Performance Pay, CEO Dismissal, and the Dual Role of Takeovers

We propose that an active takeover market provides incentives by o¤ering acqui- sition opportunities to successful managers. This allows ?rms to reduce performance- based compensation and can rationalize loss-making acquisitions. At the same time, takeovers remain a substitute for board dismissal in the replacement of poorly per- forming managers. The joint impact of the two mechanisms on managerial turnover is, however, multi-faceted: In ?rms with strong boards, turnover and performance- based pay are non-monotonic in the intensity of the takeover threat. In ?rms with weak boards, turnover (performance-based pay) increases (decreases) with the in- tensity of the takeover threat. When choosing its acquisition policy and the quality of its board, each ?rm ignores the adverse e¤ect on other ?rms?acquisition oppor- tunities and takeover threat. As a result, the takeover market is not su¢ ciently liquid and too few takeovers occur.