Prudent CEOs Are Rewarded When They Ditch Pricey Deals
Abstract:The skill and quality of a CEO is not so easy for financial markets, boards, and analysts to discern. Stock performance of a firm can fluctuate for reasons unrelated to CEO decisions, and may not necessarily reveal anything related to management at the very top. There is an observable signal, however, that reveals the skill and motivations of the CEO—the decision to withdraw an acquisition offer owing to the price being too high. SMU Cox Finance Professor Stacey Jacobsen's new research shows that the decision to not follow through on an acquisition says a lot about the CEO.
The skill and quality of a CEO is not so easy for financial markets, boards, and analysts to discern. Stock performance of a firm can fluctuate for reasons unrelated to CEO decisions, and may not necessarily reveal anything related to management at the very top. According to new research, there is an observable signal that reveals the skill and motivations of the CEO—the decision to withdraw an acquisition offer owing to the price being too high. Finance Professor Stacey Jacobsen's research shows that the decision to not follow through on an acquisition says a lot about the CEO.
To learn about the CEO, traditional investment decisions do not offer targeted information. Little may be gleaned about a CEO from, say, an R&D investment or stock-split announcement. Acquisitions are special though, says Jacobsen. CEOs are usually the final word on whether a deal completes or not. "Traditionally, researchers have used acquisitions as a proxy for identifying CEOs who make decisions that are not value-maximizing for shareholders. That is, a CEO’s decision to acquire may be driven by motives such as empire building, increased compensation, or simply overconfidence in his ability to extract value from the target," offers Jacobsen. Her research takes the opposite approach however.
"I am looking at what CEOs are not doing, — not following through with an acquisition because the price is too high," says Jacobsen. "This is an observable event; we can see the maximum amount the CEO is willing to pay. Essentially, we are putting a threshold on these non-value maximizing incentives." The signal of a bid withdrawal when the price is too high says that the CEO is not making the acquisition because of private benefits or overconfidence. "This event also says something about the CEO's skill," notes Jacobsen, "for example, perhaps the CEO has acumen in valuing the firm. It is a clear signal and positive revelation regarding the CEO’s overall quality." The research notes that when Fortune Brands’ new CEO Bruce Carbonari was outbid for Absolut vodka by the CEO of Pernod Ricard, Wall Street cheered Mr. Carbonari's restraint, and Fortune Brands shares surged 16% in the week of the withdrawn bid.
The research analyzes a hand-collected sample of 525 withdrawn merger and acquisitions (M&A) deals between 1990- 2007. In the sample, the primary reason for withdrawal must be that the price to acquire the target firm is too high. The analysis includes numerous tests to winnow down information relevant to the CEO.
In the M&A setting, the CEO's unwillingness to increase the offer price may convey three favorable signals to the market regarding his/her quality, notes the research. For one, the CEO’s preference for acquisition-related private benefits is not excessively high. If private benefits are a goal for acquisition, the CEO will increase the offer price in order to complete the deal. Additionally, a withdrawal for price-related reasons may indicate the CEO’s skill in the valuation of investment decisions. Finally, the event of a withdrawn acquisition bid suggests to the market that the CEO is not overconfident. An overconfident CEO will overestimate the value of the target and therefore be less likely to withdraw an acquisition bid.
Importantly, "the market is learning about the CEO," observes Jacobsen. The information about the quality of a CEO should be reflected in the bidding-firm's stock price in the days surrounding the announcement to withdraw a bid. The market reaction to the announcement to withdraw a bid for price-related reasons is significantly positive," states Jacobsen. Findings indicate that firms, with CEOs who show restraint, earn cumulated abnormal returns for the 3-days surrounding the withdrawal announcement that are 5% higher than firms in a comparison sample of firms that withdrew bids for other reasons.
The labor market also responds to the information contained in the CEO's actions. Jacobsen theorizes: If the labor market extracts valuable information regarding CEO quality as a result of the withdrawal, then the event should be an important factor in future career decisions involving the CEO. "What is notable, even three years after the withdrawal event, I find that the labor market response is significant," she conveys. A CEO that shows this restraint is less likely to be fired, compared to a control group of CEOs who also cancel deals and that complete similar acquisition deals. Also when a CEO leaves the original firm, they are more likely to find another CEO or Chairman role at a public firm and more likely to advance to a CEO/Chairman role at a firm larger.
Hard to Come By
CEO quality is hard to discern. "To maximize shareholder value, firms attempt to create the optimal board and compensation contract, and to attract institutional investors and analysts who have incentives to monitor and produce information about the firm," offers Jacobsen. "The assumption however is that managers are homogenous. They are not. Consider the impact of CEO Steve Jobs, formerly of Apple." The average CEO tenure isn't that long, making it even more difficult to learn about the characteristics of a CEO. Jacobsen notes that for many firms, it is hard for the average shareholder to acquire information about the CEO’s quality. In her sample of withdrawn bids, the majority of CEOs were mentioned in the financial press (e.g., The Wall Street Journal, Economist, Dow Jones news wires, etc.) less than two times in the year preceding the withdrawal announcement.
Given the immediate response of capital markets to the withdrawal and the persistence of the labor market response, "CEO-specific information is not only valuable to the market, but also hard to come by," writes Jacobsen. Boards and those that monitor firms (such as institutional investors) may benefit from not only gathering observable information such as performance metrics, but also “soft” information pertaining to a CEO’s qualities and preferences, concludes Jacobsen. "The market believes that CEOs do indeed matter, yet has difficulty acquiring information on key CEO characteristics that lead to different firm outcomes."
The paper, "The Death of the Deal: Are Withdrawn Acquisition Deals Informative of CEO Quality? by Stacey Jacobsen of Cox School of Business, Southern Methodist University, is under review.
Written by Jennifer Warren.