Who Makes Acquisitions? CEO Overconfidence and the Market’s Reaction

We analyze the impact of CEO overconfidence on mergers and acquisitions. Overconfident CEOs over-estimate their ability to generate returns, both in their current firm and in potential takeover targets. Thus, on the margin, they undertake mergers that destroy value. Overconfidence also implies that managers view their company as undervalued by outside investors. Therefore, the impact of overconfidence is strongest when CEOs can finance mergers internally. We test these predictions using the merger decisions of a sample of Forbes 500 companies between 1980 and 1994. We classify CEOs as overconfident when, in spite of their under-diversification, they hold company options until expiration. We find that such CEOs are more likely to conduct mergers on average and that this e ect is due largely to diversifying mergers. As predicted, overconfidence has the largest e ect in firms with the most cash and untapped debt capacity. In addition, we find that the market reacts negatively to takeover bids and that this e ect is significantly stronger for overconfident managers. 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, University of Chicago, Kellogg School of Management, Wharton, Duke University, University of Illinois, and Emory University for helpful comments. Felix Momsen and Justin Fernandez provided excellent research assistance. Malmendier acknowledges support from the Russell Sage Foundation and the Division of Research of the Harvard Business School. Tate acknowledges support from the Russell Sage Foundation and the Center for Basic Research in the Social Sciences (Harvard University). “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 knee-deep in unresponsive toads.” -Warren Bu et, Berkshire Hathaway Inc. Annual Report, 19811