See the Gap: Firm Returns and Shareholder Incentives

Authors:

Eitan Goldman

Indiana University - Kelley School of Business - Department of Finance; European Corporate Governance Institute (ECGI)

Jinkyu Kim

Indiana University - Kelley School of Business - Department of Finance

Wenyu Wang

Indiana University - Kelley School of Business - Department of Finance

Abstract

Smart money often trades actively during times of large corporate events. We document in the context of mergers and acquisitions (M&A) that, during the bid negotiation period, institutional investors increase their holdings of acquirers in deals that generate positive value and decrease their holdings in those that generate negative value. The resulting trading profits create a significant gap between the return to the acquiring firm and the return to these investors, and this gap renders firm return a misleading measure of investors’ incentives in pursuing mergers. On average, institutional investors earn 2.4% from M&A while the return to acquirers is only -0.9%. In deals that deliver volatile returns to acquiring firms, the gap increases to 6.3%. We further show how the trading motive impacts the ex ante holdings of institutional investors and how the trading decision and the resulting gap are impacted by the investors’ ability to vote on the deals as well as other deal characteristics such as merger size, stock liquidity, initial holdings, and the institutional investors’ trading skills. Our study highlights that the group of investors who have influence over corporate actions do not necessarily bear the full consequences of such events, and therefore accounting for the dynamics of shareholder composition is critical in measuring investors’ incentives correctly.