Growth-promoting Bonuses and Mergers and Acquisitions

Numerous studies have found that mergers and acquisitions (M&A) often destroy value for acquiring firms. This phenomenon is commonly attributed to executives’ pursuit of personal gains through empire-building, whereby a growing their firms can increase executives’ personal prestige, pay, or benefits, even if it does not benefit shareholders. These benefits from empire-building nevertheless tend to be indirect and are not explicitly outlined in advance. In our study, we take a different view and analyze the role of direct monetary incentives to grow a firm, which we term "growth-promoting bonuses" (GPBs).

GPBs are compensation contracts that directly tie managers' incentive payouts to measures of firm size, such as sales, production, and market share, thus explicitly encouraging executives to grow their firms. Notably, most companies do not exclude "inorganic" growth through M&A when calculating whether an executive has met the growth-related bonus target. These incentives can thus drive executives to acquire other companies to achieve the target and receive the bonus even when a firm's own internal growth would have been insufficient. GPBs are prevalent, as more than one-third of U.S. firms provide these incentives at any given time. Despite their prevalence, the impact of these incentives on M&A activity has not been previously analyzed.

A case in point is AbbVie's acquisition of Pharmacyclics in 2015. AbbVie's CEO had a compensation package that included a $1.8 million bonus that was tied to meeting sales targets. AbbVie narrowly met its sales target that year, triggering the GPB payment to the CEO; however, the company would have missed this target without the sales contribution from the new acquisition. Notably, AbbVie's stock price plummeted upon the acquisition announcement.

Using a sample that covers 1,200 large U.S.-listed firms from 2007 to 2017 and 5,000 acquisitions, we establish two key findings regarding GPBs and M&A. First, firms are more likely to make acquisitions when executives have GPBs. Second, these acquisitions are more likely to destroy shareholder value, primarily due to the selection of targets with lower synergies.

We find that firms with executives who have GPBs are more likely to acquire other companies. This relationship holds whether GPB-related incentives are measured by the proportion of executives with GPBs or by the GPBs' dollar value. A one-standard-deviation increase in either metric is associated with a 25% increase in the likelihood of announcing an acquisition. This suggests that executives with GPBs leverage acquisitions to achieve bonus targets.

While one possible alternative explanation is that firms that offer GPBs are more likely to benefit from growth and that the boards of these firms therefore encourage such growth with explicit bonuses, our findings suggest otherwise. GPBs are primarily associated with acquisitions of smaller target firms, indicating a desire to narrowly meet size targets rather than a general pursuit of growth. Moreover, the relationship between GPBs and acquisitions is more pronounced in firms with weaker governance and larger cash holdings, pointing to the role of agency problems.

To better establish a causal relationship between GPBs and acquisitions, we examine shocks to firms' sales from large exchange rate movements. When the U.S. dollar weakens, exporting firms benefit from a windfall in dollar-denominated sales, making it easier for the subset of exporting firms that also have GPBs to meet their targets without resorting to acquisitions. Using a triple-difference empirical strategy, we find that exporting firms with GPBs make relatively fewer acquisitions when the dollar weakens. These results provide additional evidence that GPBs drive acquisition behavior and reduce the likelihood that some omitted factor explains both the use of GPBs and the tendency to make acquisitions.

Our analysis further reveals that these acquisitions are crucial in meeting bonus targets. We find that around 30% of acquiring firms whose counterfactual sales (i.e., sales absent acquisitions) would have fallen short of the GPB threshold by 5% or less instead beat the threshold following an acquisition. In other words, these firms would have missed the target were it not for the acquisition.

We next examine the impact of acquisitions by executives with GPBs on shareholder value. We find that GPBs are associated with lower acquirer returns around acquisition announcements. Acquisitions by firms with GPBs exhibit an average announcement return of -0.21%, compared to 0.64% for firms without GPBs. This indicates that acquisitions by firms with GPBs destroy shareholder value on average. We also observe lower combined acquirer-target announcement returns for these deals. This suggests that the reason for lower acquirer returns lies in the selection of lower-synergy acquisition targets and is less about over-payment for similar targets.

Since executives often own shares in their company, they are directly concerned about the share price. Given these mixed incentives, how do executives with GPBs fare overall? Despite the overall negative returns around these acquisitions, we find that the potential bonus payouts are large enough such that executives with GPBs on average retain significant financial incentives to meet bonus targets through acquisitions, even when those acquisitions destroy value. On average, executives gain about $200,000 in bonus compensation from acquisitions, a substantial increase in their total compensation. This outweighs an average $18,000 loss in their equity portfolios from these deals being on average value-destroying.

Our study highlights how GPBs motivate executives to make acquisitions that benefit them personally but harm shareholders. It thus highlights the importance of ensuring thoughtful metrics in compensation plans that align executives' incentives with shareholder interests to prevent value-destroying investments.

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By Aazam Virani (University of Arizona), Tor-Erik Bakke (University of Illinois, Chicago), Mathias Kronlund (Tulane University), and Hamed Mahmudi (University of Delaware)

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