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Mergers and CEO Compensation Vigilant monitoring of top management pays off for shareholders, study suggests

June 1, 2002

For more information, contact: Benjamin Haimowitz,

You get what you pay for may be true for many things, but corporate management has not often seemed to be one of them. Headlines tell of exorbitantly paid chief executives presiding over floundering companies; meanwhile, management scholars puzzle over the apparent lack of any consistent relationship between the pay of CEOs and the performance of their firms.

Now a research report in the June/July 2002 issue of the Academy of Management Journal suggests an eminently common-sense answer to the puzzle: CEO pay does reflect company performance as long as vigilant outsiders are looking over the chief executive's shoulder.

The new research investigates the impact of corporate acquisitions on CEO remuneration. Acquisitions are well known to boost CEO pay -- so much so that some management scholars argue that they are undertaken more to enhance executive compensation than to benefit shareholders.

Investigating whether this is the case, the authors of the new study find a striking difference between firms with a lot of outside monitoring and those with relatively little.

"Where external monitoring is active, executive rewards are influenced by returns of acquisitions," conclude the authors, Peter Wright of the University of Memphis, Mark Kroll of Louisiana Tech University, and Detelin Elenkov of the University of Tennessee, Knoxville. "Where external monitoring is passive, however, CEO compensation is impacted by increases in firm size due to acquisitions."

In other words, in actively monitored companies, CEO pay raises connected to major acquisitions tend to reflect improved company performance. In laxly monitored companies, they tend to reflect little more than increased corporate size.

The study probed the effect of three kinds of external monitors -- security analysts, independent board members, and activist institutional investors such as pension funds or mutual funds. Comments Prof. Wright, "Each of the three had a significant effect individually, and in combination they had an even stronger effect."

The findings are based on an analysis of corporate acquisitions between 1993 and 1998 that involved publicly owned firms and met a number of conditions. One condition was that the merger had to boost the acquirer's revenues by 10 percent or more. Another was that the same CEO had to be in place the year before and the year after the acquisition. Still another was that the acquiring firm did not undertake another acquisition in the same year or during the following year.

In addition, to make the final cut for the sample, the acquiring firms had to be clearly in one group or the other -- actively monitored or passively monitored. How they were classified depended on whether they were above or below the median in terms of 1) number of stock analysts following the company, 2) percentage of ownership by activist institutions, and 3) proportion of independent board members -- that is, board members not employed by the company or beholden to it in some other way.

Eleven companies that were somewhere in between the two categories -- for example, firms with a low analyst following but a high ratio of independent board members -- were eliminated, yielding a final sample of 171 firms, 77 actively monitored and 94 passively monitored.

Increase in CEO pay for each company was measured as the percentage change in the total of salary, bonus, and value of stock options from the year before the acquisition to the year of the acquisition. The mean increase for all firms was 14.3 percent. Increase in firm size was determined by the value of sales, adjusted for inflation, from the acquisition year to the following year. The mean increase for the entire sample was 23 percent.

Company performance was gauged by one short-term measure, the activity of the company's stock immediately following the acquisition announcement, and one longer-term measure, the percentage change in the firm's return on equity from the year of acquisition to the following year.

Finally, the researchers controlled for several other factors that may affect chief executive's remuneration -- length of CEO tenure, varying pay norms in different industries, and CEO stock ownership.

For the group of actively monitored companies, the professors found increases in CEO pay to be significantly related to both of the performance measures -- a rise in stock price upon announcement of the acquisition and an increase in the firm's return on equity during the following year. Thus, CEO pay boosts reflected both the stock market's approval of the acquisition and the subsequent enhancement of the company's bottom-line results. They were not influenced, however, by the extent of the firm's revenue growth deriving from its greater size.

For the passively monitored companies, however, the findings were the reverse: increases in CEO pay bore no significant relationship to either of the performance measures but only to the amount of increase in corporate size.

The findings, in other words, are consistent with the suspicion that lax monitoring encourages top executives to adopt acquisition strategies in order to enhance their own rewards, since there tends to be a positive association between firm size or revenues and CEO compensation. In contrast, for firms with vigilant external monitoring activities, changes in CEO compensation will be directly associated with returns accruing to their shareholders due to acquisitions.

The Academy of Management Journal, a peer-reviewed publication now in its 45th year, is published every other month by the academy, an organization with about 12,000 members in 60 countries that seeks to foster the advancement of research, education, and practice in the management field.

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