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Mergers and acquisitions are well-suited events for a detailed study of the valuation effects of corporate governance structures. Using a sample of 388 takeovers announced in the friendly environment of the 1990s, I empirically show that target shareholder control, proxied by low target chief executive officer share ownership, low fractions of inside directors, and the presence of large outside blockholders, is positively correlated with takeover premiums. In contrast, studies of takeovers in the hostile environment of the 1980s have shown a negative relation between target shareholder control and takeover premiums.

How much control of a firm should rest in the hands of its managers, and how much should be retained by its shareholders? This question, and how to implement the optimal balance of power, has long been central not only to the corporate governance literature, but also to active investors and securities legislation. In this paper, I empirically examine how the balance of power between target chief executive officers (CEOs) and target shareholders affects takeover premiums in mergers and acquisitions in the 1990s. Mergers and acquisitions are in many ways ideal natural experiments to test the valuation effects of corporate governance structures.1 First, a merger generally requires the active participation of all decision makers, namely, managers, directors, and shareholders. Managers usually negotiate the merger, directors have to endorse it and are sometimes involved in the negotiations, and shareholders have to either vote on it or decide whether to tender their shares. Second, the effect of the corporate governance structure on the value of the target, given adequate control for other influences, is immediately observable in the takeover premium. Third, a merger announcement is a clearly defined and, in most cases, a surprising event. Intuitively, higher shareholder control should lead to higher shareholder value. Therefore, we should only observe corporate governance structures with high levels of shareholder control in the long run. However, maximum shareholder control might not be optimal in all situations. In an environment without takeover defenses, for example, the United States before the late 1980s, even if a target CEO is opposed to a takeover, large takeover premiums help hostile bids succeed by inducing target shareholders to fight the CEO's resistance. The more powerful the target CEO and the weaker the target shareholders, the higher the takeover premium that is required to motivate shareholders to overturn the CEO's opposition. Shleifer and Vishny (1986) and Stulz (1988) provide theoretical rationales for this result, and Song and Walkling (1993) have empirical evidence. Therefore, giving target CEOs power to make decisions that are costly to overturn for shareholders can be valuable. However, a great change is evident in the characteristics of mergers and acquisitions over the past two decades. Merger and acquisition activity in the 1980s was characterized by spectacular hostile transactions, while in the 1990s the vast majority of transactions were done on friendly terms.2 In the 1990s, effective takeover defenses were widely available and hostile offers had only a small chance of success. With this shift in the balance of power toward target CEOs, bidders had to focus their efforts on convincing target CEOs to agree to deals versus enticing target shareholders through large takeover premiums. One way to solicit a target CEO's merger approval at a reduced takeover price is for the bidder to offer private benefits to the target CEO, e.g., positions in the merged firm and improved retirement packages.3 Instead of negotiating the highest possible takeover premium, target CEOs bargain over their private benefits with the bidder. Target shareholders can intervene and block these transactions, but intervention is costly. The cost of target shareholder intervention is largely determined by the balance of power between the target CEO and the target shareholders. The more powerful the target CEO and the weaker the target shareholders, the higher the cost of shareholder intervention and the larger the reduction in the takeover premium that the target CEO can allow in return for private benefits. Therefore, in the 1990s the relationship between target shareholder control and takeover premium should be positive, while it appears to have been negative in the 1980s. Given that the level of shareholder control is not directly observable, I must rely on various proxies in my empirical analysis. I consider CEOs to be strong when they own large fractions of their firms’ stock, there are small outside blockholdings, or a large fraction of directors are insiders. I empirically show that these proxies for low target shareholder control are related to lower takeover premiums in the 1990s. Combining several of the shareholder control variables to identify distinct cases, I develop a proxy for high shareholder control. I find that bidder returns are lower and target returns are higher when target shareholders have more control. These results eliminate an important argument for high managerial power and discretion.4 Financial incentives, in particular the use of options, could substitute for direct shareholder control. I use the target CEOs’ option holdings and the sensitivity of their value to the underlying stock price as proxies for financial incentives to maximize shareholder wealth. I find little evidence that the CEOs’ stock options affect takeover premiums. The results here are of substantial economic significance. The various proxies for low shareholder control and strong CEOs reduce takeover premiums by 5 to 16 percentage points. With an average target market value of $1.2 billion, this premium reduction frees up significant amounts that can be distributed as rents to other parties. There are some related studies. Hartzell et al. (2004) examine target CEOs’ trade-offs between financial gains, including augmented golden parachutes and merger-related bonuses, and executive positions in the merged firm. They find that financial gains are reduced when target CEOs receive executive positions. Generally, target CEOs’ payoffs are comparable to the net present value of what they would have received without the merger. Takeover premiums, however, seem to be smaller in cases in which target CEOs received extraordinary treatment. My study differs from Hartzell et al. (2004) in three ways. First, they focus on the target CEOs’ trade-off between financial gains and executive positions in the merged firm, while I relate the level of target shareholder control to bidder and target announcement returns. Second, they examine only the benefits of target CEOs and do not consider bidder returns. Third, my proxies, covering various aspects of the targets’ corporate governance structures, are much broader than their variables that measure payments to the target CEO in great detail. The analysis here is also related to Wulf (2004), who shows that target managers receive preferential treatment in mergers of equals compared with mergers of nonequals. In a detailed analysis of 40 transactions, she finds higher bidder returns and lower target returns in mergers of equals, which is consistent with my results. My sample, a broader selection of 388 mergers and acquisitions, allows more powerful tests and more general and robust results. In addition, my study is less sensitive to the accurate classification of bidders and targets, a difficult task in mergers of equals. The remainder of the paper is organized as follows. Section 2 presents my main hypothesis. Section 3 develops the proxies for shareholder control. The sample description follows in Section 4. I discuss my takeover premium measures in Section 5. Section 6 presents the empirical results, and Section 7 examines various robustness checks. Section 8 concludes.

In the 1980s, target shareholder control and takeover premiums were negatively related. I show, however, that this relation is positive in the 1990s. Shareholder control is beneficial in the important market for corporate control. My results suggest that direct shareholder control through outside blockholders and outside directors is most effective, while large share ownership of the target CEO can be harmful to target shareholders. Indirect financial incentives, such as executive stock options, do not seem to mitigate the principal-agent problem. Targets that are highly controlled by shareholders are associated with lower abnormal bidder returns, and CEOs of these targets are less likely to receive executive positions in the merged firm. This evidence suggests that powerful entrenched target CEOs reduce takeover premiums, possibly in return for bidder-provided incentives. Large equity ownership appears to be an inappropriate incentive for CEOs, in particular when the firm becomes a target. The results here and in the related studies have important implications for the potential rent extraction by managers. Clearly, targets with powerful CEOs receive lower takeover premiums. However, premiums are generally positive and average more than 20%, while target CEOs generally lose large amounts of their human capital in takeovers. Given the current abundance of takeover defenses, allowing some rent extraction by managers might be beneficial for shareholders when it increases the probability of receiving profitable takeover offers. The more fundamental question becomes: Why are CEOs allowed to extract large rents when shareholders on their own, e.g., through blockholders, could presumably extract those rents for themselves? Additional research is needed to answer this question.