Diverging Motives

When voting on a merger, shareholders of the acquiring firm may not always act in the best interest of the company.

When Bank of America (BofA) announced in October 2003 that it would acquire FleetBoston Financial, the total value of BofA's outstanding stocks fell from $122 billion to $113 billion one week after the announcement while the value of FleetBoston's stocks rose by about the same amount from $33.5 billion to $42.5 billion. It is not unusual for shareholders of firms acquiring other companies to lose money after such plans are made public. Previous studies suggest that the value of an acquiring firm goes down because the market thinks the company is engaged in so-called empire-building or its managers are too confident in their ability to run vast companies.

These studies, however, do not explain why an acquiring company's shareholders would allow managers to take on a transaction that gives shareholders a bad return. Even though BofA's 10 largest investors owned about a quarter of the company, they did not stop the merger and eventually lost 10 percent of the value of their holdings—about $2 billion— in the week following the announcement.

The answer, according to a recent study titled "Crossownership, Returns, and Voting in Mergers" by University of Chicago Booth School of Business professor Gregor Matvos and Michael Ostrovsky of Stanford University, is that many of BofA's biggest investors also owned substantial stakes in FleetBoston. Because a buyer normally pays a premium to acquire a company, it is possible for shareholders of the acquiring firm to make up for their loss if they also own shares of the target company.

In fact, the 10 largest shareholders of BofA and FleetBoston had eight names in common. "They lost money in one pocket as Bank of America shareholders but made money in the other as shareholders of FleetBoston," says Matvos. As a result, instead of losing $2 billion, BofA's 10 largest investors as a group gained more than $300 million after the merger was announced.

The BofA-FleetBoston deal is not an exception. Analyzing a large sample of mergers between publicly traded firms in the United States from 1981 to 2003, Matvos and Ostrovsky find that institutional investors with stocks in both the acquiring and target companies gain from a merger while those who hold only the acquiring firm's stocks lose.

The difference in expected payoffs means that these two groups of shareholders will probably vote very differently when management proposes to acquire a company.

Returns to Cross-Ownership

The study estimates the average returns earned by a particular group of shareholders—institutional investors—around the time that a merger is announced. Institutional shareholders are often a company's biggest investors and also have the biggest voice in terms of voting for or against a potential acquisition.

Turning first to the BofA-FleetBoston merger, Matvos and Ostrovsky estimate that BofA's institutional shareholders lost about 7.5 percent of the value of their equity holdings one week after the announcement of the merger. However, many of them also owned FleetBoston's stock. After taking cross-ownership into account, it appears that BofA's institutional investors did not lose money but actually earned 0.3 percent. The gains were even larger—about 0.7 percent—for the subset of institutional shareholders who owned stocks in both the acquiring and target firms.

The authors find similar results when they extend the analysis to their entire sample. Taking cross-ownership of stocks into account, institutional investors as a group do not perform worse than the stock market during the five days before and five days after the announcement of a merger. However, institutional investors who own stock only in the acquiring company lose about 1.5 percent relative to the performance of the stock market. By contrast, investors who hold stocks on both sides of a merger increase the value of their portfolio by 2.5 percent. Thus, cross-owners earn about four percentage points more than other institutional investors who hold shares only in the acquiring firm.

The difference in average returns is even larger when the authors restrict their analysis to the 100 largest mergers in terms of the size of the target company. In this case, institutional investors who own both the acquiring and target companies' stock earn about five percentage points more than those who hold only the acquiring firm's shares.

This significant difference highlights a potential conflict of interest between shareholders who lose and those who gain. Investors who are diversified in both companies' stocks, for instance, are less likely to vote against a merger than investors who will potentially bear the full loss when a merger is announced.

Cross-Ownership and Voting in Mergers

To see how the difference in potential payoffs to institutional shareholders affects voting behavior, Matvos and Ostrovsky analyze how a particular group of institutional investors— mutual funds—tends to vote on mergers. Beginning in 2003, the Securities and Exchange Commission (SEC) required all mutual funds to disclose how they vote as company shareholders. The authors collected this information from filings submitted by the funds to the SEC between August 2004 and December 2006.

They find that mutual funds that do not hold shares in the target company are more than twice as likely to vote against a merger as those that own shares in both the acquirer and the target. The authors then restrict their analysis to only "responsive funds," or those funds that opposed a merger at least once during the sample period, because a large number of mutual funds never oppose a proposal by management. The results are more striking. Among responsive funds, mutual funds that hold only the acquirer's stocks are six times more likely to vote against a merger as cross-owners.

The authors also test whether this disparity in voting behavior only arises when markets expect a poor outlook for a merger. If investors believe that a proposed merger is a bad one, investors who own stocks in the acquiring company alone will more likely oppose the merger than those who own stocks in both the acquirer and target. It also follows that there should be no difference in voting behavior if the merger is widely expected to be good for the company, such that all shareholders are expected to vote in favor of the merger. The authors divide the sample by using the change in the acquiring company's stock price after a merger announcement as a proxy for a good or bad merger. A merger is considered bad if the value of the acquiring company's stocks falls, while a good merger is one that yields a positive return.

Matvos and Ostrovsky find that when it comes to bad mergers, mutual funds that hold shares in both the acquiring and target companies are 14 percent more likely to agree to a merger than mutual funds with shares only in the acquiring firm. In other words, investors do not mind bad mergers as long as they own sufficiently large stakes in the target company. This discrepancy disappears when a merger is predicted to increase the value of an acquiring company's stocks. As expected, both groups tend to vote in favor of the merger.

Muddled Signals

The study highlights an often-ignored area of corporate governance in the United States. "When we think about corporate governance, we mostly think about the conflict of interest between shareholders and managers rather than between groups of shareholders," says Matvos. Discussions about conflicts that arise between investor groups usually focus on emerging markets, such as Korea's predominantly family-owned and managed conglomerates and India's pyramid structure of corporate ownership and control. The study by Matvos and Ostrovsky shows that even in the United States, it is important to understand how motives and incentives may differ among shareholders.

However, it is unclear how such conflicts should be addressed, if at all. A merger announcement that causes the price of an acquiring firm's stock to fall might signal a bad merger, but as the study shows, what may be a bad merger to one group of shareholders may be considered worthwhile by other investors. Institutional shareholders cannot be expected to always look out for what is best for the company because they have a responsibility toward their own investors, such as the investors of a mutual fund. "The job of institutional shareholders is not to maximize the value of a particular firm but to maximize the value for their own investors," says Matvos.

An interesting area for future research is to examine why investors with stocks in the acquiring company alone still vote for a merger about 83 percent of the time, even if the value of their holdings would clearly fall. One possible reason is that shareholders may believe that these mergers are good for the company in the long term so they do not mind if the value of their investment falls in the short run.

Another reason is that shareholders such as mutual funds may not want to disagree with management if doing so would adversely affect their current and future business relationships— for instance, in managing a company's pension funds. The cost of disagreeing is especially higher if most shareholders vote in favor of the merger because it would be easier for management to retaliate against the one fund that votes against it.