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Journal of Financial Economics 00 (0000) 000-000
Who makes acquisitions? CEO overconfidence
boy
and the market’s reaction
Ulrike Malmendier a, Geoffrey Tate b*
a University of California, Berkeley, Berkeley, CA, 94720, USA
b University of California at Los Angeles, Los Angeles, CA, 90095, USA
Received 22 May 2006; received in revid form 18 June 2007;
accepted 17 July 2007
Abstract
D oes CEO overconfidence help to explain merger decisions? Overconfident CEOs over-estimate their ability to generate returns. As a result, they overpay for target companies and undertake value-destroying mergers. The effects are strongest if they have access to internal financing. We test the predictions using two proxies for overconfidence: CEOs' personal over-investment in their company and their press portrayal. We find that the odds of making an acquisition are 65% higher if the CEO is classified as overconfident. The effect is largest if the merger is diversifying and does not require e
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xternal financing. The market reaction at merger announcement (–90 basis points) is significantly more negative than for non-overconfident CEOs (–12 basis points). We consider alternative interpretations including inside information, signaling, and risk tolerance.cooperation是什么意思
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JEL classifications: D80; G14; G32; G34
Keywords: Mergers and Acquisitions, Returns to Mergers, Overconfidence, Hubris, Managerial Bias
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We are indebted to Brian Hall, Kenneth Froot, Mark Mitchell and David Yermack for providing us with esntial parts of the data. We are very grateful to Jeremy Stein and Andrei Shleifer for their invaluable support and comments. We also would like to thank Gary Chamberlain, D avid Laibson and various participants in minars at Harvard University, Stanford University, University of Chicago, Northwestern University, Wharton, D uke University, University of Illinois, Emory University, Carnegie Mellon University, INSEAD and Humboldt University of Berlin for helpful comments. Becky Brunson, Justin Fernandez, Jared Katff, Camelia Kuhnen, and Felix Momn provided excellent rearch assistance. The authors acknowledge support from the Rusll Sage Foundation, the Divisi
on of Rearch of the Harvard Business School (Malmendier) and the Center for Basic Rearch in the Social Sciences at Harvard (Tate). *Corresponding author contact information: E-mail address: geoff.tate@anderson.ucla.edu
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chasing pavement1Introduction
jko“Many managements apparently were overexpod in impressionable childhood years to the story in which the imprisoned handsome prince is relead from a toad’s body by a kiss from a beautiful princess.Conquently,they are certain their managerial kiss will do wonders for the profitability of Company T[arget]...We’ve obrved many kiss but very few miracles.Nevertheless,many managerial princess remain renely confident about the future potency of their kiss-even after their corporate backyards are knee-deep in unresponsive toads.”
-Warren Bu et,Berkshire Hathaway Inc.Annual Report,19811
U.S.firms spent more than$3.4trillion on over12,000mergers during the last two decades.If chief executive o!cers(CEOs)act in the interest of their shareholders,the mergers should have incread shareholder wealth.Yet,acquiring shareholders lost over $220billion at the announcement of merger bids from1980to2001(Moeller,Schlinge-mann,and Stulz,2005).While the joint e ect of mergers on acquiror and target value may be positive,acquiring shareholders appear to be on the losing end.2In this paper, we ask whether CEO overconfidence helps to explain the loss of acquirors.
Overconfidence has long had popular appeal as an explanation for failed mergers.3 Roll(1986)first formalized the notion,linking takeover contests to the winner’s cur. The implications of overconfidence for mergers,however,are more subtle than mere overbidding.Overconfident CEOs also overestimate the returns they generate internally and believe outside investors undervalue their companies.As a result,they are reluctant to rai externalfinance and may forgo mergers if external capital is required.The
1Quote taken from Weston et al.(1998).
2Andrade et al.(2001)find average stock price reactions of-0.4and-1.0%over a three-day window for acquirors during the1980s and1990s;e also Dodd(1980),Firth(1980),and Ruback and Mikkelson(1984).Targets may gain from merger bids;e Asquith(1983)and Bradley et al.(1983).Jenn and Ruback(1983)and Roll(1986)survey earlier studies.
3Recent business press articles include CFO Magazine,June1,2004(“Avoiding Decision Traps”);US Newslink,December13,2001(“Enron’s Bust:Was It the Result of Over-Confidence or a Confidence Game?”);Accenture Outlook Journal,January,2000(“Mergers &Acquisitions:Irreconcilable Di erences”).
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f overconfidence on merger frequency,then,is ambiguous.Overconfident managers are unambiguously more likely to conduct mergers only if they have su!cient internal resources.Moreover,if overconfidence increas merger frequency,it also lowers average deal quality and induces a lower average market reaction to the announcement of merger bids.
We test the hypothes using a sample of394large U.S.firms from1980to1994. We u CEOs’personal investment decisions to elicit their beliefs about their companies’future performance.Previous literature shows that risk aver CEOs should reduce their exposure to company-specific risk by exercising in-the-money executive stock options prior to expiration.4A subt of CEOs in our data persistently fails to do so.They delay option exerci all the way until expiration,even when the underlying stock price exceeds rational exerci thresholds such as tho derived in Hall and Murphy(2002).Moreover, they typically make loss from holding their options relative to a diversification strategy.
We link the beliefs CEOs reveal in their personal portfolio choices to their merger decisions.Wefind that CEOs who fail to diversify their personal portfolios are signif-icantly more likely to conduct mergers at any point in time.The results hold when we identify such CEOs with afixed-e ect(“Longholder”)or allow for variation over time(“Post-Longholder”and“Holder67”).They are robust to
controlling for standard merger determinants like Q,size,and cashflow,and usingfirmfixed e ects to remove the impact of time-invariantfirm characteristics.The e ect is largest amongfirms with abundant internal resources and for diversifying acquisitions.Taking diversification as a proxy for value destruction,5the results confirm the overconfidence hypothesis.
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We also analyze the market’s reaction to merger announcements,which provides a more direct measure of value creation.Wefind that investors react significantly more negatively to merger bids of Longholder CEOs.Over the three days around announce-ments,they lo on average90basis points,compared to12basis points for other CEOs.
,Lambert et al.(1991).
5Graham,Lemmon,and Wolf(2002)and Villalonga(2004),among others,question the in-terpretation of the diversification discount and attribute the e ect to pre-existing discounts or econometric and data bias.Schoar(2002),however,confirms the negative impact of diversi-fication via acquisition using plant-level data.
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The result holds controlling for relatedness of target and acquiror,ownership stake of the acquiring CEO,board size of the acquiror,and method offinancing.While an-nouncement e ects may not capture the overall value created by mergers,due to market frictions and ine!ciencies(Shleifer and Vishny,2003;Mitchell,Pulvino,and Sta ord, 2004),the di erential reaction to bids of Longholder CEOs is likely to be orthogonal to the factors and,thus,to capture value di erences.
We consider veral explanations for the link between late option exerci and merg-ers:positive inside information,signaling,board pressure,risk tolerance,taxes,procras-tination,and overconfidence.Only positive CEO beliefs(inside information or overcon-fidence)and risk preferences(risk tolerance),however,provide a straightforward expla-nation for both personal overinvestment and excessive merger activity.Among the explanations inside information(or signaling)is hard to reconcile with the loss CEOs incur on their personal portfolios by delaying option exerci and with the more negative reaction to their merger bids.Similarly,risk eking is di!cult to reconcile with the ob-rved preference for cashfinancing and diversifying mergers.Overconfidence,instead, is consistent with allfindings.
To further test the overconfidence interpretation,we hand-collect data on CEO cover-age in the business press.We identify CEOs characterized as“confident”or“optimistic”versus“reliable,”“cautious,”“conrvative,”“practical,”“frugal,”or“steady.”Charac-terization as confident or optimistic is significantly positively correlated with our port-folio measures of optimistic beliefs.And,our main results replicate using a press-bad measure of overconfidence.
Our results suggest that a significant subt of CEOs is overconfident about their future cashflows and engages in mergers that do not warrant the paid premium.Over-confidence may createfirm valu
e along some dimensions—for example,by counteracting risk aversion,inducing entrepreneurship,allowingfirms to make credible threats,or at-tracting similarly-minded employees6—but mergers are not among them.
Our paper relates to veral strands of literature.First,we contribute to rearch on
6See Bernardo and Welch(2001),Goel and Thakor(2000),Schelling(1960),and Van den Steen(2005).
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the explanations for mergers.Much of the literature focus on the e!ciency gains from ,Lang,Stulz,and Walkling,1989;Servaes,1991;Mulherin and Pouln, 1998).Overconfidence,instead,is clost to agency theory(Jenn,1986and1988). Empire-building,like overconfidence,predicts heightened acquisitiveness to the detri-ment of shareholders,especially given abundant internal resources(Harford,1999).Un-like traditional empire-builders,however,overconfident CEOs believe that they are act-ing in the interest of shareholders,and are willing to personally invest in their companies. Thus,while excessive acquisitiveness can result both from agency problems and from overconfidence,the relation to late option ,CEOs’personal overinvestment in their companies,aris only from overconfidence.
The paper also contributes to the literature on overconfidence.Psychologists suggest that individuals are especially overconfident about outcomes they believe are under their control(Langer,1975;March
and Shapira,1987)and to which they are highly committed (Weinstein,1980;Weinstein and Klein,2002).7Both criteria apply to mergers.The CEO gains control of the target.And a successful merger enhances professional standing and personal wealth.
We also contribute to the growing strand of behavioral corporatefinance litera-ture considering the conquences of biad managers in e!cient markets(Barberis and Thaler,2003;Baker,Ruback,and Wurgler,2006;Camerer and Malmendier,2007).A number of recent papers study upward bias in managers’lf-asssment,focusing on corporatefinance theory(Heaton,2002),the decision-making of entrepreneurs(Landier and Thesmar,2003),or indirect measures of“hubris”(Hayward and Hambrick,1997). We complement the literature by using the decisions of CEOs in large companies to measure biad managerial beliefs and their implications for merger decisions.Seyhun (1990)also considers insider stock transactions around mergers,though overconfidence is not his primary focus.Our approach is most similar to Malmendier and Tate(2005),
7The overestimation of future outcomes,as analyzed in this literature,is sometimes referred to as“optimism”rather than“overconfidence,”while“overconfidence”is ud to denote the underestimation of confidence intervals.We follow the literature on lf-rving attribution and choo the label“overconfidence”for the overestimation of outcomes related to own abilities (such as
IQ or managerial skills)and“optimism”for the overestimation of exogenous outcomes (such as the growth of the y).
