Cross‐Border Mergers and Differences in Corporate Governance

• DOI: http://doi.org/10.1111/irfi.12008
• Author: Kelsey D. Wei,Laura T. Starks
• Published date: 01 September 2013
• Date: 01 September 2013

Cross-Border Mergers and

Differences in Corporate

Governance*

LAURA T. STARKS†AND KELSEY D. WEI‡

†Department of Finance, McCombs School of Business, The University of Texas at

Austin, Austin, TX, USA and

‡Naveen Jindal School of Management, University of Texas at Dallas, Richardson,

TX, USA

ABSTRACT

We examine whether corporate governance differences affect f‌irm valuation

in cross-border mergers. We f‌ind that takeover premiums are decreasing in

the quality of the foreign acquirer’s home country governance for deals

completed with stock, suggesting that the acquirers compensate target share-

holders for the resulting exposure to inferior corporate governance regimes.

Correspondingly, we f‌ind that the acquiring f‌irm stockholders’ abnormal

returns at the merger announcement are increasing in the quality of corpo-

rate governance for stock offers. Finally, we f‌ind that foreign acquirers from

countries with better corporate governance are more likely to make stock

offers.

I. INTRODUCTION

Corporate governance practices vary across countries, and within countries,

across companies. Whether these variations are related to variations in f‌irm

value is a question that has been debated for some time. Although a number of

studies have examined the question of whether corporate governance has an

effect on f‌irm value (La Porta et al. 2000; Gompers et al. 2003; Klapper and Love

2004; and Black et al. 2006), the endogeneity between the two variables makes

it diff‌icult to arrive at a def‌initive conclusion. In this paper, we take a novel

approach to the issue by examining whether corporate governance differences

affect f‌irm valuation in cross-border mergers.

When two f‌irms merge, there are often takeover gains to be shared between

the target and bidder f‌irm shareholders. The extent to which these gains are

shared depends in part on the target and bidder f‌irm shareholders’ expectations

*The authors would like to thank Bernard Black, David Denis, Jay Hartzell, Murali Jagannathan,

Srini Krishnamurthy, Adair Morse, David Ravenscraft, Hong Yan and seminar participants at Bing-

hamton University, Georgetown University,University of North Carolina, University of Oklahoma,

University of Washington and the FMA European Meeting for helpful comments. A previous version

of this paper won the Best Paper Award at the 2004 FMA European meetings.

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International Review of Finance, 13:3, 2013: pp. 265–297

DOI: 10.1111/irf‌i.12008

© 2013 International Review of Finance Ltd. 2013

regarding the values of their participation in the merged f‌irm. When the merger

is conducted with stock as the method of payment, the target f‌irm shareholders

not only become shareholders of the merged f‌irm, they also become subject to

the corporate governance practices of the merged f‌irm, which in the case of a

cross-border merger, depend greatly on the home country of the bidder f‌irm.

Thus, the end result of a cross-border merger can be a change in governance

structure faced by the target f‌irm shareholders.

To test the link between corporate governance practices and f‌irm value, we

develop hypotheses regarding how changes in governance practices induced by

cross-border mergers affect shareholders through the takeover premium in the

merger. Our primary hypothesis focuses on the target f‌irm shareholders. Target

f‌irm shareholders whose shares are exchanged for shares of f‌irms from countries

with poorer corporate governance regimes or investor protection should

demand compensation for the increased risk exposure to inferior corporate

governance. Correspondingly, these stockholders should be willing to relin-

quish compensation if their protections are increased. Thus, the takeover

premium should be decreasing in the quality of the corporate governance of the

bidder f‌irm, where in our context should be closely related to the corporate

governance system of the bidder f‌irm’s home country. In addition, the bidder

f‌irm stockholders’ gains also depend on the quality of their home country

corporate governance practices. These hypotheses should hold primarily for

takeover offers in which the method of payment is in the bidder f‌irm stock as

the target shareholders in cash offers do not face effects from changes in

governance quality.

The hypotheses we develop in this paper can also be tested among domestic

mergers, but because of the greater dispersion in corporate governance across

countries than across companies within a country, our tests have more power to

detect valuation effects deriving from corporate governance changes. However,

testing across countries presents its own problems because differences in gov-

ernance and numbers of mergers vary across pairs of countries. For example,

Khanna et al. (2006) f‌ind that pairs of economically interlinked countries show

similarities in their formal corporate governance systems. Further, Rossi and

Volpin (2004) f‌ind a higher incidence of target f‌irms from countries with poorer

investor protection. Thus, in our tests we control for both of these issues by

restricting our sample to target f‌irms from a single country, the United States.

Despite some scandals just following our sample period, the United States

corporate governance system is considered to be one of the best in the world

(Reese and Weisbac 2002; Holmstrom and Kaplan 2003), which implies that the

premiums required by US target f‌irm shareholders from their cross-border

bidders should be higher than would be the case for comparable domestic

mergers.

Our sample of cross-border mergers with US target f‌irms covers the 1980–

1998 period. For mergers in which the method of payment is stock, we f‌ind

that the takeover premium is signif‌icantly decreasing in the quality of the

bidder f‌irms’ home country corporate governance regimes, consistent with our

International Review of Finance

266 © 2013 International Review of Finance Ltd. 2013

hypothesis.1Also consistent with our hypotheses, we do not f‌ind the same

degree of association between takeover premiums and corporate governance

proxies for the mergers conducted in cash. This result would be expected

because when the target f‌irm shareholders receive cash as the method of

payment, they no longer hold shares and thus, do not face a new corporate

governance regime.

Examination of the abnormal returns to the bidder shareholders at the

takeover announcement allows further tests of our hypotheses. We f‌ind that for

mergers conducted in stock, the bidder f‌irm abnormal returns are signif‌icantly

increasing in the quality of the corporate governance regimes. These results are

consistent with our hypothesis that bidder f‌irms must compensate target f‌irm

shareholders if the quality of the corporate governance regime is reduced.

We also show that the negative effects of the higher premiums paid by

bidders from countries with poorer corporate governance on their announce-

ment abnormal returns are smaller if US targets are public f‌irms. We argue that

this result occurs because the bidders also benef‌it from acquiring US public

targets due to possible increased investor scrutiny or awareness. Further, this

f‌inding suggests that the potentially greater information asymmetry associated

with acquirers from worse corporate governance regimes cannot fully account

for our results. As explained in Moeller et al. (2007), under the information

asymmetry models (e.g., Myers and Majluf 1984), a positive relation between

acquirer abnormal returns and the proxies for information asymmetry is

expected for acquisitions of public f‌irms paid for with cash. If acquirers from

worse corporate governance regimes are likely to be associated with greater

information asymmetry regarding their fundamental values, we would have

expected that they earn greater abnormal returns from acquiring US public

targets with cash. But our result indicates the opposite.

Further consistent with our hypotheses on corporate governance differences

driving merger terms, we f‌ind that more cross-border than domestic mergers are

conducted in cash, despite the fact that in our sample period, the value of the

average cross-border merger is more than twice as great as the value of the

average domestic merger. We also f‌ind that the likelihood of making a takeover

offer in stock is signif‌icantly increasing in the quality of the acquirer’s corporate

governance, controlling for other potential explanatory variables.

A further contribution of our paper is that we are able to help resolve a puzzle

regarding differences in abnormal returns between targets of foreign versus

domestic bidders. Previous studies have found that US targets of foreign bidders

tend to receive greater premiums than do US targets of domestic bidders (e.g.,

Harris and Ravenscraft 1991; Swenson 1993), but have been unable to provide

solid evidence regarding the source of the difference.2Our results explain the

rationale for the premium difference – the required compensation to the US

1 The measure of target takeover premium we employ is the difference between the offer price

and the target f‌irm’s stock market price a week before the merger announcement.

2 Harris and Ravenscraft (1991) provide weak evidence that the difference in premium may be

due to the effect of foreign exchange rate movements.

Cross-Border Mergers and Corporate Governance

267© 2013 International Review of Finance Ltd. 2013