As anyone who reads business headlines can attest, the comeback in merger and acquisition activity that began last fall is continuing to surge ahead in 2004. While bank pairings have predominated lately – with Bank of America acquiring FleetBoston and J.P. Morgan Chase linking up with Chicago-based Bank One – Comcast Corp. jumped in the fray this week with a $54.1 billion unsolicited takeover bid for The Walt Disney Co.


Chief executives say they do these sorts of deals to benefit shareholders. Inevitably, they talk about synergies, market share and economies of scale. Yet the data suggest that most deals don’t make money for shareholders in acquiring companies.


And that has led skeptical scholars to accuse acquisition-hungry executives of being empire builders. Under this line of thinking, CEOs don’t acquire companies to benefit their shareholders. They do it for themselves. A bigger company means a bigger paycheck, a bigger fiefdom and more attention from the media.


But Wharton finance professor Geoffrey Tate sees a way of reconciling the woeful performance of stocks in acquiring companies with their CEOs’ pie-in-the-sky pronouncements. He and his co-author, Stanford finance professor Ulrike Malmendier, mix the insights of finance and psychology and, in effect, give corporate bosses the benefit of the doubt.


In a recent paper titled, Who Makes Acquisitions? CEO Overconfidence and the Market’s Reaction, the researchers acknowledge that mergers often appear to destroy value for shareholders. But executives, they say, may not be putting their interests ahead of their shareholders’. Instead, they may be too confident in their own abilities and thus in their companies’ prospects. In other words, they believe that their deal will trump all the mediocre ones that have come before. Their confidence – critics might call it hubris – blinkers them.


“Overconfident CEOs overestimate the positive impact of their leadership and their ability to select profitable future projects,” the researchers write. “They may also overestimate the synergies between their company and a potential target or underestimate how disruptive a merger will be.” That leads them to charge ahead with mergers, despite evidence that the transactions destroy shareholder value.


Overconfidence also colors how executives choose to finance their acquisitions. “Overconfident CEOs view their company as undervalued by outside investors who are less optimistic about the prospects of the firm,” Tate and Malmendier write. “This perceived undervaluation makes [them] reluctant to issue equity.” For example, the market says a stock is worth $50 a share, but the CEO is sure it’s worth at least $75. By this way of thinking, issuing stock to do a deal means “giving away” $25 a share.


Using this line of reasoning, how exactly did Tate and Malmendier determine which CEOs are overconfident? Surveying hundreds of them would take too much time and could yield misleading answers. Overconfident ones might wish to appear more prudent and shade their answers accordingly. Cautious ones might be feeling especially ebullient on the day of the survey. 


Tate and Malmendier heeded the adage that actions speak louder than words. They measured overconfidence by assessing how CEOs in a sample of Forbes 500 companies handled their stock options. Specifically, they examined 477 firms during the period from 1980 to 1994. If a CEO ever held options in his company until the year they expired, he was classified as overconfident.


Why? “Previous literature in corporate finance shows that risk averse CEOs should exercise stock options well before expiration,” the authors write. A CEO’s financial fate is tightly bound to his company’s. He draws a salary from the firm and, even before exercising options, probably holds more stock in it than in any other. By exercising his options early, he can diversify his portfolio.


“Holding an option until its final year, even when it is highly in the money, indicates that the CEO has been consistently ‘bullish’ about the company’s prospects,” Tate and Malmendier explain. “The CEO is repeatedly betting his personal wealth on the company’s future returns.”


When the authors compare the behavior of these CEOs with the more cautious ones in their sample – they call them “rational CEOs” – they find that “overconfident CEOs are more likely to conduct mergers than rational CEOs at any point in time.”


Consider Wayne Huizenga, former boss of Dallas-based Blockbuster. He led the company during the seven years that it appeared in the sample. He held some of his options until their expiration year, qualifying him as overconfident. He also did six acquisitions. Similarly, David Farrell headed St. Louis-based May Department Stores during the 15 years in which it appeared in the sample. He, too, qualified as overconfident. He did five deals.


Contrast them with J. Willard Marriott, chairman and CEO of Bethesda, Md.-based Marriott International. Like Farrell, he led his company for all 15 years. Unlike him, he didn’t hold options until expiration, and he didn’t do any deals.


The difference in behavior doesn’t just crop up among companies. Sometimes, it appears within a single firm. Keith Crane, CEO of New York-based Colgate-Palmolive, led the company for the first four years of Tate and Malmendier’s sample. He didn’t hold options till their expiration year, and he didn’t do acquisitions. Reuben Mark took over in 1984 and remained CEO for the next 11 years. He sometimes held options until their expiration year, and he did four deals.


To backstop their overconfidence measure, Tate and Malmendier created a second one. They compared the way CEOs were characterized in major newspapers and business publications, categorizing them as either overconfident or cautious. When they substituted this measure for their first, their predictions still held up – overconfident CEOs were more likely to do deals.


Tate and Malmendier also found that overconfident CEOs were most likely to make acquisitions when they could avoid selling new stock to finance them and that they were more likely to do deals that diversified their firm’s lines of business. Prior research has shown that diversifying mergers are the least likely to create value.


Assuming Tate and Malmendier are right, their conclusions could lead companies to rethink their governance. Tate, for example, suggests that they might want to make sure that they have more independent directors on their boards. And these directors might “need to play a more active role in project assessment and selection,” the paper says. Corporate boards, Tate explained in an interview, need “people who are able and willing to take a view contrary to the CEO’s.” In other words, they need someone who is willing to pull the CEO aside and point out that, despite his Armani-sized paycheck, he’s wearing no clothes.


Tate and Malmendier’s analysis also suggests that executive compensation in the form of stock options may not adequately align the interests of executives and shareholders. After all, an overconfident executive believes he’s acting in the interest of his company’s shareholders – and thus his own – when he undertakes a merger. He just often happens to be wrong. Giving him more options probably won’t change his thinking.


But debt might. Requiring a company to carry a fairly high level of debt could provide the necessary reality check for overconfident executives, Tate suggests.


Finance professors have long argued that a high level of debt disciplines managers, putting a check on what John Maynard Keynes called their “animal spirits.” It forces them to go to the market and ask for money, typically in the form of equity, if they want to do acquisitions. When they do that, investors have a chance to assess the proposed acquisition. If they think it’s a bad idea, they won’t finance it.


High leverage, the authors note, “may effectively counterbalance an overconfident CEO’s eagerness to invest and acquire, given his reluctance to issue equity he perceives as undervalued.”

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