CEO Overconfidence in Mergers & Acquisitions – Literature Review

Published on Author Kristoffer

“Many managements apparently were overexposed in impressionable childhood years to
the story in which the imprisoned handsome prince is released from a toad’s body by a
kiss from a beautiful princess. Consequently, they are certain their managerial kiss will
do wonders for the profitability of Company T[arget]…We’ve observed many kisses but
very few miracles. Nevertheless, many managerial princesses remain serenely confident
about the future potency of their kisses-even after their corporate backyards are kneedeep
in unresponsive toads.”

-Warren Buffet, Berkshire Hathaway Inc. Annual Report, 1981 

The nature of M&A activity has always been filled with ambiguity. Initially neoclassical theories of M&A activity proposed that CEO’s are rational and will try to maximize shareholder value by activating synergy effects and efficiency when undergoing M&A deals (Jensen & Ruback, 1983).  Furthermore, they found that Industry shocks also play a role in M&A activity according to Mitchell & Mulherin (1996).

The literature has yet to agree on the predominant independent variable that affects M&A overbidding.  Roll (1986) initially proposed a ‘hubris’ theory where he indicates that CEO overbidding could be explained by overconfidence. Roll (1986) argue that markets are efficient but CEO’s are overconfident and overestimate their ability to create synergy effects. Shleifer & Vichny (2003) take the opposite stand and argue that stock markets are inefficient and CEO’s are completely rational when paying a high premium for firms. They simply take advantage of the stock market inefficiencies. Jensen (1986) also contributes to the discussion by presenting agency costs as the explaining variable for CEO overbidding. Jensen (1986) claim that CEO’s are not overconfident but rather empire builders. He argue that CEO’s will complete M&A deals to increase their company size at the expense of the shareholders.

This literature review will focus on the behavioral literature supporting Roll (1986). It is necessary to understand some of the methodologies for measuring overconfidence, which will be used in the following research design. In the field of psychology, the term overconfidence can be split into the following forms, ‘better-than-average’ effect (Taylor & Brown, 1988), miscalibration (Oskamp, 1965), ‘illusion-of-control” (Langer, 1975), unrealistic optimism (Weinstein, 1980).

Most of the scholars within behavioral finance has focused on behavioral biases of the private investors. Odean (1999) finds that overconfidence can be found in the frequency of stock trades. Overconfident investors will trade too much and destroy returns because of excessive trading costs. Doukas & Petmezas (2007) builds on the frequency theory from Odean (1999) and put it in the perspective of CEO’s and their M&A deals. Doukas & Petmezas (2007) compared high order CEO’s (five or more deals within a three-year period) with low order CEO’s (first deal) and find that high order CEO’s tend to be associated with worse post-merger performances. This is consistent with Roll (1986) who writes that CEO’s will continue to complete deals despite bad valuations in the past.

Roll (1986) claims that CEO’s convince themselves that their valuation was correct and that the market is simply not correctly valuing the newly combined firm. One critique of Roll’s hubris hypothesis is that shareholders should naturally prevent the CEO’s from carrying on more deals if they continuously overvalue targets.

Malmendier and Tate (2008) have found that CEO’s who fail to diversify their private portfolios are likely to complete M&A deals. However, they also stress that the private portfolio proxy cannot accurately predict whether a CEO will go through with more deals since financing has a significant effect on the results. They found that if the firm has abundant internal resources then an overconfident CEO would unambiguously be more likely to make lower-quality M&A deals.

M&A’s are complex processes and may be explained by many different variables other than overconfidence. A lot of the literature on M&A underperformance has looked at the role of market valuations. Rosen (2006) finds that the acquirer’s stock price is likely to experience short-term abnormal positive returns after an M&A if they are in a “hot” M&A market or if the stock market is doing well. Nevertheless, high market valuations lead to lower long-run abnormal stock performances.

One of the key problems with this literature review is that it does not focus on cross-border M&A deals specifically. Most of the current literature combines national and cross-border M&A deals in their samples or specifically focus on deals within a specific country. One key element of cross-border deals is the increased level of uncertainty. It is possible to look at the literature of analyzing stocks where Kumar (2009) finds that investors display stronger behavioral biases in uncertainty situations where stocks are harder to value than normal. It is possible to argue that the same may be true for CEO’s that are evaluating cross-border M&A deals. However, the opposite effect may also be true. Russo and Schoemaker (1992) find that increased awareness of the uncertainty is a countermeasure of overconfidence. It must be emphasized that both Kumar (2009) and Russo & Schoemaker (1992) study empirical data which lies far from the complex nature of M&A deals. Nevertheless, they still provide useful insights into the possible results of this proposed research of behavioral biases in cross-border M&A.



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