Who Makes Acquisitions? CEO Overconfidence and the Market’s Reaction by Ulrike Malmendier and Geoffrey Tate

1. Who Makes Acquisitions? • CEO Overconfidence and the Market’s Reaction • by • Ulrike Malmendier and Geoffrey Tate • Builds on Roll’s (1986) Hubris Hypothesis of corporate takeovers.

2. Overconfident CEOs (page 2) • Roll’s (1986) Hubris Hypothesis of corporate takeovers • Likely to overvalue a takeover target because they overestimate returns they can generate from the combined firm. • Likely to overvalue their contribution to their own company. • Overconfidence implies that managers view their company as undervalued by outside investors who are less optimistic about the prospects of the firm.

3. Two Predictions regarding behavior of overconfident CEOs (pages 22-23) • More likely to engage in takeovers, especially when they have access to internal funds. • More likely to engage in bad mergers: mergers that create no value or destroy value for acquiring shareholders.

4. Both overconfidence and empire-building managerial preferences predict greater takeover activity (page 22). • Overconfident CEO believes she is acting in the interest of shareholders. • Overconfident CEOs not responsive to traditional remedies like greater equity stake. • Debt requires regular cash outflows to bondholders. Debt may serve to clamp down takeover tendencies of CEOs. • (Not mentioned: Board oversight. How do you get board-members to be more pro-active in refusing to authorize (value-destroying) mergers?)

5. Measure of CEO overconfidence: Timing of option exercises (pages 24-26). • . CEOs own stock in their company. • CEO’s compensation/human capital/reputation tied to company performance. • Hence, CEOs quite likely to be underdiversified. Should exercise their options as soon as they can. • Typical CEO option has 10 year term to maturity, and fully vests after 4 years. • CEOs holds her options at least once till expiration even though it is 40% in the money: Longholders.

6. CEOs holds her options at least once till expiration even though it is 40% in the money: Longholders. • Examples on pages 27-28: • David Farrell: longholder: 5 acquisitions. • JW Marriott: never holds option till expiration: No acquisitions. • Colgate Palmolive • Keith Crane: never holds option till expiration: No acquisitions. • Reuben Mark: : longholder: 4 acquisitions.

7. Table 3: Do Longholder CEOs complete more mergers? YES. Table 5: Do Longholder CEOs complete more diversifying mergers? YES. Table 6: Stock market response is more negative to Longholder CEOs’ mergers. Table 7, Panel A: Are overconfident CEOs wise to hold their options? NO.

8. Table 8, Panel B: Longholders positively correlated with media stories about CEO being “confident,” and “optimistic.” Table 9: Overconfident CEOs more likely to engage in mergers, especially diversifying mergers.

9. Do Bad Bidders Get Fired? By Mengxin Zhao and Kenneth Lehn Anecdote: Pages 2-3: Quaker Oats announces acquisition of Snapple in 1994: Market value of Quaker Oats drops $493 million in one day. CEO of Quaker Oats pressured to resign less than three years later.

10. Page 8: Disciplinary CEO turnover: “Fired,” “Forced to step down,” rarely reported in the media. Retirement that is not announced six months before effective date. Table 2: Fired CEOs are younger, have less tenure, and less likely to be Chairman. Table 3: Prior stock market performance: Similar. Prior operating margin poorer for fired CEOs.

11. Table 4: Stock market response to acquisition announcement: More negative for CEOs that were ultimately fired. Table 8: Probability of getting fired is higher – more negative the announcement return, and more negative the post-acquisition stock market performance.