Who Makes Acquisitions ? CEO Overcon dence and the Market s Reaction

Does CEO overcon dence help to explain merger decisions? Overcon dent CEOs overestimate their ability to generate returns. Using a simple model, we show that overcon dent CEOs overpay for target companies and undertake value-destroying mergers. The e¤ect is strongest if they have access to internal nancing. We test these predictions with two overcon dence proxies: CEOspersonal over-investment in their company and their press portrayal. The odds of overcon dent CEOs making an acquisition are 65% higher. The e¤ect is largest if the merger does not require external nancing. The market reaction at merger announcement (100 basis points) is signi cantly more negative than for nonovercon dent CEOs. We consider alternative interpretations including inside information, signaling, and risk tolerance. (JEL G34, G14, G32, D80) We are indebted to Brian Hall, Kenneth Froot, Mark Mitchell and David Yermack for providing us with essential 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, David Laibson and various participants in seminars at Harvard University, Stanford University, University of Chicago, Northwestern University, Wharton, Duke University, University of Illinois, Emory University, Carnegie Mellon University, INSEAD and Humboldt University of Berlin for helpful comments. Becky Brunson, Justin Fernandez, Jared Katse¤, Camelia Kuhnen, and Felix Momsen provided excellent research assistance. The authors acknowledge support from the Russell Sage Foundation, the Division of Research of the Harvard Business School (Malmendier) and the Center for Basic Research in the Social Sciences at Harvard (Tate). yThe Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104-6367, ph. : 215-898-7543, fax: 215-898-6200, email: tate@wharton.upenn. edu 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 pro tability of Company T[arget]. Weve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely con dent about the future potency of their kisses-even after their corporate backyards are knee-deep in unresponsive toads.  -Warren Bu¤et, Berkshire Hathaway Inc. Annual Report, 19811 U.S. rms spent more than $3.4 trillion on over 12,000 mergers during the last two decades. If chief executive o¢ cers (CEOs) act in the interest of their shareholders, these mergers should have increased their shareholderswealth. Yet, acquiring shareholders lost over $220 billion at the announcement of merger bids from 1980 to 2001 (Moeller, Schlingemann, and Stulz, 2005). While the estimates of the overall value created by mergers vary across studies, acquiring shareholders often appear to be on the losing end.2 In this paper, we ask whether CEO overcon dence helps to explain this evidence. Managerial biases like overcon dence are gaining increasing attention in the corporate nance literature (Barberis and Thaler, 2003; Baker, Ruback, and Wurgler, forthcoming). Imperfect governance mechanisms make it di¢ cult for investors to correct ine¢ cient managerial choices. Overcon dence, in particular, has long had popular appeal as an explanation for failed mergers.3 Roll (1986) rst formalized the notion, linking takeover contests to the winners curse. We present a simple model showing that overcon dent CEOs may indeed pursue valuedestroying mergers and overpay for targets. The implications of overcon dence are, however, more subtle than mere overbidding. Overcon dent CEOs also overestimate the returns they Quote taken from Weston et al. (1998). Andrade et al. (2001) nd average stock price reactions of -0.4 percent and -1.0 percent for acquirors during the 1980s and 1990s (over a three-day window surrounding the mergers). See also Dodd (1980), Firth (1980), and Ruback and Mikkelson (1984) for acquiror losses. See, e.g. Asquith (1983), Bradley et al. (1983), and Andrade et al. (2001) for target gains. Whether the net e¤ect is signi cantly positive varies with the data (SDC, CRSP), the time period, and the event study methodology. See Jensen and Ruback (1983) and Roll (1986) for surveys of earlier studies. Some recent business press articles are US Newslink December 13, 2001 (Enrons Bust: Was it the result of Over-Con dence or a Con dence Game? ); CFO Magazine June 1, 2004 (Avoiding decision traps); Accenture Outlook Journal January 2000 (Mergers & Acquisitions: Irreconcilable Di¤erence).