How management compensation can cause mergers to fall short for investors

corporate mergersCorporate mergers are highly celebrated events in the investment world, mainly because of the way that they will often come with a purchasing premium for shareholders to pocket. However, long-term investors sometimes grumble at the implications of an acquisition because of the way in which they can actually stand to degrade the long-term value of an acquired company’s investment value.

While there are a number of reasons why it is that an investor might oppose an acquisition, one of the most important ones to keep in mind arises as a result of poorly designed management incentives, which encourage an acquiring company to make acquisitions that grow the size of a company’s balance sheet rather than create sustainable growth opportunities into the future. By understanding how it is that poor corporate governance practices can create incentives for managers to engage in meaningless acquisitions, we can then start to look at the implications of these transactions on our personal portfolios, and protect ourselves from the risks inherent.

When evaluating a management team’s incentives to make an acquisition, the first thing that an investor should take into consideration is a management’s compensation base. Specifically, we want to look at how it is that the team’s performance-based compensation measures will relate to this acquisition. Firstly, we want to evaluate what kind of equity-options the management team receives as compensation, because the value of these shares will be directly related to the outcome of an acquisition event in two ways.

In the event that the proposed acquisition goes through, the value of the equity based premium is very likely to increase based on the increased size of the company’s overall balance sheet, even if the acquisition is structured in a potentially unfavorable way. For example, if a company takes on a great deal of debt to finance an expensive purchase, the company’s stock price will likely increase as a result of increased asset size, but create a great deal more operating risk for investors because of the newly acquired interest payments.

The second thing to look for after determining the presence of equity-compensation packages is to find long-term risk-mitigation mechanisms that are structured into the compensation package itself. The most common way to do this for equity-compensation packages is to put a lock-up period on the shares, which means that the management team is not allowed to access the shares until a certain period of time has passed.

This means that the company would need to maintain its value for 3-5 years after an acquisition before the manager would be allowed to cash in on their purchase. If the management team had completed an acquisition that was particularly risky, the probability of the company being able to maintain the acquisition premium for 3-5 years is very low, and therefore management has less of an incentive to complete such a transaction.

In putting this information together, the main take-away to remember is to think about the motivations behind a transaction before buying into it. There’s a bit more to it than just looking at how it is that a management team is compensated, but if there’s a compensation motivation, there’s a risk that needs to be vetted.

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