Despite the enormous uncertainty and disruption caused by the ongoing COVID-19 pandemic, the total value of global mergers and acquisitions in 2021 will top $5 trillion for the first time. Many experts predict that the current wave is just the beginning of what could be a years-long merger frenzy. The pressure on well-funded companies to accelerate growth, scale and digitize is driving them to pay a premium to close deals.
Premium takeovers are nothing new: Over the past 20 years, U.S. public companies have paid an average of 36% more than the target's market value before the takeover announcement. In the current hot takeover market, however, the risk of overpayment increases significantly. However, according to our research, organizations may be able to reduce this risk by studying and changing the power dynamics in top management.
A large number of empirical studies have found that the main reasons why companies pay too high acquisition prices are behavioral biases and the misalignment of interests between management and the organization. In particular, the CEO, who is often the main decision maker for acquisitions, is always overconfident in his ability to deal. They tend to overestimate the target's intrinsic value and realized synergies and underestimate execution and integration risks. In addition, corporate executives may be more likely to acquire personal benefits such as power, prestige and additional compensation through acquisitions than other major capital expenditures. In many cases, their decisions are not closely monitored because they have enormous influence over the acquisition process and the company's board of directors.
We assume that the person best suited to reduce the risk of overpayment is the company's chief financial officer (CFO). In addition to the fiduciary duty and core responsibility for overseeing important financial decisions, the CEO may have the same information that they have access to, while outside directors may not have as comprehensive a picture. But when the CFO has more power, does the risk of companies paying super premiums for acquisition targets really decrease?
To investigate this question, we analyzed 1,983 public acquisitions by 926 U.S. public companies between 1992 and 2019. The findings confirm our main thesis that firms with greater CFO power pay lower acquisition premiums. This finding complements the findings of a recent UK study. In the US system of corporate governance, however, the CEO has disproportionate formal power and discretion, so we believe it is important to look at traditional sources of formal power (such as the executive's position in the top management, in the company's board seats) to understand where the CFO’s influence in acquisition decisions comes from.
We found that CFOs of companies that paid a lower premium for acquisitions had one or more of the following characteristics: possessed generalist skills, demonstrated independence from the CEO, and enjoyed a higher position in the organization. These characteristics appear to give them three informal sources of power, which we call skill-based, relationship-based, and status-based power. Below are the results of our analysis.
generalist skills
Companies that hire CFOs with general management skills pay a 9% lower premium for acquisitions than companies with specialized CFOs. Sadly, however, many acquisition firms in the U.S. lack generalist CFOs. About 40 percent of CFOs at large acquisition firms can be considered specialists, meaning they have deep expertise in traditional finance functions such as accounting, financial control, budgeting, auditing, tax and treasury management.
Our analysis shows that, in response to the governance and compliance requirements of the Sarbanes-Oxley Act of 2002, and the increased focus on financial risk management in the aftermath of the 2008 financial crisis, U.S. buyout firms have become increasingly concerned about professional Appointment rates for talented CFOs began to be higher than for generalist CFOs, often from within the company.
Generalist CFOs not only have deep financial knowledge based on higher education and early work experience, but also have extensive experience in non-financial roles and settings, such as in different organizations, industries, or countries. Retired Walmart CFO Charles Holley and Est e Lauder CFO Tracy Travis are two vivid examples of generalist CFOs.
Hawley started his career working as an accountant and then joined Tandy, a retail and consumer electronics group, as the financial director of its international business, where he was responsible for managing new start-ups, negotiating overseas joint ventures and doing business overseas, where he gained a wealth of business experience . Next, he became Managing Director of Europe, a position in which he gained experience running a company. Hawley said he was well-positioned for a financial leadership role at Walmart thanks to his skills and diverse experience in finance, operations and international business.
Travis' career development experience is similar to Hawley's. She emphasizes that it is important for her to expand her skillset through extensive experience, especially early in her career. She also noted that all her roles at five companies in different industries have given her the opportunity to be involved in corporate strategy.
Both executives made it clear that they were able to develop effective relationships with the company's board and CEO because they had a deep understanding of company strategy and operations through generalist skills.
independence
Companies with independent CFOs (i.e. CFOs not appointed by the current CEO) paid an 18% lower premium for acquisitions. However, 61% of CFOs are actually appointed by the current CEO.
Of course, the relationship between the CEO and CFO is complex and requires both executives to work closely with each other. Therefore, it is also plausible that new CEOs will often insist that they choose their own executive team members. We've seen this recently at Boeing, Ford, and Intel. But the downside of this CEO-CFO relationship is that the CFO's independence is often compromised.
CFOs appointed by current CEOs are more likely to align with the CEO's preferences and have an incentive to echo rather than question or oversee the CEO's major decisions. Such CFOs may conflict with the fiduciary duty and responsibility to oversee financial decisions while remaining loyal to the CEO who hires them. Therefore, we can view "appointment by current CEO" as an important indicator of the CFO's lack of sufficient independence.
A CFO who can maintain sufficient independence from the CEO will have more power in acquisition decisions. They may actively disagree based on actual data, and urge CEOs and boards to carefully assess the value of synergies versus the post-merger implementation costs in order to make more objective decisions. At Walmart, Hawley worked with two CEOs who took the helm after Hawley was named executive vice president of finance and CFO, respectively. Hawley said the most important role he plays in M&A decision-making as the company's CFO is "to counterbalance the optimism in the boardroom with a healthy dose of skepticism that some M&A leaders may push forward with. Transactions that do not fit with the overall strategy, or make some business case that may not necessarily be supported by actual data.”
Our findings clearly show that when the CFO is not appointed by the incumbent CEO, more effective oversight and control can be implemented, and acquisition premiums can be substantially reduced. Yet less than 40 percent of buyout company treasurers are independent CFOs.
high status
Companies with high CFO status (judged by the smaller pay gap between the CFO and CEO) pay a 7% lower premium for acquisitions. In most companies, however, the pay gap between the CFO and the CEO is quite large.
The formal power of executives comes from their positions and titles, while their actual status is related to their social status and the level of importance they receive in the organization by virtue of their personal characteristics. However, these status indicators are sometimes not directly observable, so previous research has often used compensation as an objective indicator of executive status, as did ours.
High-status individuals also receive high levels of social respect and influence. Therefore, if the CFO is in a high position, he can win the board and other possible stakeholders to support his point of view. Hawley believes this social influence is especially critical to the CFO's role in acquisitions. "In mergers and acquisitions, in addition to exercising authority, the CFO also needs to exert influence and persuasion," he points out.
On average, however, CFOs are paid less than 40 percent of the CEO's. In fact, the total pay gap between CFOs and CEOs has even widened over the past 10 years, which is clearly in the CEO's favor. This shows that the position of the CFO relative to the CEO has been declining.
Taken together, our findings suggest that when the CFO gains informal power in the company by virtue of his skills, independence, or status, the entire leadership makes more informed decisions on the all-important issue of acquisitions. So how can boards and CEOs be more effective at recruiting or developing CFOs with the right characteristics?
Where to find a generalist CFO
For companies looking to hire generalist CFOs, large investment banks, diversified industry groups (such as General Electric, Pepsi and Procter & Gamble) and technology companies (such as Alphabet and Amazon) are the best external talent pools. In these companies, the finance function tends to cover a wide range of responsibilities, and finance professionals often gain experience outside the finance function from a variety of industries and geographies. For example, Ruth Porat, CFO of Google's parent company Alphabet, was previously Morgan Stanley's CFO, global head of the financial institutions group, and co-head of technology investment banking. Although she has spent most of her career in the finance industry, she has also held a variety of key positions in the technology industry, involved in M&A transactions, initial public offerings (IPOs) and crisis management, as well as consulting in government and academia.
Brian Newman is in a similar situation. When he was hired as CFO by UPS, the company was planning to expand capital expenditures to capture a larger share of the e-commerce market and increase same-day delivery. Newman started his career as an investment banker before joining PepsiCo, where he held various leadership roles in finance, operations and strategy in Europe, Asia, North and South America. When he was hired by UPS, he was the chief strategy officer of PepsiCo, and recently launched the company's global e-commerce business.
Bringing fresh external perspectives into the senior finance leadership team and ensuring that internal candidates face external competition for executive positions can be beneficial both strategically and culturally. Large companies, however, should continue to develop internally large numbers of generalists qualified for advancement to financial leadership positions, with a clear goal for succession planning.
Clearly, there are many ways to help talented financial professionals grow into generalist CFOs. In general, companies should expose such professionals to a variety of business functions early in their careers or, in their finance work, provide them with the opportunity to apply deep financial knowledge to different product lines and geographies. Next, the company should assign them tasks that require general management responsibilities to expand their horizons and skills and allow them to see the company's markets, strategies and operations from a holistic perspective.
PepsiCo CFO Hugh Johnston is a prime example of such an in-house generalist. Johnston has spent his entire career at PepsiCo, with the exception of three years in general management at Merck. After studying Finance and earning an MBA, he held various positions in finance, mergers and acquisitions and strategy at PepsiCo headquarters and its North American snack and beverage business, as well as senior vice president of transformation and executive vice president of global operations. Former PepsiCo CEO Indra Nooyi, who saw Johnston's potential early in his career, talked about how she "pulled him out of his financial comfort zone" and involved him in shaping the company's strategy.
Cultivating CFO independence
When Leo Apotheker took over at HP, Catherine Lesjak had been with the company for more than 30 years and as CFO for four years. The two are at odds over whether HP should spend $11 billion to buy British software company Autonomy. That price represents a 60% premium and is 11 times the company's revenue, while comparable companies were valued at about three times their revenue during the same period.
Les Jacques first told Apotheker privately that she opposed the deal because she thought the price was too high. Later, she vehemently opposed the takeover in front of the board, expressing her stance: "I can't possibly support ... I don't think it's a good idea. We're not ready, it's too expensive. I'll just say it straight. , this transaction is not in the best interests of the company.” Les Jaques did not lose her job, but she later said Apotheker had told her after a board meeting that she would be fired.
The CEO insisted on going ahead with the acquisition, and although the decision was eventually approved, he later lost his job on the deal when the company had to write down Autonomy's assets by $8.8 billion. Since then, succeeding CEO Meg Whitman (Meg Whitman) appointed Les Jacques to oversee the acquisition.
HP's case vividly illustrates the importance of the CFO's ability to act independently, especially in the early stages of the M&A process, but also illustrates that the CFO's fiduciary duty and responsibility for overseeing financial decisions can bring them into sharp conflict with the CEO. We recommend that the board take a leadership role in the CFO selection process to increase the independence of the CFO. When a company needs to appoint a new CFO, the board should lead the process, including defining the required qualifications based on the company’s strategic needs — sourcing the right candidates from within and outside the company, interviewing the shortlisted, and making the final hiring decision. Of course, the CEO's opinion is also important, as in any working partnership there needs to be a good relationship between the partners, but we advise the CEO not to dominate the CFO selection process. Since the CFO is directly accountable to the board and shareholders, the board-led leadership of the CFO's succession will also send the right signal to all parties that the CFO's tenure and career prospects in the company are primarily determined by the board, not the CEO.
In the company's M&A decision-making process and strategy, the CFO must act as an independent leader and supervisor to help the company achieve growth and value creation. At the same time, they will also work closely with the CEO in the subsequent stages of deal execution and target company integration. Switching between these roles can be complicated. However, CFOs who are appointed, mentored and evaluated within a board-led framework should be more willing and able to undertake this role transition.
We therefore recommend that, in companies with high M&A activity, the board should provide clear guidance to the CFO on performance expectations at various stages of the M&A process. Common practices today do not adequately separate the CFO's performance metrics in the M&A process from the CEO, and often give the CEO too much power in assessing and rewarding CFO performance. We strongly recommend that boards avoid these practices.
Does the CFO's role need to be improved?
In 2019, Nooyi retired as CEO of PepsiCo. She said in a 2016 interview that she had a "near-equal" relationship with Johnston, who has been CFO since 2010: "We would argue over a lot of issues. When it comes to the executive committee, you have to show solidarity...It's very important that the CEO and CFO are on the same page, and we discuss the issues ahead of time...Johnston and I can complement each other's speech. That's why we can Constructive debate and dialogue that ultimately lead to better outcomes."
Nooyi said that although she is a well-known CEO in the corporate world and has considerable power in the company, due to her high CFO status, her role in the top management Power is subject to certain checks and balances. Johnston's long-term experience and prestige at PepsiCo, as well as serving as a board member for several organizations and chairman of the Microsoft Corporation's (Microsoft) Audit Committee, have earned him social influence. He is also featured frequently on prominent business media channels and is often listed on top CFO lists. Johnston's high status clearly helps create a more equal power dynamic between the CEO and CFO, allowing for open communication and healthy debate between the two executives on important issues. In addition, the CFO's strategic recommendations will have more opportunities to be taken seriously and highly valued by company leaders and directors.
However, based on recent empirical research on the CEO-CFO relationship in US companies and our findings, PepsiCo's CEO-CFO relationship appears to be more of the exception than the rule. Therefore, we recommend that boards raise the position of the CFO and thereby create a more balanced power dynamic between the two executives, thereby making the M&A decision-making process more objective.
Other executives and CEOs are not on a par with the CEO in terms of status and organizational influence, perhaps most clearly marked by the large pay gap between the two—a gap that the acquirer’s board may do all it can to close, especially When it comes to CFOs. From our research and anecdotal evidence, we can infer that highly regarded CFOs demonstrate not only deep knowledge and strong leadership within the finance function, but also extensive management experience and an excellent track record outside the finance function. They maintain a close relationship with the company's board of directors, as well as have a large external network and external visibility. Appointing a CFO with many of the above characteristics helps ensure that the CFO has the necessary social influence to balance the power of the CEO at the top, thereby improving the quality of the company's M&A decisions.
Outside directors must develop a close relationship with the CFO to leverage and enhance the CFO's position. But in practice, this may be difficult for many companies to do because the CEO has formal governance over the CFO-board relationship and largely determines the timetable and agenda for board-CFO interaction. Therefore, we recommend that outside directors of the company control their relationship with the CFO. For example, they can invite the CFO to attend board meetings when important strategic issues such as growth and M&A strategy are discussed, and they can actively invite the CFO to board events such as board retreats or board luncheons before the annual shareholder meeting. In addition, CFOs are often promoted if they serve on outside boards, so outside directors can support the CFO in nurturing their own outside contacts, and perhaps in companies or organizations with which they are connected, to help them gain access to their boards seats.
CFOs with greater social influence may have greater control over the M&A process from the outset, making it easier to express their concerns and question assumptions about value creation and transaction prices. As Hawley puts it: “CFOs can use their influence over business leaders and the expertise of finance teams to help companies keep mergers and acquisitions on a given strategic path and avoid chasing what might be on paper or in the headlines. Seemingly dazzling 'flash balls' that ultimately fail to deliver the desired results."
Excessive acquisition premiums have long plagued companies seeking to expand through mergers and acquisitions. Our research shows that the power dynamics of top management is an important factor. If the company can strengthen the informal power of the CFO, it can reduce the risk of overpaying the target company. When a company's CFO has generalist skills, is sufficiently independent of the CEO, and has a high status, it is more likely to have the tools necessary to overcome weaknesses such as management agency issues and behavioral biases in the M&A decision-making process, thereby avoiding overpayment by the company for the acquisition. High fees.
Companies face an increasingly complex and volatile environment due to the disruptive impact of digitization and the COVID-19 pandemic, with a wider stakeholder group pressing for sustainable value creation. In this context, the CFO's role has also become more strategic, dynamic and broader. The insights we draw from our research can guide companies to optimize their governance systems, allowing the CFO to perform a dual role in such a system: providing expert-level independent guidance to the board on important strategic decisions while working with the CEO.
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