There has been a long-standing question on why U.S. shareholders remain largely inactive in standing up against acquisitions that destroy shareholder wealth. Although not all acquisitions require the voting approval of shareholders, large shareholders can still exert their influence through other means such as the threat of exit or behind-the-scenes interventions. However, in our recently published paper in the Journal of Financial Economics, we suggest that many acquiring firm shareholders may not actually have the incentive to ex-ante prevent and ex-post oppose acquisitions that are seemingly value-destroying, even if they have the capability to do so.
Using a sample of horizontal mergers between U.S. public firms from 1988 to 2016, we first document that most top shareholders of the acquiring firms also hold shares across a significant number of non-merging industry rivals of the merging firms. There is robust and consistent evidence in the M&A literature that non-merging industry rivals on average gain upon the announcement of a merger in their industry, due to reasons such as efficiency gain at the expense of the merging firms, a change in industry structure, or takeover threats inducing an improvement in corporate policies. Therefore, it is important to study whether acquiring firm shareholders’ rival ownership can affect their incentives regarding these acquisitions.
When shareholders hold a diversified portfolio of multiple firms within the same industry, they internalize the industry externalities of an individual firm’s corporate decisions at the portfolio level. Monitoring is costly, while shareholders have limited attention and resources. Therefore, it is unlikely that diversified shareholders monitor every decision by every portfolio firm. We argue that shareholders with a diversified industry portfolio may take a portfolio approach when evaluating a firm’s corporate decisions, that is, only when a firm’s decision generates externalities large enough to have value implications for the shareholders’ overall industry portfolio will such shareholders devote resources to get involved in said decision.
We find that losses from stakes in the acquirers are largely mitigated by gains on rival ownership during the deal announcement window. While the average acquiring firm shareholder loses 1.43% from acquirer ownership in our sample, the average announcement return is zero at the industry portfolio level. Close to a third of acquiring firm shareholders in the sample of “bad deals” end up with a net gain at the industry portfolio level. Therefore, a large portion of shareholders are not actually losing from such seemingly bad deals from a portfolio perspective.
Is this portfolio incentive perspective actually related to firms’ M&A decisions? We show that firms in which shareholders hold more ownership in industry rivals are more likely to pursue acquisitions of lower quality ex-ante. Value-destroying deals are also more likely to be completed ex-post when shareholders have more at stake in non-merging industry rivals. This result is robust to controlling from time-varying industry-specific cycles and persistent firm-specific acquisition performance. The result also cannot be simply explained by dilution due to having a large and diversified portfolio, as shareholders’ ownership in non-rival firms does not have any significant effect on deal quality. Furthermore, we find that as the number of top shareholders with industry portfolio gain increases, a “bad deal” is more likely to be completed, providing further support to our internalization hypothesis. When a seemingly bad deal has over half of its top ten shareholders gaining at the portfolio level, its completion probability increases by an average of 5.6%. On the other hand, we find that in “good deals”, as the number of top shareholders with industry portfolio loss increases, such deals are less likely to be completed. This suggests that shareholders do react and take actions against certain acquisitions when such deals incur portfolio level losses for them. Overall, this combination of evidence supports the notion that when shareholders hold a diversified industry portfolio, firm managers may account for their shareholders’ often lack of incentive in opposing bad deals and decide to pursue value-destroying acquisitions.
Finally, we focus on a sample of deals that do require shareholder voting. In the United States, only deals that are financed by issuing equity of more than 20% of the acquiring firm’s outstanding shares require shareholder approval. By examining the voting records of these deals, we find that acquiring firm shareholders with more ownership in industry rivals are less likely to vote against the deal. Shareholders with a significant gain at the industry portfolio level are also less likely to vote against the deal. However, we find that when shareholders suffer a significant loss at the industry portfolio level, they are more likely to vote against the deal, even when the deal has a positive announcement return or when the Institutional Shareholder Services (ISS) recommends voting for it. This gain provides support to our hypothesis that shareholders with a diversified industry portfolio tend to take a portfolio approach when evaluating firm-level decisions.
There is a growing number of U.S. institutional shareholders holding a diversified portfolio of peer firms within the same industry. Our study suggests that a portfolio-value-maximization approach in corporate governance by such shareholders can, to some extent, explain why some of the value-destroying corporate decisions may not be properly monitored. This portfolio approach thus may also create conflicts of interest affecting concentrated and minority shareholders, who focus more on value maximization at the firm level.
The complete paper is available for download here.