Interesting Read from Hindu Business Line
WHY are some corporate heads so gung-ho about mergers and acquisitions (M&A) when the empirical evidence available strongly suggests that the value created by these exercises accrues almost completely to shareholders of the target company rather than to those of the acquiring firm?
If the popular assumption that corporate chiefs act rationally isvalid, why do so many mergers and acquisitions nevertheless take place? Does this mean that the assumption about the rationality of all corporate heads may, not be entirely valid?
These are some of the questions addressed in a recent study titled Who Makes Acquisitions? CEO Overconfidence and the Market's Reaction, by Ulrike M. Malmendier, assistant professor of finance at the Graduate School of Business, Stanford University, and Geoffrey A. Tate, assistant professor of finance at the Wharton School of the University of Pennsylvania.
In their study, which has been in circulation in the US as a National Bureau of Economic Research working paper, the authors argue that "overconfidence among acquiring CEOs is an important explanation of merger activity", which they describe as "among the most significant and disruptive activities undertaken by large corporations."
"The staggering economic magnitude of these deals has inspired a myriad of research on their causes and consequences. Most theories focus on the efficiency gains that motivate takeover activity, often for specific epochs. The empirical results on returns to mergers, however, are mixed, suggesting that mergers may not create value on average.
Moreover, even if there are gains from mergers, they do not appear to accrue to the shareholders of the acquiring company.
There is a significant positive gain in target value upon the announcement of a bid, and a significant loss to the acquirer. These findings suggest that mergers are often not in the interest of the shareholders of the acquiring company."
But how do we spot overconfidence in a CEO?
Overconfident CEOs, according to Malmendier and Tate, "over-estimate their ability to generate returns." Thus, on the margin, they undertake mergers that destroy value. They also perceive outside finance to be over-priced. "We classify CEOs as overconfident when, despite their under-diversification, they hold options on company stock until expiration (emphasis added). We find that these CEOs are more acquisitive on an average, particularly via diversifying deals." The effects are largest in firms with abundant cash and untapped debt capacity.
Using press coverage as "confident" or "optimistic" to measure overconfidence, confirms these results. We also find that the market reacts more negatively to takeover bids by overconfident managers.
The authors tested their thesis empirically on a sample of Forbes 500 firms from 1980 to 1994.
Their main empirical measure of overconfidence made use of time series data on the CEOs' holdings of company stock options in their private portfolios. "Previous literature in corporate finance shows that risk averse CEOs should exercise stock options well before expiration due to the sub-optimal concentration of their portfolio in company-specific risk.
As in Malmendier and Tate (2003), we classify CEOs as overconfident when they display the opposite behaviour, that is, if they hold company stock options until the last year before expiration.
This behaviour suggests that the CEO is persistently bullish about his company's future prospects. We find that overconfident CEOs are more likely to conduct mergers than rational CEOs at any point in time. The higher acquisitiveness of overconfident CEOs — even "on average" — suggests that overconfidence is an important determinant of merger activity."
"Moreover, the effect of overconfidence on merger activity comes primarily from an increased likelihood of conducting diversifying acquisitions. Previous literature suggests that diversifying mergers are unlikely to create value in the acquiring firm. Thus, it is consistent with our theory that overconfident managers are particularly likely to undertake them.
Second, we find that the relationship between overconfidence and the likelihood of doing a merger is strongest when CEOs can avoid equity-financing, that is, least equity dependent firms. Overconfident CEOs strongly prefer cash-or debt-financed mergers to stock deals, unless their firm appears to be overvalued by the market."
"Additional empirical tests corroborate our results. We show that the observed differences in option exercises and merger decisions are not due to inside information. Instead, the hypothetical returns, CEOs could have obtained by exercising their options earlier are positive on average. In addition, the acquisitions of overconfident managers are distributed uniformly over their tenures suggesting that the effect of overconfidence is a true managerial fixed effect."
To bolster their portfolio measure of overconfidence, Malmendier and Tate constructed an alternative measure based on how a CEO was characterised in the press. They analysed the difference in merger activity between CEOs who were portrayed in the business press as "confident" and "optimistic" and CEOs who were portrayed as "reliable," "cautious," "conservative," "practical," "frugal," or "steady."
Controlling the total number of press mentions, they performed the same empirical analysis as with the portfolio overconfidence measure. The results replicated. Furthermore, the two measures turned out to be "highly correlated."
Finally, they looked directly at the market's perception of the merger decisions made by overconfident CEOs. Using standard event study methodology, they demonstrated that outside investors reacted more negatively to the announcement of a bid if the CEO was overconfident.
This result also held for controlling relatedness of the target and acquirer, ownership stake of the acquiring CEO, corporate governance of the acquirer, and method of financing the merger. Their results suggested that, even if overconfident, CEOs created firm value along some dimensions — and mergers and acquisitions were not among them.
"Our theory of managerial overconfidence provides a natural complement to standard agency theory." Both "empire-building preferences" and overconfidence predict heightened managerial acquisitiveness — as given abundant internal resources — and, as shown in Malmendier and Tate (2003), a heightened sensitivity of corporate investment to cash flow.
Unlike empire-builders, overconfident CEOs believe that they are acting in the interest of the shareholders. Thus, overconfidence, cast as an agency problem, challenges the effectiveness of stock and option grants to top executives as an incentive mechanism. On the other hand, it provides additional underpinning for models of debt overhang.
High leverage may effectively counterbalance an overconfident CEO's eagerness to invest and acquire, given his reluctance to issue equity he perceives as undervalued. In addition, the failure of traditional incentives to mitigate overconfidence underscores the importance of an independent board of directors.