Mergers of Overconfident CEOs Fall Short

They're the corporate equivalent of vain movie stars and boastful sports celebrities—the brash chief executives with an outsized sense of their own business talent. And they may be an important reason why so many corporate acquisitions fall flat.

It's long been known that investors are suspicious of takeovers, fearing that acquirers may be overpaying. The share prices of acquiring companies often tumble after deals are made public. In a 2008 paper, Ulrike Malmendier, a professor of finance at UC Berkeley's Haas School of Business, and co- author Geoffrey Tate, concluded that CEO overconfidence could be the reason why. Looking at 394 big corporations from 1980 to 1984, Malmendier and Tate found that overconfident CEOs accounted for 44 percent of stock market losses following acquisition announcements, even though they represented less than 11 percent of chief executives. These corporate chieftains may have been sure they could make takeovers succeed, but investors weren't buying it.

Overconfident CEOs "are more likely to undertake value-destroying projects that rational managers would forgo," the authors wrote in a pathbreaking article, "Who makes acquisitions? CEO overconfidence and the market's reaction," in the Journal of Financial Economics.

Malmendier and Tate identified overconfident CEOs by examining the stakes they held in the companies they ran. Investment advisors urge executives to avoid holding too much of their companies' stock. But some CEOs ignore this advice, apparently believing they can make their businesses perform better than investors expect. Specifically, the authors looked at stock options, which give holders the right to buy a company's shares at a pre-set price. They found that 10.8 percent of the CEOs they studied held on to stock options until the year the options expired at least once, even though these executives could have profited by cashing them out earlier. Keeping the options was a sign of the faith these CEOs had in their ability to drive their companies' shares higher. This willingness of overconfident CEOs to put so much of their personal wealth in their own companies distinguishes them from empire-building chief executives who crave corporate power, but diversify their investments.

Business press coverage offered another way to uncover overconfident CEOS and offered a glimpse into the kinds of personalities common among this group. The authors looked for articles in The Wall Street Journal and other business publications that characterized chief executives as "confident" or "optimistic," as opposed to "cautious" or "conservative." They then refined these observations to develop a press-based measure of overconfidence.

Both personal investment behavior and press portrayal told the same story—overconfident CEOs were more aggressive acquirers than their peers. Chief executives who held options until expiration were 1.65 times more likely to make at least one acquisition than other CEOs. Meanwhile, CEOs identified as overconfident by analyzing press coverage were 1.8 times more likely than their peers to carry out their first acquisition. What's more, their takeovers were lower quality as measured by stock market reaction to deal announcements. Why did their acquisitions flop so often? "Overconfident executives overestimate their ability to create value," Malmendier and Tate argue. "As a result, they overestimate the returns they can generate both in their own company and by taking over other firms."

To be sure, the overconfidence story is not always straightforward. One complication is that overconfident CEOs may be convinced that investors are undervaluing their companies and that their stocks are worth more than the prices they command in the marketplace. That could make these executives reluctant to issue new stock or raise the capital needed to pay for takeovers, putting a damper on CEO acquisitiveness. The aggressiveness of overconfident CEOs is clearest when companies can pay for mergers without seeking external financing.