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Tuesday, 15 October 2013

Hubris in Acquisitions - We can pay top dollar, as we'll make it work

The psychology of acquiring firm managers provides an interesting contrast to the views of finance, economics, and strategy researchers who assume a logical, well thought out progression through acquisition strategy formulation and decision making.

An interesting paper by Roll The Hubris Hypothesis of Corporate Takeovers was the first to argue that successful bids for an acquisition target are due to hubris, defined by wikipedia as extreme pride or arrogance… a loss of contact with reality and an overestimation of one's own competence, accomplishments or capabilities, especially when the person exhibiting it is in a position of power.”

Senior managers have a track record of success, and overcoming difficult problems. As they progress in their career, the issues they deal with become larger, yet they are still able to deal with them, and become supremely confident in their ability to deal with whatever problems may arise. Managers may make a couple of small acquisitions, which are integrated quickly and profitably, further proof of their ability and the ability of their firm. An opportunity then develops to acquire a company which will transform their business. Over confident in their ability to run the business better than its existing managers, they make a highly competitive if not excessive bid, but beyond the capability of managers to implement, resulting in acquisition failure.

Roll's position is that if the bid for an acquisition is below the market price it will not be accepted. If the bid is accepted, it shows an overly optimistic valuation of the company (paying more than the firm is worth), which acquiring firm managers should terminate but do not as they are overly confident that they are right, and stubbornly continue with the acquisition convinced that they know best.

In Explaining the Premiums Paid for Large Acquisitions: Evidence of CEO Hubris Hayward and Hambrick examined the impact of Chief Executive Officer hubris on acquisition processes and the size of premiums paid. The study used the takeover premiums obtained from cumulative abnormal security returns (CAR) for two returns, immediate returns five days prior and five days after the acquisition announcement, and one year returns 30 days prior and 331 days after the announcement, for 106 acquisitions undertaken in 1989 and 1992, with payments over $US 100 million used as they were large enough to attract Chief Executive Officer attention. 

The results found that Chief Executive Officer hubris had a substantial impact on the size of premiums paid for acquisitions. If the acquiring firm was perceived to be performing well, if the Chief Executive Officer was praised in the media, if the Chief Executive Officer was paid substantially more than other company executives, and if the board had a greater number of internal directors or the Chief Executive Officer was also the Board Chairman, then the price paid for the acquisition increased. While a later study Who Makes Acquisitions? CEO Overconfidence and the Market’s Reaction by Malmendier and Tate found that overconfident CEOs are “unambiguously more likely” to undertake value-destroying acquisitions, and more likely to make acquisitions when their firm has abundant internal financial resources.

Hayward and Hambrick make an interesting comment when discussing Chief Executive Officer confidence: “It may be that only CEOs with considerable confidence (or perhaps simply a political foothold) will consider making a large acquisition. Then, among them, the greater the confidence, the greater the price paid”.

The hubris hypothesis gives a different view on why Chief Executives undertake acquisitions, and why they persist with an acquisition that destroys value for shareholders, despite information that should result in their withdrawal.

Acquirers need to pay attention to the psychological aspects of an acquisition, and ensure that board and management processes are in place to prevent an outbreak of hubris.