Darryl Laws

 Mergers and Acquisitions. Literature on mergers and acquisitions identifies three main motivations for takeovers; first the creation of synergies so that the value of a new combined entity is greater than the sum of its previously separate values (Bradley,1988; Dyer, 2004 and Tease, 1986), the second motivation exists because of agency issues (Eisenhardt, 1989) between managers and shareholders. Jensen (1986) suggests that managers may rationally pursue their own objectives at the expense of shareholder’s interests, and the third motivation for takeovers is managerial hubris (Roll, 1986) and behavioral bias. Roll’s hubris hypothesis suggests that managers of acquiring firms make valuation errors because they are too optimistic about the potential of combined synergies in a buyout or takeover. As a result, CEOs often overbid for target firms to the detriment of their stockholders.

Thus, there are two main theories; 1) rational responses to agency costs and 2) irrational response to managerial hubris that have been detrimental to explain why managers make value destroying acquisitions. Although the hubris hypothesis has considerable intuitive appeal it has only been lesser subjected to empirical testing. Behavioral assumptions such as overconfidence have become common in articles written on asset prices, but corporate finance literature has largely neglected behavioral economic assumptions in models of managerial decision-making (Barberis, 2003). In the real world of uncertainty, competitiveness, macro-economic change or competitor pre-emption may render apparently realistic acquisition targets unavailable or unattractively expensive (Bradley, 1988). All management teams face the same dilemmas when making takeover decisions, any acquisition target carries the risk of overpayment, which may be founded on unconscious irrational justifications, such as an over-optimistic expectation of combined synergies or growth opportunities or becoming trapped in an escalating bidding contest. Underbidding, failing to pay the price required to secure a critical target may result from framing the opportunity in isolation by failing to recognize new growth options and to fully appreciate the value of a target as part of a larger consolidation strategy (Jensen, 1986).

CEO Hubris. CEO hubris is generally defined as a CEO’s exaggerated self-confidence or pride. Prior research has studied the impacts of CEO hubris or overconfidence on firm decisions and outcomes including acquisition premiums (Hayward and Hambrick, 1997), investment distortion and venture failure (Hayward et al., 2006). Their findings generally suggest that companies with overconfident CEOs pay higher premiums for acquisitions, rely on internal rather than external financing, miss their own forecasts of earnings, and often undertake more value-destroying mergers. Empirical evidence has shown that CEOs tend to be overconfident. This factor can be particularly true and tempting in the kind of environment that typically surrounds highly successful executives who may have already executed a string of accretive value transactions. This is managerial hubris, an unrealistic belief held by the bidding company’s managers that they can manage the assets of a target company more efficiently than its current management team (Hayward and Hambrick, 1997). This goes hand-in-hand with excessively optimistic expectations. This kind of bias in a serial strategy may be path dependent, since the acquiring company’s past successes (recent media attention on the CEO) can increase the risk of overconfidence.

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Darryl Laws

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