Cash holdings, corporate governance, and acquirer returns Seoungpil Ahn and Jaiho Chung May 11, 2012

Intuition  Is competition good?  Milton Friedman( ) would say yes and always yes  Average parents in Korea would say NO for their kids  Are the restrictions on shareholders’ rights bad?  Yes, if entrench managers  No, if talkative(?) shareholders impair timely decision makings  Conditional on the current level of the restrictions and firm characteristics  We examine this conditional effect of governance provisions

Governance Provisions and Firm Performance  A milestone work by Gompers, Ishii, and Metrick (GIM, 2003)  Governance Index based trading strategy yields abnormal returns during the 1990s.  Short poorly governed firms (many anti-takeover provisions, ATPs)  Long well governed firms (few ATPs)  produced AR of 8.5% annually  The abnormal return disappears in the later period after 2001 [Bebchuk, Cohen, Wang, 2012; Core, Guay, and Rusticus, 2006]

Does causality run from ATPs to firm performance?  Spurious correlation  ATPs may reflect risk that is not captured by expected return models [GIM, 2003; Core, Guay, and Rusticus, 2006]  Endogeneity issues [Masulis et al., 2007; Danielson and Karpoff (1998) among others]  Look-ahead adoption of ATPs before the impending events  The influence of omitted factors [Core, Guay, and Rusticus, 2006]  Poor past performance or other unobservable factors covary with ATPs  Causal relation  Market participants learn the performance difference between well governed firms and poorly governed firms [Bebchuk, Cohen, and Wang, 2012; Cremers and Nair, 2005]

Attention to corporate governance  Attention to governance from the media, institutional investors, and academic researchers has exploded since early [Netter, Poulsen, and Stegemoller, 2009; Bebchuk, Cohen, and Wang, 2012]

Structural break of market learning  Market participants become aware of the importance of corporate governance by the end of 2001 [Bebchuk, Cohen, and Wang, 2012]  Learning hypothesis  Anomaly in the pre-SOX period: ATPs indeed reduce firm value  Market learning eliminates AR in the period (Post-SOX period)

A Caveat  When market participants are aware of the detrimental impact of ATPs, how do ATPs survive under shareholders’ activism and the pressure from institutional investors and policy makers?  G-Index includes 24 provisions  BCF Index includes 6 most entrenching provisions Pre-SOX ( ) Post-SOX ( ) F[χ2]F[χ2] G-Index 9.29 [9.00] 9.29 [9.00] 0.00 [0.26] BCF 2.12 [2.00] 2.40 [2.00] *** [40.72] ***

Our study  We re-examine bidder returns  Weak shareholder protection:  Lower bidder announcement returns in [Masulis et al., 2007]  Focusing on the influence of omitted factors:  If the market learning does not lead to the abolishment of ATPs, what are the exact channels through which the effect of ATPs disappear in the post-SOX period?  The role of excess cash holdings  The influence of external governance (EG)  Public pension fund holdings (ownership by 19 largest pension funds)  Industry competition (industry Net Profit Margin)

The interaction among governance indices, excess cash, and external governance mechanisms  Excess cash holdings for poorly governed firms:  Lower value of cash holdings  Dissipate cash quickly in capital expenditures [Dittmar and Mahrt-Smith, 2007; Harford, Mansi, and Maxwell, 2008]  For the relation between ATPs and bidder returns:  No main effect [Masulis et al., 2007]  Interaction effect?  We examine the impact of ATPs on bidder returns when ATPs and excess cash interact

 The strength of external governance mechanisms:  Various governance mechanisms interact  The effect of ATPs depends on:  Product market competition [Giroud and Mueller, 2010]  The presence of large institutional investors [Cremer and Nair, 2005]  The effectiveness of CEO incentives depends on the strength of external governance [Kim and Lu, 2011]  We expect that the impact of ATPs on bidder returns to depend on the strength of external governance (EG) forces.  No main effect [ Masulis et al., 2007]  Interaction effect?

Data  Firms covered in Investor Responsibility Research Center (IRRC ) database  For the period of  1995,1998,2000,2002, 2004, and 2006 volumes of IRRC. Interpolate the skipping years.  Firms completed acquisitions from SDC M&A database  Control less than 50% and then 100% after the transaction  Deal value > $1m  Stock price data available in CRSP

Final sample  3,340 acquisitions in the period  by 1,217 unique firms  1,767 acquisitions in the pre-SOX period and 1,549 acquisitions in the post-SOX period.  We also utilize panel data set for these firms conducted acquisition at least once during the sample period.

First look at the data All Period Pre-SOX ( ) Post-SOX ( ) F[χ2]F[χ2] G-Index 9.29 [9.00] 9.29 [9.00] 9.29 [9.00] 0.00 [0.26] BCF 2.25 [2.00] 2.12 [2.00] 2.40 [2.00] *** [40.72] *** CAR MM (-2, +2) *** [0.311] *** [0.169] *** [0.493] *** 7.35 *** [7.85] *** CAR MAR (-2, +2) *** [0.530] *** ** [0.225] ** *** [0.732] *** 7.97 *** [11.29] *** N3,3401,7671,549

Table 1 Panel C. The correlation between CAR MM (-2, +2) and ATPs All Period Pre-SOX ( ) Post-SOX ( ) BCF ** G-Index ** 0.011

Table 2. Descriptive Statistics

The relation between bidder return and the BCF-index  CAR MM (-2,+2) =  +  1  BCF Index +  Controls +   Learning hypothesis:  Negative in the pre-SOX period  Insignificant in the post-SOX period  The influence of omitted factors:  Negative in the presence excess cash and under weak EG  Insignificant in the absence of excess cash and under strong EG  Weak EG:  pension ownership is below the sample median value  Industry NPM is above the median value

Table 3 Regression of acquirer returns on antitakeover provisions

Table 4 External governance, antitakeover provisions, and acquirer returns

Table 5 The interactive effect of antitakeover provisions and pension holdings, industry competition, and excess cash

Evidence so far:  The adverse impact of anti-takeover provisions on bidder returns:  In much narrowed context than previously thought  Only for firms amassing excess cash and facing weak EG  Not independent effect of ATPs  Suggesting that ATPs are not necessarily value-destroying for all firms

Robustness Tests in Table 6  Include CEO incentives  delta and vega  Include board characteristics  board size, % independent directors, CEO-chair duality  Use CAR MAR (-2, +2)  Alternative definition of EG  block ownership, industry median sales expenses  Alternative governance indices  G-index and classified boards  Sub-sample test for the pre- and post-SOX periods

Endogeneity  Econometric approach:  3SLS where CAR, BCF, and MtoB are jointly determined  Instrument variables approach  Dynamic panel GMM [Wintoki, Linck, and Netter, 2011]  Qualitative approach:  Actions of pension funds in marginalizing the adverse impact of ATPs  One possible channel:  Pension funds exert pressure on firms to eliminate ATPs when they hurt shareholder wealth  We thus test the probability of removal by strong EG

Summary of Table 7 3SLS estimation

Table 8 Probability of a decrease in governance index

Table 9 Probability of abolishing individual provision

The role of active pension funds ATPs Firm Value (a) Market Learning Hypothesis(b) Our Evidence

Conclusion  We identify the influence of omitted variables:  The effect of ATPs interact with excess cash and EG  ATPs alone are not necessarily value-destroying  A decrease in excess cash and an increase of pension ownership in the post- SOX period  Alternative explanation to market learning  Better explanation than market learning  Knowing the adverse impact of ATPs, market learning implies complete elimination of ATPs:  Pervasiveness of ATPs for a majority of firms until recent years  No evidence of price adjustment  No direct link between market learning and the disappearance of the adverse impact  Only partial elimination of ATPs by active pension funds  Thereby, the wealth effect of ATPs is neutral