to those who do not serve the best interests of their shareholders.}

7 _{In Fuller et al. (2002), bidders’ acquisitions of private firms tend to generate positive announcement returns}

while acquisitions of public firms generate negative announcement returns. Specifically, it is found that there is negative 1 percent announcement returns when targets are public firms and positive 2.1 percent when targets are private firms. In addition, Fuller et al. (2002) showed that offer premiums to private targets are lower than public targets, which is also consistent with the finding in a study of French M&As over the period of 1966 and 1982 by Eckbo and Longohr (1989).

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Studies have shown one of the main sources for agency problems is the compensation

rewarded to top managers engaging in M&As. Studying a large sample of U.S. M&As, Harford

and Li (2007) found it was a great incentive for a bidder CEO to undertake an acquisition as CEOs’ pay increases substantially after an acquisition regardless of the wealth of shareholders.

This is also supported by Guest (2009) who studied a comprehensive U.K. sample between

1984 and 2001. He established that CEOs’ salaries increase within a year after an acquisition even though takeovers destroy the firm’s value.

Grinstein and Hribar (2004) revealed that it is managerial power that influences compensations

but not the deal performance, offering little evidence that better M&A performance increases

pay to the managers. Their study showed that 39% of companies reward their CEOs involved

in a completed deal due to the efforts the CEOs made, where efforts of those in the important

positions are easily to be seen. In contrast, Datta et al. (2001) and Falato (2008) found that CEOs’ compensation is positively related to stock performance, indicating that compensation

boosts the firm’s performance, implying that there is low probability that compensation causes

agency problems.

Studies have also documented that not only bidder managers but also target managers could

cause agency problems, reflected in that target managers exchange private benefits such as

compensation or positions in the bidder firms following a merger for lower M&A offer

premiums. Analysing 311 large U.S. firms between 1995 and 1997, Hartzell et al. (2004) found

that target managers are likely to persuade shareholders to give up their control of a firm when

Chapter 2. Literature Review: M&A Motives

25

Likewise, Wulf (2004) in a sample of “mergers of equals”8 in the U.S. market between 1991 and 1999 found that target managers exchange shared governance in the bidder firms for lower

M&A offer premiums, which destroys the wealth of target shareholders, leading to 5.6 percent

lower than average abnormal returns. However, Bargeron et al. (2010) argued that target managers’ retention is not as the result of lower M&A premiums. Their findings contradict

those of Hartzell et al. (2004) and Wulf (2004), indicating that bidders retain targets’ managers

who have skills and experience in the new combined firm to increase its value.