JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS Vol. 49, Nos. 5/6, Oct./Dec. 2014, pp. 1365–1401
COPYRIGHT 2015, MICHAEL G. FOSTER SCHOOL OF BUSINESS, UNIVERSITY OF WASHINGTON, SEATTLE, WA 98195 doi:10.1017/S0022109014000593
Inside Debt and Mergers and Acquisitions
Hieu V. Phan∗
I empirically investigate the relation between chief executive officer (CEO) inside debt holdings and mergers and acquisitions (M&As), and find evidence consistent with the agency theory’s prediction of a negative relation between CEO inside debt holdings and corporate risk taking. Further analysis shows that CEO inside debt holdings are positively correlated with M&A announcement abnormal bond returns and long-term operating performance, but negatively correlated with M&A announcement abnormal stock returns.
Finally, I find evidence that acquirers restructure the postmerger composition of CEO compensation that mirrors their capital structure in order to alleviate incentives for wealth transfer from shareholders to bondholders or vice versa.
Following the seminal paper by Jensen and Meckling (1976), several studies have investigated the relationship between executive compensation contract design and corporate behavior, mostly focused on salary, bonus, stocks, and stock options as major forms of compensation (e.g., Amihud and Lev (1981), Agrawal and Mandelker (1987), and Fenn and Liang (2001)). Prior research documents that equity-based compensation (EBC), in the form of stocks and stock options, aligns the interests of managers and stockholders and incentivizes managers to take risks for the shareholders’ interests (e.g., Jensen and Meckling (1976), Smith and Stulz (1985), Guay (1999), Coles, Daniel, and Naveen (2006), and Low (2009)). A recent growing stream of literature reports that debt-like compensation, in the forms of pension benefits and deferred compensation, accounts for a significant part of the total executive compensation package, and in some firms, ∗Phan, hieu firstname.lastname@example.org, Manning School of Business, University of Massachusetts Lowell, 1 University Ave, Lowell, MA 01854. This paper was written while the author was a Ph.D. student at the University of Connecticut. I am especially grateful to an anonymous referee, whose comments on the paper substantially improved the exposition and analyses. I also appreciate the helpful comments from Assaf Eisdorfer, Carmelo Giaccotto, Joseph Golec, Jarrad Harford (the editor), Shantaram
Hegde, Greg Nagel, Kartik Raman, Anh Tran, and Reilly White as well as session participants at the 2012 Financial Management Association International Annual Meetings and the 2012 Eastern Finance Association Annual Meeting, and seminar participants at Central Michigan University, Rhode
Island College, and the University of Massachusetts Lowell. I also thank Angela Jacobs for excellent proofreading. All errors remain the sole responsibility of the author. 1365 1366 Journal of Financial and Quantitative Analysis managers even hold more debt-like compensation than EBC (e.g., Bebchuk and
Jackson (2005), Sundaram and Yermack (2007), Gerakos (2010), and Wei and
Yermack (2011)). Managers’ pension benefits and deferred compensation are debt-like compensation, since they represent fixed obligations by the company to make future payments to corporate insiders/managers (hence, these are usually referred to as “inside debt”). Inside debt is expected to align managers’ interests with those of external debtholders and alleviate managers’ risk-taking incentives, since inside debt is typically unsecured and unfunded, and if the firms go bankrupt, managers have claims equal to those of other unsecured creditors (Sundaram and Yermack (2007), Gerakos (2010), and Cassell, Huang, Sanchez, and Stuart (2012)). Consistent with the notion that inside debt aligns manager interests with those of external debtholders, Anantharaman, Fang, and Gong (2014) document a negative relation between chief executive officer (CEO) inside debt and bond yield spread. Wei and Yermack report that the disclosure of large CEO inside debt holdings leads to a transfer of value from equity to debt, a decrease in the volatility of both securities, and a decrease in overall firm value.
In this research, I examine the link between CEO inside debt holdings and corporate risk taking in merger and acquisition (M&A) activities and its implications for bondholder, shareholder, and firm value. M&As are among the largest and most readily observable forms of corporate investment. Furfine and Rosen (2011) document that, on average, M&As increase the default risk of the acquiring firms; therefore, they represent discretionary risk taking by the CEOs. In addition, M&As tend to intensify the inherent conflicts of interest among shareholders, bondholders, and managers (e.g., Jensen and Meckling (1976), Masulis,
Wang, and Xie (2007)). For these reasons, M&As provide a unique ground for testing the potential effects of debt-like compensation on corporate investment and financing strategies and the implications of these effects for shareholder, bondholder, and corporate manager wealth. Following the theoretical arguments (e.g., Jensen and Meckling (1976), Edmans and Liu (2011)) and empirical applications (e.g., Sundaram and Yermack (2007), Wei and Yermack (2011), and
Cassell et al. (2012)), the construct of interest is the CEO debt-to-equity ratio relative to the firm’s respective ratio. Following prior research, I use the following four variables as proxies for the construct in my empirical tests: relative CEO leverage, which is measured as the ratio of the CEO’s debt-to-equity scaled by the firm’s debt-to-equity ratio (Sundaram and Yermack (2007), Edmans and Liu (2011), and Cassell et al. (2012)); relative CEO leverage > 1 dummy, which takes a value of 1 if the relative CEO leverage exceeds 1, and 0 otherwise (Sundaram and Yermack (2007), Cassell et al. (2012)); relative CEO incentive, which is the ratio of the marginal change in the value of CEO inside debt holdings to the marginal change in CEO inside equity holdings given the change in firm value, all scaled by the firm’s respective ratio (Wei and Yermack (2011), Cassell et al. (2012)); and relative CEO incentive > 1 dummy, which takes a value of 1 if the relative CEO incentive exceeds 1, and 0 otherwise (Wei and Yermack (2011),