See the Gap: Firm Returns and Shareholder Incentives

Smart money often trades actively during times of large corporate events. We document in the context of mergers and acquisitions that, during the public bid negotiation period, institutional investors increase (decrease) their holdings of acquirers in deals that generate positive (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 of acquiring firms earn 2.4% from M&A while the return to the acquirer is only -0.9%. The gap widens to 6.3% in deals that deliver volatile returns. We further show how institutional investors' strategic trading and the resulting gap are impacted by deal characteristics such as merger size and stock liquidity as well as institution characteristics such as initial holdings, portfolio weight, and trading skills. Importantly, institutions that earn a high return gap are associated with weak governance in preempting and correcting value-destroying mergers. 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' governance incentives correctly.