Family control and dilution in mergers

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1 Famly control and dluton n mergers * Nlanjan Basu ** Lora Dmtrova and *** Imants Paegls Current verson: Aprl, 007 JEL classfcaton: G3, G34 Keywords: Famly frms, mergers and acqustons * Assstant Professor of Fnance, John Molson School of Busness, Concorda Unversty, 1455 de Masonneuve Blvd. West, Montreal, Quebec H3G 1M8, Canada. e-mal: nbasu@jmsb.concorda.ca. Phone: (514) , ext Fax: (514) ** MSc. Student n Fnance, John Molson School of Busness, Concorda Unversty, 1455 de Masonneuve Blvd. West, Montreal, Quebec H3G 1M8, Canada. e-mal: l_dmtr@jmsb.concorda.ca *** Assstant Professor of Fnance, John Molson School of Busness, Concorda Unversty, 1455 de Masonneuve Blvd. West, Montreal, Quebec H3G 1M8, Canada. e-mal: paegls@jmsb.concorda.ca. Phone: (514) , ext Fax: (514) For helpful dscussons, we thank Sandra Betton and Dogan Trtroglu. We gratefully acknowledge fnancal support from the Insttut de Fnance Mathematque de Montreal (IFM ). We reman solely responsble for any remanng errors.

2 Famly control and dluton n mergers Abstract We examne the nfluence of famly control on value gans n mergers nvolvng newly publc famly frms. The spectrum of potental outcomes for foundng famles (no change n control, dluton, full ext) allows us to observe the nfluence of the level as well as the change n famly ownershp on value creaton n mergers. We fnd that foundng famles wth low levels of ownershp ndulge n value-reducng acqustons and are more lkely to use cash as the medum of exchange (thus avodng dluton and mantanng ther control of the frm). Famles wth hgh levels of ownershp, on the other hand, make value-creatng acqustons. The dluton of the famly s ownershp due to the use of stock as the medum of exchange changes the famly s ncentves and thus nfluences frm value. Fnally, we fnd that acqustons of targets wth low levels of famly ownershp are assocated wth greater value creaton. Overall, our results are consstent wth the entrenchment of the foundng famly at low levels of ownershp and a better algnment of the nterests of the foundng famly and those of mnorty shareholders at hgh levels of ownershp.

3 Famly control and dluton n mergers 1. Introducton Foundng famles represent a unque group of actve, long-term owners, holdng concentrated equty postons n ther frms. Frst, ther ownershp s usually concentrated n the hands of a sngle ndvdual (as opposed to a group of top managers). Second, foundng famles are also actvely nvolved n the management and governance of ther frms. Thrd, famles mantan a long-term nvestment horzon snce the ntergeneratonal transfer of manageral control s a stated objectve of most famly frms. Yet, despte ther sgnfcant presence even n mature publc frms and ther unqueness due to the characterstcs mentoned above, foundng famles only recently have started to receve attenton n the academc lterature. Most of ths emergng lterature has focused on mature and ndex-lsted famly frms (see, e.g., Anderson and Reeb, 003; Vllalonga and Amt, 006), whle the newly publc famly frms have receved very lttle attenton. It s, however, n the newly publc frms that the costs and benefts of famly ownershp are lkely to be more pronounced. Frst, as ponted out by Schwert (1985), the founder s probably the most mportant asset of the frm n ts formatve stages. Second, n ts early lfe, a frm does not yet have an establshed reputaton and has to rely heavly on the reputaton of the foundng famly. Thrd, n a newly publc frm, the foundng famly s lkely to own a sgnfcant fracton (majorty) of ts equty and exert a more sgnfcant and drect nfluence on the frm (ether postve or negatve) than t would n the mature stages. Fourth, as shown by Paegls and Trtroglu (005), newly publc famly frms are less lkely to be the subject of montorng and scrutny by varous fnancal market partcpants (such as fnancal analysts and nsttutonal nvestors), allowng the foundng famly a more unhndered control over the frm. In ths paper, we examne the relatonshp between famly control and value creaton n mergers that nvolve newly publc frms as ether acqurers or targets. Snce mergers affect famly 1

4 ownershp and control, they provde a unque opportunty to examne the effects of changes n famly ownershp on frm value. On one hand, famles that are acqurers n cash transactons do not face any dluton or reducton n ther control of the frm. Acqurers n stock-fnanced transactons, on the other hand, face some dluton of ther holdngs. Thus, cash-fnanced mergers allow us to observe the drect nfluence of famly ownershp on value gans n mergers, whle stock-fnanced ones allow us to examne the relatonshp between the dluton of famly ownershp and value creaton. Fnally, foundng famles of targets are left wth lttle or no ownershp n the merged entty and therefore experence an almost complete loss of control. If the foundng famly uses ts nfluence over the frm prmarly to derve prvate benefts of control or otherwse explot mnorty shareholders, ther loss of control would be seen by the market as a value-creatng event. If, on the other hand, the foundng famly s an asset to the pre-merger frm, ther ext would be vewed by the market as a value-destroyng event. Thus, the market reacton upon an acquston announcement wll reveal the foundng famly s nfluence on the pre-merger value of ther frm. Ths dsperson n potental outcomes for famly ownershp (.e., complete, partal, or no loss of control) provdes a rch dataset for us to test the relatonshp between famly ownershp and value. We fnd that famly ownershp s ndeed an mportant determnant of the returns earned by both acqurers and targets. For cash-fnanced acqustons, we fnd a negatve (postve) relatonshp between ownershp and acqurer abnormal returns upon the acquston announcement for frms wth low (hgh) famly ownershp. 1 The observed relatonshp s consstent wth the entrenchment of the famly at low levels of ownershp and an ncreasng algnment of the nterests of the famly and the mnorty shareholders at hgher levels of famly ownershp. For acqurers n stock-fnanced transactons, we fnd that the dluton of the famly s 1 Snce our results ndcate that the negatve relatonshp between ownershp and value reaches ts peak at around 30% famly ownershp, from now on, we wll refer to the ownershp levels below 30% as low, and those above 30% as hgh.

5 stake results n hgher (lower) abnormal returns when the pre-merger ownershp s low (hgh). Ths suggests that dluton s benefcal at low levels of ownershp (as t potentally reduces the entrenchment of the famly) and detrmental at hgh levels of ownershp (as t reduces the ncentve algnment). We perform two robustness tests. Frst, we examne the determnants of the choce of the medum of exchange. We fnd that an acqurer wth a low (hgh) level of famly ownershp s more (less) lkely to choose cash as the medum of exchange, ceters parbus. These fndngs mply that famles wth low levels of ownershp are more lkely to protect ther prvate benefts of control (whch, as reported above, are hgher for frms wth low levels of famly ownershp) and therefore less lkely to dlute ther holdngs by choosng stock as the medum of exchange. Frms wth a hgh level of famly ownershp, due to the better algnment of ther nterests wth those of mnorty shareholders, are less worred about the mantenance of ther control of the frm and therefore less lkely to choose cash as the medum of exchange. Second, snce as shown above, the choce of the medum of exchange s a functon of famly ownershp, the relatonshp between the abnormal returns and famly ownershp documented above could be drven by a self-selecton bas. Therefore, as an addtonal robustness test, we explctly control for ths possblty usng a swtchng regresson model wth endogenous swtchng. Our results are robust to ths correcton. Fnally, as dscussed above, the market reacton upon the announcement of a famlycontrolled target s acquston wll reveal (and be nversely related to) the foundng famly s nfluence on the pre-merger value of the frm. For targets acqured n cash-fnanced transactons, we fnd that, at low (hgh) levels of ts pre-merger ownershp, the famly has a postve (negatve) nfluence on the abnormal returns earned by the target upon the acquston announcement. In other words, the ext of a foundng famly wth a low level of ownershp s seen by the market as a value-creatng event, whle the ext of a famly wth a hgh level of ownershp s vewed as a 3

6 value-destroyng event. Our fndngs suggest that foundng famles wth low (hgh) levels of ownershp had a negatve (postve) mpact on the pre-merger value of ther frm. Agan, ths s consstent wth the entrenchment of the famly at low levels of ownershp and a better algnment of the nterests of the famly and the mnorty shareholders at hgh levels of famly ownershp. Our paper s related to and contrbutes to several areas of research. Frst, a growng body of research examnes the unque valuaton and control ssues assocated wth famly frms (see, among others, Anderson and Reeb, 003; Vllalonga and Amt, 006). Most of ths lterature, however, has focused on mature and ndex-lsted famly frms. We fll ths gap n the famly frm lterature by examnng newly publc famly frms. Second, an even larger body of lterature has studed the nfluence of manageral ownershp on the value creaton (or lack thereof) n mergers (see, e.g., Lewellen et al., 1985; Hubbard and Pala, 1995). Ths lterature has so far focused almost exclusvely on establshed frms. 3 Snce these frms have relatvely low levels of nsder ownershp, we have only a lmted understandng of the effect of hgh levels of nsder ownershp on value gans n mergers. In addton, there s lmted evdence on the relatonshp between famly ownershp and value creaton n mergers. 4 Our sample of newly publc famly frms ncludes a relatvely large number of frms wth hgh levels of famly ownershp. 5 Ths allows us to provde a more complete pcture of the costs and benefts of hghly concentrated ownershp. To our knowledge, the only paper that examnes newly publc famly frms s Paegls and Trtroglu (005). 3 For notable exceptons see Feld and Mulhern (1999) and Wggenhorn and Madura (004). 4 The only study on mergers of famly frm we are aware of s Ben-Amar and Andre (006) n whch they examne the dfferences n the market reacton upon the acquston announcements made by Canadan famly and non-famly frms. They, however, do not examne the relatonshp between famly ownershp and the resultng changes n control, on the one hand, and abnormal returns upon the merger announcement, on the other. In addton, ther focus s on famly frms as acqurers (.e., they do not study acqustons of famly-controlled targets). 5 th For frms used by Lewellen et al. (1985) and Hubbard and Pala (1995), the 80 percentle of nsder ownershp s between 10 and 1%. In contrast, for frms n our sample the 80 th percentle of famly ownershp s 47.1%. 4

7 Fnally, another strand of the lterature on mergers and acqustons focuses on ssues related to ownershp and control. In partcular, Amhud et al. (1990) and Martn (1996) have examned the relatonshp between nsder ownershp and the lkelhood of usng stock as the medum of exchange. The use of stock and the resultng changes n control, n turn, should also nfluence frm value. However, to our knowledge, the above relatonshp has not been studed n the lterature. We provde evdence that changes n nsder ownershp resultng from the use of stock as the medum of exchange have a sgnfcant mpact on the value creaton n mergers. The rest of the paper s organzed as follows. Secton develops the hypotheses that wll serve as the bass for our emprcal tests. Secton 3 revews the characterstcs of our sample, whle secton 4 descrbes our methodology and reports results. Secton 5 concludes.. Theory and hypotheses Famly ownershp can nfluence the frm value n two offsettng ways. Frst, ncreasng famly ownershp should better algn the nterests of the famly wth those of mnorty shareholders, and thus enhance frm value. In partcular, Jensen and Mecklng (1976) argue that ncreased manageral ownershp leads to a non-lnear decrease n the agency costs of equty by reducng ncentves to consume perqustes and to exproprate wealth from mnorty shareholders. In addton, Leland and Pyle (1977) argue that manageral ownershp can serve as a postve sgnal of a frm s value. From now on, we wll refer to the postve nfluence of ownershp on frm value as the ncentve algnment effect. Second, ncreasng ownershp may also lead to the famly s entrenchment and the use of value-reducng polces wthout the fear of shareholder actvsm. 6 From now on, we wll refer to the negatve nfluence of ownershp on frm value as the entrenchment effect. The extent to whch one or the other of these two effects wll domnate at a partcular level of famly ownershp s an emprcal ssue. 6 See e.g., Stulz (1988), McConnell and Servaes (1990), and Morck et al. (1988). 5

8 Snce acqurers n cash-fnanced transactons experence no loss of control, the returns earned by such acqurers are expected to depend on the value generated by the transacton, whch, n turn, wll be nfluenced by the extent to whch the famly s ncentves are algned wth those of the mnorty shareholders as well as the extent of the famly s entrenchment. Ths leads to our frst testable hypothess. Hypothess 1: The market reacton upon the announcement of a cash-fnanced acquston wll reflect the nfluence of famly ownershp on frm value. The partcular shape of ths relatonshp wll depend upon the relatve mportance of the ncentve algnment and the entrenchment effects at varous levels of famly ownershp. For acqurers n stock-fnanced transactons, there s some loss of control due to the dluton of ther shareholdngs. The mportance of ths dluton and therefore the market reacton to t, wll depend on the domnance of ether the ncentve algnment or the entrenchment of the famly at any gven level of ownershp. In partcular, over the range of ownershp for whch the ncentve algnment effect domnates the entrenchment effect, dluton wll be detrmental snce t leads to a reducton n the algnment of ncentves. Over the range of famly ownershp for whch the entrenchment effect domnates the ncentve algnment effect, however, we expect the dluton to have a benefcal nfluence on the frm value. Frst, any reducton n the level of famly s entrenchment should lead to an ncrease n the frm value. Second, an entrenched famly s choce of stock as the medum of exchange can, by tself, sgnal the famly s ntenton not to exproprate wealth from mnorty shareholders. In partcular, consder a settng n whch the market vews all founders of frms wth a certan level of famly ownershp as entrenched. 7 In such a settng, dluton credbly sgnals that the famly s presence n the frm s not motvated prmarly by the prvate benefts of control. Ths s because the resultng reducton n the famly s control over the frm ncreases the lkelhood of the famly s ouster (by ether mnorty shareholders or other 7 Ths s lkely to be the case for the newly publc famly frms studed n ths paper snce the market has not yet had enough tme to dstngush between good and bad founders. 6

9 players n the market for corporate control). Therefore, only famles that are less lkely to exproprate wealth from mnorty shareholders would choose stock as the medum of exchange. Thus, our second testable hypothess s as follows. Hypothess : For stock-fnanced acqustons, the relatonshp between abnormal returns and famly ownershp observed for cash-fnanced acqustons should be at least partally reversed by the dluton effect workng n the opposte drecton. We now turn to the dscusson of our hypotheses on the target sde. In cash-fnanced transactons, the foundng famly of the target ends up wth no stake n the merged entty. In other words, an acquston of a famly-controlled target n a cash-fnanced transacton results n a complete loss of control by the foundng famly and therefore provdes evdence on the value of famly ownershp n the pre-merger frm. If the foundng famly uses ts nfluence over the frm prmarly to derve prvate benefts of control or otherwse explot mnorty shareholders, ther loss of control would be seen by the market as a value-creatng event. If, on the other hand, the foundng famly s an asset to the pre-merger frm, ther ext would be vewed by the market as a value-destroyng event. 8 Therefore, our thrd hypothess s as follows. Hypothess 3: The market reacton upon the announcement of a cash-fnanced acquston of a famly-controlled target wll reflect the value of famly ownershp n the pre-merger frm. The partcular shape of ths relatonshp wll depend upon the relatve mportance of the ncentve algnment and the entrenchment effects at varous levels of famly ownershp. Fnally, there are two potental reasons why the market reacton to a stock-fnanced acquston of a famly-controlled target may dffer from that to a cash-fnanced one. Frst, the foundng famly can become a blockholder n the merged frm and thus mprove the montorng 8 For potental reasons why ether entrenched or ncentve-algned famly would decde to ext ther frm, see Klasa (005), who reports that exts of foundng famles are largely motvated by personal (e.g., the age of the founder and the absence of famly successors) rather than frm characterstcs. 7

10 of the acqurng frm s management. Second, as dscussed by Chang (1998), there are two reasons why the acquston of a closely-held target may be characterzed by a lower level of asymmetrc nformaton between the acqurer and the target, and therefore result n a more postve market reacton (as compared to a stock-fnanced acquston of a target wth dspersed ownershp). In partcular, the acqurer s managers are more lkely to dsclose ther prvate nformaton to the founder of ther target (who s lkely to own a large fracton of the frm s shares) rather than to a large number of dspersed shareholders. Also, the famly wll evaluate the acqurer s future prospects carefully because a sgnfcant proporton of ther wealth s lkely to be nvested n the acqurer s shares after the merger. To put t dfferently, the foundng famly s acceptance of the acqurer s stock can be seen as a certfcaton of the value of the offer. Both of these effects (blockholder creaton and certfcaton) are lkely to ncrease the value of acqurer s shares whch the famly wll own after the merger. Further, the mportance of both of these effects s ncreasng wth the famly ownershp n the target, ceters parbus. Ths, n turn, mples that the pure lossof-control effect observed n the case of cash-fnanced acqustons wll be at least partally mtgated n the case of stock-fnanced acqustons of famly-controlled targets. Ths leads to our fourth testable hypothess. Hypothess 4: In the case of a stock-fnanced acquston of a famly-controlled target, the loss of control effect observed n the case of a cash-fnanced acquston of a famlycontrolled target wll be mtgated by the potental benefts of the target s foundng famly becomng a blockholder n the merged frm and / or by the famly s certfcaton of the acqurer s value, especally n the case of a hgh famly ownershp n the target. 3. Data and sample selecton Venture captalsts have been shown to nfluence (1) the replacement of founders (Hellman and Pur, 00); () the market s percepton of survvng founders n venture-backed 8

11 frms (Paegls and Trtroglu, 005); and (3) the post-ipo merger decsons of the venture-backed frms (see, e.g., Masuls and Nahata, 006). Therefore, to examne the drect nfluence of famly ownershp on the value creaton n mergers and acqustons, we exclude venture-backed frms from our sample. Our ntal sample, consstng of 7 non-venture-backed US frms that went publc between 1993 and 000, s obtaned from the SDC New Issues database. We exclude fnancal acqurers and targets (defned as frms wth SIC codes startng wth 6) from our sample and requre both the targets and the acqurers to be publc frms. We classfy the frms as ether famly or non-famly, based on the nformaton n the management sectons of IPO prospectuses. We then use the SDC Mergers & Acqustons database to dentfy all mergers nvolvng our sample frms that occurred between the tme of the IPO and December 31, 004. We exclude fnancal acqurers and targets (defned as frms wth SIC codes startng wth 6) from our sample and requre both the targets and the acqurers to be publc frms. The acquston announcement dates are confrmed by searchng Factva (formerly Dow Jones News Retreval) for up to a year before the announcement date reported n the SDC Mergers & Acqustons database. Ths ensures that we have dentfed the frst announcement of a partcular merger. Fnally, we collect the data on the foundng famly s pre-merger ownershp from the closest proxy statement precedng the acquston announcement. Our fnal sample, descrbed n Table 1, conssts of 103 acqurers and 118 targets. It s nterestng to note that famly frms seem to prefer cash as the medum of exchange. In partcular, whle almost one half of famly acqurers chose cash as the medum of exchange, only about one thrd of non-famly frms dd so. In the next secton we explore ths dfference n detal. Table provdes summary statstcs of the ndependent varables used n our emprcal tests. The average (medan) famly ownershp for acqurers n our sample s 36.% (37.9%), whle the correspondng values for targets are 30.3% (6.7%). The average (medan) frm age at the tme of acquston s 9.3 (18) years for acqurers and 17.4 (15) years for targets. The 9

12 average (medan) market captalzaton for acqurers s $919 (96) mllon, whle the correspondng number for targets s $17 (94) mllon Emprcal tests and results Ths secton descrbes the testng methodology and reports results for acqurers and targets n Sectons 4.1 and 4., respectvely Famly ownershp and acqurer returns Basc results To better understand the role of famly ownershp n mergers, we regress the cumulatve abnormal returns (CARs) earned by the acqurers upon the acquston announcement on several explanatory and control varables as descrbed by the followng equaton: CAR = β + β 0 + β 1FAMOWN + βfamownsq + β3stock + β4famstock 5FAMSTOCKSQ + β6lmkt + β7lfage + β8relsize + ε (1) The dependent varable s the CAR over a two-day event wndow startng on the announcement date. 10 To allow for non-lnearty n the relatonshp between famly ownershp and value creaton n mergers, we use a quadratc specfcaton. 11 FAMOWN s the famly ownershp n the acqurng frm, as reported n the closest proxy statement precedng the acquston announcement. 1 FAMOWNSQ s famly ownershp squared. STOCK s a dummy varable that takes on a value of one f the medum of exchange s stock, and zero otherwse. FAMSTOCK and FAMSTOCKSQ are constructed by multplyng STOCK wth FAMOWN and FAMOWNSQ, 9 In comparson, Anderson and Reeb (003), who study mature and S&P500-lsted famly frms, report an average famly ownershp of 17.88% and the average total assets of $9.6 bllon for ther sample frms. 10 We have also used cumulatve abnormal returns over varous other event wndows as dependent varables. The results are qualtatvely unchanged. 11 We have also replcated the results reported below usng a pecewse specfcaton wth the Morck et al. (1988) cut-offs of 5 and 5%. The results are qualtatvely unchanged n ths alternatve specfcaton. 1 Our measure of famly ownershp s the percentage of votng rghts controlled by the foundng famly. In these and subsequent tests we have also used the dfference between cash flow rghts and votng rghts as an addtonal control varable. In addton, we have also replcated all the results excludng frms wth the dual class share structure. The results are qualtatvely unchanged n these alternatve specfcatons. 10

13 respectvely. LMKT s the natural log of market captalzaton, measured on the 0 th tradng day precedng the acquston announcement. LFAGE s defned as the natural log of one plus the number of years between ether the year of ncorporaton or the start of operatons, whchever s earler, and the tme of the acquston announcement. RELSIZE s the value of the target as a fracton of the market captalzaton of the acqurer. 13 As dscussed above, cash-fnanced acqustons provde the cleanest evdence about the nfluence of famly ownershp on value gans n mergers snce the counteractng effect of dluton s not present. Therefore, the sgns of the coeffcents β and β 1 wll depend only upon the relatonshp between famly ownershp and value created or destroyed by the merger. In partcular, as descrbed n Secton, ncreasng famly ownershp could be assocated wth both a better algnment of famly s ncentves wth those of mnorty shareholders and a greater entrenchment of the foundng famly. If the entrenchment effect domnates the ncentve algnment effect at low levels of famly ownershp, whle the opposte s true at hgh levels of ownershp, we expect β 1 to be negatve and β to be postve. If, on the other hand, the ncentve algnment effect domnates the entrenchment effect at low levels of ownershp, whle the opposte s true at hgh levels of ownershp, we expect β 1 to be postve and β to be negatve. Any stock-fnanced merger, on the other hand, wll result n a dluton of the famly s control. The coeffcents β 4 and β 5, therefore, are expected to capture the market s percepton of the value of the dluton effect due to the use of stock as the medum of exchange. In partcular, ths dluton effect s expected to have a postve (negatve) nfluence on the value creaton for the range n whch the entrenchment (ncentve algnment) effect domnates. Thus, the sgns of the coeffcents of β 4 and β 5 are expected to be mrror mages of those of β 1 and β. As dscussed n Secton, there are two nterrelated sources of the value gans due to the dluton over the range of ownershp n whch the foundng famly s entrenched. Frst, dluton 13 We have also used year dummes as addtonal control varables to control for the varaton n the merger actvty across years. The results are qualtatvely unchanged n ths alternatve specfcaton. 11

14 reduces the level of famly s entrenchment and thus ncreases frm value. Second, dluton can be seen as a credble sgnal of the foundng famly s ntentons not to engage n value-reducng actvtes. The frst source of value creaton should be present for all stock-fnanced acqustons as any value gans are drectly related to the level of dluton resultng from a partcular merger. The second one, however, s lkely to be more pronounced for the very frst acquston announced by the frm after gong publc. By the tme of subsequent acqustons, any sgnalng benefts should be at least partally reflected n the stock prce and therefore have a mnmal mpact on the value creaton. To dstngush between the two sources of value gans from dluton dscussed above, we report the results for the full sample as well as for the subsample that ncludes only the frst acquston by each acqurer. For all our tests on the acqurer sde (Tables 3 to 5), n columns 1 and we report the results for the full sample, whle n columns 3 and 4 we report the results for the subsample that ncludes only the frst acquston by each acqurer. The emprcal tests of Eq. (1) are reported n Table 3. For cash-fnanced acqustons, we fnd that the coeffcent estmate for β 1 s negatve, whle the coeffcent estmate for β s postve for all specfcatons. Both coeffcent estmates are statstcally sgnfcant at the 1% level. Ths mples a convex relatonshp between famly ownershp and the market reacton upon an announcement of a cash-fnanced acquston. In partcular, we fnd that the abnormal returns decrease wth famly ownershp untl ownershp reaches 8%, and then ncrease. At ts lowest pont, the dfference n the CARs between famly and non-famly frms reaches 7.6%. Our results suggest that the foundng famly makes value-enhancng decsons at hgh levels of ownershp and value-reducng decsons at low levels of ownershp. For stock-fnanced acqustons, consstent wth our predctons, the sgns of the coeffcent estmates for β 4 and β 5 are opposte of those for β1 and β and both are statstcally sgnfcant at the 1% level. Our results suggest that n stock-fnanced acqustons, the value 1

15 destructon due to the entrenchment of the foundng famly (observed for cash-fnanced acqustons by frms wth low levels of famly ownershp) s offset by the benefts stemmng from the dluton of such entrenchment. At the same tme, the value creaton due to the algnment of ncentves (observed for cash-fnanced acqustons by frms wth hgh levels of famly ownershp) s offset by the reducton n the ncentve algnment resultng from the dluton. If dluton s the underlyng factor explanng the dfference n the nfluence of famly ownershp on the abnormal returns between cash- and stock-fnanced acqustons, we expect to observe a statstcally sgnfcant relatonshp between the dluton of famly s ownershp stake and the abnormal returns upon the acquston announcement. We further examne ths conjecture by estmatng the followng regresson: CAR = β 0 + β1dilution + βhigh + β3dilution _ HIGH + + β5lmkt + β6lfage + β7relsize + ε β 4STOCK () DILUTION s a rato of the dfference between famly s pre- and post-merger ownershp to ts pre-merger ownershp. 14 The post-merger ownershp s obtaned from the frst proxy statement after the effectve date of the merger. Snce the nfluence of dluton s expected to vary wth the level of famly ownershp, we frst create a dummy varable, HIGH, that takes on a value of one f before the merger the famly controls more than 50% of votng rghts, and zero otherwse. 15 We then create an nteractve dummy varable, DILUTION_HIGH, by multplyng DILUTION wth HIGH. At low levels of famly ownershp, dluton s expected to have a postve nfluence on the abnormal returns snce t ether reduces the famly s entrenchment and / or sgnals that the famly s presence n the frm s not motvated prmarly by the prvate benefts of control. 14 We have also used the absolute dfference between famly s pre- and post-merger ownershp as our measure of dluton. The results are qualtatvely unchanged n ths alternatve specfcaton. 15 Our choce of the 50% cut-off s based on a framework smlar to Stulz (1988). Beyond that pont there s no addtonal entrenchment of the nsders and any ncrease n ownershp can only better algn the nterests of majorty and mnorty shareholders. We have also estmated Eq. () usng two alternatve defntons of HIGH (wth 45% and 55% ownershp cut-offs). The results are qualtatvely unchanged n these alternatve specfcatons. 13

16 Therefore, we expect the sgn of the coeffcent β 1 to be postve. At hgh levels of famly ownershp, on the other hand, dluton s expected to have a negatve nfluence on the abnormal returns snce t reduces the ncentve algnment. Consequently, the sgn of the coeffcent β 3 s expected to be negatve. The results are reported n Table 4. As expected, the coeffcent estmate for β 1 s postve n all specfcatons. It s, however, statstcally sgnfcant only for the subsample of frst acqustons (columns 3 and 4). Our results suggest that the relatonshp between the dluton of famly ownershp and acqurer returns at low levels of famly ownershp s drven prmarly by the sgnal nherent n the choce of stock as the medum of exchange. The coeffcent estmate for β 3 s negatve and statstcally sgnfcant at the 1% level. The magntude of the coeffcent estmate for β 3 s also economcally meanngful. In partcular, a 5% dluton n the ownershp of famles wth hgh pre-merger equty stakes leads to about 1.5% declne n the abnormal returns upon the acquston announcement. Ths declne s roughly equal to 75% of the average abnormal return upon the announcement of a stock-fnanced acquston for our sample frms. Our results suggest that dluton of famles wth hgh levels of ownershp due to the use of stock as the medum of exchange results n a negatve market reacton. Ths s consstent wth the reduced ncentve algnment between foundng famly and mnorty shareholders. As an addtonal robustness test, we examne the relatonshp between famly ownershp and the choce of the medum of exchange by estmatng the followng logt regresson: STOCK * = β + β FAMOWN + β FAMOWNSQ + β LMKT + β LFAGE β RELSIZE + β CDEAL + ε (3) STOCK * denotes a latent contnuous varable that proxes for the propensty to use stock as the medum of exchange. STOCK takes on a value of one f STOCK * s greater than zero, and zero otherwse. CDEAL s the rato of acqurer s holdngs of cash and marketable securtes at the end of the fscal year precedng the acquston announcement to the value of the transacton. We 14

17 hypothesze that entrenched famles are more lkely to be nterested n preservng ther control of the frm and therefore more lkely to choose cash as the medum of exchange. Famles, for whch the ncentve algnment effect domnates the entrenchment effect, on the other hand, are more lkely to do what s best for the frm, even f t results n some loss of control. 16 Therefore, snce our fndngs above mply entrenchment of famles wth low levels of ownershp and ncentve algnment of famles wth hgh levels of ownershp, we expect the coeffcent β 1 to be negatve and the coeffcent β to be postve. The results are reported n Table 5. As expected, the coeffcent estmate for β 1 s negatve, whle the coeffcent estmate for β s postve. Both coeffcent estmates are statstcally sgnfcant at the 5% level. Our results are also economcally sgnfcant. In partcular, the lkelhood of a stock acquston s declnng from 70% for non-famly frms to around 40% for frms wth famly ownershp of 40% and then starts ncreasng. Our results suggest that control consderatons nfluence the choce of the medum of exchange n acqustons. In partcular, famles wth low levels of ownershp, who, as shown above, are more lkely to be entrenched, are more lkely to avod dluton and therefore more lkely to choose cash as the medum of exchange. Incentve algnment at hgh levels of famly ownershp, on the other hand, leads to a lower lkelhood of cash as the medum of exchange Robustness tests Snce, as shown above, the choce of the medum of exchange s a functon of famly ownershp (and therefore endogenous), the coeffcent estmates of STOCK (and nteractve dummes based on t) n Eq. (1) may be nconsstent (for detals see Appendx). To correct for ths 16 The choce of stock as the medum of exchange n ths case ndcates that the benefts of usng stock (due to, for example, asymmetrc nformaton about both the acqurer and the target, or tax consderatons) exceed the value loss due to the reduced algnment of the foundng famly s ncentves wth those of mnorty shareholders. 15

18 17 potental self-selecton bas we use the swtchng regresson model wth endogenous swtchng. In partcular, we estmate the followng model: STOCK * = γ + ε (4.1) Z CARcash _ X 1 + u1 = β (4.) CARstock _ X + u = β (4.3) Equaton (4.1) s the selecton equaton as specfed by Eq. (3). The sample s then splt nto two groups based on the medum of exchange. The second-stage equatons, Eqs. (4.) and (4.3), estmated separately for the cash-fnanced acqustons and the stock-fnanced ones, respectvely, are specfed as follows: CAR RELSIZE + u = β0 + β1famown + βfamownsq + β3lmkt + β4lfage + β5 (5) 18 We use CDEAL as an nstrumental varable. The model s estmated usng the full nformaton maxmum lkelhood method. 19 The results of the estmaton of Eqs. (4.) and (4.3) are reported n Table 6. We fnd that for cash-fnanced acqustons, even after controllng for the self-selecton bas, there s a negatve (postve) and statstcally sgnfcant relatonshp between famly ownershp and abnormal returns upon an acquston announcement at low (hgh) levels of famly ownershp. For stockfnanced acqustons, however, nether of the coeffcent estmates of FAMOWN and FAMOWNSQ s statstcally sgnfcant. We test for the equalty of the coeffcent estmates of FAMOWN and FAMOWNSQ across the two equatons usng a Wald-test and fnd that they are statstcally sgnfcantly dfferent. In addton, the lkelhood rato (LR) test fals to reject the ndependence of the two equatons. Our fndngs suggest that OLS results reported n prevous subsecton are not drven by a self-selecton bas. 17 For a detaled dscusson of ths model, see Maddala (1983). Ths model has also been used by Dunbar (1995) and Fang (005). 18 We have also used the target s market-to-book rato as an nstrument (see Carleton et. al, 1983, who argue that ths rato s postvely correlated wth the potental captal gans tax lablty of target frm shareholders). Our results are qualtatvely unchanged n ths alternatve specfcaton. 19 For the detals of the model estmaton, see Appendx. 16

19 Summary Overall, our fndngs on the acqurer sde can be summarzed as follows. Frst, we fnd that frms wth low levels of famly ownershp make value-reducng acquston decsons, whle frms wth hgh levels of famly ownershp make value-creatng acquston decsons. We conjecture that ths s due to the entrenchment of foundng famles wth low levels of ownershp and the ncentve algnment at hgh levels of famly ownershp. Ths conjecture s further supported by our fndng that frms wth low levels of famly ownershp are more lkely to choose cash as the medum of exchange and thus preserve ther control of the frm (and the resultng benefts of control). Second, we fnd that the dluton of famly ownershp n stock-fnanced acqustons has a sgnfcant nfluence on value gans n mergers. In partcular, at hgh levels of famly ownershp, the dluton affects the nature of the relatonshp between famly control and frm value by decreasng the level of ncentve algnment. At low levels of famly ownershp, dluton seems to serve as a credble sgnal of the famly s ntentons not to exproprate wealth of mnorty shareholders. Our results contnue to hold even after correctng for a potental selfselecton bas. 4.. Famly ownershp and target returns We now turn to the examnaton of the relatonshp between famly ownershp and abnormal returns for target frms. We do so by estmatng Equaton (1) for target frms. All varables are target-sde counterparts of those defned for Eq. (1). As dscussed earler, an acquston of a famly-controlled target n a cash-fnanced transacton results n a complete loss of control by the famly. Ths mples that the market reacton upon a cash-fnanced acquston of a famly target wll reveal the nfluence of famly ownershp on pre-merger frm value. In partcular, an ext of an entrenched famly wll be seen by 17

20 the market as a value-creatng event, whle an ext of a famly, whose ncentves are algned wth those of mnorty shareholders, s expected to be seen as a value-destroyng event. If the entrenchment effect domnates the ncentve algnment effect at low levels of famly ownershp, whle the opposte s true at hgh levels of ownershp, we expect β 1 to be postve and β to be negatve. If, on the other hand, the ncentve algnment effect domnates the entrenchment effect at low levels of ownershp, whle the opposte s true at hgh levels of ownershp, we expect β 1 to be negatve and β to be postve. For stock-fnanced acqustons of famly-controlled targets, as dscussed n Secton, there are two effects that could mtgate the pure loss-of-control effect present n the case of cashfnanced acqustons. Frst, a stock-fnanced acquston can be seen as only a partal ext of the famly whch can become a blockholder n the merged frm and montor the acqurer s management. Second, by acceptng acqurer s stock n exchange for ts shares, famly s mplctly certfyng the value of the acqurer s stock. The magntude of both of these effects s lkely to be ncreasng wth the level of famly s ownershp. Therefore, we expect the sgns of the coeffcents of β 4 and β 5 to be mrror mages of those of β 1 and β. The results are reported n Table 7. For cash-fnanced acqustons of famly-controlled targets, we fnd that the coeffcent estmate for β s postve, whle the coeffcent estmate for β 1 s negatve. Both coeffcent estmates are statstcally sgnfcant at the 5% level. Ths mples a concave relatonshp between famly ownershp and the market reacton upon an announcement of a cash-fnanced acquston. In partcular, we fnd that the abnormal returns are ncreasng wth famly ownershp untl the latter reaches 38%, then start decreasng, but stay postve for frms wth famly ownershp below 76%. At ts hghest pont, the dfference n the cumulatve abnormal returns between famly and non-famly frms reaches 15.6%. In other words, an ext of an entrenched famly s seen by the market as a value-creatng event, whle an ext of a famly, whose ncentves are algned wth those of mnorty shareholders, s seen as a value-destroyng 18

21 event. Our results suggest that famles wth hgh levels of ownershp are an asset to ther (premerger) frms, whle famles wth low levels of ownershp are a lablty. For stock-fnanced acqustons of famly-controlled targets we fnd that, consstent wth our predctons, the sgns of the coeffcent estmates for β 4 and β 5 are opposte to those for β1 and β. Nether of the coeffcent estmates, however, s statstcally sgnfcant. Overall, our results on the target sde are consstent wth our prevous fndngs on the acqurer sde and provde an addtonal evdence of entrenchment of famles wth low levels of ownershp and ncentve algnment of famles wth hgh levels of ownershp. 5. Conclusons Foundng famles represent a unque group of actve, long-term owners, holdng concentrated equty postons n ther frms. Usng a sample of newly publc famly frms, ths paper examnes the nfluence of ths group of nvestors on value creaton n mergers. Our focus on newly publc famly frms provdes a new perspectve not only on famly frms but also on mergers. Frst, most of the emergng lterature on famly frms has focused on mature and ndexlsted frms, whle the newly publc famly frms have receved very lttle attenton. Second, mergers, as corporate control events, provde an deal settng to examne the relatonshp between famly ownershp and frm value. In partcular, the spectrum of potental outcomes for famles (no change n control, dluton, full ext) allows us to observe the nfluence of the level and changes n famly ownershp on value creaton n mergers. Our fndngs can be summarzed as follows. For acqustons by famly frms, low levels of famly ownershp are assocated wth value-reducng acquston decsons. A hgh level of famly ownershp, on the other hand, s assocated wth value-creatng acquston decsons. We conjecture that ths s due to the entrenchment of foundng famles wth a low level of ownershp and the ncentve algnment at hgh levels of famly ownershp. Ths conjecture s further 19

22 supported by our fndng that frms wth low levels of famly ownershp are more lkely to choose cash as the medum of exchange and thus preserve ther control of the frm (and the resultng benefts of control). Our results regardng the relatonshp between famly ownershp and value creaton n mergers contnue to hold even after correctng for a potental self-selecton bas. Further examnaton reveals that the dluton of famles n stock-fnanced acqustons s an mportant consderaton n mergers. In partcular, at hgh levels of famly ownershp, the dluton affects the nature of the relatonshp between famly control and frm value by decreasng the level of ncentve algnment. At low levels of famly ownershp, dluton serves as a credble sgnal of the famly s ntentons not to exproprate wealth of mnorty shareholders. For acqustons of famly controlled targets, we fnd that the market perceves a full loss of control by the foundng famly as a value-creatng event f the famly ownershp s low and as a value-destroyng event f the famly ownershp s hgh. These results provde addtonal evdence of entrenchment of famles wth low levels of ownershp and the algnment of famly and mnorty shareholder ncentves at hgh levels of famly ownershp. Our study contrbutes to the understandng of famly frms n several ways. Frst, the mpact of famly ownershp on the value gans documented n ths paper provdes a further pece of evdence that the ownershp by the foundng famly s an mportant determnant of the value of such frms. Second, pror research on famly frms has largely used cross-sectonal tests usng market-to-book or accountng ratos as measures of value. The use of an event study approach provdes a dfferent perspectve on ths ssue. Fnally, we provde evdence that newly publc famly frms dffer n sgnfcant ways from ther mature and ndex-lsted counterparts. In partcular, the entrenchment of the famly and the algnment of ts nterests wth those of mnorty shareholders occur at dfferent ownershp levels n the two groups. A detaled study of the sources of ths dfference could further our understandng of the nfluence of famly ownershp on the frm value. 0

23 Our fndngs also have mplcatons for the merger lterature. Although the change n ownershp and control s a natural outcome of stock-fnanced mergers, the relatonshp between changes n famly ownershp and value creaton n mergers has not, to our knowledge, receved any attenton n the lterature. Our fndngs suggest that dluton of famly ownershp s ndeed a sgnfcant determnant of value gans and losses n mergers. 1

24 Appendx A potental concern wth the OLS estmaton of Eq. (4.1) to (4.3) s that the abnormal return upon the acquston announcement (the dependent varable n Eqs. (4.) and (4.3)) s a condtonal varable, whch depends upon the choce of the medum of exchange (STOCK). Takng expectatons of Eq. (4.3), we obtan ] [ 0] [ 0] * [ 1] [ ] [ γ ε β ε γ β Z u E X Z u X E STOCK CAR E STOCK CAR E CAR E > + = > + + = > = = = (A1) If u 1 and ε are correlated, the last condtonal expectaton term n (A1) does not have a zero mean, and OLS estmaton of Eqs. (4.) and (4.3) wll generate nconsstent estmates. We therefore use the swtchng regresson model wth endogenous swtchng. Assumng that the error terms,, and 1 u u ε are normally dstrbuted wth zero mean and covarance matrx (A) Σ = ε ε ε ε ε σ σ σ σ σ σ σ σ σ we can express the last term of (A1) as follows:, ) ( ) ( ) ( 1 ) ( ] [ Φ = Φ = > γ γ φ σ γ γ φ σ γ ε ε ε Z Z Z Z Z u E (A3) where φ and are the densty and cumulatve dstrbuton functons of the normal dstrbuton, respectvely. The term Φ Φ ) ( ) ( γ γ φ Z Z n (A3) s usually referred to as the nverse Mlls rato. If ths term s added to the regresson as a rght-hand-sde varable, we can use OLS to consstently estmate β as well as ε σ. In partcular, estmaton of the followng equatons wll gve us consstent estmates of all the coeffcents:

25 cash Z Z X CAR _ ) ( ) ( ξ γ γ φ σ β ε + Φ = (A4.1), ) ( 1 ) ( 1 _ stock Z Z X CAR ξ γ γ φ σ β ε + Φ + = (A4.) where and 1 ξ ξ are error terms. The two-step procedure descrbed above, however, s not effcent. We therefore use the followng full nformaton maxmum lkelhood procedure. Frst, to fnd good ntal estmates for the maxmzaton of the log-lkelhood, we run a probt on Eq. (4.1), yeldng the estmates of Φ ) ( ) ( γ γ φ Z Z Φ ) ( 1 ) ( γ γ φ Z Z and. Second, the nverse Mlls ratos estmated above are then used n OLS regressons of (A4.1) and (A4.) to obtan,, σ 1 σ, and σ 1ε ε σ. Fnally, we maxmze the log-lkelhood usng the parameters estmated n the frst two steps as ntal values. Wth ths method, all parameters n (4.1), (4.), and (4.3) are estmated consstently and asymptotcally effcently. 3

26 References Amhud, Y., Lev, B., Travlos, N., Corporate control and the choce of nvestment fnancng: the case of corporate acqustons. Journal of Fnance 45, Anderson, R., Reeb, D., 003. Foundng-famly ownershp and frm performance: evdence from the S&P 500. Journal of Fnance 58, Ben-Amar, W., Andre, P., 006. Separaton of ownershp from control and acqurng frm performance: the case of famly ownershp n Canada. Journal of Busness Fnance and Accountng 33, Carleton, W., Gulkey, D., Harrs, R., Stewart, J., An emprcal analyss of the role of the medum of exchange n mergers. Journal of Fnance 38 (3), Chang, S., Takeover of prvately held targets, methods of payment, and bdder returns. Journal of Fnance 53, Dunbar, C., The use of warrants as underwrter compensaton n ntal publc offerngs. Journal of Fnancal Economcs 38, Fang, L., 005. Investment bank reputaton and the prce and qualty of underwrtng servces. Journal of Fnance 60 (6), Feld, L., Mulhern, H., Newly publc frms as acquston targets: A comparson wth establshed target frms. Workng paper, Penn State Unversty. Hellman, T., Pur, M., 00. Venture captal and the professonalzaton of start-up frms: emprcal evdence. Journal of Fnance 57 (1), Hubbard, R., Pala, D., Benefts of control, manageral ownershp, and the stock returns of acqurng frms. RAND Journal of Economcs 6, Jensen, M., Mecklng, W., Theory of the frm: manageral behavor, agency costs and ownershp structure. Journal of Fnancal Economcs 3, Jensen, M., Ruback, R., The market for corporate control: the scentfc evdence. Journal of Fnancal Economcs 11, Klasa, S., 005. Why do controllng famles of publc frms sell ther remanng ownershp stake? Forthcomng n Journal of Fnancal and Quanttatve Analyss. Leland, H., Pyle, D., Informaton asymmetres, fnancal structure, and fnancal ntermedaton. Journal of Fnance 3 (), Lewellen, W., Loderer, C., Rosenfeld, A., Merger decsons and executve stock ownershp n acqurng frms. Journal of Accountng and Economcs 7, Maddala, G., Lmted dependent and qualtatve varables n econometrcs. Econometrc Socety Monographs No. 3. (Cambrdge Unversty Press, Cambrdge) 4

27 Martn, K., The method of payment n corporate acqustons, nvestment opportuntes, and management ownershp. Journal of Fnance 51 (4), Masuls, R., Nahata, R., 006. Acqurer returns when targets are venture captal backed. Workng paper, Vanderblt Unversty. McConnell, J., Servaes, H., Addtonal evdence on equty ownershp and corporate value. Journal of Fnancal Economcs 7, Morck, R., Shlefer, A., Vshny, R., Management ownershp and market valuaton: an emprcal analyss. Journal of Fnancal Economcs 0, Paegls, I., Trtroglu, D., 005. Foundng famly: an asset or a lablty? Evdence from IPOs. Workng paper, Concorda Unversty. Schwert, W., A dscusson of CEO deaths and the reacton of stock prces. Journal of Accountng and Economcs 7, Slovn, M., Sushka, M., Ownershp concentraton, corporate control actvty, and frm value: evdence from the death of nsde blockholders. Journal of Fnance 48, Stulz, R., Manageral control of votng rghts: fnancng polces and the market for corporate control. Journal of Fnancal Economcs 0, Vllalonga, B., Amt, R., 006. How do famly ownershp, control and management affect frm value? Journal of Fnancal Economcs 80, Wggenhorn, J., Madura, J., 004. Performance of acqustons by newly publc frms. Workng paper, Barry Unversty. 5

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