Top of Mind: Why CEOs Like to Dine

Mergers and acquisitions (M&As) frequently fail to increase shareholder value and often have a negative impact on revenue growth. Management consultants have produced study after study in an effort to pinpoint the causes behind such failures and report a wide variety of reasons for unrealized expectations.

For example, a recent McKinsey company study of some of the most acquisitive U.S. companies measured M&A success across eight goals: adding capabilities, expanding geographically, buying growth, consolidating, increasing scale, diversifying portfolio, innovating, and defending the business. Their research shows that unrewarded acquirers, those who lagged in post-M&A performance, are less likely to use M&As to support strategy and more likely to use them as a strategy in itself. They also are more likely to use M&As to block competitors, diversify their portfolio, expand geographically, and buy growth, and they are less likely to pursue M&As to innovate and to increase scale.

Unrewarded acquirers also mention more reasons why they pursue acquisitions than rewarded acquirers, indicating that they may be making their decisions more lightly than companies that demonstrate better post-M&A performance.

Why do companies whose M&A activities fail to produce improved performance results keep acquiring? Some academics point toward research that indicates that CEO compensation could be a factor.

Following an acquisition, CEO compensation levels usually increase, even when the purchase turns out to be unprofitable, according to the University of Washington's Jarrad Harford and the University of British Columbia's Kai Li. This is because while a bad merger can decrease the value of a company's stock and options, CEOs typically acquire new stock options once the deal goes through, making up for any financial losses suffered as a result of the buy.

"There are major personal financial gains to be made by CEOs after any merger or acquisition, so even if it ends up being a financial loss, shareholders suffer but CEOs nearly always come out ahead financially," says Harford. "The net effect is that a CEO's wealth actually increases even if he makes a poor acquisition decision. The experience is quite different for the shareholders."

For their study, the researchers examined 370 mergers of publicly traded U.S. companies between 1993 and 2000. They compared the net worth of the CEOs of the purchasing companies a year before and a year after the acquisitions. Wealth was determined by calculating their salaries and stock and option grants.

Harford and Ki divided the CEOs of the purchasing companies into two groups: those whose stock increased after the merger and those whose stock suffered. The stock value of the underperforming companies lagged the broader market by roughly 52 percent. Yet because of new stock and option grants, three-quarters of the time those CEOs became wealthier despite the downturn.

Does this mean that most CEOs view potential acquisitions through the eyes of greed? Such a cynical view can be easily overridden with common sense; the benefits to CEOs of good acquisitions will almost always win in the long term. And in companies with good governance practices, independent board members will be instrumental in protecting the best interests of the enterprise and all of its stakeholders. "Companies whose boards of directors are more independent from management and generally exercise stricter corporate governance are more likely to penalize executives for unprofitable merger deals," says Harford.

Still, finance executives should weigh the CEO compensation factor when evaluating potential acquisitions. "While CEOs are still better off making good acquisition decisions, there is little penalty in making bad ones, so this sets up a strong incentive to acquire, even when the chance of failure is high," says Harford. "The sheer magnitude of new stock and options grants given when the firm's size increases more than offset the effect of the acquisition on the CEO's premerger portfolio.