Darryl Laws

 Malmendier and Tate (2008) examine the extent to which over-confidence can help to explain merger / acquisition decisions and various characteristics of the deal itself. They find that overconfident CEOs are; 1) more likely to pursue acquisitions when their firms have abundant internal resources, 2) are significantly more likely than other CEOs to undertake a diversifying merger and 3) that overconfident CEOs use cash to finance their mergers / acquisitions more often than rational CEOs. They have developed a unique model for CEO overconfidence that shows the impact of overconfidence on merger / acquisition decisions. Their model empirically and quantitively test the predictions on a data set of large U.S. companies from 1980 to 1994. They use the CEOs’ personal portfolio decisions to measure overconfidence, they find that overconfident CEOs conduct more mergers / acquisitions and, in particular, more value-destroying mergers / acquisitions. They prognosticate that these effects are most pronounced in firms with abundant cash or untapped debt capacity. Furthermore, the market’s assessment of overconfident CEOs, reflected by press coverage in major business publications and the stock price reaction to merger / acquisition announcements, corroborates their overconfidence theory.

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.

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