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The main challenge with the agency theory approach is that, the motive behind managers’
desire to acquire shares and even hold a higher number of them is not clear. If managers bear any cost for holding some shares in firms, then, they are likely to hold more of these shares only if there is a commensurate compensation for that. Since managers expect to be compensated for holding some shares by shareholders, in the final analysis, shareholders do not benefit or gain, even if the incentives of managers to maximise shareholder value increases as managerial ownership increases. The contracting approach, which builds on principal-agent models such as Holmstrom (1979), takes into consideration of these costs.
Consider a firm owned by separate or unconnected shareholders. These shareholders have in some way try to address their collective action problem, so that they can act as a group. They must recruit managers and design incentive packages for these managers in order to maximise the value of the firm.
In situations like this, the shareholders must solve an optimisation problem where conditions about the managers’ contract should that, the managers’ participation constraint is met. The shareholders problem becomes more difficult in the sense that, naturally, shareholders may not be able to monitor all the actions of managers. This hidden action problem allows managers to concentrate on their objectives instead of the interest of shareholders. For example, managers may decide to shirk because shareholders find it difficult to find it out.
Once managers are in place, the additional challenge that shareholders face is that, certain information managers have do not become available to them.
Since managers are seized with better information compared to what shareholders have, and because shareholders are not able to always determine whether actions managers undertake maximise the value of the firm, the contracting approach generally reaches the conclusion that the optimal contract for managers involves compensation that is sensitive to changes in firm value. This sensitivity of compensation to changes in firm value can be realised even if no shares are owned by management.
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can result in entrenchment of insiders who may escape market discipline and take decisions that are inappropriate and detrimental to the creation of value, resulting in hubris effect.
Situations such as these are likely to occur in emerging markets. For instance, India with its numerous group affiliated and family owned firms may not create value through mergers and acquisitions, particularly in acquisitions that are not related (Bhaumik et al., 2010).
Literature suggests that, managerial holdings of more than 20% may assure total control over a firm and managers can efficiently control decisions of a firm and therefore could seriously influence decision to undertake mergers and acquisitions (Faccio & Masulis, 2005). Other prior researches define 25% and 5% as managerial ownership cutoff points that would allow managers to have control and power over decisions of firms. The 25% cut-off point is suggested by Weston (1979) who maintains that, an unfriendly bid for a firm is not likely to be successful if the level of ownership is more than 20-30% while the 5% is also suggested by Herman (1981) who argues that, an ownership level of 5% is the focal stake above which managerial ownership is considered significant.
It is a well-documented and agreed fact that, self-interest of managers plays a major role in acquisition transactions. Studies reveal that, returns of acquirers are usually higher when acquiring firms’ managers are the major shareholders (Lewellen et al., 1985), but reduces when management are minority shareholders (Lang et al., 1991; Harford 1999). This, therefore, implies that, managers concentrate more on acquisition transactions when they are personally involved financially. Additionally, it offers support to ‘the managerial theories of the firm and agency cost agency cost’ (Berle and Means, 1932; Marris, 1963), which largely argue that, managers undertake M&A transactions that are self-serving, and which mostly result in value destruction.
According to Jensen and Meckling (1976), firms with higher managerial levels of ownership align shareholders’ interest to that of managers, and lower agency costs to increase the value of the firms. However, Stulz (1988) suggests a framework of firm value that initially rises as ownership level of inside managers rises, and then reduces as ownership levels of insiders become concentrated because high levels of managerial ownership serve as protection against external takeovers which leads to entrenchment of management.
Akerlof (1970), Brealey et al. (1977) and Spence (1973) provide a complimentary model of agency theory where managerial ownership is used by management as an indication to investors who are outside to know the quality of their firms. Studies that relate to managerial
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share ownership and firms’ value relationship are varied. Hermalin and Weisbach (1991) and Demsetz and Lehn (1985) suggest a nonexistence of a relationship for managerial share ownership levels and profitability. Morck et al. (1988) also state a positive relationship between managerial share ownership and firm which is measured by Tobin’s q. McConnell and Servaes (1990) find a positive relationship of about 40 per cent to 50 per cent and then a negative relationship in excess of 50 per cent for managerial ownership and firm value. Chen, Hexter and Hu (1993), however, find that, the value of firms reduces as ownership management exceeds 12 per cent and increases when ownership falls between 0 per cent and 5 to 7 per cent.
Ang, Cole and Lin (2000), Mehran (1995), Singh and Davidson (2003) provide support for Jensen and Meckling’s position of inside managerial ownership. Mehran (1995) reveals that, there is a positive linear relationship existing between ownership of top management and Tobin’s Q. In addition, Singh and Davidson (2003) indicate that, agency costs reduce as ownership of managers increases, using asset utilisation as a proxy.
This study expands upon these views to investigate whether managerial ownership in emerging market acquirer firms motivate them to pursue acquisition and further explore whether it also influences these firms’ decisions on the sizes of target firms they pursue during acquisition. Further, according to the neoclassical theory, managers have the tendency to undertake acquisition investments especially when these types of projects or investments appear to provide a net present value which is positive. However, the theory of managerial motive suggests that, managers behave in ways that will benefit them but will adversely affect shareholders value by issuing shares at the time where there is separation between ownership and management. In supporting this claim, Schmidt and Fowler (1990) states that, managers’ compensation to some extent is positively related with the size of firm, which motivates them to expand sizes of firms they control as much as they can without taking into account the economic viability of M&As. Eventually, such strategies for firm expansion by managers further increase their status power (Brooks, Feils & Sahoo, 2000). In line with the same thinking, the view Peel et al. (1995) expresses is that, as the number of shares owned by management increases with a substantial separation of ownership from control, the likelihood for managers to undertake investments that will enhance their private welfare is also high.
This opinion of management self-interest being a motivating factor for mergers and