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Beware of Empire Builders

http://www.nytimes.com/2007/05/13/business/yourmoney/13stra.html

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Shareholders Benefit When Managers Have a Serious Stake

May 13, 2007
By MARK HULBERT

If you own stock in a company that is ripe for takeover, you should hope the company isn’t acquired by a private equity firm.

That, at least, is the conclusion of a new study, which found that public companies often pay a much higher price than private equity firms when buying other companies.

The study, “Why Do Private Acquirers Pay So Little Compared to Public Acquirers?,” began circulating last month as a National Bureau of Economic Research working paper. Its authors are four finance professors: René M. Stulz of the Ohio State University, and three from the University of Pittsburgh: Leonce L. Bargeron, Frederik Schlingemann, and Chad Zutter. A version of their paper is available at www.nber.org/papers/w13061.

…The authors of this new study analyzed cash-only acquisitions of publicly traded domestic companies completed from 1990 through 2005. In total, they focused on 1,292 deals, 32 percent of which involved a private bidder and 68 percent involved a public bidder. They found that “target shareholders receive 55 percent more if a public firm instead of a private equity fund makes the acquisition.”

The professors were unable to account for this big price disparity in terms of any observable differences in the kind of companies that were acquired. It was not the case, for example, that private equity firms tended to purchase less profitable companies than public bidders did. Nor did private equity firms tend to acquire companies that were growing more slowly, or ones whose recent stock performance was poorer.

The professors concluded that, if differences among the target companies cannot explain the huge price disparity, then differences among the acquiring firms must be the cause. Sure enough, the professors found that the highest prices tended to be paid by publicly traded acquirers whose managers owned the least amount of their companies’ stock. Indeed, upon eliminating from their database those publicly traded acquirers whose managers had ownership stakes amounting to less than 20 percent, the professors found no difference in the average price paid by private and public acquirers.

This finding suggests that it is not fair to say that private equity firms systematically pay too little to acquire other companies. Instead, it would be more accurate to say that acquisition prices tend to be too high when the acquirer is publicly traded and its management has a low ownership stake.

Why would the percentage of shares owned by management have anything to do with the price paid to acquire another company? The professors say that when corporate managers have only a small ownership stake, they are more likely to pursue acquisitions that do not enhance shareholders’ long-term value. In such cases, Professor Stulz said in an interview, their motivations may simply be to satisfy their egos by building a corporate empire.

It might be tempting to view the News Corporation’s recent bid to acquire Dow Jones & Company as a good example of this empire-building, especially since the offer of $60 a share is so much higher than the price at which the stock had been trading. But in fact it’s not a good illustration of the pattern identified by the professors: Rupert Murdoch, chairman of the News Corporation, owns nearly 30 percent of the company through various family trusts. In addition, Professor Stulz points out, “it is not clear that Dow Jones’s current owners have maximized shareholder value.” (Disclosure: MarketWatch, my employer, is a wholly owned subsidiary of Dow Jones.)

How should you react if you own stock in a company that receives an acquisition bid from a publicly traded company whose management has a small ownership stake? You may want to sell your stock immediately upon the announcement of that bid, Professor Stulz said, since chances are high that the bid will have inflated the price of your stock to overvalued levels. By selling immediately, you lock in much of that higher price and protect yourself from the possibility of the deal’s falling through.

A more general investment implication, according to Professor Stulz, is that investors should pay close attention to the incentives under which corporate managers operate.

“You should favor companies whose managers are working on behalf of long-term shareholder value and not personal aggrandizement,” he said. One clue that managers’ interests are aligned with shareholders’ is that they have a large ownership stake.
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