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How Do Acquirers Retain Successful Target CEOs?

The Role of Governance

Julie Wulf Harbir Singh

Graduate School of Business Administration The Wharton School

Harvard University University of Pennsylvania

September 2009

Abstract: The resource-based view argues that acquisitions can build competitive advantage partially

through retention of valuable human capital of the target firm. However, making commitments to retain

and motivate successful top managers is a challenge when contracts are not enforceable. Investigating the

conditions under which target CEOs and directors are retained in a sample of mergers in the 1990s, we

find greater retention of better-performing CEOs, and that the performance-retention link is stronger when

the acquirer‘s ownership is more concentrated. It is not common for acquirers to retain target CEOs.

However, good bidders retain CEOs through a governance environment that protects managerial

discretion when commitments are not enforceable. Based on a joint analysis of retention and governance,

our findings are largely consistent with the managerial human capital explanation of retention.

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1. Introduction

Over the past two decades, the characteristics of mergers and acquisitions have changed dramatically.

Transactions during the 1980s were often characterized as hostile takeovers, yet during the 1990s,

transactions were commonly characterized as friendly mergers that involved negotiations between two

willing parties (Andrade, Mitchell and Stafford, 2001). The decade of the 1990s also has witnessed

significant changes in governance and higher rates of CEO turnover with an increasing fraction of

turnover caused by mergers and acquisitions (Booz & Co., 2006).1 While a number of perspectives on the

role of target CEOs in mergers have been discussed in the literature, we develop the managerial human

capital explanation which argues that acquisitions can build competitive advantage partially through

retention of top managers with value-creating human capital. In contrast to the literature that focuses on

the monitoring and disciplining aspects of governance, we argue that the ownership and governance

structure of the acquiring firm can play a role in retaining successful target CEOs when commitments are

not enforceable.

The challenges that target CEOs face in evaluating promises or commitments made by acquiring

firms is illustrated by the circumstances around NationsBank Corporation‘s acquisition of BankAmerica

(1998):

When the merger was completed, Hugh McColl (CEO of the acquiring firm--

NationsBank) became CEO of the merged firm. In the SEC filing that described the

terms of the merger agreement, NationsBank noted that it was the present intention

of the boards of directors and McColl that David Coulter (CEO of the target firm--

BankAmerica) would take over as Chairman and CEO upon McColl‘s retirement.

1 The decade of the 1990s also has witnessed significant changes in governance including: (i) an increase in

shareholder activism leading to greater monitoring and influence over firm decisions by both institutional and block

shareholders (Useem, 1993; Daily, Dalton and Rajagopalan, 2003); (ii) a trend toward more independent boards

with a higher proportion of outside directors; (iii) an increase in CEO ownership through stock options to align

incentives (an indirect measure of internal governance) (e.g., Murphy, 1999 and Kaplan and Holmstrom, 2001); and

(iv) increasing recognition that CEOs are heterogeneous in their ability to generate rents for firms (Bertrand and

Schoar, 2004 and Wang and Barney, 2006). During this same time period, there has been a more active labor market

for CEOs (Himmelberg and Hubbard, 2002) leading to higher turnover rates, lower tenure, and CEOs more

commonly being replaced or succeeded by external hires (Huson, Parrino and Starks, 2001). The trend toward

friendly, synergistic mergers combined with substantial shifts in corporate governance and fundamental changes in

CEO labor markets makes the 1990s an interesting decade in which to explore the role of target CEOs and directors

in the governance of the merged entity.

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At the time, the financial press expected McColl‘s retirement within 2 years of the

acquisition. Instead, Coulter was forced to resign in the year of the merger.2

More broadly, succession agreements for target CEOs in mergers are generally not honored and thereby

provide an example of a failed promise or commitment made by acquiring firms.3 And, while this type of

agreement is not common, it is easy to extend the concept to a more general case in which the acquiring

firm promises the target CEO the right to ―be the boss‖ or the authority to make decisions post-merger.

In this paper, we investigate the conditions under which acquiring firms retain successful target CEOs

and directors in a study of mergers during the 1990s. We argue that ownership structure and governance

differentiate acquiring firms in their ability to make credible commitments to protect post-merger decision

rights of target CEOs and the likelihood of retention. Using measures of ownership concentration and a

widely-used governance index from the finance literature, we find evidence that is broadly consistent with

this explanation. To our knowledge, this is the first paper that acknowledges and documents a potential

role of the acquirer‘s ownership and governance structure in retaining successful target management.

Managerial Human Capital and Target CEO Retention: The managerial human capital explanation

posits that the acquirer‘s governance structure provides appropriate incentives for successful target CEOs

to stay with the merged firm. Target CEOs can be important ―assets‖ (or critical resources) to acquiring

firms because they may represent valuable human capital that leads to good performance. Their unique

expertise may derive from firm-specific investments that provide the basis by which the firm can build a

long-term competitive advantage (Barney, 1991; Shleifer and Summers, 1988, Castanias and Helfat,

1991).4 While acquiring firms may want to retain successful target CEOs, retention is a joint decision by

both acquiring firms and the CEOs themselves (Buchholtz, Ribbens, and Houle, 2003). Moreover, from

2 ―Mergers of NationsBank BankAmerica and Banc One, First Chicago Unveiled—Huge Deals Could Mark the

Beginning of Move to National Banking‖, S. Lipin and G. Fairclough, The Wall Street Journal, 4/14/1998. 3 Hartzell, Ofek and Yermack (2004) document the existence of explicit succession agreements for target CEOs in

only 3% of their sample (9 of 311 mergers) and find that none of these agreements were honored. See Wulf (2004)

for a description of succession agreements in mergers of equals transactions. 4 Castanias and Helfat (1991, 1992) develop the notion of ―managerial or earned rents‖ as ―those portions of the

firm‘s rents that management creates from its superior management skills‖ that provide incentives for managers to

make investments in firm-specific human capital and to perform well .

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the CEO‘s perspective, certain governance environments may be more attractive.5 For example, if target

CEOs value the right to make decisions in the post-merger firm (or to ―be the boss‖), they are more likely

to stay when the acquiring firm can commit to protecting managerial discretion [or private benefits of

control (Aghion and Tirole, 1997; Grossman and Hart, 1986)]. It is then easier for acquiring firms with

such governance environments to retain successful target CEOs.

Human capital is critical to a firm‘s competitive advantage. Since acquiring firms want to retain

successful target CEOs, they may make commitments to protect their decision rights in order to get them

to stay. However, since it is difficult to enforce commitments contractually because unforeseen

contingencies often render contracts incomplete and ineffective, the value of a commitment depends on

the credibility of the party making it. The ability of an acquiring firm to make credible commitments--and

increase the odds of retaining a successful target CEO--is a function of both the firm‘s ownership

structure and the governance environment more broadly. Acquiring firms with powerful shareholders--

block shareholders or CEOs with large ownership stakes-- can make credible commitments relative to

firms with diffused shareholders. Select governance provisions that support and protect managers, e.g.,

anti-takeover laws, employment agreements, and golden parachutes (Lambert and Larcker, 1985;

Knoeber, 1986, Castanias and Helfat, 1991), enable acquiring firms to credibly commit to protecting the

decision rights of target CEOs in the merged firm.

The managerial human capital view recognizes heterogeneity among target CEOs. It posits that

acquiring firms want to retain valuable target CEOs and directors and are able to do so by providing a

governance environment in which successful managers elect to stay. In contrast to the characterization of

5 The excerpt from a Booz & Co. study (Lucier, Kocourek, and Habbell. 2006) describes the reasons why target

CEOs might choose to stay: ―Why do so many former chiefs stay on? There are three reasons. First, being

acquired by a larger company may be a passport to greater opportunity, even for executives who are losing their

CEO title. … Second, CEOs may stay with the acquiring company because there is a reasonable chance that they

could move on to the chief executive role of the larger company in the future. … Third, when a deal takes an

acquirer into a new business, that company will often insist that much-needed senior talent remain with the new

entity. In this case, the CEO may agree, as part of the deal to remain with the new company, particularly if his or

her skill set and leadership are viewed as critical for success.‖ A more recent example of the importance in retaining

a successful target CEO is when JP Morgan Chase acquired Banc One with the plan to promote its CEO (Jamie

Dimon) to the chief executive of the merged entity.

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governance simply as a mechanism for owners to monitor and discipline ―entrenched‖ managers, we

broaden the potential scope of governance by acknowledging a role in attracting and retaining valuable

managerial human capital.

Several early empirical papers on M&A, based on transactions during the 1980s, find evidence

consistent with the managerial human capital view. For example, Cannella and Hambrick (1993)

document that post-acquisition performance and retention of target management is positively correlated.

Matsusaka (1993) finds positive event returns when acquirers retain the top management team of the

target firm and negative returns when acquirers replace target management. 6 In a very recent paper,

Bargeron, Schlingemann, Stulz, and Zutter (2009) find that target CEO retention is positively correlated

with firm performance and that target announcement abnormal returns are higher when private bidders

retain target CEOs. Broadly consistent with our theory, the authors propose that certain classes of

bidders (e.g., private vs. publicly-traded firms) are more likely to retain valuable CEOs. First, we

establish a positive relationship between target management retention and various measures of firm

performance, and then document how the acquiring firm’s ownership and governance affects this

retention-performance relationship.

In addition to CEOs, the human capital view has implications for the decision to retain target directors

since their expertise and advice may be valuable over and above their monitoring role. Moreover,

retention of target directors may enhance the acquirer‘s ability to make credible commitments to

successful target CEOs (Wulf, 2004) and increase the odds that they will stay.

In this paper, we examine the evidence in light of the managerial human capital perspective.

Specifically, we analyze a sample of mergers in the 1990s to understand under what conditions successful

target CEOs and directors are retained in the governing body of the merged entity. As a baseline, we first

establish that target CEO retention is positively correlated with proxies for target CEO success—firm

performance—prior to the acquisition. We then address the following research questions: (i) Are

6More recently, Zollo and Singh (2004) show that the capabilities of managers in both the acquiring and target firms

are an important factor in determining post-merger performance.

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successful CEOs more likely to be retained under certain ownership and governance structures? (ii) Are

firms that make acquisitions that are well-received by the market (i.e., good bidders) more likely to retain

target CEO and directors in certain governance environments?

We find evidence that is broadly consistent with the managerial human capital view. First, we show

that successful target managers, as measured by firm performance, are more likely to be retained. Of

potentially greater and more novel interest, we find that the governance of the acquiring firm is important

to the firm performance- CEO retention link. Better-performing target CEOs are retained when acquiring

firms have more concentrated ownership, as measured by blockholder shareholdings and CEO ownership.

This is consistent with the argument that large shareholders of the acquiring firm are more able to

credibly commit to protecting decision rights of target CEOs. We then analyze good bidders (firms that

make acquisitions that are well-received by the market) and find that they retain target CEOs when

governance is characterized by provisions that protect managerial discretion (e.g., anti-takeover laws,

employment contracts, and golden parachutes). We measure firm governance by using two proxies: the

G-index from Gompers, Ishii, and Metrick (2003) 7 and whether the firm is incorporated in a state that is

protected by Business Combination laws. Finally, we find that good bidders retain target directors when

blockholders hold a higher fraction of shares in the acquiring firm. These results are broadly consistent

with the managerial human capital explanation: concentrated ownership and manager-supportive

governance provisions strengthen the acquiring firm‘s ability to make credible commitments that protect

managerial discretion and increase the odds of retaining a successful target CEO.

Overall, our findings suggest that successful target CEOs are valued by acquiring firms and they

agree to stay on when the governance of the acquired firm creates an environment which protects

managerial discretion. Taken together as a whole, we find support for a more nuanced view of the role of

governance in retaining valuable human capital in the governing body of the post-merger entity. We

7The Gompers, Ishii, and Metrick governance index characterizes the degree to which the firm‘s governance

provisions support owners versus provisions that support managers. This index considers 24 different provisions in 5

categories (refer to Table A-1 for a detailed list by group).

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conclude that certain governance structures can be beneficial to both owners and managers--managers and

owners do not necessarily need to be at odds.

We contribute to the existing research in several ways. First, we re-orient the governance discussion

in M&A transactions away from monitoring and dismissal of bad managers toward attraction and

retention of good managers. We extend the managerial human capital view to the context of M&A by

developing a theory for how governance choices of acquiring firms lead to retention of successful target

CEOs when commitments are not enforceable. Second, to test the theory, we jointly analyze retention and

governance in a sample of friendly mergers and find that both ownership structure and governance

provisions of the acquiring firm help explain the conditions under which valuable managerial human

capital of target firms are retained. To our knowledge, this is the first paper to find a moderating effect of

the acquiring firm‘s governance on the retention of successful target CEOs. The implications of our

analysis suggest that a firm‘s governance choices help contribute to the ultimate success of M&A

transactions.

2. Prior Literature and Hypothesis Development

2.1. Target CEOs as “Assets”: The resource-based view considers acquisitions as a means to improve

competitive advantage and perceives target firm executives as part of the critical resources that are

acquired. In other words, target executives can be valuable assets, not liabilities (Walsh and Ellwood,

1991)—a perspective that is consistent with the notion that firms are comprised of both physical and

human capital (Harris and Helfat, 1997; Rajan and Zingales, 1998; and Bailey and Helfat, 2003). Target

CEOs with valuable human capital can improve firm performance through various mechanisms—by

working harder or in a more productive manner, or by leveraging greater ability or skill. CEO skills can

include both general management skills and firm-specific skills.8 Managers can invest in developing

8 Becker (1962) distinguishes between ―general‖ human capital (which is valued by all potential employers) and

―firm-specific‖ human capital (which involves skills and knowledge that have productive value in only one

particular company). More recently, Lazear (2003) has argued that a more informative view of firm-specific human

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knowledge or relationships that are specific to the firm, for example, a deep understanding of a

technology or relationships with customers, suppliers and critical employees. It is these firm-specific

skills of managers that ultimately contribute to the superior returns of strong-performing firms.

The managerial human capital view recognizes heterogeneity among managers and suggests that

acquiring firms should only seek to retain target CEOs that are successful. What constitutes a successful

CEO? One direct way to characterize successful CEOs is to identify those that are effective in improving

firm performance. While CEOs cannot control many events that determine how well their firm performs,

countless studies (especially those analyzing turnover) use firm performance as a measure of a CEO‘s

effectiveness or success (e.g., Weisbach, 1988). Certainly, boards of directors must at least consider an

executive‘s track record in evaluating their effectiveness. Building on this research, we use several

measures of pre-acquisition performance of the target firm to characterize successful target CEOs

including return on assets, revenue growth, and Tobin‘s Q. We expect target firm performance (pre-

acquisition) to be positively correlated with target CEO retention.

Another way to characterize CEO success is by using compensation of the target CEO prior to the

acquisition. Wages are a reasonable proxy for the marginal productivity of labor whether the productivity

is a result of greater effort by the employee, greater skill, or a combination of the two. Harris and Helfat

(1997) argue that CEO compensation might be one indicator of the value of the human capital that the

CEO brings to the target firm. Firm-specific skills generate rents and firms can choose to share these rents

with managers for several reasons—first, in order to retain them and, second, to provide an incentive for

managers to continue to make investments in these skills. Parsons (1972) models firm and employee

investments in firm-specific human capital and resulting implications for turnover. The model predicts

that workers who receive a wage-premium for skills (i.e., capturing returns on specific investments) will

be less likely to quit. This is broadly consistent with a positive association between pay levels and a

capital is that each job requires a slightly different combination of a multiplicity of general skills and ―firms use the

skills in different combinations with different weights attached to them.‖

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higher probability of retention. As a result, we expect CEO compensation (pre-acquisition) to be

positively correlated with target CEO retention.

Finally, we use tenure in position of the CEO to represent the extent of the CEO‘s firm-specific skills

or experience. Some argue that CEOs with extended tenure are more likely to be entrenched or resist

change, while others find evidence that more extensive firm-specific experience (longer tenure) has

beneficial performance effects (e.g., Kor and Mahoney, 2005). In developing our hypotheses, we adopt

the view that CEO experience and tenure contribute to firm-specific human capital and expect tenure in

the CEO position (pre-acquisition) to be positively correlated with target CEO retention.

We employ all three measures to represent target CEO success or the value of the target CEO‘s

human capital. While each measure has drawbacks, by using all three, we hope to mitigate some of the

limitations of each. To sum up, the managerial human capital view suggests that target CEO retention

should be positively correlated with target firm performance, CEO compensation, and CEO tenure in the

position just prior to the acquisition.

2.2. The Role of Acquiring Firm’s Governance in Retention of Target CEOs: Acquiring firms want

to retain successful target CEOs because their valuable human capital leads to good performance.9

However, even if CEOs are given the option to stay, they may choose to leave. In the spirit of the

literature on private benefits of control (e.g., Grossman and Hart, 1986), we assume that successful target

CEOs value decision rights or managerial discretion—that is, they prefer to ―be the boss.‖ In order to

retain successful CEOs, acquiring firms would like to commit to protect their decision rights in the

merged entity. But, commitments are not necessarily credible since contracts are incomplete. Aghion and

Tirole (1997) analyze a principal-agent relationship and show that the principal may prefer to delegate

decision rights to the agent, even if the agent‘s preferences are not perfectly aligned. Baker, Gibbons and

9 See Coff (1997) for a broad discussion how firms might mitigate challenges in managing human assets or capital.

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Murphy (1999) point out that commitments to delegate decision rights often are not credible. They

propose that relational contracts may serve as a commitment device to partially resolve this problem.

So, what is an example that illustrates the challenge in making credible commitments? The acquiring

firm may promise and sign a contract stipulating that the target CEO and his/her management team will

have the authority to make key strategic decisions after the acquisition. But, since contracts cannot

specify all contingencies and are inherently incomplete (and unenforceable by a court of law), the target

CEO may not trust the terms of the contract. If the acquiring firm can credibly commit to protecting

decision rights, this increases the odds that the successful target CEO will choose to stay. We argue that

the ability of the acquiring firm to credibly commit and fulfill the promise is a function of (i) ownership

stakes of block shareholders and CEOs and (ii) governance provisions that support managerial discretion

(represented by the G-index and the presence of Business Combination laws). In the following discussion,

we consider each in turn.10

Agency theory suggests that owners of large blocks of shares have both the incentives and influence

to ensure that managers operate the firm efficiently. Since blockholders have much wealth at stake in the

firm, the benefits of monitoring and disciplining managers outweigh the costs (Demsetz, 1983). In

addition, block shareholders have far more voting power than small, diffuse shareholders and are more

effective in influencing firm outcomes. As an example, Bethel and Liebeskind (1993) find that

blockholder ownership is associated with corporate restructuring, suggesting that managers restructured

their corporations only when pressured to do so by large shareholders. Furthermore, Dennis and Serrano

(1996) show that blockholders can facilitate CEO succession in firms subject to unsuccessful control

contests. They find that CEO turnover is higher in poorly performing firms after the contest when outside

blockholders acquire an ownership stake in the target firm, again suggesting that blockholders facilitate

restructurings. Evidence suggests that block shareholders have the incentive and the ability to force

turnover of poor-performing target CEOs.

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For a related paper, see Burkart, Gromb, and Panunzi (1997) who develop a theoretical model of the trade-off

between gains from monitoring and those from managerial discretion in which they argue ―that a firm‘s ownership

structure can act as a commitment device to delegate a certain degree of control to management.‖

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Instead of focusing on the role of ownership in monitoring and disciplining poor-performing

management, our theory explores how influential shareholders might enhance retention of better-

performing target CEOs. Blockholders might have a preference for more talented managers (Bethel and

Liebeskind, 1993). Or, good target CEOs may simply prefer to stay with acquiring firms that are better-

performing.11

Our theory proposes that successful target CEOs value decision rights and thereby prefer

acquiring firms with governance environments that credibly commit to protecting managerial discretion.

Since large, influential shareholders have greater power and influence than diffuse shareholders, they are

more effective in making credible commitments. As a result, we expect the odds of retaining successful

target CEOs to be higher when the acquiring firm has block shareholders. In an analogous argument,

acquirer CEO ownership can also affect the retention of target management. CEOs with larger ownership

stakes have more influence over firm outcomes and thus more able to credibly commit to protecting

decision rights for target CEOs. To sum up, we expect higher odds of retaining successful target CEOs

when the acquirer‘s ownership is comprised of block shareholders and CEOs with large equity holdings.

In addition to ownership concentration, external governance mechanisms can play an important and

distinct role in a target CEO‘s decision to stay. For example, anti-takeover defenses (e.g., poison pills)

and anti-takeover state laws (e.g., business combination laws) shift the balance of power from owners to

managers. Golden parachutes and severance agreements can be thought of as payments to target CEOs in

exchange for firm-specific human capital investments (Castanias and Helfat, 1991). As such, they align

incentives of target CEOs with shareholders thereby leading to efficient transactions and transfer of

control to acquiring firms (Lambert and Larcker, 1985; Knoeber, 1986; Singh and Harianto, 1989).

In this paper, we use the GIM governance index (G-index) based on a broad set of twenty four

provisions to characterize firm governance as supportive of owner vs. managerial discretion or ―the

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The data do not support this simple explanation. In a regression of target CEO retention on acquiring and target

firm performance measures (ROA, sales growth, Tobin‘s Q) and the interactions between acquiring and target

performance, we find no evidence that better-performing acquiring firms are more likely to retain good target CEOs.

Moreover, there is no evidence that the performance of the acquiring firm is positively correlated with the

governance measures in our sample. In regressions of acquirer performance (ROA, sales growth, or Tobin‘s Q) on

the two measures of concentrated ownership (block shareholdings or CEO ownership) and the governance measures,

all coefficients on the ownership/ governance measures are statistically insignificant (unreported).

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balance of power between shareholders and managers‖ (Gompers, Ishii, and Metrick, 2003). (This index

is described in further detail in the ―Methods‖ section.) To the extent that the governance index proxies

for provisions that make it difficult for shareholders to "punish" or overrule management, and if they are

costly to change, such provisions limit shareholder interference in the running of the company by top

management. While much of the finance literature assumes that the managerial supportive provisions lead

to ―entrenchment‖ and ultimately destroy shareholder value, there are clearly costs and benefits of

governance provisions.12

Fisman, Khurana, and Rhodes-Kropf (2005) adopt a more balanced view by

analyzing trade-offs of different governance environments and find evidence that ―entrenchment‖ can be

beneficial in certain circumstances. Similarly, we argue that if the acquiring firm has governance

provisions that protect managerial discretion (e.g., high G-index or protection from Business Combination

laws), this will increase the odds of retaining successful target CEOs who value decisions rights.

The discussion above leads to two sets of hypotheses regarding target CEO retention. One is related

to the relationship between target CEO success and retention (H1), establishing a baseline for additional

hypotheses. The second, more novel hypothesis is related to the relationship between the retention-

performance link and the acquiring firm‘s ownership and governance (H2). The managerial human capital

explanation leads to a positive relation between target CEO retention and proxies for CEO success in the

year prior to the merger (t-1): pre-acquisition performance, compensation, and tenure in position. As a

baseline, we introduce the following hypothesis.

Hypothesis 1: Conditional on a merger, the probability of acquiring firms retaining target CEOs will

be positively related to the success of the target CEO.

Hypothesis 1a: Target CEOs of better-performing firms will be more likely to be retained.

Hypothesis 1b: Target CEOs with higher compensation will be more likely to be retained.

Hypothesis 1c: Target CEOs with longer tenure in the position will be more likely to be retained.

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Gompers, Ishii and Metrick (2003) find that firms with stronger shareholder rights (or discretion) perform better

than firms with stronger managerial discretion.

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In addition to CEO success, and as discussed at length earlier, ownership structure and governance

may affect target CEO retention by acquiring firms. The human capital view argues that certain

ownership and governance structures enhance the ability of the acquiring firm to credibly commit to

protecting target CEO discretion in the merged firm. Specifically, greater protection of decision rights is

more likely in firms with concentrated ownership and governance provisions that protect management. As

such, we would expect a higher probability of retaining successful target CEOs when the acquiring firm‘s

governance is characterized by: (i) more concentrated ownership (i.e., a higher fraction of stock held by

block shareholders or a higher fraction of stock held by the acquiring CEO) and (ii) governance

provisions that protect managerial discretion (i.e., provisions that support and protect managers,

represented by the governance index defined earlier and the presence of Business Combination laws).

Hypothesis 2a: The higher the concentration of ownership in the acquiring firm, the greater the

ability to credibly commit to protecting target CEO decision rights and the more positive the

relationship between target pre-acquisition performance and CEO retention.

Hypothesis 2b: The greater the use of governance provisions by the acquiring firm that protect

managerial discretion, the more positive the relationship between target pre-acquisition

performance and CEO retention.

Retention of Target Directors: Until now, we have focused our discussion on the retention of target

CEOs. However, in addition to CEOs, acquiring firms make decisions about the role of target directors

on the post-merger board. There is extensive literature on a firm‘s choice of directors to serve on boards

(e.g., Hermalin & Weisbach, 1988). However, research on target directors in mergers is much more

limited. Let us now turn to discussing retention of target directors.

The human capital view suggests that target directors provide expertise and advice and not just

monitoring. Castanias and Helfat (2001) explicitly discuss the importance of human capital and the

expertise of boards of directors, both as direct inputs to the management of the company and in improving

the ability of board members to perform their monitoring function. Directors supply firms with human

capital that is derived from several sources: education, experience that is specific to the firm and the

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industry, and from their networks of ties to other firms and external contingencies (Certo, 2003). Also,

there is some evidence that directors provide specialized advice, e.g., financial experts on boards

significantly affecting corporate decisions (Guner, Malmendier and Tate, 2008).

Finally, and possibly most relevant when contracts not enforceable, acquiring firms may retain target

directors to help retain successful target CEOs. Target CEOs may consider retention of sympathetic

directors as another way in which the acquiring firm can credibly commit to protect decision rights (Wulf,

2004). If the merged board is comprised of more target directors, the target CEO may perceive the board

as being generally more supportive. Moreover, target directors have experience working with the top

management team of the firm which may be valuable for many reasons—an important one being to

improve the merger integration process since management retention is important to integration capability

(Zollo and Singh, 2004).

2.3. Good Bidders and Target CEO/ Director Retention: Previous literature documents that, on

average, acquiring shareholders do not benefit from acquisition announcements, while target shareholders

do benefit. Cumulative abnormal returns are positive for target shareholders, while returns for acquirers

are either zero or slightly negative (Andrade, Mitchell and Stafford, 2001). Agency theory explains this

set of facts in the following way. Target shareholders gain when inefficient, poor-performing and

entrenched managers are removed. Acquirers, on average, make bad acquisitions in an effort to empire-

build or exhibit hubris in decisions to expand through acquisitions (Roll, 1986).

This leads us to an interesting set of questions: do good bidders (i.e., firms that make acquisitions that

are well-received by the market) differ from bad bidders in terms of their decisions to retain target CEOs

and directors? Is retention in acquisitions by good bidders related to the acquiring firm‘s governance?

We begin by characterizing firms that make acquisitions that are well-received by the market (i.e.,

larger acquirer abnormal returns) as good bidders. We build on the logic that good bidders should make

better decisions in identifying successful target CEOs. Yet, whether CEOs decide to stay with the merged

firm is ultimately their decision. Analogous to the earlier discussion, they are more likely to stay if the

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ownership and governance structure of the acquiring firm protects their rights to make decisions. We

expect good bidders with governance structures that protect managerial discretion to successfully retain

target CEOs and directors. 13

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Hypothesis 3a: Good bidders (larger acquirer abnormal returns) are more likely to retain target CEOs

when ownership is more concentrated and when governance provisions protect CEO discretion.

Hypothesis 3b: Good bidders (larger acquirer abnormal returns) are more likely to appoint a higher

proportion of target directors to the merged board when ownership is more concentrated and when

governance provisions protect managerial discretion.

3. Data and Econometric Specification

3.1. Sample: The data in this paper come from a variety of sources. Data on merger transactions come

from Securities Data Company (SDC). Information on ownership, board structure, and target CEO and

director retention comes from Securities and Exchange Commission (SEC) filings surrounding the merger

announcement and completion dates. CEO characteristics come from proxy statements and ExecuComp.

Firm financials come from Compustat and stock returns come from the Center for Research in Securities

Prices (CRSP). Corporate governance provisions come from Investor Responsibility Research Center

(IRRC) as reported by Gompers, Ishii, and Metrick (2003) and Business Combination laws as reported by

Bertrand and Mullainathan (2001). We also use the Directory of Corporate Affiliations and Dun and

Bradstreet Million Dollar Directory to verify target CEO post-merger status as SEC filings only cover the

top-five highest paid executives in the firm. Finally, we analyze merger announcements through

Lexis/Nexis to verify dates and to document announced plans for target CEO and/ or director retention.

The initial sample of mergers includes all U.S. mergers listed by SDC with announcement dates

between 1/1/1994 and 12/31/1998 that meet the following criteria: (i) the merger is not classified as a

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We are not arguing that bidders generate larger abnormal returns through announcing their plans for retention. To

test whether our empirical results are driven by this, we analyze press releases of merger announcements and

identify those which include detailed plans regarding retention of management and/ or directors. In a regression of

bidder CARs on our measures of retention, we find little evidence that announced retention plans have any

systematic effect on acquirer cumulative abnormal returns. 14

See Lehn and Zhao (2005) for a similar argument in analyzing whether CEOs that are bad bidders in mergers face

higher turnover after the acquisition. They find that a significant inverse relation exists between bidder returns and

the likelihood of CEO turnover.

16

share repurchase, a self-tender, or a sale of a minority interest; (ii) the method of financing is classified as

either a stock swap or a tender offer transaction; (iii) both acquirer and target firms are publicly traded

and listed on the CRSP database, and (iv) the market capitalization of target firms is greater than $50

million. A key feature of this study distinct from earlier empirical work is that we focus on characteristics

of both the acquirer and the target firms and their management. As such, we require the firms to have

proxy data on both acquirer and target for the study period and for them to be covered by ExecuComp.

This results in a sample of 220 transactions comprised of 188 completed and 32 uncompleted mergers. In

this paper, since we are focused on target CEO and director retention, we analyze only completed

mergers. 15

To collect detailed information on both acquirer and target firms, CEO characteristics, ownership and

board structure, we use three SEC filings: (i) the proxy statement, Form 10-K, or similar document

containing ownership data in advance of the last annual meeting before the acquisition announcement; (ii)

the proxy statement, Form S-4, Form DEF 14, or other document filed in connection with the transaction;

and (iii) the first and second proxy statement of the acquiring company filed after the merger becomes

effective.

3.2. Econometric Specification: To explore the determinants of target CEO retention rates, we estimate

the following probit model conditional on the firm being a target in transaction i at time t:

itititititititit XTettCEORET )*()arg/Pr( 151411312111 (1)

15

One important issue in the use of our sample selection criteria is how representative our sample is of merger

transactions during this time-frame. By using the above screens, do we systematically bias the sample in such a way

that the study results are not representative of a larger sample of transactions? To address this, we conduct some

comparisons between the study sample and a sample of more than 1000 mergers covered by SDC during a similar

timeframe. This larger sample of transactions is based on the first three screens for the study sample, but we do not

impose that the market capitalization is greater than $50 million. We then exclude the study sample transactions

from this larger sample. We compare the means and medians of transaction characteristics, and both acquirer and

target firm characteristics for both the study sample and the broader sample of transactions and find that summary

statistics are generally qualitatively similar between the two samples. Another selection issue that is not possible to

address with our data is that we don‘t observe those CEOs that are offered a position by the acquiring firm, but

choose not to stay.

17

where CEORET is a dummy variable equal to one if the target CEO is retained by the acquiring firm in

the year after the merger (t+1) and zero otherwise; T, X, and Z represent target firm characteristics,

target and acquirer governance characteristics, target and acquirer CEO characteristics, and transaction

characteristics, respectively, in the year prior to the merger (t-1). Target firm characteristics include size,

return on assets, revenue growth, and Tobin‘s Q, while target CEO characteristics include compensation

paid in the year prior to the acquisition and tenure in position in the year prior to the acquisition. Acquirer

and target governance characteristics include block shareholder ownership, CEO ownership, and the

governance index. We include interaction terms between pre-acquisition performance, cumulative

abnormal returns, and governance measures as appropriate to evaluate support for each hypothesis.

Importantly, our null hypothesis is that the coefficient on each interaction term is zero. Implicit in this

hypothesis is a definition of the ―interaction effect‖ based on the coefficient. This is in contrast to

hypotheses that define the interaction effect as the marginal effect which have to be tested at each value of

all variables (refer to Wiersama and Bowen, 2007). Transaction characteristics include whether the

acquisition is a tender offer or merger, whether the acquirer and target operate in similar industries (i.e.,

related merger), the relative size of the target to the acquirer and the number of days from announcement

to merger completion. Due to concerns about multi-collinearity, all models use mean-centered variables

(or deviations from the mean) for interaction terms and the respective main effects.

To explore the determinants of target director representation on the merged board, we define the

dependent variable as the target director share of the post-merger board in (t+1) and then estimate both

tobit regressions and OLS regressions (the latter are unreported). The tobit specification address the

concern about left censoring of the dependent variable (approximately 40% of the observations are zero).

We include year indicators and report heteroskedastic-robust standard errors in all specifications.

Dependent Variables: Data collection on CEO and director retention begins with both announcement

and completion dates of the merger as reported by SDC (and verified using Lexis/Nexis). The fiscal year

of the target firm prior to the year of announcement is considered to be year (–1). Year (+1) is the fiscal

18

year of the merged firm following completion of the merger, while year (+2) is the second fiscal year

following the completion of the merger.

For each target firm in the fiscal year prior to the announcement date (–1), the individual occupying

the position of CEO is identified using the proxy statement filed with the SEC. In each of the two years

following the completion of the merger ((+1) and (+2)), the acquirer‘s proxy statement is analyzed to

determine retention rates of target CEOs. The first definition of retention is whether the target CEO is

reported in any capacity (i.e., as an officer or director of the merged firm) in the acquirer‘s proxy

statement in the year following merger completion and is represented by an indicator variable. Additional

retention measures include retention as an officer in each of two years following the merger represented

by distinct indicator variables: in the first year (+1) and in the second year (+2).

To represent target director retention, we collect detailed information on the structure of the post-

merger board of directors in the year after merger completion: board size, the number of directors from

the acquiring firm, and the number of directors from the target firm. As our measure of post-merger

governance of the board of directors, we use the target director share of the merged board in year (+1).

Independent Variables: In this paper, we use two measures to represent the value of the target CEO

to the acquirer: target firm performance, target CEO compensation, and target CEO tenure in position (all

in the year prior to the acquisition, t-1).

To represent target firm performance in the years prior to the merger, we use several industry-

adjusted accounting measures from Compustat. The first is return on assets (ROA) and is defined as

operating income divided by assets in t-1. The second is revenue growth in the year prior to the merger

(i.e., growth in revenues between year‘s t-1 and t-2). And, the third is Tobin‘s Q or market-to-book ratio

in t-1. All of these measures are deviated from industry medians. For completeness and to avoid

misclassifying performance due to outliers, we also calculate three-year averages of the above three

measures (based on t-3, t-2 and t-1). Turning to CEO pay, we measure compensation as the logarithm of

total compensation as in ExecuComp (which includes salary, bonus and the value of stock options,

19

restricted stock and other forms of long-term incentives). In addition to target performance, we use tenure

or the number of years in position as CEO as a proxy for the target CEO‘s firm-specific human capital.

In this paper, we use four measures to characterize the acquiring firm‘s governance: (i) block

shareholder ownership, (ii) CEO ownership, (iii) broad governance provisions represented by the GIM

index and (iv) the presence of Business Combination (BC) laws in the state of incorporation. While, the

first two measures have been used extensively in prior research, the governance index and the presence of

BC laws are commonly used in more recent research.

We calculate and report the percentage of the firm owned for two categories of owners: CEOs and

blockholders (excluding the CEO). We use the number of shares listed in SEC proxy statements in year

(t-1) and divide that by the total number of shares outstanding as reported directly in SEC filings. In

addition to CEOs, blockholders are important since they have substantial voting control to influence

management. Blockholders are shareholders with an ownership greater than 5% of the firm‘s outstanding

shares. Finally, by using blocks of all stockholders, rather than just institutional blockholders (the

common measure used in large sample studies), we avoid the potential for a systematic relationship

between non-institutional blockholders and CEO retention.

The governance index characterizes the degree to which the firm‘s governance provisions support

owners versus provisions that support managers. This index considers 24 different provisions in 5

categories—tactics for delaying hostile bidders, voting rights, director/officer protection, other takeover

defenses, and state laws (refer to Table A1 for details by group). The index, G, is formed by adding one

point if the firm has a specific defensive provision in place and zero otherwise, leading to values between

0 and 24. Larger values of G represent stronger managerial support or discretion and more restrictions on

owners.16

Because this index is the simple sum of various governance measures, it is relatively common

16

As described in GIM: ‗We divide the rules into five thematic groups and then construct a ―Governance Index‖ as

a proxy for the balance of power between shareholders and managers. Our index construction is straightforward: for

every firm we add one point for every provision that reduces shareholder rights. This reduction of rights is obvious

in most cases; the few ambiguous cases are discussed. Firms in the highest decile of the index are placed in the

―Dictatorship Portfolio‖ and are referred to as having the ―highest management power‖ or the ―weakest shareholder

20

in the corporate governance literature to use quartiles of the index (e.g., Cremers and Nair, 2005).

Moreover, since our focus is on the interaction term between the governance index and bidder returns and

the effect on retention, and not the level effect of the governance index on retention, we construct an

indicator variable equal to one if G is in the bottom quartile of the index (i.e., less than seven) and classify

these firms as those with acquirer owner discretion. Or said another way, firms with G greater than or

equal to seven are firms with provisions that support managers and increase the ability of the acquiring

firm to credibly commit to the target CEO.

In addition to using the G-index and as a check for robustness, we also focus on a single governance

provision that is arguably exogenous (in contrast to many governance choices) and represents the ability

of the board to protect management from the threat of takeover: whether the acquiring firm is

incorporated in a state in which Business Combination (BC) laws are in effect. (This is one of the state

law measures that contribute to the G-Index.) The BC laws strengthen the power of board of directors to

resist takeovers (Bertrand and Mullainathan, 2001).17

If the acquiring firm is protected by a BC law, they

have a greater ability to credibly commit to target CEOs that are retained (since the laws reduce the

probability of hostile takeovers). We create a dummy variable that equals one if the acquiring firm is

incorporated in a state with a BC law.

To classify mergers as value-creating from an acquirer shareholder‘s perspective, we use cumulative

abnormal returns at the announcement date as a measure of the market‘s perception of the expected

merger gains to acquirer shareholders. We calculate abnormal returns using the market model and

standard cumulative abnormal return methodology (Bradley, Desai, and Kim, 1988) as detailed in the data

appendix. The cumulative abnormal returns are calculated by summing the abnormal returns over the

event window which spans from 1 day before the announcement of the merger to the first announcement

rights‖; firms in the lowest decile of the index are placed in the ―Democracy Portfolio‖ and are described as having

the ―lowest management power‖ or the ―strongest shareholder rights.‖‘ 17

States protected by takeover laws are those that have passed a Business Combination (BC) law [from Bertrand

and Mullainathan (2001)]. BC‘s impose a moratorium on specified transactions between a target and a raider

holding a specified threshold of stock, unless the board votes otherwise. Specified transactions include sale of

assets, mergers, and business relationships between raider and target. BC laws give the target board and, in turn,

target management the right to ―veto‖ a takeover by making it more difficult to finance one.

21

date (2-day CARs (-1,0)). To address concerns about outliers, we winsorize CARs at the one-percent

level. We assume that the acquirer‘s ability to make value-creating acquisitions is increasing in the

cumulative abnormal returns to the acquirer shareholder.

We control for a number of variables that are important to merger outcomes including characteristics

specific to the transaction, the target firm, the target CEO, and the target industry. First, we include a set

of control variables related to the transaction. When the size of the target firm is large relative to the

acquiring firm, the challenge of post-merger integration may be more difficult (Zollo and Singh, 2004).

We might expect the likelihood of target CEO retention to be higher, so we control for the size of the

target firm relative to the size of the acquiring firm. To measure relative size, we calculate the ratio of the

target market capitalization to that of the sum of the market capitalization for the acquirer and target firm,

all measured 10 days prior to the announcement of the merger. When acquirers operate in different

industries than the target firm, the industry-specific skills of target CEOs and directors should be of

greater value to the acquiring firm. We expect lower retention rates of target CEO and directors when the

acquiring and target firms operate in the same industry (Walsh, 1989; Buchholtz, Ribbens, and Houle,

2003). We create an indicator variable equal to one if the acquirer and target firms operate in the same 3-

digit SIC industry and zero otherwise. The time it takes to complete a merger can be a function of the

complexity of merger negotiations between the acquiring and target firms. This might be larger when

negotiations involve retention of valuable human capital. We include the number of days until completion

(i.e., the number of days between announcement and completion of the merger) as reported by SDC.

Next, we control for target firm characteristics. Larger and more complex firms may require

managers with unique skills and may allow managers more opportunities to create value (Finkelstein and

Hambrick, 1989). To control for firm size, we include the logarithm of target market capitalization 10

days prior to the transaction announcement as reported in CRSP.

Finally, we include one measure related to the target firm‘s industry. Target industry homogeneity is a

proxy for the homogeneity of firms in the target‘s industry and is measured by the correlation between

common stock returns within 2-digit SIC industries over the period 1970 through 1988 (Parrino, 1997).

22

Regulated industries are typically comprised of firms that are more homogeneous (similar to one another)

(Castanias and Helfat, 2001). We might expect industry expertise of target management (both CEO and

directors) to be valuable to acquiring firms, particularly so in industries that are homogeneous.

4. Results

In Table 1 Panel A, we report summary statistics of target CEO retention rates and characteristics of

firm, CEOs and transactions for our sample. The average retention rate between years (–1) and (+1) for

target CEOs in any capacity (i.e., as either an officer of the merged company or director of its board) is

50%. The comparable retention rate as an officer of the merged firm is 33% between years (–1) to (+1)

and drops to 22% between years (–1) to (+2). These percentages imply turnover rates that are much

higher in comparison to the approximate figure of 10% found in other studies analyzing firms without a

change in control (e.g., Martin & McConnell (1991)). However, it is not surprising that target CEOs are

either forced to leave or voluntarily choose to after their firm has been acquired. Other notable statistics

are the industry-adjusted performance measures for both acquiring and target firms. On average, both

target and acquiring firms have higher ROA and Tobin‘s Q relative to industry peers, but lower revenue

growth. Similar to large sample studies, bidder cumulative abnormal returns are negative, on average, and

are statistically different from zero (p-value= 0.0023).

In Table 1 Panel B, we report summary statistics for post-merger board structure in the year following

the merger, and the ownership and governance index for both acquiring and target firms. Boards have

approximately thirteen directors on average, comprised of eleven acquirer directors and approximately

two target directors. The variable that we use in our regressions is target share of directors which on

average is 13% and ranges from zero to 47%. Acquirer and target governance structures are quite

comparable, with the exception that target firms have a somewhat higher percentage of stock held by

block shareholders, on average, relative to acquiring firms.

The probit regressions analyzing the relation between target CEO retention and measures of the value

of the CEO are shown in Table 2 columns 1 through 10. All regressions include year dummies and

heteroskedastic-robust standard errors. We report probit regression results using two distinct definitions

23

of retention as our dependent variable. We designate the target CEO as being retained if he remains as an

officer or director in the merged firm in the year following the merger (+1). We also restrict the definition

to only those that remain as an officer in the 2nd

year following the merger (+2). In columns 1 though 3,

we evaluate the relationship between target CEO retention and three measures of pre-acquisition

performance and find that they are positively correlated. In columns 4 through 7, we find that target CEO

compensation (logarithm) is positively correlated with target CEO retention. We exclude firm

performance measures because they are highly correlated with target CEO pay.18

Plus, the number of

observations decline due to missing data in ExecuComp on target CEO pay. Our evidence suggests that

higher paid target CEOs are more likely to be retained. Finally, in columns 8 through 10, we evaluate the

tenure of the target CEO and find no relationship between tenure in position and the probability of

retention.19

The positive and significant coefficients on the three measures of target firm performance and target

CEO compensation in the year prior to the merger supports Hypothesis 1a and 1b. However, we find no

support for Hypothesis 1c (although in the model with governance characteristics, we do find some

support). Three other findings are worth noting. Target CEOs are more likely to be retained in deals with

relatively larger target firms and in deals that take longer to complete suggesting that CEOs are retained

in more complex transactions. It is possible that deals in which the target CEOs are retained take longer

precisely because of the challenges involved in clarifying job responsibilities and making commitments to

the target CEO. Interestingly, target CEOs are less likely to be retained in transactions that are tender

offers. Much of the earlier finance research which supports the disciplinary motives of the market for

corporate control are based on samples of tender offer transactions. This latter finding is consistent with

18

When we include firm performance (ROA) in the regressions with CEO pay, the sign on the coefficient on pay

remains positive, but is no longer statistically significant. While pay and firm performance are conceptually different

constructs, they are highly correlated especially for the component of pay that is contingent on performance. When

we include salary only in these regressions, the sign on the coefficient is generally positive, but not statistically

significant. 19

We also experimented with specifications that allow for non-linear relationships between retention and tenure by

including squared-terms of tenure, but find no robust results. We did the same with target CEO age (or proximity to

retirement), but found no consistent patterns.

24

the notion that acquisitions (represented by tender offer transactions) are quite different than mergers in

retention of human capital of the target firm.

Overall, we find support for the managerial human capital explanation. Target CEOs are more likely

to be retained as either an officer or director in the merged firm when the target firm is better-performing

measured by industry-adjusted ROA, sales growth, and Tobin‘s Q. A more novel result is that higher paid

target CEOs are more likely to be retained. We know of no other study that has documented this

relationship. Finally, the weak results on tenure are generally consistent with other studies (e.g.,

Buchholtz, Ribbens, and Houle, 2003).

4.1. Role of Governance: Let us now analyze the relationship between the retention of the target CEO

and firm performance and how that varies with the acquiring firm‘s governance environment. In Table 3,

we again report probit regression results using two distinct definitions of retention as our dependent

variable. In all regressions, we include our three measures of governance for the acquiring firm: the

fraction of shares owned by block shareholders (excluding the CEO), the fraction of shares owned by the

CEO, and the governance indicator representing owner discretion (i.e., if G is in the bottom quartile of the

index, G<7). We include the three measures directly and also include interaction terms between each

governance measure and target ROA (all variables are mean-centered).20

In columns (1) & (2), we define

target CEO as being retained if he remains as an officer or director in the merged firm in the year

following the merger (+1). The coefficient on target ROA is positive and statistically significant. Of

greater interest, the coefficient on the interaction between acquirer CEO ownership and target ROA is

positive and significant. The Wald Chi-sq. tests evaluate the joint significance of the performance and

governance variables by comparing the restricted model (which excludes firm performance, governance

variables and the interactions between the two) to the fully-specified model reported in the tables. The

20

As mentioned earlier, our null hypothesis is that the coefficient on each interaction term is zero. Implicit in this

hypothesis is a definition of the ―interaction effect‖ based on the coefficient. This is in contrast to hypotheses that

define the interaction effect as the marginal effect which have to be tested at each value of all variables (refer to

Wiersama and Bowen, 2007).

25

associated p-values are statistically significant in columns (1) and (2). Consistent with H2a, better-

performing target CEOs are more likely to be retained when the acquiring CEO owns a higher percentage

of the firm‘s stock. No other governance coefficients are significant.

In columns (3) and (4), we further restrict the dependent variable to the retention of target CEOs as

officers in the second year following the merger. The coefficients on interaction terms between

ownership (both block shareholdings and CEO ownership) and target ROA are positive and significant.

The p-value of the Wald test for joint significance are statistically significant in column (4). Better-

performing target CEOs are more likely to be retained when the block shareholders or the CEO of the

acquiring firm own a higher fraction of the firm‘s stock. These results are both consistent with

Hypothesis 2a. Said another way, target CEO retention-performance sensitivity is increasing in the

acquiring firm‘s ownership concentration as measured by block shareholdings and CEO ownership.

There are several other notable results in Table 3. First, the coefficient on days until completion is

positive and significant in three of the four specifications. The fact that mergers that retain target CEOs

take longer to complete is consistent with our theory and the idea that getting promises or commitments

from influential shareholders may extend the negotiations and lead to longer completion times. Second,

once we control for governance characteristics in column (4), the coefficient on target CEO tenure

becomes positive and significant. Consistent with H1c, this suggests that target CEOs with more

experience in position are more likely to be retained as officers of the merged company. Finally, the

coefficient on tender offer is no longer estimated in columns (3) and (4) because, in the sub-sample of

tender offer transactions, target CEOs are almost never retained for two years after the merger. This

explains the decline in the number of observations in column (4) and demonstrates the limitations of some

of the earlier finance research that analyzed only tender offer transactions.

4.2. “Good” Bidders and Target CEO/ Director Retention: We now ask the question: under what

conditions do ―good‖ bidders retain target CEO and directors? As defined earlier, we classify good

bidders by acquirer announcement effects (as measured by acquirer CARs). In Table 4, we estimate

26

regressions using the most restrictive definition of CEO retention, i.e., two years after the merger. In

these probit models, we include our measures of governance for the acquiring firm directly and also

include interaction terms between each governance measure and acquirer CARs (all variables are mean-

centered). To evaluate the robustness of the G-index result, we also include whether the acquirer is

incorporated in a state protected by business combination laws (and the corresponding interaction term

with CARs). We include all control variables and year indicators and report robust standard errors.

In column (1) in Table 4, we find a positive coefficient on the interaction term between acquirer CEO

ownership and CARs and a negative coefficient on the interaction term between acquirer owner discretion

and CARs. In column (2), when we evaluate the effect of a BC law, we find a positive and significant

coefficient on the interaction term with CARs (with the other results robust to this addition). Finally, in

column (3), when we include both governance measures, we find robust results and the p-value for the

Wald test of joint significance is statistically significant. Good bidders are more likely to retain target

CEOs when the acquirer CEO owns more stock and when the governance provisions of the acquiring firm

protect managerial discretion. Good bidders with greater owner discretion (smaller G-index) are less

likely to retain the CEO, while good bidders protected by stronger takeover laws (BC laws) are more

likely to retain the CEO. These findings are consistent with H3a. We conclude that we find support for

the managerial human capital explanation. Manager-supportive provisions (e.g., anti-takeover laws,

employment agreements, and golden parachutes) and concentrated ownership differentiate acquiring

firms in their ability to credibly commit to protecting post-merger decisions rights for target CEOs.

Let us now turn to analyzing the determinants of target director retention (H3b). In Table 5, our

dependent variable is the target director share of board and is defined as the share of the board seats filled

by target directors on the post-merger board in the year following the merger. We estimate tobit

regressions due to concerns about censoring since our dependent variable takes on the value of zero for

approximately 40% of the transactions. In column (1), we begin by regressing target director share of

board on acquirer CARs, the fraction of shares owned by block shareholders in the acquiring firm and an

interaction term between the two. We include all control variables and year indicators and report robust

27

standard errors. The coefficient on the interaction between acquirer block shareholders and CARS is

positive and significant. Moreover, the coefficient on the interaction between owner discretion and CARs

is negative and significant. The p-values for the F-test of joint significance are statistically significant in

all three specifications. Good bidders that have more concentrated ownership and governance provisions

that support managerial discretion are more likely to appoint a higher fraction of target directors to the

post-merger board. These findings are consistent with Hypothesis 3b. When we include the effect of BC

laws in column 4, we find a positive, but statistically insignificant coefficient on the interaction term with

CARs. However, all other results are robust to this inclusion.

Taken together, our findings are consistent with the human capital explanation: good bidders retain

target CEOs and directors and are more likely to do so because of a governance environment which

allows them to credibly commit to protecting post-merger discretion. In turn, valuable human capital of

the target firm elects to stay.

There are three other notable results in the director retention regressions in Table 5. First, there is a

positive and significant coefficient on the relative size of the target in all specifications. Acquiring firms

appoint a higher share of target directors to the board when the target is larger relative to the acquirer.

Second, there is a negative and significant coefficient on the tender offer indicator in all specifications.

Again, this is consistent with the explanation that tender offers (or acquisitions) are fundamentally

different transactions than mergers. There is a positive and strongly significant coefficient on target

industry homogeneity. When the target firm‘s industry is comprised of more homogenous firms, a higher

fraction of target directors are appointed to the merged board. One possible explanation is that

homogeneity may be a proxy for degree of industry regulation, and target directors with industry-specific

experience, particularly in these types of industries, may be valued assets to acquiring firms.

To sum up, we find broad support for Hypotheses 3a and 3b. Good bidders with concentrated

ownership or governance provisions that support managers are more likely to retain target CEOs and

directors. In turn, CEOs are more likely to stay because the acquiring firm‘s governance environment

protects managerial discretion.

28

5. Discussion and Conclusion

In contrast to physical capital or assets, human capital cannot be ―owned.‖ As such, one of the most

significant challenges facing acquiring firms is how to retain the valuable human capital of the firm that

you are buying. We develop the managerial human capital view in the context of M&A that recognizes

the importance of the acquiring firm‘s governance structure in retaining successful target management

when contracts are unenforceable. In a joint analysis of retention and governance, we explore the

conditions under which target CEOs and directors are retained by acquiring firms. We find evidence that

is broadly consistent with the managerial human capital view: acquiring firms retain successful target

CEOs and are able to do so when their governance environment protects managerial discretion post-

merger. Large, influential shareholders and select governance provisions that support managers allow

acquiring firms to credibly commit to promises made to target CEOs. We find evidence of heterogeneity

among acquiring firms in their approaches to retention of human capital of the target firm. Taking our

findings together as a whole, they suggest a more nuanced view of the role of governance in retaining

valuable human capital in the governing body of the post-merger entity.

As a baseline to test more-refined hypotheses, we show that successful target CEOs—as measured by

firm performance and compensation--are more likely to be retained. Of greater interest and a more novel

contribution, we find that acquiring firm governance plays a role in retention outcomes. Target CEOs of

firms with stronger pre-acquisition performance are retained when acquiring firms have more

concentrated ownership as measured by fraction of shares owned by blockholders and CEOs.

Furthermore, we find that good bidders retain target CEOs when the acquiring firm‘s governance supports

managers (as measured by the G-index and Business Combination laws). Also, we find that good bidders

retain target directors when blockholders hold a higher fraction of shares in the acquiring firm.

These findings together suggest that successful target CEOs are valued by acquiring firms and they

agree to stay on when the governance environment allows acquirers to commit to protecting target CEO

discretion. Based on these findings, we conclude that good bidders appear to be making optimal decisions

29

to retain valuable CEOs and directors in the presence of governance structures that are simultaneously

beneficial to both managers and owners. Managers and owners may not necessarily be at odds.

Much of the early research that supports the disciplinary view of takeovers is based primarily on

tender offer transactions occurring in hostile settings where managerial interests clearly conflict with

those of shareholders (e.g., Martin & McConnell, 1991). We use a sample of friendly mergers during the

1990s that typically involve negotiations between the CEOs of both the acquiring and target firms.

Negotiated mergers are interesting to study because, it is exactly these settings in which target managers

may be valuable assets to acquiring firms, and the governance environment may determine the bidder‘s

ability to retain valuable human capital.

Clearly, there are several limitations with this study. First, our measure of retention is based on

archival sources, and as a result, we cannot determine the degree of authority given to the target CEO that

stays with the merged firm. One of the reasons why we also consider director retention is that the role of a

director is a more consistent proxy of control rights since directors have voting rights. The second

limitation is that we use cumulative abnormal returns to measure the performance of the acquisition since

measuring post-acquisition performance requires a longer observation period. However, other studies use

announcement effects (e.g., Kroll, Wright, Toombs, and Leavell, 1997) and previous research documents

robust results to the use of select long-run measures of performance (e.g., post-merger operating

performance (Healy, Palepu and Ruback, 1992) and long-run abnormal returns (Andrade, Mitchell and

Stafford, 2001)). Finally, while the governance index that we use is comprehensive and based on a broad

set of provisions, and while we narrow this measure by evaluating the effect of Business Combination

laws, future research may employ finer-grained measures that identify the most effective corporate

governance provisions from this longer list.

Despite these limitations, we believe that our results identify the conditions under which successful

target CEOs are retained by acquiring firms. One advantage of focusing on retention around mergers,

rather than retention in general, is that we are able to isolate a specific corporate event in which decision-

makers of both the acquiring and target firms make a decision that potentially has important implications

30

for the success of the merger. Our tests address the marginal impact of ownership structure and

governance provisions that lead to the successful retention of human capital in the post-merger firm.

The evidence presented in this paper provides a new and interesting insight into the relationship

between managers and owners in M&A and the role that governance may play in the retention of valuable

human capital of the target firm. The traditional view of the market for corporate control and efficiency

arguments typically consider target managers as ―liabilities‖ and emphasize the monitoring and

disciplining of managers by owners. In contrast, this paper considers managers as ―assets‖ and presents

evidence suggesting the objectives of owners and managers are not necessarily at odds. Owners of

acquiring firms can benefit from retaining human capital of target firms as they may be valuable resources

central to the firm‘s long-term competitive advantage (Barney, 1991). Acquiring firms retain these

valuable resources when the ownership structure and governance environment provide credible

commitments to protecting managerial discretion.

Our findings suggest that the human capital explanation might be more consistent with the

characteristics of the friendly, negotiated mergers during the 1990s. The increasing importance of

institutional shareholders and blockholders over the past several decades has been well-documented.

Perhaps increased involvement by influential blockholders in corporate decisions has contributed to a

more nuanced approach to retention of the human capital of target firms. Instead of an indiscriminate

approach to layoffs of target CEOs, both owners and management of acquiring firms may have learned

about the importance of human capital and the trade-offs associated with various choices of ownership

and governance. In response, they may have developed enhanced skills in identifying valuable human

capital and creating a governance environment in which successful managers choose to stay. Our

theoretical and empirical contributions shed light on changes in how the market for corporate control

operates while providing some direction for future research.

31

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34

TABLE 1: Summary Statistics

Panel A: Target CEO Retention, Firm, CEO, and Transaction Characteristics

Variable Obs. Mean Std. Dev. Min Max

Target CEO Retention In any capacity (+1) 187 0.50 0.50 0.00 1.00

As officer (+1) 186 0.33 0.47 0.00 1.00

As officer (+2) 179 0.22 0.42 0.00 1.00

Firm-Acquirer Assets ($M) 188 18149.09 45743.76 97.50 386555.00

ROA (-1) (industry-adjusted) 182 0.03 0.07 -0.12 0.36

Sales Growth (-1) (industry-adjusted) 187 -0.19 2.83 -35.85 2.03

Tobin‘s Q (-1) (industry-adjusted) 170 0.70 1.68 -1.78 11.73

Cumulative Abnormal Return (wins. 2-day CAR) 181 -0.012 0.042 -0.075 0.060

Firm-Target Assets ($M) 187 10614.12 38645.05 61.90 310897.00

ROA (-1) (industry-adjusted) 182 0.02 0.06 -0.13 0.24

Sales Growth (-1) (industry-adjusted) 175 -0.12 0.58 -2.94 1.67

Tobin‘s Q (-1) (industry-adjusted) 169 .25 1.19 -2.10 7.17

Cumulative Abnormal Return (wins. 2-day CAR) 181 0.133 0.123 -0.020 0.367

CEO-Acquirer Tenure in CEO position (years) 182 6.86 5.35 0.00 34.00

Age (years) 187 53.40 6.69 37.00 83.00

Proximity to Retirement (Age >60 years) 188 0.18 0.39 0.00 1.00

CEO-Target Tenure in CEO position (years) 175 6.55 5.65 0.00 31.00

Age (years) 183 54.53 7.32 34.00 78.00

Proximity to Retirement (Age >60 years) 188 0.26 0.44 0.00 1.00

Total Compensation ($ 000s) 157 2438.22 4105.50 0 41484.55

Transaction Related Merger (Same 3-digit SIC) 188 0.58 0.49 0.00 1.00

Target Market Value/(Target Value + Acquirer Value) 188 0.25 0.17 0.00 0.84

Tender Offer 188 0.18 0.38 0.00 1.00

# Days between announcement & completion 188 153.51 113.15 30.00 893.00 The fiscal year of the target firm prior to the year of announcement is year (–1). Year (+1) is the fiscal year of the merged firm following completion of the merger,

while year (+2) is the second fiscal year post-merger.

35

Panel B: Governance Measures: Post-Merger Board Structure, Ownership, Governance Index, BC Law

Variable Obs. Mean Std. Dev. Min Max

Post-Merger Board (+1) Board Size 186 12.85 4.47 5.00 32.00

Number of Acquirer Directors 186 11.03 3.84 3.00 29.00

Share of Target Directors 186 0.13 0.14 0.00 0.47

Acquirer CEO ownership (%) 185 2.13 4.26 0.00 31.20

Block Shareholdings (excl. CEO) (%) 183 17.72 15.45 0.00 83.70

Governance Index 179 9.73 2.73 4.00 17.00

Owner Discretion (Bottom quartile of G Index, G<7) 179 0.16 0.37 0.00 1.00

Acquirer protected by Business Combination Law 179 0.91 0.29 0 1

Target CEO ownership (%) 182 2.55 4.67 0.00 36.90

Block Shareholdings (excl. CEO) (%) 181 23.33 19.41 0.00 98.40

Governance Index 142 9.37 2.79 4.00 16.00

Owner Discretion (Bottom quartile of G Index, G<7) 142 0.21 0.41 0.00 1.00

Target protected by Business Combination Law 142 0.92 0.27 0 1 The fiscal year of the target firm prior to the year of announcement is year (–1). Year (+1) is the fiscal year of the merged firm following completion of the merger,

while year (+2) is the second fiscal year post-merger. The governance index is based on Gompers, Ishii and Metrick (2003).

36

Table 2 (H1): Target CEO Retention

1 2 3 4 5 6 7 8 9 10

Target

CEO

retained as

Officer or

Director

(t+1)

Target

CEO

retained as

Officer or

Director

(t+1)

Target

CEO

retained as

Officer or

Director

(t+1)

Target

CEO

retained as

Officer

(t+2)

Target

CEO

retained as

Officer

(t+2)

Target

CEO

retained as

Officer or

Director

(t+1)

Target

CEO

retained as

Officer or

Director

(t+1)

Target

CEO

retained as

Officer

(t+2)

Target

CEO

retained as

Officer

(t+2)

Target

CEO

retained as

Officer or

Director

(t+1)

Target ROA 4.79 4.588

(1.901)** (1.919)**

Target Sales Growth

0.422

(0.206)**

Target Tobin‘s Q

0.267

(0.104)***

Log( Target CEO pay)

0.356 0.303 0.282 0.122

(0.137)*** (0.174)* (0.113)** (0.154)

Target Tenure as CEO

0.004 0.02 -0.001

(0.019) (0.025) (0.021)

Log Target Market Value 0.153 0.159 0.103

0.027

0.186

0.035 0.132

(0.103) (0.101) (0.113)

(0.134)

(0.117)

(0.105) (0.094)

Target Relative Size 2.896 2.613 2.53

3.061

3.256

2.641 3.458

(0.727)*** (0.740)*** (0.726)*** (0.847)*** (0.849)*** (0.817)*** (0.782)***

Related-3 Digit 0.385 0.347 0.362

-0.082

0.096

0.13 0.126

(0.240) (0.243) (0.265)

(0.273)

(0.256)

(0.257) (0.245)

Days Until Completion 0.003 0.003 0.002

0.001

0.001

0.001 0.001

(0.001)** (0.001)*** (0.001)**

(0.001)

(0.001)

(0.001) (0.001)

Tender Offer -1.736 -1.748 -1.576

-1.35

-1.386

-1.712

(0.477)*** (0.468)*** (0.466)*** (0.594)**

(0.403)***

(0.470)***

Constant -2.844 -2.936 -1.923 -2.524 -3.216 -1.568 -3.745 -0.205 -1.622 -2.35

(1.404)** (1.411)** (1.588) (1.049)** (1.584)** (0.881)* (1.403)*** (0.358) (1.386) (1.305)*

Year Dummies Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes

Observations 182 175 169 150 150 155 155 169 149 175

Pseudo R-squared 0.29 0.31 0.29 0.11 0.24 0.05 0.27 0.03 0.12 0.29

***, **, * represent significance at the 1%, 5%, 10% level, respectively; heteroskedastic-robust standard errors reported in parentheses; interaction terms and

respective main effects are based on mean-centered variables.

37

Table 3 (H2): Target CEO Retention, Target Performance, and Acquirer Governance

1 2 3 4

Target CEO

retained as

Officer or

Director (t+1)

Target CEO

retained as

Officer or

Director (t+1)

Target

CEO

retained as

Officer (t+2)

Target

CEO

retained as

Officer (t+2) Target ROA 4.597 5.912 -0.149 -0.027

(1.727)*** (2.103)*** (1.947) (2.051)

Acquirer Block Shareholdings X Target ROA 0.052 0.15 0.307 0.469

(0.152) (0.180) (0.159)* (0.185)**

Acquirer Block Shareholdings -0.012 -0.015 -0.002 -0.004

(0.009) (0.009) (0.010) (0.012)

Acquirer CEO Ownership X Target ROA 1.136 1.248 1.222 1.124

(0.516)** (0.571)** (0.578)** (0.515)**

Acquirer CEO Ownership 0.059 0.059 -0.063 -0.042

(0.035)* (0.036) (0.043) (0.038)

Acquirer Owner Discretion X Target ROA 5.627 4.245 6.17 4.812

(4.429) (4.968) (4.245) (4.492)

Acquirer Owner Discretion -0.422 -0.485 -0.106 -0.223

(0.331) (0.353) (0.344) (0.337)

Related-3 digit 0.277 0.312 0.111 0.168

(0.237) (0.276) (0.262) (0.270)

Log Target Market Value 0.306 0.229 0.072 0.09

(0.117)*** (0.120)* (0.114) (0.119)

Target Relative Size 2.648 3.231 2.371 2.498

(0.821)*** (0.877)*** (0.809)*** (0.862)***

Days Until Completion 0.003 0.002 0.001 0.002

(0.001)*** (0.001)** (0.001) (0.001)*

Target CEO Tenure in Position

0.003 0.049

(0.024) (0.024)**

Tender Offer

-1.514

(0.452)***

Constant -5.212 -3.929 -2.549 -3.381

(1.554)*** (1.626)** (1.544)* (1.666)**

Year dummies Yes Yes Yes Yes

Observations 175 175 149 149

Pseudo R-squared 0.25 0.35 0.17 0.21

Wald Chi-Sq 23.27 24.45 10.81 16.36

Deg, of Freedom/p-value 7/.0015 7/.0010 7/.1473 7/.0221

***, **, * represent significance at the 1%, 5%, 10% level, respectively; heteroskedastic-robust standard errors

reported in parentheses; interaction terms and respective main effects are based on mean-centered variables. Wald tests

compare restricted models (without ROA and governance variables) to the fully-specified model.

38

Table 4 (H3a): Target CEO Retention, Acquirer Announcement Effects (CARs), and Acquirer Governance

1 2 3

Target CEO

Retained as

Officer (t+2)

Target CEO

Retained as

Officer (t+2)

Target CEO

Retained as

Officer (t+2)

Acquirer CARs -2.014 -3.432 -4.566

(2.285) (2.324) (2.457)*

Acquirer Block Shareholdings X Acquirer CARs 0.096 0.015 0.049

(0.181) (0.189) (0.186)

Acquirer Block Shareholdings -0.002 -0.007 -0.005

(0.010) (0.011) (0.011)

Acquirer CEO Ownership X Acquirer CARs 1.664 1.576 1.817

(0.894)* (0.917)* (0.947)*

Acquirer CEO Ownership 0.022 0.018 0.021

(0.033) (0.035) (0.035)

Acquirer Owner Discretion X Acquirer CARs -16.319

-16.608

(8.180)**

(8.155)**

Acquirer Owner Discretion -0.412

-0.393

(0.433)

(0.444)

Acquirer BC Laws X Acquirer CARs

35.52 35.724

(14.551)** (14.516)**

Acquirer BC Laws

1.309 1.292

(0.611)** (0.625)**

Related-3 digit 0.129 0.09 0.028

(0.270) (0.268) (0.279)

Target Relative Size 3.42 3.732 3.675

(0.889)*** (0.896)*** (0.936)***

Log Target Market Value 0.072 -0.016 0.016

(0.112) (0.118) (0.117)

Days Until Completion/100 0.106 0.132 0.142

(0.112) (0.111) (0.113)

Target Industry Homogeneity 3.306 3.385 3.556

(1.708)* (1.735)* (1.763)**

Constant -3.96 -2.755 -3.252

(1.557)** (1.562)* (1.602)**

Year dummies Yes Yes Yes

Observations 157 157 157

Pseudo R-squared 0.22 0.23 0.25

Wald Chi-sq 8.23 11.03 15.26

Deg. of freedom/p-value 7/.3131 7/.1375 9/.0839 ***, **, * represent significance at the 1%, 5%, 10% level, respectively; heteroskedastic-robust standard errors reported in parentheses; interaction terms

and respective main effects are based on mean-centered variables. Wald tests compare restricted models (without ROA and governance variables)

to the fully-specified model.

39

Table 5 (H3b): Target Director Retention, Acquirer Announcement Effects (CARs), and Acquirer Governance

1 2 3

Target Director Share of

Merged Board

Target Director Share

of Merged Board

Target Director Share of

Merged Board

Acquirer CARs 0.413 0.428 0.413

(0.201)** (0.210)** (0.204)**

Acquirer Block Shareholdings X Acquirer CARs 0.045 0.039 0.045

(0.017)*** (0.017)** (0.017)***

Acquirer Block Shareholdings 0.000 -0.001 0.000

(0.001) (0.001) (0.001)

Acquirer CEO Ownership X Acquirer CARs -0.065 -0.041 -0.064

(0.075) (0.078) (0.076)

Acquirer CEO Ownership -0.006 -0.005 -0.006

(0.004)* (0.004) (0.004)*

Acquirer Owner Discretion X Acquirer CARs -1.029

-1.026

(0.574)*

(0.583)*

Acquirer Owner Discretion -0.094

-0.094

(0.034)***

(0.035)***

Acquirer BC Laws X Acquirer CARs

0.62 -0.031

(0.929) (0.930)

Acquirer BC Laws

0.021 0.003

(0.042) (0.042)

Related-3 digit 0.029 0.033 0.029

(0.025) (0.026) (0.025)

Target Relative Size 1.126 1.11 1.126

(0.095)*** (0.097)*** (0.095)***

Log Target Market Value 0.001 -0.003 0.001

(0.011) (0.012) (0.012)

Days Until Completion/100 0.014 0.017 0.014

(0.011) (0.011) (0.011)

Target Industry Homogeneity 0.399 0.451 0.4

(0.160)** (0.165)*** (0.160)**

Tender Offer -0.586 -0.556 -0.586

(0.095)*** (0.097)*** (0.095)***

Constant -0.307 -0.255 -0.31

(0.161)* (0.171) (0.167)*

Year dummies Yes Yes Yes

Observations 162 162 162

Pseudo R-squared 1.59 1.51 1.59

F-stat/Prob.>F 3.38/.0022 1.88/.0773 2.63/.0076 ***, **, * represent significance at the 1%, 5%, 10% level, respectively; heteroskedastic-robust standard errors reported in parentheses; interaction terms

and respective main effects are based on mean-centered variables. Models are tobit models that address left-censoring of the dependent variable (target

directors share of board seats in merged entity). F tests compare restricted models (w/o ROA and governance variables) to fully-specified model.

40

Table A1: Governance Provisions of Gompers, Ishii, Metrick (2003)

(Table I, pg. 112)

Delay

Blank check

Classified board

Special meeting

Written consent

Protection

Compensation plans

Contracts

Golden parachutes

Indemnification

Liability

Severance

Voting

Bylaws

Charter

Cumulative voting

Secret Ballot

Supermajority

Unequal voting

Other

Antigreenmail

Directors‘ duties

Fair price

Pension parachutes

Poison pill

Silver parachutes

State

Antigreenmail law

Business combination law

Cash-out law

Directors‘ duties law

Fair price law

Control share acquisition law

41

Data Appendix:

1. Calculation of Cumulative Abnormal Returns (CARs)

To classify mergers as value-creating from an acquirer shareholder‘s perspective, we use cumulative

abnormal returns at the announcement date as a measure of the market‘s perception of the expected

merger gains to acquirer shareholders. We calculate abnormal returns using the market model and

standard cumulative abnormal return methodology (Bradley, Desai, and Kim, 1988). Market model

statistics are obtained for the acquirer and target using the CRSP equally-weighted market index and an

estimation window consisting of all available trading data from 300 trading days before the first

announcement associated with the acquisition to 60 trading days before the first announcement. The

general methodology for calculating abnormal returns is outlined in Bradley, Desai, and Kim (1988). The

estimation equation to calculate the abnormal return to firm i on day t is:

mtiiitit RRAR with t= -300 to -60

The market return, mtR , is calculated using the equally-weighted CRSP index. The cumulative abnormal

returns to firm i are calculated by summing the abnormal returns over the event window which spans

from 1 day before the announcement of the merger to the first announcement date (2-day cumulative

abnormal returns (-1,0)).