The impact of principal-agent conflicts on mergers and acquisitions

I theoretically and empirically examine the role that principal-agent conflicts play in the division of merger gains. I model the choice between hostile and friendly takeovers and offer an explanation for the prevalence of friendly mergers between large acquirers and small targets. Negotiated mergers, by virtue of the ability to make side payments to the target manager, allow the target manager to be better compensated for his loss of private benefits while simultaneously mitigating the agency conflict in the bidder firm. The direct cost of the side payment is borne by the target shareholders, but they benefit indirectly from the bidding manager having an increased incentive to investigate takeover targets. When the private benefits accruing to the bidding manager are correlated with size, bidder shareholders grant the manager relative autonomy in negotiating small mergers and monitor large mergers more closely. The model generates specific predictions about the relation between principalagent conflicts of both the bidder and the target firm and the division of gains from mergers. Using a large sample of mergers and acquisitions announced in the 1990s, I examine the influence of a variety of corporate governance variables on takeover premiums. While hostile mergers and acquisitions were the central focus of attention in the 1980s, the 1990s were characterized by the dominance of friendly deals. Interestingly, the relationship between targets’ agency conflicts and takeover premiums in the 1990s differs distinctly from what earlier research found in studies of the 1980s takeover market. The main empirical results are: (i) powerful entrenched target CEOs and weak target shareholders reduce takeover premiums, (ii) a lower feasibility of side payments from the bidder to the target CEO increases target returns and decreases bidder returns, and (iii) bidder CEO private benefits from a merger decrease both bidder and target returns. These results are consistent with the predictions of the model where bidders provide side payments to target managers in return for lower takeover premiums in friendly deals. My results suggest that the impact of the target management’s entrenchment in an environment of friendly mergers differs from its role in hostile deals.