The performance of white-knight management.
The story begins in 1979, the year Tonka appointed Stephen Shank as president and chief executive officer, and the first year the company had ever omitted its dividend. In 1980, Tonka sued Mego International to force it to sell its 19% stake in Tonka and to prevent it from acquiring more shares, a move that may not have been in its shareholders' best interests. In 1981, Tonka bought back 600,000 shares at $34.50 each.
Except for frequent announcements of earnings losses, all appeared to be quiet at Tonka from 1981 through 1983. But in February 1984, Tonka fired its chief financial officer for allegedly making an unauthorized and improper investment of company funds. In 1985, the SEC accused Tonka of failing to maintain adequate internal controls. Due to declines in its stock price, Tonka withdrew a proposed public offering of one million common shares. In 1986, Tonka's "Star Fairies" doll was declared a flop, and Hasbro Inc. sued the company for allegedly misappropriating a top-secret new toy. This same year, the board amended the corporation's bylaws and adopted antitakeover measures. In 1987, the year it acquired Kenner Parker, Tonka announced losses of $8 million.
Tonka's losses continued until Stephen Shank, who was CEO throughout this saga, arranged for Hasbro to acquire Tonka in 1991. Even with the highly visible, value-decreasing decision to acquire Kenner Parker, top management maintained control of the company. Shareholders continued to suffer losses while management continued to destroy value.
Is this scenario typical of white knights? Are white-knight managers inefficient?
Are these managers replaced when they make highly visible, value-decreasing acquisition decisions? This study addresses these questions.
In this paper, we place the white knight's decision to enter the control contest in a broader context. Is the white knight's bad decision to make a bid for the target part of a pattern of bad decisions, i.e., decisions that do not enhance shareholder value? If so, do shareholders react by replacing management?
In Section I, we examine prior studies of white knights and discuss the use of Tobin's q as a measure of managerial performance. We present the data and methodology in the second section. Section III compares the efficiency of white-knight management with that of hostile-bidder management. In Section IV, we compare the frequency of replacement of upper management. Section V summarizes the paper.
I. Previous Research
Several studies have assessed the impact of the white knight's bid on common stock returns. However, these studies focus on the reaction of the market to a single decision. In this paper, we are interested in both the short-run effect of management's decision to make a white-knight bid and the long-term cumulative effect of all decisions made by management. Thus, the second part of our literature review looks at Tobin's q as a method of measuring the long-term quality of management's decisions.
A. White-Knight Bidders
Earlier studies find that white-knight bidders earn negative abnormal returns around the announcement of their entry into the bidding contest. Two recent studies that look specifically at white knights, Banerjee and Owers (1992) and Niden (1993), find that white-knight bidders experience significant, negative abnormal returns, but hostile bidders have significant, positive abnormal returns. In contrast, Smiley and Stewart (1985) find that white knights experience no significant abnormal returns. However, they study a period (1972-78) before the takeover boom of the 1980s when the white-knight defensive tactic became more prominent. Bradley, Desai, and Kim (1988) find that subsequent bidders, including white knights, earn significant, negative abnormal returns. They attribute the reduction in bidder returns in multiple-bidder contests to the negative returns of "late-bidder" acquirers.
Prior research also suggests that white-knight management is inefficient, in the sense that it might not consistently make decisions that are in the shareholders' interest. White-knight management might not be strongly motivated to act in the shareholders' interest because, as Banerjee and Owers (1993) show, white knights' compensation packages have a lower percentage of options and stock appreciation rights than do those of hostile bidders. In their earlier study, Banerjee and Owers (1992) indicate that white-knight management might not exercise the same care and diligence in assessing the value of the bidder-target combination as would other types of bidders.
The average number of days between the hostile bid and the white-knight bid is only 27, which could indicate that white knights bid hastily. Thus, managers of white-knight firms could be acting in their own interests by entering the control contest to increase their firm's size, while expanding their power and compensation base. Ciscel and Carroll (1980), in analyzing the executive compensation of Standard & Poor's 500 companies, find that cash compensation and size are positively correlated. McConaughy and Mishra (1996) find that pay-performance sensitivity increases risk-adjusted firm performance. Thus, Banerjee and Owers' (1993) finding that the compensation of white-knight managers is largely cash-based suggests that white-knight managers bid for the target to enhance their own interests. In this study, we examine more directly whether white-knight management generally makes value-enhancing decisions.
B. Tobin's q as a Measure of Managerial Performance
We use Tobin's q as a measure of managerial performance and compute it for the year before the acquisition. If Tobin's q indicates that white-knight management has made investment decisions that enhance shareholder value, then the bid for the target is an aberration in an otherwise consistent record of making positive-net-present-value (NPV) decisions. On the other hand, if Tobin's q indicates that white-knight management is inefficient, in the sense that it has historically operated inefficiently, then the bid for the target is part of a pattern of bad investment decisions. This defines inefficient management as one that has made negative-NPV decisions (overinvested) and is indicated by a q ratio of less than one. This definition is consistent with prior research.
Tobin's q is the ratio of the market value of a firm's assets to the replacement cost of those assets. A value greater than one indicates that the going-concern value of a firm exceeds the current cost of the assets necessary to generate the cash flow. If the value of a firm is separated into assets-in-place and growth opportunities, then a market value greater than replacement value indicates that the firm has positive-NPV projects.
A q less than one indicates that the firm's current projects, and perhaps also its future growth opportunities, have negative NPVs. q is an increasing function of the firm's current and anticipated projects under existing management and, in this sense, is a measure of managerial efficiency (Lang, Stulz, and Walkling, 1989, 1991). Although prior research does not address white knights and hostile bidders specifically, relevant studies (Hasbrouck, 1985; Lang, Stulz, and Walkling, 1989, 1991; Servaes, 1991) use q as a measure of managerial efficiency in examining returns to bidders and targets in general. Lang, Stulz, and Walkling (1989) find a direct relation between well-managed bidding firms (q [greater than] 1) and gains to bidders in successful tender offers. High-q bidders experience the greatest gains, earning approximately 10%. Low-q bidders have losses of almost 5 %. Servaes reconfirms Lang, Stulz, and Walkling's (1991) results, and finds that the relation holds for mergers as well as tender offers.
II. Data and Methodology
To be classified as a white knight, the bidder must meet both of the following criteria:
1. Target management must initially reject the unsolicited bid, making the initial bidder a hostile bidder.
2. The white knight's bid must come subsequent to the announcement of a hostile bid.
For the period 1976-1992, we identified from Mergerstat Review and from a listing of white knights provided by Securities Data Corporation a total of 224 white-knight contests that met these requirements. From the 224 contests, we identified 109 white knights and 112 hostile bidders with enough publicly available data to compute abnormal returns.
Table 1 contains selected descriptive statistics for the firms in the sample. The white knights in the sample are larger and more likely to be exchange-traded than are the hostile bidders. We followed the history of each contest by examining the Wall Street Journal (WSJ), the Dow Jones News Wire, and the Lexis/Nexis Business News Service, and we cross-checked the announcement dates in all three sources. We used the earliest announcement date as the event date.
To assess the impact of the bidder's entry announcement, we measure abnormal returns by using the standard event-study methodology presented in Fama, Fisher, Jensen, and Roll (1969) and refined by Dodd and Warner (1983). To measure expected returns, we use the single-index market model. We estimate parameters with 200 daily returns over the period beginning 210 days prior to the entry announcement and ending 11 days preceding the announcement.
In addition to abnormal percentage returns, we estimate abnormal dollar returns by using the methodology presented in Dennis and McConnell (1986). When the bidder is substantially larger than the target, the price increase in the target represents such a small gain or loss to the acquirer that the loss is hidden in the bid/ask spread and in the noise of daily return volatility (Roll, 1986). Jarrell and Poulsen (1989) also furnish evidence that size may influence the bidder's returns. We calculate the dollar amounts of abnormal returns in terms of n-day market-adjusted cumulative abnormal returns (SCAR):
$CAR = n-day CAR*Price on day[([t.sub.-1] - 1).sup.*] number of shares (1)
where [t.sub.t-1] -1 is the day before the event window.
Our procedure for estimating Tobin's q ratios for each firm follows the Perfect and Wiles (1994) method:
q = MarketValue/Replacement Value (2)
The market value of the firm is the sum of the year-end market values of the bidder's common equity, debt, and preferred stock. The year-end value of the common equity is the number of shares outstanding at year-end multiplied by the year-end stock price.
Because many of the preferred shares are traded infrequently, we estimate the market value of preferred stock by capitalizing total preferred dividends by the Standard & Poor's preferred stock yield index. The market value of short-term debt is its book value. The procedure for estimating the market value of long-term debt is complex. For more detailed explanations of the estimation procedures for all variables, see Perfect and Wiles (1994).
The data required for calculating q ratios were taken from the Compustat data tapes, which we supplemented with the Standard & Poor's Stock Guide. Because all the data necessary to compute the q ratios were not always available, we reduced the sample for this portion of the study to 86 white knights and 72 hostile bidders.
III. Managerial Inefficiency
Table 2 shows the measures of abnormal returns and the estimates of Tobin's q. Our results are consistent with prior research: measured as either dollar or percentage returns, the announcement of a white-knight bid results in negative, significant excess returns, and the announcement of a hostile bid results in positive, significant abnormal returns.
We ask whether white knights' negative abnormal returns are part of a consistent pattern of bad decisions. The mean Tobin's q for the white knights is less than one, indicating that these firms have consistently made non-value-enhancing decisions. The hostile bidders' average q of 1.022 indicates they have not overinvested.(1)
If management usually makes good decisions, it will probably also make good decisions when it makes a bid as a white knight. Tobin's q indicates the cumulative effect of many decisions; the CARs for the firm indicate the efficiency of the decision to bid on the target. Thus, firms with qs greater than one are more likely to have positive [TABULAR DATA FOR TABLE 1 OMITTED] abnormal returns than those with qs less than one.
The results in Table 2, Panel B are consistent with this argument. White knights have negative CARs regardless of q; however, those with q greater than one have CARs that are less negative. For hostile bidders, the CARs are positive for those with q greater than one. The hostile bidders with q less than one have negative CARs. Firms that generally make bad decisions will probably make a bad decision in a white-knight bid.
The results in Table 3 show that of the 57 white knights with q ratios less than one, only 2 firms have positive abnormal dollar returns. The overwhelming majority, 55 firms, have negative abnormal dollar returns. While the average three-day abnormal return for the two firms with positive CARs is statistically insignificant, the average abnormal dollar return for the 55 firms with negative CARs is a significant loss of $154.8 million. There is evidence that firms with inefficient managers - managers who have apparently made bad investment decisions in the past - lose market value when they make a white-knight bid.
IV. Do Shareholders Replace Management?
Since an acquisition is a highly visible investment decision that often requires a large dollar outlay, we ask whether entry into the contest draws investors' attention to an inefficient management team and whether investors replace these decision-makers. To examine this question, we first look at management replacement for all white knights and then focus on only those white-knight managers who make value-decreasing acquisition decisions. In each case, we look at two types of turnover, the replacement of the top executive by an insider or outsider and the replacement of the top executive by an outsider.
A. Management Turnover for Inefficient White Knights
Table 4, Panel A, indicates the number of top executives who are not replaced in the years following the acquisition (Year t) for all white knights. Our evidence indicates that there is no apparent tendency to replace inefficient white-knight management teams who make another value-decreasing decision.
Of the 81 firms with data for the year following the acquisition (t+1), 12% do not have the same top executive one year after the acquisition, 18% two years after, and 25% three years later. These percentages do not differ significantly from hostile-bidder management retention (Table 4, Panel A), although hostile bidders initially make value-increasing investment decisions.
In addition, white-knight management turnover is comparable to the dismissal rates among the general population of firms. based on the number of CEO replacements over a ten-year period (Jensen and Murphy, 1990), we calculate a 10.68% average annual turnover ratio. Coughlan and Schmidt (1985) find a 12.7% annual CEO turnover ratio for the years 19781980. For additional comparison, we calculate a 15.25% turnover ratio for CEOs listed in the annual Forbes compensation survey (Forbes, 1997). The 12% CEO turnover ratio for white knights compares favorably to these estimates of CEO turnover in the general management population. Thus, it is difficult to believe that a highly visible, significantly value-decreasing investment decision results in top management replacements among white-knight firms.
Next, we determine whether the replacements of CEOs come from insiders or outsiders. Are those few CEOs [TABULAR DATA FOR TABLE 2 OMITTED] who lose or leave their jobs replaced with the number two executive? If the new top executives are the result of promotions from the number two spot, then it is difficult to argue that the inefficient management "team" has been replaced or that the replacement is due to managerial inefficiency.
Table 4, Panel B, indicates that replacements for top executives usually come from the number two spot. In the year following the acquisition, only four firms have new top executives who were not part of top management in the year of the acquisition. Thus, the replacement of the top executive does not appear to [TABULAR DATA FOR TABLE 3 OMITTED] be due either to managerial inefficiency or to a value-decreasing acquisition that draws shareholders' attention to the inefficiency of the management team.
Table 4. The Replacement of White-Knight Management Teams Year t is the year of the acquisition. Years t+1, t+2, and t+3 represent one, two, and three years following the acquisition. The numbers in the table indicate the number and percent of executives in each year that are the same as the executives in the year of the acquisition. Panel A. Bidders in Which the Top Executive in Year t is the Same as the Top Executive in Years t +1 to t + 3(a) White Knights Hostile Bidders % Difference N % N % % t + 1 74 88 67 93 -5 t + 2 68 82 62 86 -4 t + 3 62 75 56 78 -3 Panel B. Bidders in Which at Least One of the Top Two Executives in Year t is Also One of the Top Two Executives in Years t + 1 to t + 3(b) White Knights Hostile Bidders % Difference N % N % % t + 1 80 95 69 96 -1 t + 2 75 90 65 90 0 t + 3 75 90 60 83 7 *** Significant at the 0.01 level. ** Significant at the 0.05 level. a Cumulative dollar returns and cumulative percentage returns are accumulated over interval [-1,+1] and are expressed in millions of dollars. b The mean difference between hostile-bidder and white- knight dollar CARs is statistically significant using a t-test assuming unequal variances and the nonparametric Mann-Whitney test.
Although most of the white knights in our sample have made value-decreasing acquisitions, the managements of some firms did make acquisition decisions that are in shareholders' interests. Table 5 examines executive replacements following value-increasing and value-decreasing acquisition decisions, according to the level of managerial efficiency. We define top executive replacement as a top executive who is different from the prior year's. For the white knights with inefficient management teams (q [less than] 1) who made highly visible value-decreasing investment decisions (CAR [less than] 0), only 7 of the 50 white knights with complete data for the Years t - 1 to t+3 replace the top executive in the two years after the acquisition. Of these replacements, only three are hired from outside the existing management team. In the three years after the acquisition, only 9, or 18%, of the 50 white knights replace the top executive. Of these replacements, three are hired from outside. This is consistent with entrenched management rather than shareholders that closely monitor managerial actions and replace managers who consistently make bad decisions.
B. Management Turnover for Efficient White Knights
Another interesting result emerges from Table 5: there is a strong tendency to replace the CEO of firms with efficient management teams that make a value-decreasing acquisition decision with another member of the existing management team. Among white knights with qs greater than one and negative CARs, seven, or 35%, replace the top executive within three years following the acquisition. Only two, or 10%, replace the top executive from outside the existing management team. Replacing from inside could be in the shareholders' interest, since the management team has made positive-NPV decisions (q [greater than] 1), and inside officers are familiar with the company. The replacement percentages for this group are higher than for those white knights whose management is inefficient. Thus, there is some evidence that shareholders do replace some top executives when these executives make value-decreasing investment decisions, but only when they are accustomed to that management having made good investment decisions in the past. On the other hand, for firms with inefficient management, there is not a strong tendency for shareholders to replace the existing management team with outsiders. This finding is consistent with the idea that entrenched management makes investment decisions that are in their own best interests, rather than to enhance shareholder wealth.(2)
C. Shareholder Losses and Management Turnover
Examining combined bidder and target excess returns yields additional insights into management turnover. The tendency to replace CEOs following a bad bid does not depend on whether the management made either a bad choice of targets or else made a good choice but overbid. This is consistent with the findings of Hermalin and Weisbach (1991). Combined white-knight and target CARs are presented in Table 6, Panel A. Since data were not available for all targets in the sample, the number of observations in this table is smaller than in previous tables. Positive combined CARs signify a positive-NPV investment, an investment that has enhanced the wealth of the combined shareholders.
Panel B indicates that white knights in this group lose value. These acquisitions may have been good acquisitions, but the white knights apparently overbid for the target, resulting in a loss in shareholder value. Negative combined CARs represent bad investments that do not create positive synergies. Panel B shows that the white knights in this group also lose value. Thus, regardless of whether those contests create or destroy value, white knights lose value, either because they made a bad choice of target firm or because they made a good choice but apparently paid too much.
Among white knights whose initial bids create value but who might have overpaid, 11 CEOs out of 32 (34%) are replaced at some point during the three years after the bid. Of these 11 firms, five CEOs are replaced with outsiders. Among the white-knight management teams in value-destroying contests, 12 of 51 CEOs (24%) are replaced at some time during the three years following [TABULAR DATA FOR TABLE 5 OMITTED] the acquisition. Of these 12 CEOs, 7 (58%) are replaced with outsiders. Although the percentage of CEO replacements in value-destroying contests is smaller than that in value-increasing contests, the difference is not significant. The CEO turnover ratios in the three-year period are comparable to the 10% annual turnover ratio found by Jensen and Murphy (1990) and the 15% annual turnover ratio in the Forbes survey. In general, there is not a strong tendency to replace either those CEOs who made good choices but overbid, or those who made bad choices. However, there is some evidence that white-knight managers who are replaced include those who make the biggest, most costly mistakes for their shareholders. The combined CAR for those CEOs who select a bad target and are subsequently replaced is significantly more negative than the CAR for those who were not replaced. This indicates that the combinations that lose the most are the biggest mistakes. Apparently, these CEOs either chose the worst targets for their companies or selected bad targets and overbid. These white knights are also the ones whose shares lost the most; thus, these managers' investment decisions cost their shareholders the most.
The excess returns for these white knights are significantly more negative than for any other group. Apparently, if management makes a big enough mistake and the decline in share price is large enough, these CEOs are likely to lose or leave their jobs. Although there is no general tendency for shareholders to replace an inefficient management when it makes a value-decreasing acquisition, if white-knight shareholders perceive the cost of the bad acquisition as being too high, managers do lose or leave their jobs.
D. Managerial Efficiency and Acquisitions
Table 7 presents comparisons of combined bidder and target abnormal returns among white knights and hostile bidders. Positive combined bidder and target abnormal returns indicate a combination with positive synergy. The results are generally insignificant for white knights while the results show that the hostile bidders experience significantly positive abnormal returns. Regardless of managerial efficiency, hostile bidders usually make better initial investment decisions than do white knights.
Approximately half of the white knights with efficient management teams buy targets with positive synergy, and the other half make value-destroying acquisitions. More than two-thirds of the white knights with inefficient management teams make value-destroying acquisitions. On average, white knights with inefficient management teams make acquisition decisions that are value-destroying.
On the other hand, on average, hostile bidders make initial bids that result in a combination with positive synergy. This is true regardless of the hostile bidder's pattern of prior performance. An overwhelming majority of hostile bidders who have historically made value-enhancing decisions make another value-enhancing decision when they bid for the target. Hostile bidders who have previously made negative-NPV investment decisions generally make an initial value-enhancing decision to bid for the target.
V. Summary and Conclusions
White knights generally make acquisition decisions [TABULAR DATA FOR TABLE 6 OMITTED] that do not enhance shareholder value. In this paper, we find that these decisions represent a pattern of bad investment decisions. On average, white-knight managers who make bad investment decisions before their decision to bid for the target are, in this respect, less efficient managers than those of hostile bidders.
Buying a target is a highly visible, important investment decision that often requires a major cash outlay. Shareholders might reasonably assess managerial performance at this time. However, the evidence presented in this study indicates that on average, shareholders do not replace inefficient managers. The management turnover among inefficient managers is comparable to the turnover in the general [TABULAR DATA FOR TABLE 7 OMITTED] population of firms and also to the turnover among hostile bidders in white-knight contests. This implies entrenched management. In other words, the white-knight managers who make bad acquisition decisions and are inefficient are exactly the ones who are the most likely to keep their jobs.
While most inefficient managers who make bad acquisition decisions are not replaced, some are. Those who are replaced are the ones who have made the biggest and most costly acquisition mistakes for their shareholders. Apparently, CEOs who have an established pattern of making value-decreasing investment decisions and subsequently make a bad acquisition decision do not have to worry about losing their jobs unless they make a huge value-destroying acquisition decision.
Among efficient white knights, the story is different. When managers have made value-increasing investment decisions, sometimes they are replaced when they make a value-decreasing acquisition decision. Often, the replacement is the executive who is second in command.
Managers of white knights who make negative-NPV decisions are primarily experienced managers. Relatively few top executives are newly appointed to the position. Those that are newly appointed tend be promotions from the number two position. The experience levels of white-knight management are similar to those of hostile bidders, and hostile bidders as a matter of course make value-enhancing investment decisions. Even among those white knights with management teams that make positive-NPV investment decisions, inexperience in the top executive position cannot explain why these executives make bids that are apparently not in their shareholders' interest.
We wish to thank the Editors and especially the referee whose comments and suggestions greatly improved the paper. We are responsible for any remaining errors.
1 The q ratios are similar to those found in previous studies (Chung and Pruitt, 1994; Perfect and Wiles. 1994; Servaes, 1991; and Lang, Stulz, and Walkling. 1989).
2 In addition to the bivariate tests, we examine the following LOGIT regressions:
Yj = [a.sub.0][a.sub.1][X.sub.1j] + [a.sub.2][X.sub.2j] + [a.sub.3][X.sub.3j] + [[Epsilon].sub.j]
Yj = a binary variable with a value of 1 if the executive team was replaced
[X.sub.1j] = dollar value of residual return
[X.sub.2j] = a binary variable with a value of 1 if the bidder has a q less than one
[X.sub.3j] = a binary interaction variable with a value of 1 if the bidder has both a negative abnormal return and a q less than one
Regressions with different measures of executive replacement as the dependent variable provide similar results. These include whether or not the top executive is replaced in each of the three years following the takeover bid, whether the top executive is replaced with an insider or an outsider, and whether either of the top two executives is replaced. None of the coefficients is significant, confirming that a bad investment decision by a top executive who generally makes value-decreasing investment decisions does not lead to replacement.
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Carolyn Carroll is an Associate Professor of Finance at University of Alabama. John M. Griffith is an Assistant Professor of Finance at University of Minnesota-Duluth. Patricia M. Ruldolph is a Professor of Finance at University of Alabama.
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|Author:||Carroll, Carolyn; Griffith, John M.; Rudolph, Patricia M.|
|Date:||Jun 22, 1998|
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