Involving Founders in Consolidations Improves Market Success
Corporate governance has a formidable impact on the market fortunes of an industry consolidation.
ANN ARBOR, Mich. Having the proper initial governance structure is the key determinant of a successful industry consolidation, says a University of Michigan Business School researcher in a new study forthcoming in the Review of Financial Studies.
"Our results indicate that industry consolidations have greater market success if they provide the original founders with incentives and control," says Amy Dittmar, assistant professor of finance at the Michigan Business School. "If the managers and owners of the firms included in the transaction remain involved in the business as shareholders and directors, both operating and stock-price performance improve, and future acquisitions are better received by the market."
In contrast, higher ownership by the sponsor of the transaction leads to a reduction in performance, in large part because the sponsor's compensation is often excessive and drains wealth from the newly formed entity, according to Dittmar and colleagues Keith Brown of the McCombs School of Business at the University of Texas and Henri Servaes of the London Business School.
The three researchers examined 47 service-sector, construction and durable-goods wholesale firms that engaged in roll-up initial public offerings between 1994 and 1998 in order to determine what type of corporate-governance structure is most successful in delivering shareholder value.
Roll-up IPOs are transactions in which a shell company goes public while simultaneously merging with other firms that operate in the same industry. This method of consolidating highly fragmented industries of considerable size was developed and became popular in the United States in the mid-1990s, although potential financing for these transactions dried up after 1998 because roll-ups performed poorly on average.
In their study, Dittmar, Brown and Servaes report that long-run stock-price performance is higher when a greater number of the roll-up firm's directors come from the founding companies. Specifically, there is a 2.8 percentage point increase in returns for every percentage point increase in the fraction of directors who are founders.
In addition, they find that roll-ups perform better if the original founders own more shares of the new company at the time of going public. In this case, every percentage point increase in founder ownership raises stock-price returns by 1.9 percentage points.
Although the average accounting performance of the roll-up firms in the study is not worse than industry benchmarks, their actual earnings generally fall far short of investors' expectations and analysts' forecasts, the researchers say.
"These firms are sold and initially trade at higher valuations relative to other firms in the industry, which indicates the market holds high expectations for these deals," Dittmar says. "Our evidence suggests that only the firms with the right governance structure in place at the IPO stage are able to live up to market expectations. Accounting performance is significantly better if the original founders own more stock and control a larger fraction of the board."
The study further shows that operating return on sales is 0.10 percentage point higher for each percentage increase in founder ownership.
"Roll-up firms with more founder involvement from the start also make better acquisitions and experience less top-management turnover after the IPO," Dittmar says. "To ensure success, consolidations should make sure that the founders of the acquired companies continue to own shares in the new firm and serve as members of the board."
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