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Building an Empire

Why Do Managers Undertake Acquisitions?

Research by Judith Chevalier

Executives rarely boast about the business empires they have single-handedly diminished in size and scope. Even in the era of downsizing, many executives want to expand and diversify business operations -- sometimes at the expense of shareholder wealth. But why? If managers abandon the interests of shareholders in order to build empires, what are the private benefits managers gain from controlling larger firms?

Most people would assume that the primary benefit is an increase in compensation. But economics professor Judith Chevalier of the University of Chicago Graduate School of Business and co-authors Christopher Avery of Harvard University and Scott Schaefer of Northwestern University discover that the big payoff is not necessarily found on the bottom line.

In recent research published in the Journal of Law, Economics and Organizations entitled "Why Do Managers Undertake Acquisitions? An Analysis of Internal and External Rewards for Acquisitiveness," Chevalier and her co-authors ask: What incentives do managers have to undertake acquisitions which are not in the best interest of shareholders? They find that a major benefit of growing an empire may possibly lie in earning the more intangible assets of prestige and power.

"Our findings do not support the argument that chief executive officers (CEOs) have an incentive to pursue acquisitions in order to increase their own compensation," says Chevalier. "But the results lend support to the argument that CEOs have an incentive to pursue acquisitions to increase their prestige and standing in the business community."

Rewards of Empire Building

To answer the question of why managers undertake acquisitions, Chevalier and her co-authors examined two private benefits that could accrue to managers who undertake acquisitions: compensation and prestige.

Both of these possible motivations for undertaking acquisitions have been articulated repeatedly by academics. Despite the prominence of the claim that acquisition activity is rewarded with increased compensation, there has been relatively little work done by economists to compare compensation outcomes for executives who buy other firms to those who do not. Furthermore, virtually no academic effort has been devoted to measuring the extent to which acquisitions affect an executive's prestige, perhaps due to the difficulty of measuring social prominence and power.

First, the authors tested the hypothesis that managers can increase their salaries by undertaking acquisitions.

Compiling a comprehensive database, the authors studied the effect of a firm's acquisitions on the subsequent career of its CEO. They examined executive pay changes surrounding all of the acquisitions valued at greater than $25 million undertaken by CEOs in the Forbes Compensation Survey in 1986, 1987 and 1988.

"We find no evidence that a CEO can increase his or her salary or bonus by undertaking an acquisition," says Chevalier. "In addition, the effect of acquisitions on compensation does not depend on whether the acquisition increased shareholder wealth or decreased shareholder wealth, or on whether or not the acquisition was diversifying."

Next, the authors examined the hypothesis that managers can gain power, prestige and standing in the business community by purchasing other firms.

In order to measure an increase in prestige, the authors focused on one plausible benchmark: the number of seats an executive holds on outside boards.

"Do managers who undertake acquisitions get more seats on outside boards? I think they do," says Chevalier. "The idea is that the number of board seats offered to an executive reflects what the business community thinks of this individual's abilities and competence."

Using the same data set from the compensation study, the authors examine whether CEOs were more likely to gain board seats over the 1986 to 1991 period than CEOs who did not undertake acquisitions.

"CEOs who completed acquisitions were significantly more likely to gain outside directorships than those who did not complete acquisitions," reports Chevalier. "Our results lend support to the argument that CEOs have an incentive to pursue acquisitions to increase their prestige and standing in the business community."

Of the 215 managers in the directorship sample who did not make an acquisition, 27 percent gained one or more board seats, while 31 percent lost one or more board seats. On the other hand, of the 131 managers who did make acquisitions, 41 percent gained seats, while only 19 percent lost seats.

In addition, the authors show that managers who undertake acquisitions are less likely to be replaced as CEO, controlling for other aspects of firm performance. These results are preliminary, but are consistent with the theory proposed by Chicago finance professor Robert Vishny and Harvard co-author Andrei Shleifer, which states that managers undertake acquisitions in order to entrench themselves.

One caveat to consider, according to the authors, is that although their compensation estimates suggest that a manager's salary and bonus are not sensitive to acquisitions made by the manager, this does not imply that acquisitions have no consequences for executive wealth; stock and stock options typically comprise a substantial share of executive remuneration. Clearly, a manager whose wealth is significantly tied to his company's share price will partially internalize the effects his decisions have on the firm's shareholders. While the authors do not have data on stock or stock option holdings, this fact does not place a serious limitation on their study. They are only interested in dimensions along which the CEO's interests differ from those of the shareholders.

Value of the Board

"The results contradict the view that corporate compensation committees are so unsavvy, or so completely controlled by the management, that they would reward activities that are not in the best interest of shareholders," says Chevalier. This still leaves the puzzle: Why do CEOs who undertake acquisitions gain a disproportionate number of outside directorships?

Perhaps the CEO gains connections, skills and experience by undertaking an acquisition, increasing the CEO's desirability as a board member. The completion of a successful acquisition may serve as a signal to the business community that the CEO has the ability to manage a large, diverse enterprise, and that he or she can make valuable contributions as an advisor to other companies.

"Our results strongly suggest that it would be beneficial to learn more about the outside directorship selection process," said Chevalier. "Further research should focus on how outside directors are chosen, how much CEOs value outside directorships, and what actions, other than acquisitions, might increase their probability of gaining board seats."

Judith Chevalier is an associate professor of economics at the University of Chicago Graduate School of Business.

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