Santa Clara University

Connected Directors

Why Mergers That Have Them Seem to Work out Better

Mergers and acquisitions have been prominent in business news for decades, yet for all the money and effort that goes into them, the acquiring firm is often afflicted with “winner’s curse”—a term used to describe market backlash over the value of the deal, often related to perceived overpayment for the target company.

Ye Cai, assistant professor of Finance, was intrigued by the phenomenon and wondered if “winner’s curse” was as prevalent when there were board connections between the acquiring and acquired firms. Accessing data recently made available, she and her co-author Merih Sevilir were able to determine that M&A transactions where such a connection existed were more likely to turn out better for the acquiring firm.

“When we started on this research we weren’t sure what to expect,” she says. “Some previous papers had suggested that the presence of informed insiders, such as interconnected directors, would help acquiring firms because they would be familiar with details about the acquired company and their presence might cause other bidders to back off. What we found supported that.”cai

Cai and Sevilir’s conclusions are laid out in the paper “Board Connections and M&A Transactions,” published in the Journal of Financial Economics. They began by looking at 5,055 M&A transactions between 1996 and 2008 for which documents were recently placed online under a mandate from the Securities and Exchange Commission. After winnowing out transactions where information was insufficient, they ended with 1,664 that were subjected to further review.

Board connections were broken down into two types. First-degree connections are those in which both the acquiring and acquired company share at least one common member of their board of directors. Second-degree connections are those where one director from the acquirer and one director from the target have been serving on the board of a third firm before the deal announcement. For example, when Wells Fargo was acquiring Wachovia, a director from each bank was also serving on the board of Vulcan Industries.

In deals where a first-degree connection existed, announcement returns— the acquirer’s stock price in the days immediately before and after the deal is announced—were 2.45 percent greater than those in non-connected transactions. Where there was a second-degree connection, announcement returns were still a healthy 1.67 percent greater than in non- connected transactions.

“Our results suggest that first-degree connections benefit acquirers by providing them with an information advantage about the true value of the target firm, limiting competition from outside less informed bidders, and allowing them to acquire underperforming firms at an attractive price,” Cai and Sevilir write. “In addition, advisory fees paid to investment banks are significantly lower in the presence of a first- degree connection.

“Second-degree connections, on the other hand, appear to facilitate efficient deal- making as evidenced by greater overall value creation experienced by acquirer and target shareholders at the deal announcement, and better operating performance of the combined firm after the deal completion.”

First-degree connections are restricted to some degree by federal law, which prohibits a director of one firm from serving on the board of a competing firm. Still, Cai says, a director who sits on the board of the acquired firm and the acquirer can still exercise influence behind the scenes, and the question of what constitutes a competing firm is fluid. In 2009, Google CEO Eric Schmidt stepped down from the board of Apple because the two companies are increasingly seen as competitors, rather than occupants of separate niches within the high-tech industry.

However those connections may play out, Cai’s paper documents their significance. “Overall,” she says. “our paper provides new evidence that board connectedness plays an important role in corporate investment policy and leads to greater value creation.”

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