Darryl Laws

 The idea that mergers are driven by biases of the acquiring manager has popular appeal, as evidenced in finance literature by authors such as by Roll (1986) who first introduced the hubris hypothesis of corporate takeovers. Building on this literature, Malmendier and Tate posit that overconfident CEOs overestimate the positive impact of their leadership and their ability to select profitable future projects, whether in their current company or in the combined merged companies. Typically, they overestimate the synergies between their company and a potential target’s or underestimate how disruptive the merger will be. As a result, overconfidence induces mergers / acquisitions that are value destroying. At the same time, overconfident CEOs view their company as undervalued by outside investors who are less optimistic about the prospects of the firm. This perceived undervaluation makes overconfident CEOs reluctant to issue equity to finance a merger.

The trade-off between perceived undervaluation and high returns from acquisitions leaves the question of whether overconfident CEOs are more likely, on average, to conduct mergers / acquisitions an empirical matter. Malmendier and Tate’s model makes the unambiguous prediction that overconfident managers are more likely to conduct value-destroying mergers. They posit that overconfident CEOs are more likely to conduct mergers if their firm has abundant sources of internal finance and they do not need to issue undervalued equity shares to finance the deal. The authors also conclude that the lower the average quality of merger / acquisition undertaken by overconfident CEOs should be reflected in a (more) negative market reaction to the merger announcement. This negative announcement effect is reinforced by the tendency of overconfident CEOs to overpay for their acquisitions in the face of competition.

Previous literature in corporate finance shows that risk averse CEOs should exercise stock options well before expiration due to the suboptimal concentration of their portfolio in company-specific risk. Malmendier and Tate (2008) classify CEOs as overconfident when they display the opposite behavior. Example: if they hold company stock options until the last year before expiration. This behavior suggests that the CEO is persistently bullish about his company’s future prospects.

Malmendier and Tate (2008) find that overconfident CEOs are more likely to conduct mergers / acquisitions than rational CEOs at any point in time. The higher acquisitiveness of overconfident CEOs on average suggests that overconfidence is an important determinant of merger / acquisition activity. Further, 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 (Lamont and Polk, 2002).  Thus, it is consistent with current theory that overconfident managers are particularly likely to undertake diversified mergers / acquisitions. Additionally, the authors found that the relationship between overconfidence and the likelihood of doing a merger is strongest when CEOs can avoid equity financing to facilitate the gap in value. More often overconfident CEOs typically prefer to use internal cash or leveraged debt (senior and sub-debt) to finance their mergers / acquisition in lieu of their using their company’s stock as a check book unless their company appears to be overvalued by the capital market.

Darryl Laws