No . 1798 Who Makes Acquisitions ? CEO Overconfidence and the Market ’ s Reaction Ulrike

Overconfident CEOs over-estimate their ability to generate returns. Thus, on the margin, they undertake mergers that destroy value. They also perceive outside finance to be over-priced. We classify CEOs as overconfident when, despite their under-diversification, they hold options on company stock until expiration. We find that these CEOs are more acquisitive on average, particularly via diversifying deals. The effects are largest in firms with abundant cash and untapped debt capacity. Using press coverage as "confident" or "optimistic" to measure overconfidence confirms these results. We also find that the market reacts significantly more negatively to takeover bids by overconfident managers. (JEL G34, G14, G32, D80). “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 Buffet, Berkshire Hathaway Inc. Annual Report, 19811 Mergers and acquisitions are among the most significant and disruptive activities undertaken by large corporations. The staggering economic magnitude of these deals has inspired a myriad of research on their causes and consequences. Most theories focus on the efficiency gains that motivate takeover activity, often for specific epochs. The empirical results on returns to mergers, however, are mixed, suggesting that mergers may not create value on average.2 Moreover, even if there are gains from mergers, they do not appear to accrue to the shareholders of the acquiring company. There is a significant positive gain in target value upon the announcement of a bid, and a significant loss to the acquiror.3 These findings suggest that mergers are often not in the interest of the shareholders of the acquiring company. In this paper, we argue that overconfidence among acquiring CEOs is an important explanation of merger activity. We develop a model of CEO overconfidence that shows the impact of overconfidence on merger decisions. We test the predictions on a data set of large US companies from 1980 to 1994. Using the CEOs’ personal portfolio decisions to measure overconfidence, we find that overconfident CEOs conduct more mergers and, in particular, more value-destroying mergers. As predicted, 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 announcements, corroborates the overconfidence theory. The idea that mergers may be driven by biases of the acquiring manager has long had popular appeal, as evidenced by our introductory quote. In the finance literature, Roll (1986) first introduced the “hubris hypothesis” of corporate takeovers.4 Subsequent studies have found experimental evidence on overconfidence in market entry decisions (Camerer and Lovallo, 1999) and on the underestimation of cultural conflicts in mergers (Weber and Camerer, 2003). Building on this literature, we propose that overconfident CEOs overestimate the positive impact of