managerial shareholdings, firm value, and acquired corporations

The Quarterly Review of Economics and Finance45 (2005) 781–795

Managerial shareholdings, firm value, and acquiredcorporations�

Paul Halperna, Robert Kieschnickb, ∗, Wendy Rotenbergc

a University of Toronto, School of Management Richardson, TX 75080, USAb University of Texas at Dallas, School of Management Richardson, TX 75080, USA

c University of Toronto, School of Management Richardson, TX 75080, USA

Received 6 May 2004; accepted 1 June 2004Available online 19 February 2005

Abstract

Prior research on the relationship between managerial shareholdings and firm value provides con-flicting evidence. We take a different approach to its analysis and focus on managerial shareholdingsin acquired firms. We argue that in a relatively unfettered market for corporate control, prior evidenceof a nonlinear relationship between moral hazard costs and managerial shareholdings suggests thatacquired corporations can be segmented according to managerial shareholdings, and that these seg-ments will differ according to the source of wealth gains, managerial resistance, who acquires thecompany, and how target shareholders are paid. We find evidence consistent with these predictions.© 2005 Board of Trustees of the University of Illinois. All rights reserved.

JEL classification: G32; G34; L21

Keywords: Mergers; Acquisitions; Buyouts; Managerial Shareholdings

1. Introduction

The relationship between managerial shareholdings and firm value or performance con-tinues to be the subject of debate. On one side are those who argue that market forces lead

� An earlier version of this paper was presented at the Multinational Finance Society annual meetings and wonthe Teppo Martkainen Best Paper Award.

∗ Corresponding author. Tel.: +1 972 883 6273.E-mail address: [email protected] (R. Kieschnick).

1062-9769/$ – see front matter © 2005 Board of Trustees of the University of Illinois. All rights reserved.doi:10.1016/j.qref.2004.06.003

782 P. Halpern et al. / The Quarterly Review of Economics and Finance 45 (2005) 781–795

to firm value maximizing ownership structures. For example,Demsetz (1983)argues thatmarket forces, such as product and capital market competition, lead to value maximizingcorporate ownership structures by limiting managerial pursuit of self-interest. Consistentwith Demsetz’s arguments,Demsetz and Lehn (1985)provide evidence that the marketvalue of equity varies linearly with managerial shareholdings and firm risk measures.

The other side of the debate argues that corporate ownership structures are not alwaysvalue maximizing. For instance,Morck, Shleifer, and Vishny (1988a), McConnell and Ser-vaes (1990), andAnderson and Lee (1997)present evidence that firm value, as proxied by afirm’s q-ratio, increases in managerial equity at low levels of managerial equity and decreasesin managerial equity at high levels of managerial equity.1 Such a nonlinear relationshipsuggests that the moral hazard costs borne by outside shareholders change over the rangeof managerial shareholdings and are not mitigated by other shareholders.

Cho (1998)andHimmelberg, Hubbard, and Palia (1999)question this nonlinear relation-ship arguing that such research ignored the simultaneous nature of the relationship betweenmanagerial ownership and firm value or performance. Accounting for this, they provide ev-idence more consistent with Demsetz and Lehn’s arguments. However, there are problemswith their evidence. First there are sampling biases in each of these studies. Cho studieslarge corporations (Fortune 500 companies) whose ownership distribution is skewed right,and Himmelberg, Hubbard, and Palia study a panel with significant survivorship bias (theirsample drops from 600 in 1982 to 330 in 1992). Consistent with this point, we should notethatHabib and Ljungqvist (2005)estimate Himmelberg, Hubbard, and Palia’s specificationwith a different panel having a much lower attrition rate, and fail to replicate their results.2

Second,Barnhart and Rosenstein (1998)demonstrate that these results are sensitive tomodel specification and instruments and argue for sensitivity analysis of such evidence,which none of these studies provides.

Our view of this debate considers both arguments to have merit within the proper context.Unless firms are considered always to be in equilibrium, then at any moment in time weshould observe a number of firms in disequilibrium. Consequently, in a cross-section offirms there will be some firms with non-value maximizing ownership structures, asMorcket al. (1988a)describe. However, if the market mechanisms discussed inDemsetz (1983)are operative, then in a relatively unfettered market for corporate control, many of thesenon-value maximizing firms will be acquired. Thus within this context, if the evidencepresented inMorck et al. (1988a)and others is correct, acquired corporations can be sortedinto three groups according to managerial shareholdings. These three groups should differin their value, or performance, prior to their acquisition, with acquired firms in the tails ofthe distribution of prior managerial shareholdings performing relatively poorly.

We refer to the categorization of acquired companies into different segments or clustersbased on prior managerial shareholdings as the segmentation hypothesis and expect thisrelationship to have implications for other characteristics of these acquisitions. We useFig. 1to organize our discussion of these additional implications.

1 Consistent with prior literature, we make no distinction between managerial equity and management’s pro-portional ownership of their firm’s stock.

2 Separately,Zhou (2001)criticizes Himmelberg, Hubbard, and Palia’s results because of their use of fixedeffects estimators.

P. Halpern et al. / The Quarterly Review of Economics and Finance 45 (2005) 781–795 783

Fig. 1. Graphical depiction of the segmentation hypothesis.Note: It is important to recognize that the abovefigure presumes that all other factors are held constant. There are mechanisms for controlling the potential moralhazard costs associated with managers having little equity interest in their firms (e.g., compensation schemes) andconsequently observed firms will deviate from the above curvewhen these mechanisms are effective. However,we presume that these mechanisms were ineffective in some acquired firms.

On the left side ofFig. 1 are firms with low managerial shareholdings (Cluster #1). Inthese firms, outside shareholders are exposed to the risk that managers will pursue non-value-maximizing actions because management has too small a share of the firm. Whenmanagers fail to pursue firm value maximization, their firms will be subject to takeoverattempts.3 Since these target managers are exposed to a significant risk of removal, they willoften resist such acquisition offers (seeStulz, 1988andMorck, Shleifer, & Vishny, 1988b),and consequently these transactions will frequently be ‘hostile’ acquisitions. Further, if suchfirms have excessive discretionary cash flows, they may be taken over by an investment groupin a leveraged buyout for reasons provided inJensen (1986). Consequently, acquired firmsin which management had a small portion of their firm’s stock should be a mix of operating

3 There are a number of mechanisms for controlling the conflicts of interest between managers and shareholderswhen managers own little of their firms’ stock. If such mechanisms are operating as intended, it is less likely thefirm will be a target, or if a target, the less likely we will observe a segmentation of acquired firms as conjectured.


company acquisitions (i.e., MAs) and investment group acquisitions (i.e. LBOs). Given thenature of the anticipated gains, target management’s likely hostility to the transaction andthe potential for bidder competition in these disciplinary transactions, bidders will oftenpay with cash or cash and debt, rather than with stock.

In the middle ofFig. 1are acquired firms whose management teams had mid-range equitypositions (Cluster #2). For these firms, management’s and outside shareholders’ interests aregenerally better aligned, thereby reducing outside shareholder’s exposure to moral hazardcosts. Because of this better alignment, we expect such firms to be predominantly acquiredin friendly transactions by another operating company. Further, stock, rather than cash, willbe used more frequently to effect these acquisitions because target managers will be able tobargain more effectively to insure that the method of payment serves their interests. Targetmanagers may prefer stock to cash so as to share in the expected synergistic gains from theproposed combination, to insure their retention in the post-acquisition entity (e.g.,Ghosh& Ruland, 1998), or to time the taxation of their transaction gains.

Finally, acquired firms from the right side ofFig. 1 (Cluster #3) have high managerialshareholdings. In these firms, outside shareholders risk being exposed to the moral hazardcosts associated with entrenched managers who have poorly diversified personal portfolios.While these managers have an incentive to liquidate some or all of their shareholdings, theresulting loss of control can be avoided by issuing debt to take the firm private in an LBO.In this way, managers maintain or increase their control of the resulting firm’s voting rightswhile reducing their dollar investment in the firm. Consistent with this point,Crawford(1987), Frankfurter and Gunay (1992), andKaplan and Stein (1993)all report evidence ofmanagers in management buyouts reducing their dollar investment in the new firm whileincreasing their share of the voting rights. Effectively, these managers are using the LBOto restructure the ownership and incentive structure of these firms.4 Further, they tend toremain private companies, consistent withFama and Jensen’s (1983)argument that thisform is a more efficient organizational form for such firms. Finally, since management hassufficient voting rights to block unacceptable bids, these firms will be acquired in friendlytransactions.

To test the above arguments we examine a sample of acquired corporations during aperiod when the market for corporate control was relatively unfettered. Two points aboutour design are appropriate at the outset. First, if internal mechanisms to align inside andoutside shareholder interests operate as intended, then one should not observe firms beingacquired except for synergistic reasons. Second, if takeover defenses operate effectively,by virtue of state law or internal defenses, firms with a misalignment of inside and outsideshareholder interests are unlikely to be acquired. Thus, the bias in our study, unlike that ofstudies of continuing public corporations, isagainst finding evidence consistent with ourhypotheses.

We organize our examination as follows. In Section2, we describe our sample andvariables. In Section3, we test for a nonlinear relationship between prior managerial share-holdings and firm value using our sample of acquired firms. In Section4, we examine the

4 Elitzur, Halpern, Kieschnick, and Rotenberg (1998)provide a model of such transactions to examine theirstructuring and incentive effects.


relationship between prior managerial shareholdings and takeover premiums where the pre-mium is an indication of the potential gains from a restructuring transaction. In Section5we separate sample firms into three groups according to target managerial shareholdingsand examine differences between these groups in terms of the target’s prior equity value, thetype of acquirer, the form of payment, and the resistance of management to the acquisition.Section6 concludes our paper.

Our evidence is consistent with the segmentation hypothesis and as a result, we providethe first evidence of such a nonlinear relationship for acquired concerns rather than goingconcerns. However, this evidence also reconciles conflicting evidence on a number of issues,including the relationship between managerial ownership and firm performance. Giventhis reconciliation, we argue that future research should focus on the study of factors thatinfluence the adjustment process.

2. Sample and variables

To test our hypothesis, we examine acquired corporations over the time period1981–1986. We chose this time period for two critical reasons. First,Morck et al. (1988b)andAmbrose and Megginson (1992)use approximately the same period. Thus our choicepermits a comparison of our results to theirs. Second and more importantly, over this timeperiod the market for corporate control was active and relatively unfettered (seeTrimbath,Frydman, & Frydman, 2001andHolmstrom & Kaplan, 2001for evidence on this point).This consideration is important since we are less likely to observe a nonlinear relationshipbetween prior firm value and prior managerial shareholdings, if it exists, if the market forcorporate control is impeded by state antitakeover laws, for example.5

Using Thompson’s SDC Merger and Acquisition database, we identified over 15,000separate transactions for our sample period. Since we need to examine SEC filings for eachtarget firm, both prior to and in conjunction with their transaction, along with news sto-ries on each transaction in order to develop some of our variables, we decided againstthe typical sampling approach of including all corporations with complete data in thesample. Instead, we use a stratified sampling design, which is more efficient for ourstudy.

Based upon our earlier arguments, we expect LBOs to be sampled from the tails of thedistribution of corporate managerial shareholdings. Thus, we want to include all LBOs of apublic corporation that occurred during our time period in our sample in order to have suffi-cient observations from the tails of the distributions. To this end, we used information fromthe journalMergers & Acquisitions to supplement the information in the SDC Mergers andAcquisition database to identify all completed LBOs of a public corporation that occurredduring our sample period. We identified and included in our sample 126 such firms, forwhich SEC filings were available.

We next chose a random sample of non-LBO acquisitions of a public corporation, equalin number to that of our LBO sample for each sample year. We employ this temporal

5 The appropriateness of our study period is also demonstrated indirectly by the evidence reported inGarveyand Hanka (1998).


Table 1Comparison of acquired corporations by type of acquirer

Investment group (LBOs) Operating company (MAs)

Managerial shareholdings (MSH)Mean 29.343 19.796Median 26.355 16.070S.D. 22.536 17.213

Market to book ratio (MTBR)Mean 1.218 1.513Median 1 1.269S.D. 0.790 0.971

Industry adjusted market to book ratio (MTBR* )Mean −0.162 0.265Median −0.286 0.034S.D. 0.771 1.820

PaymentCash or cash and debt 126 89Stock or stock and cash 0 37Total 126 126

Managerial response to bidHostile 54 37Friendly 72 89Total 126 126

Managerial shareholdings, the percentage of stock held by officers and directors prior to the acquisition of theircompany was determined from S.E.C. filings, primarily proxies, prior to their transaction. MTBR represents afirm’s market to book ratio of equity on the balance sheet date just prior to its acquisition. MTBR* represents thedifference between a sample firm’s market to book ratio and the median of its industry’s market to book ratiosfor a comparable period. We use sample firms’ two-digit SIC to define their industry. An acquisition is deemedhostile if there is any news story that indicates that management resisted the offer for the firm.Payment takes onthe value 1 if cash or cash and debt is used to pay off existing shareholders and 0 if stock or stock and cash is used.The form of payment was determined from the proxy associated with acquisition.

matching procedure, as didAmbrose and Megginson (1992), to adjust for economy-wideinfluences. We use a matched sample design followingManski and McFadden (1981)whoshow this design is the most efficient sampling design for choice-based samples andLohr(1999)who shows it is a reasonable stratified sampling design. We decided not to stratifyour sample in more than one dimension (e.g., according to industrial classification) becausesuch stratification procedures would introduce additional biases, making it more difficultto draw inferences in our subsequent analysis.6

For each sampled firm, we collected data from various sources to create the variablessummarized inTable 1. First, we identify from the proxy whether the firm was acquiredby an investment group or another operating company. Next, we identify the percent-

6 To correct for these biases, we would need to know the distribution of firms within each additional strataaccording to the other stratification criteria employed: a daunting, if not a prohibitively costly task given existingdatabases.


age of an acquired firm’s stock held by management prior to its acquisition by search-ing the firm’s SEC filings. We use data from the most recent SEC filing (typically aproxy) prior to the announcement date of the first bid for the firm. The data reportedin Table 1suggests that prior managerial shareholdings were greater in sample invest-ment group acquisitions than in sample operating company acquisitions (Kruskal–Wallischi-square test statistic = 11.048, with marginal significance level of 0.00). This resultis consistent with the notion that a number of firms from the right tail of the own-ership distribution of public corporations are included in the investment group sam-ple.

To measure firm value, we focus on a firm’s market to book value of equity ratio (MTBR).Our approach is consistent withVaraiya, Kerin, and Weeks (1987)andAmit, Livnat, andZarowin (1989)who show that this ratio is a reasonable proxy for a firm’s Tobin q measuredin other ways.7 We also compute an industry adjusted measure for each firm and this proxymeasure improves data availability. We use Compustat data to compute both a sample firm’smarket to book value of equity ratio as of its fiscal year just prior to the first announcementof a takeover offer and the market to book ratio for all firms in a sample firm’s two-digitSIC.8 We compute a sample firm’s industry adjusted market to book ratio (MTBR* ) asthe difference between its ratio and the median of its industry’s market to book ratiosfor the same time period. We use the median to avoid problems introduced by potentialoutliers. The data reported inTable 1suggests that the unadjusted and industry adjustedmarket to book ratios of investment group acquisitions were significantly less than those ofoperating company acquisitions (the Kruskal–Wallis test statistics were significant at the 1%marginal significance level in either case). These results are consistent with our argumentthat investment group acquisitions will be drawn more often from firms experiencing moralhazard costs.

Payment is a dummy variable characterizing the form of payment given to target share-holders for their stock. This variable equals one if the acquirer used cash or cash and debt,and zero if the acquirer used stock or stock and cash. The form of payment in each casewas determined by examining the material sent to shareholders in conjunction with theacquisition. As expected,Table 1shows that only operating companies use stock to acquirea target.

Finally, followingMorck et al. (1988b), we examined Lexis-Nexus for news stories con-cerning the transaction for evidence of managerial resistance to the acquisition. A dummyvariable for managerial resistance (hostile) was set equal to 1 when there was evidenceof management resistance to the offer and 0 otherwise. According to evidence reported inTable 1, management tended to resist being acquired by an investment group more frequentlythan being acquired by an operating company.

7 We should point out that our valuation metric can be motivated on grounds other than its being a reasonableapproximation to a firm’s q ratio. For example, our valuation metric is also a standard comparables valuationmetric as well.

8 We use a two-digit SIC definition of industry because many sample firms have segments in more than one 4digit SIC and these segments can often be grouped under the same two-digit SIC. Further,Clarke (1989)arguesthat more aggregate SIC classifications are better characterizations of an industry.


3. The relationship between managerial ownership and firm value

The segmentation hypothesis requires a nonlinear relationship between moral hazardcosts and managerial shareholdings, implying a nonlinear relationship between a firm’svalue prior to its acquisition and its management’s pre-transaction equity position. To testthis hypothesis, we followMcConnell and Servaes (1990)andAnderson and Lee (1997)and fit a quadratic function of managerial shareholdings to the unadjusted market to bookratios of our sample firms. Our estimated equation is as follows:

MTBR = 1.1777(0.1258)

+ 0.0216MSH(0.0124)

− 0.0002MSH2

(.00009), (1)

where MSH is managerial shareholdings (percentage of total shares outstanding held by of-ficers and directors). Heteroskedasticity-consistent standard error estimates reported withinthe parentheses below each coefficient estimate suggest that each coefficient is significantlydifferent from zero at the 5% level or less. These results are consistent with those reported inMcConnell and Servaes (1990)andAnderson and Lee (1997). They imply a nonlinear rela-tionship between a firm’s value prior to its acquisition and its management’s pre-transactionequity position.

To control for industry related factors, we calculate the adjusted market to book ratio(MTBR* ) and regress it on a quadratic function of sample firms’ managerial shareholdings.We obtain the following results:

MTBR∗ = −0.2588(0.1162)

+ 0.0230MSH(0.0127)

− 0.0002MSH2

(.00001)(2)

Again, based on heteroskedasticity-consistent standard error estimates, we concludethat all coefficients are significant at the 5% level. These results imply that sample firms’market to book ratios are below the median of their industry’s market to book ratios whenmanagerial pre-transaction shareholding is either at the low or the high end of the distributionof managerial shareholdings.

Both regressions provide evidence consistent with a nonlinear relationship between moralhazard costs and managerial shareholdings. Further, the second regression directly impliesthat there is a misalignment of inside and outside shareholder interests in firms at eitherend of the range of prior managerial shareholdings, since the market to book ratio of thesefirms falls below of the median market to book ratios of their respective industries. Thusthese firms are valued less than the typical firm in their industry. As noted earlier, thestrength of the nonlinear relationship is probably understated as there is a bias againstfinding such evidence if mechanisms designed either to align inside and outside shareholderinterests (e.g., compensation) or to prevent such an alignment (e.g., takeover defenses) areeffective.

4. The relationship between managerial ownership and takeover premiums

With a nonlinear relationship between moral hazard costs and managerial shareholdingsas depicted inFig. 1, premiums paid to acquire firms in Clusters #1 or #3 should reflect the


potential gains from restructuring the target firm. For acquired firms within Cluster #2, thispotential source of gains should be less important.

To test this hypothesis, we cluster our sample firms into groups according to managerialshareholdings as suggested byFig. 1, and then examine the relationship between takeoverpremiums and the potential for restructuring gains within each of these groupings. Wemeasure the final premium paid in sample transactions as a percentage markup, defined asthe ratio of the difference between the final traded share price and the share price one weekprior to the first rumor of takeover relative to the latter price (scaled by 100).9 Potentialrestructuring gains (PRG) are measured by the extent to which a sample firms’ industrymedian market to book ratio exceeds the sample firm’s market to book ratio.10 We arguethat the further a firm’s market to book ratio is below its industry’s median market to bookratio, the greater the potential gain from restructuring it.

Identifying the relevant clusters is more difficult. AsMorck et al. (1988a)point out, breakpoints for managerial ownership levels are sample specific. However, using breakpointsidentified on the basis of our prior regression results may needlessly condition our evidenceon our sample’s breakpoints. Consequently, in this and subsequent analyses, we use thebreakpoints identified inMorck et al. (1988a)to identify the relevant clusters of acquiredfirms (Cluster #1: 0–5%, Cluster #2: 5–25%, Cluster #3: 25% and greater) because they arethe widely used in the literature and overcome any argument that our results are specific toour sample based identifications.

For each of these three clusters of sample firms, we regress our takeover premium measureon our measure of the potential gains from restructuring the target and report the resultsin Table 2. These results suggest a number of interesting implications. First, for targets inClusters #1 and #3, there is a significantly positive relationship between the premiums paidto acquire these firms and the potential for gain from restructuring these firms. Second,for targets within Cluster #2, this relationship is not statistically significant. Given thedifferences between our sample breakpoints and Morck, Sheifer, and Vishny’s breakpoints,these inferences are likely to be robust to slight variations in cluster identifications.11Further,the evidence reported inTable 2is consistent with the earlier regressions and withFig. 1.The potential for gains from restructuring the target appear to figure significantly in thepremiums paid to acquire firms in the tails of the distribution of prior managerial equitypositions.

5. Comparison of corporate acquisitions sorted according to target managerialshareholdings

The prior analyses addressed the relationships between prior firm values, takeover pre-miums and pre-transaction managerial shareholdings, the primary implications of our hy-

9 We examined the stock price records of each sample firm for three months prior to the base dates for ourpremium measure to reveal if these were contaminated from price run-ups prior to our measurement dates. Wefound no evidence of such contamination for our sample firms.10 This relationship is just the reverse of our prior industry adjusted market to book ratio.11 It is worth noting that if we use our sample based breakpoints of 0–13, 13–40, and >40, that we derive the

same inferences, though with different coefficient estimates and levels of significance.


Table 2Analysis of acquisition premiums

Constant PRG F-statistic

Cluster #1 (0–5%): 48 firmsCoefficient 17.261 9.234 8.31P-value 0.00 0.005 0.004

Cluster #2 (5–25%): 96 firmsCoefficient 17.807 5.796 0.83P-value 0.00 0.36 0.36

Cluster #3 (25% and above): 105 firmsCoefficient 26.217 2.799 6.47P-value 0.00 0.01 0.01

The dependent variable in each regression is the percentage gross premium paid per share to acquire a samplefirm (i.e., the ratio of the difference between the final traded share price and the share price one week prior to thefirst rumor of takeover relative to the latter price, scaled by 100). PRG represents the difference between a samplefirm’s median industry market to book ratio and its market to book ratio and so represents the potential gains fromrestructuring the target. Standard errors are estimated using White’s estimators.

potheses. We now consider our conjecture that these relationships also have implicationsfor other characteristics of these acquisitions. As illustrated inFig. 1, we expect differencesto exist across clusters for the mood of the transaction, the method of payment and the typeof acquirer when clusters are determined by managerial pre-transaction ownership.

To test these expectations, we continue to use the breakpoints: 0–5%, 5–25%, and greaterthan 25%.12 In Table 3, we report basic statistics on these features over each range ofmanagerial pre-transaction shareholdings. In addition to the above characteristics, we alsotest the robustness of our earlier results by comparing the market to book ratio and adjustedmarket to book ratio of sample firms across these groupings.

Beginning with a sample firm’s market to book ratio prior to its acquisition, we observethat the market to book ratios of Cluster #1 and Cluster #3 firms are less than those of Cluster#2 firms. For the industry adjusted market to book ratio, we observe the same pattern. Ineither case, the Kruskal–Wallis test statistics are significant at the 1% level, suggestingthat our prior evidence is robust with respect to our identification of clusters. These resultsconfirm the robustness of our earlier results with respect to the identification of breakpoints.

Further, consistent with our earlier arguments, we also observe that the majority of firmsin Cluster #3 are acquired by an investment group, while the majority of firms in Cluster#2 are acquired by an operating company. The Kruskal–Wallis test statistic of 16.215 wassignificant at the 1% level.

Examining data on the method of payment, we observe that over all the clusters, cashor cash plus debt is the preferred transaction payment method. However, for Clusters #1and #3 the payment of cash or cash plus debt is more concentrated than in Cluster #2. TheKruskal–Wallis test statistic of 9.98 was again significant at the 1% level. Consequentlythese data are consistent with our prior argument that acquirers will typically use cash whenacquiring poorly performing firms that can be restructured to create value. Our argument

12 We should note that we derive the same inferences if we use our sample-based breakpoints.


Table 3Tests of differences between acquired corporations sorted by target managerial shareholdings

0–5% 5–25% >25%

Market to book ratio (MTBR)Mean 1.190 1.470 1.34Median 1.033 1.215 0.965S.D. 0.553 0.794 1.086

Industry adjusted market to book ratio (MTBR* )Mean −0.267 0.053 −0.195Median −0.286 0.052 −0.104S.D. 0.465 0.687 2.048

Type of acquirerInvestment group 21 (44%) 37 (37%) 68 (65%)Operating company 27 (56%) 62 (62%) 37 (35%)Total 48 (100%) 99 (100%) 105 (100%)

Method of paymentCash or cash and Debt 45 (94%) 76 (77%) 94 (90%)Stock or stock and cash 3 (6%) 23 (23%) 11 (10%)Total 48 (100%) 99 (100%) 105 (100%)

Managerial response to bidHostile 30 (63%) 35 (35%) 26 (25%)Friendly 18 (37%) 64 (64%) 79 (75%)Total 48 (100%) 99 (100%) 105 (100%)

Managerial shareholdings, the percentage of stock held by officers and directors prior to the acquisition of theircompany was determined from S.E.C. filings, primarily proxies, prior to their transaction. MTBR represents afirm’s market to book ratio of equity on the balance sheet date just prior to its acquisition. MTBR* represents thedifference between a sample firm’s market to book ratio and the median of its industry’s market to book ratios fora comparable period. We use sample firms’ two-digit SIC to define their industry. An acquisition is deemedhostileif there is any news story that indicates that management resisted the offer for the firm. The type of acquirer andthe method of payment were determined by reading the proxy associated with acquisition.

and evidence are also consistent withLinn and Switzer (2001), who provide evidence thatoperating performance changes after a takeover are greater for cash acquisitions than forstock acquisitions.

Turning to management’s response to these acquisition offers, we observe that the greateris managerial stock ownership, the more likely is the transaction to be friendly. This resultis significant (at the 1% marginal significance level) and consistent with prior expectations.

Taken together the univariate analyses are consistent with our earlier hypotheses. How-ever, to allow for joint effects, we use conditional multinomial logistic regression analysis.Because of our sampling design, we followLohr (1999)and condition our likelihood func-tion on our sampling weights.13 The results of two such multinominal regressions arereported inTable 4. The first regression (Panel A) uses a sample firm’s unadjusted marketto book ratio as the firm value metric and the second (Panel B) uses a sample firm’s industryadjusted market to book ratio.

13 Fortunately, our statistical package, STATA, makes this adjustment process fairly easy as it has built-in proce-dures for different sampling designs.


Table 4Comparison of ownership groups

Panel A Panel B

Cluster #1 firmsvs. Cluster #2firms




Constant −1.913 (0.33) −1.305 (0.63) −2.103 (0.23) −1.712 (0.13)MTBR −0.193 (0.03) −0.100 (0.02)Industry adjusted MTBR −0.577 (0.04) −0.153 (0.06)Acquirer type −0.373 (0.30) 1.111 (0.00) −0.476 (0.23) 1.141 (0.00)Payment 0.957 (0.01) 0.568 (0.00) 0.841 (0.02) 0.822 (0.00)Hostile 0.994 (0.06) −0.953 (0.09) 1.000 (0.00) −0.909 (0.06)Chi-square 37.79(0.00) 40.11(0.00)

The reported estimates are derived from a conditional multinominal logistic regression estimated using Cluster #2firms as the base category. Cluster #1 firms represent acquired firms in which management held less than 5% of thefirm’s stock prior to the transaction. Cluster #3 firms represent acquired firms in which management held more than25% of the firm’s stock prior to the transaction. Cluster #2 firms represent acquired firms in which managementheld between 5% and 25% of their firm’s stock prior to its acquisition. MTBR represents the firm’s market to bookratio of equity and is a proxy for its Tobin’sq ratio.Industry adjusted MTBR represents the difference between thefirm’s market to book ratio and the median of its industry’s (two-digit SIC) market to book ratios.Acquirer typetakes on the value 1 if acquirer is an investment group, and 0 if another operating company.Payment takes on thevalue 1 if cash or cash and debt is used to pay off existing shareholders and 0 if stock or stock and cash is used.Hostile takes on the value 1 if target management resisted the takeover offer and 0 if it did not. The values reportedin the parentheses represent theP-values associated with az-test of the significance of the associated coefficient.Standard errors were estimated using Huber–White robust estimators.

Either set of regressions report results consistent with our above results. Specifically,firms in Cluster #3 are more likely than firms in Cluster #2 to be acquired by an investmentgroup. Firms in Clusters #1 and #3 are more likely than firms in Cluster #2 to be acquiredthrough the payment of cash. And finally, firms in Cluster #1 are more likely than firms inCluster #2 to have their acquisition resisted by incumbent management. All of these resultsare consistent with our univariate analyses and our earlier hypothesis.

6. Summary and conclusions

There is an ongoing debate in the literature between those (e.g.,Demsetz, 1983) whobelieve that market forces will cause ownership structures to be consistent with firm valuemaximization and others (e.g.,Morck et al., 1988b) who believe there can be a misalignmentof inside and outside shareholders’ interests in corporations when management owns toolittle or too much of their firms’ stock. This debate has generated evidence on the relationshipbetween managerial share ownership and corporate performance or value supporting oneor the other position without clear resolution.

We argue these two positions are not as antithetical as it might appear, once the slownessof the equilibrating processes is recognized. At any point in time some firms will be indisequilibrium with an observed misalignment of inside and outside shareholders’ inter-ests. However, with a well functioning market for corporate control, persistence in such


misalignment will result in these firms being acquired. Consequently there should be anonlinear relationship between prior firm value or performance and managerial ownershipin acquired firms if such a relationship existsand if equilibrating processes operate.

Consistent with this conjecture, we find evidence of a significant quadratic relationshipbetween our proxy for pre-acquisition firm value and prior managerial shareholdings. Thesample used includes corporations acquired during the 1981–1986 period, a period duringwhich the market for corporate control was relatively active and unfettered. Moreover, themarket to book ratio of a sample firm falls below that of its industry’s median market tobook ratio when managerial shareholdings in the firm are at either the low or high end ofthe range of managerial shareholdings. This evidence holds even when we useMorck et al.(1988a)separation of managerial shareholdings. Such evidence is the first evidence of sucha relationship for acquired concerns, rather than going concerns.

We also find evidence that premiums paid are significantly and positively correlated withthe potential gains from restructuring the target when prior managerial equity in the targetis either in the lowest or highest range of prior managerial shareholdings. Consequentlythe existence of a nonlinear relationship between the moral hazard costs borne by a firmand managerial shareholdings is confirmed by our data in several different ways. Further,our evidence is not subject to the same biases as studies of continuing public corporationssince our exclusion of controls for anti-takeover laws, anti-takeover defenses, managerialcompensation, and board monitoring from our analysis only acts to minimize the likelihoodof our observing the evidence that we do observe. Thus, where there is a potential bias, itis against our maintained hypotheses.

Separately, we conjecture that the nonlinear relationship also has implications for whotypically acquires the firm, the method of payment and management’s resistance to thetakeover. Specifically, acquired corporations whose prior managers had low equity stakesand engaged in non-value maximizing behavior tend to be acquired in hostile takeoverswhether by an investment group or by another operating company. Acquired corporationswhose pre-transaction managers owned a large proportion of their firms’ stockand engagedin non-value maximizing behavior will tend to be acquired by an investment group, typicallyorganized by some of the managers, in friendly transactions. Finally, acquired firms whoseprior management had a significant, but moderate, share of the firms’ stockand did notengage in non-value maximizing behaviors tend to be acquired by another operating com-pany in friendly transactions. Underlying these relationships are the effects of a manager’sshare of the firm’s stock on the alignment of inside and outside shareholders interests anda manager’s ability either to resist an unsolicited bid through his or her control of votingrights or to force a self-serving bargain. The evidence from our sample of acquired firms isconsistent with these additional arguments as well.

Our arguments and evidence have three interesting implications. First, the debate overthe relationship between firm value and managerial shareholdings should move on to focuson the speed and operation of equilibrating processes. For example,Mikkelson and Partch(1989)find that the intensity of takeover activity varies over time and affects the intensity ofboard discipline. Further, LaPorta, Lopez-de-Silanes, and Shleifer (1998) provide evidencethat managerial pursuit of the private benefits of control is more pervasive in some economiesthan in others. Thus the adjustment process appears to vary with changes in a legal systemand across different legal systems.


Second, in contrast to prior research,Comment and Schwert (1995)provide evidence thatthe spread of poison pills and third generation antitakeover amendments had little impacton the incidence of corporate acquisitions. However, their evidence is based on a sampleof all exchange listed target firms from 1975 through 1991. Our segmentation hypothesissuggests that the relevant focus for studying the effect of the spread of poison pills and stateanti-takeover amendments should be on corporations in the left tail ofFig. 1. The rationalefor this suggestion is that these defensive actions will have little impact on the incidenceof takeovers of firms in which target management already possess enough voting rights toblock a takeover. Thus, to determine the impact of such actions research should focus onlyon firms for which these actions would provide added protection.

Third, Schwert (2000), unlike prior studies, fails to find significant economic differ-ences between groups of acquired firms classified as ‘hostile’ or ‘friendly’ using differentdefinitions of these terms. However, if corporations acquired in ‘friendly’ transactions aresampled from the middle and upper ranges of managerial shareholdings, such varied re-sults are to be expected and will depend upon the mix of the two types of acquired firmsin the researcher’s sample of ‘friendly’ acquired firms. Thus, the segmentation hypothesispotentially reconciles the conflicting evidence from studies of hostile takeovers.

Acknowledgements

Funding provided by the Social Sciences and Humanities Research Council is gratefullyacknowledged. The authors wish to thank Dan Asquith, John Byrd, Doug Cook, BruceMcCullough, and Randall Morck for helpful comments on prior drafts.

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