M&A Incentives and ESG: A Look at the New Paradigm
By Arthur Kohn, Skytop Contributor / February 9th, 2022
Arthur Kohn has practiced law since 1986, focusing on compensation and benefits matters, including executive compensation, pension compliance and investment, employment law, corporate governance and related matters. In 2021, he was appointed as a fellow to the American College of Governance Counselors.
Arthur is an adjunct professor at New York University School of Law and a regular guest lecturer at Columbia Law School. He frequently speaks and writes about executive compensation, taxation and corporate governance matters. He repeatedly has been recognized for his work by the business and legal press, including Best Lawyers, Chambers USA, The Legal 500, Super Lawyers of New York and others.
Arthur received a B.A. from Columbia University and a J.D. from Columbia Law School, where he was admitted into the Accelerated Interdisciplinary Legal Education program, was appointed a Harlan Fiske Stone Scholar and received Phi Beta Kappa honors.
Incentives and Revolutionary Change
The way the world thinks about incentives has undergone revolutionary change in the last 100 years.
One of my former partners was very fond of an old story about incentives. As told by National Public Radio in “How to Stop Sea Captains from Killing Their Passengers” (here), the story is about how, back in the 1700s, the British government paid sea captains to take felons to Australia.
Initially, the sea captains were paid based on the number of prisoners boarding a ship. The mortality results of the voyages being not so good, an economist came up with a better idea. “Instead of paying for each prisoner that walked on the ship in Great Britain, the government should only pay for each prisoner that walked off the ship in Australia. And in fact, this was the suggestion which in 1793 was adopted and implemented. And immediately, the survival rate shot up to 99%.”
Nowadays, we recognize that people don’t always behave as rational economic actors. They are frequently influenced by other things.
Behavioral psychology, and its intellectual predecessors, and more recently behavioral economics, has changed the way we all think about incentives, to the point that the new way of thinking is now intuitive. For example, what does it take to get people to be vaccinated in a pandemic? Who really knows, but we all know that it’s not as simple for everyone as offering cash. Beyond that, the question is being studied, of course. As reported here, perhaps surprisingly, “monetary payments seem to motivate Democrats, and relaxing cautionary guidelines [i.e., eliminating mask mandates, etc.] seems to work for Republicans”. Theories in various disciplines attempt to explain that observation.
Still, the field of executive compensation is almost entirely about how to use financial incentives to affect executive behavior, and compensation incentives are the prevalent means by which senior executives are formally incentivized by corporations.
Incentivizing M&A
Quickly, why does it seem relatively easy to incentivize corporate executives to spend money to buy other businesses? The answer is obvious, right? Executives invest in M&A in order to make more money – to maximize profits.
Actually, there are decades of academic studies on whether M&A is profitable for the buyers, the results of which are . . . . inconclusive.
Preliminarily, as to the premise of that question, the aggregate amounts spent around the world by companies to buy businesses is large and growing. According to Reuters, “Global M&A volumes topped $5 trillion for the first time ever [in 2021], comfortably eclipsing the previous record of $4.55 trillion set in 2007, Dealogic data showed. The overall value of M&A stood at $5.8 trillion in 2021, up 64% from a year earlier, according to Refinitiv” (here).
Incentivizing ESG
By “relatively” easy, what I mean is relative to what it takes to convince corporate executives to spend money on environmental and social issues.
It is much harder even to find data on ESG-focused spending by corporations. Note the omission of such data here (“Global Survey Finds Businesses Increasing ESG Commitments, Spending”), here (“Five ways that ESG creates value”) and here (“Executives Say Big Increase in ESG and Sustainability Investment Coming”). Data on ESG-focused investing by investors is plentiful, but that is different than spending by corporations.
The available data on ESG spending by corporations (see “Companies Spend Big on ESG Investments, Hoping for Long-Term Payoff”, Wall Street Journal (June 14, 2021), here) suggests that such spending, including spending on acquisitions in furtherance of ESG goals, a new hot topic, is a tiny fraction of spending on M&A. The Wall Street Journal article ends with the thoughts of one corporate executive: “it remains difficult to pinpoint potential returns that socially responsible investments will yield . . . ‘Sometime[s] we just recognize that it’s very difficult to put a number’ on it, he said.”
The Financial and Stock Price Impact of M&A
In fact, it is also apparently very difficult to pinpoint potential returns from M&A investments.
Academic studies on the investment returns of M&A are numerous and varied. There are size, geographic and industry-based studies, studies of deals in emerging versus mature markets, studies that compare cash to stock deals and friendly to hostile deals, studies that compare short-term and long-term impacts, and studies that investigate many other factors (e.g., “we examine the determinants of merging firms’ choice of a common or separate mergers and acquisitions adviser and the consequences of this choice on several deal outcomes”, here, and “our findings suggest that investment banks matter for M&A outcomes, and contrast earlier studies that show no positive link between various measures of advisor quality and M&A returns”, here).
There are, invariably, different methodologies employed in different studies. Furthermore, there are groups of studies that measure whether a deal is successful based on financial metric performance and others that measure based on stock price performance.
I found a 2012 doctoral thesis (here) that seems to do a thorough job of summarizing the results of all these studies, as follows:
I present a survey of studies that estimate the effects from M&A on firms’ profitability, market share, market power, productivity, employment, skill-intensity, and wages, and I provide an overview of the empirical results over the last decades. For each performance parameter, I will first provide an overview of earlier studies, and then present the results from recent studies, mostly published since year 2000. I will show that the results are often ambiguous. . . . I discuss why empirical analysis does not give clear answers about effects of M&A. . . .
From a theoretical point of view, the average merger should generate positive profits if managers maximize profits and have rational expectations. . . . . Nevertheless, empirical studies provide a different picture and present ambiguous results. . . . The conclusion from a large number of empirical studies from the last decades about effects from M&A on profits is that mergers do not necessarily increase profits, and it seems even more likely that a large proportion of mergers even decrease merging firms’ profits.
If mergers are motivated by profit maximizing reasons, productivity changes after M&A are expected to be positive. . . . Summarizing, the majority of earlier studies concluded that M&A reduces productivity, and this is in line with the results from several studies identifying a negative impact of M&A on profits. . . . In contrast to these earlier studies, a large majority of recent studies found positive productivity effects, . . . [h]owever, this seems somewhat puzzling with respect to the results from studies about the effects on profits and sales. . . .
Event studies are a different way to assess the success of mergers. The methodology goes back to Fama, Fisher, Jensen, and Roll (1969) and analyzes abnormal returns of stock prices around the announcement of an acquisition. . . . However, event studies are also not able to present an unambiguous picture about effects of M&A.
So far, empirical studies about effects of M&A do not present an unambiguous picture. Instead, studies even find opposing effects. . . . The large number of studies that found profit losses after mergers suggest that a high fraction of managers do not merge for profit maximizing reasons.
I am confident that there is ongoing research about the profit and stock price impact of M&A. My point is NOT to suggest that I think that M&A, either generally or in any specific context or from any particular perspective, is not good in any way. To the contrary, my point is that the profit and stock price impact of M&A is quite definitely unclear based on decades of academic research, more or less in the same way that it is very difficult to pinpoint potential returns from ESG investments.
Non-Financial Incentives
So, why is it relatively easy to motivate corporate executives to spend money buying other companies and relatively hard to motivate corporate executives to spend money on ESG?
As one would expect, there are a bunch of theories about what motivates corporations to buy businesses notwithstanding the data referred to above. The same 2012 doctoral thesis discusses a long list of potential motivations:
The “empire building” hypothesis posits that managers merge because they pursue the firm’s size growth instead of profit maximization. One explanation for this is the positive correlation between managers’ income and the firms’ size. Other explanations are the pursuit of non-monetary goals like increased power or prestige.
The “free cash flow” hypothesis posits that firms merge because they have excess cash flow, which they do not wish to pay out to shareholders.
The “hubris” hypothesis posits that acquisitions happen because managers overestimate their M&A competence and claim to have better knowledge than the efficient capital market about the target’s true value.
The “speculative motives” hypothesis posits that mergers are caused by profits to be earned by service providers (consultants, bankers, lawyers, accountants).
The “adaptive (failing firm)” hypothesis posits that mergers are seen as an alternative to bankruptcy, but that theory mostly explains the actions of the target, rather than the buyer in any transaction.
The “market for corporate control” hypothesis posits that corporate acquisitions are motivated by differences in the ratio of market values to book values of firms’ assets.
The “economic disturbance” hypothesis posits that corporate acquisitions arise from expectations about future profits of targets.
There are two hypotheses about “financial efficiencies”. The first posits that acquisitions occur because bigger firms have lower borrowing costs than smaller firms. The second posits that risk pooling, rather than the cost of capital, is the determining factor.
The “capital redeployment” hypothesis posits that multidimensional organized firms are able to establish an internal capital market, and thus, avoid the dangers of external capital markets.
As the doctoral thesis notes, “of course, no single hypothesis about M&A is able to explain all mergers, but all hypotheses are able to explain at least some of them”. One study tested which of the competing hypotheses seemed most impactful, and concluded that it is plausible to identify the hubris hypothesis as that one. Coming in second was the empire building hypothesis.
The Speculative Motives Hypothesis and ESG
A few papers presented at a June 2021 Global Corporate Governance Colloquia Conference at Yale (here) considered similar questions concerning motivations relating to ESG. One paper considered the way corporate action on environmental and social issues is impacted by retail investors (here). Two papers considered how legal requirements influence corporate action on environmental issues (here and here).
A fourth paper, which was most interesting to me, is entitled “The Corporate Governance Machine” (here). It argues that “in the United States, corporate governance has become a ‘system’ composed of an array of institutional players, with a powerful shareholderist orientation.”
More specifically, the article makes two points, one of which seems exactly right to me, and the second of which seems debatable. The exactly right point is a premise, implied but not explicitly fleshed out. The premise is that focusing on the “system”, or the infrastructure of players and their perspectives and the connections among them, is the key to thinking about motivating corporate conduct. In other words, the premise is that in making strategic decisions executives are highly influenced by the context in which they operate. That seems highly intuitive, but I would argue that it is not trivial. Executives (like most others of us) react to the internalized, seemingly natural, understandings of the players that form their environment, even when their actions (e.g., speculative spending on M&A) would be more highly scrutinized by them in a different environment.
The debatable point is that the current powerful shareholderist orientation is unlikely to change in the short or medium term.
The important point, for my purposes at the moment, is that the paper argues that ESG investment decisions in the U.S. are motivated in significant ways through a mechanism similar to that posited by the speculative motives hypothesis for explaining M&A investment.
The System
The paper describes an infrastructure of actors that underlies a broadly accepted notion concerning corporate governance: “a vast array of institutional players—proxy advisors, stock exchanges, ratings agencies, institutional investors and associations—enshrine shareholder primacy in public markets”. According to the paper, the infrastructure consists of not just those institutional players, but also state and federal laws, the regulatory orientations of the Securities Exchange Commission and the U.S. Department of Labor, particularly influential investors, industry associations, the sponsors of stock indexes, professional education organizations, the media and political interests.
Referring to the infrastructure as a “system” and a “machine” implies something sinister that it is not clear the article intended to imply. But the paper seems right that we have an infrastructure of actors that developed from and that currently support a broadly accepted view about the purpose of the corporation. The view is that corporations naturally should be singularly focused on shareholder value, and that it is odd to think that corporations should be expected to devote resources to social and environmental issues that do not directly impact their ability to make profits. The view is not in fact a natural law, as evidenced by the fact that it wasn’t always so in the U.S. But it has been accepted to a very high degree.
A comparable system exists in the world of M&A. Delaware and federal laws, and regulators, are very accommodating to M&A activity, taking into account and including the antitrust regulators. Activists and other deal-making investors have huge influence. The market is focused on potential acquisition activity because of the potential for very short-term gain. There are very large groups of service-providers, whose livelihoods depend on M&A activity, and M&A activity is amply served by the media as well as political interests, as evidenced by the long-running carried interest legislative drama. Numerous professional and educational groups and institutions support the activity. Courts focus on developing an accommodating and clear legal environment for M&A activity.
In sum, the amount of corporate investment in M&A is significantly influenced by the existence of a whole metaverse of actors motivating corporate executives to do deals. More than ESG metrics in annual bonus plans, ESG needs more of that kind of motivation.
Long-Term Likelihood of Change
The Corporate Governance Machine article concludes with the following summary:
The key point is that as the shareholder primacy viewpoint has become enmeshed in our cultural and institutional understanding of good governance, and as multiple powerful players operate as gatekeepers for the shareholder primacy norm, it becomes difficult to move to another paradigm—one that gives power to other stakeholders or allows corporate executives to make decisions based on the corporate entity, overall social value, or something else. And without a substantial shock to the system, such as a federal chartering requirement directing companies to adopt a stakeholder governance model, stakeholderism is unlikely to dethrone shareholder primacy as the dominant decision making framework.
How persuasive is that conclusion? I am not inclined to be overly optimistic, but it seems to me that the article itself explains why that view is too pessimistic.
Sure, the effort to change the system is encountering, and will continue to encounter, a lot of pushback. There are a lot of entrenched interests. But as the article’s very good summary of the history of the corporate purpose debate itself notes, the pendulum swings:
[In 1932], Adolf Berle and Gardiner Means published their . . . landmark book, The Modern Corporation and Private Property. Building on earlier thinkers, Berle and Means documented the rise of large corporations with dispersed stock and the weakening of shareholder control. But instead of concluding the solution was to reestablish shareholder power as it had existed before the rise of giant industrial companies, they highlighted that the transformation of American capitalism called for a more profound rethinking of “the ends for which the modern corporation can or will be run.” . . . Berle and Means’ vision of corporate managers as socially responsive trustees came to fruition as the economy recovered after World War II. By the mid-twentieth century, “managerial capitalism” reached its zenith, in which “neither boards nor shareholders acted as a robust check on potentially wayward executives.” . . .
The 1970s mark the key inflection point that started to turn the tide away from managerial capitalism and set in motion our contemporary system. [In 1976], economist Michael Jensen and business school dean William Meckling injected the economic concept of agency costs into debate about corporations. A normative overlay of what constitutes “good” corporate governance swiftly emerged and came to predominate debates in law and business. . . . In all, the principal-agent model provided the simple, sticky idea that had been lacking—“a workable model of how a corporation behaves internally.” In 1982, for example, Daniel Fischel wrote in The Corporate Governance Movement: “As residual claimants on the firm’s income stream, shareholders want their agents—the firm’s managers—to maximize wealth.”
Conclusion
The social and environmental issues facing the U.S. (well, and other markets around the world) seem significant enough to force a change in perspectives about corporate purpose from those that evolved in the 1970s. The argument that the only acceptable purpose of a corporation is to increase corporate profits seems not very persuasive in the current environment. The very large amounts of money that corporations spend on M&A illustrates that highly certain prospects of profits are not the only carrot that can motivate corporate executives to act. ESG advocates should focus on building networks of all of the diverse stakeholders and thought leaders that can contribute to a change in perspective about the purpose of the corporation. It is possible that a new paradigm, more relevant to the time in which we live, will swiftly emerge and come to predominate debates, similar to what happened 50 years ago.