CEO Overconfidence, Corporate Investment, and the Market's Reaction
Using a dataset of large U.S. companies from 1980 to 1994 and the CEOs' personal portfolio decisions as measures of overconfidence, they find that overconfident CEOs conduct more mergers and, in particular, more value-destroying mergers.
How does the overconfidence of CEOs affect their corporations' performance? And how do investors perceive and react to CEO overconfidence? In two NBER Working Papers, authors Ulrike Malmendier and Geoffrey Tate examine the critical issue of CEO overconfidence as it affects investment options and corporate value.
In CEO Overconfidence and Corporate Investment (NBER Working Paper No. 10807), they depart from the traditional approach of tying corporate investment decisions to firm characteristics and examine instead how investment is related to the personal characteristics of the top decision-maker inside the firm. One important link between investment levels and cash flow, for example, is the tension between the beliefs of the CEO and the market about the value of the firm.
Malmendier and Tate find that managerial overconfidence can explain corporate investment distortions. Overconfident managers overestimate the returns to their investment projects and view external funds as unduly costly. Therefore, they over-invest when they have abundant internal funds, but curtail investment when they require external financing. Using panel data on personal portfolio and corporate investment decisions of Forbes 500 CEOs, the authors classify CEOs as overconfident if they persistently fail to reduce their personal exposure to company-specific risk. They find that the investment of overconfident CEOs is significantly more responsive to cash flow, particularly in equity-dependent firms.
In Who Makes Acquisitions? CEO Overconfidence And The Market's Reaction (NBER Working Paper No. 10813), the authors move the empirical analysis of CEO overconfidence one step further. They combine the portfolio measure of overconfidence with a new measure, based on CEOs' characterization in media outlets, to study both the impact of overconfidence and the market's assessment (in the press and in the stock market) in the context of mergers. Mergers and acquisitions, of which there are currently a staggering number, are among the most significant and disruptive activities undertaken by large corporations. However, existing results on returns to mergers are mixed, suggesting that mergers may not create value on average. And 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 the target company's value upon the announcement of a bid, and a significant loss to the acquirer. This suggests that mergers are often not in the interest of the shareholders of the acquiring company.
Building on these stylized facts, the authors propose that overconfidence among acquiring CEOs is one important explanation of merger activity. Using a dataset of large U.S. companies from 1980 to 1994 and the CEOs' personal portfolio decisions as measures of overconfidence, they find that overconfident CEOs conduct more mergers and, in particular, more value-destroying mergers. These effects are most pronounced in firms with abundant cash or untapped debt capacity.
Malmendier and Tate demonstrate that, from a theoretical perspective, overconfidence does not unambiguously predict a higher frequency of mergers. Overconfident CEOs are more eager to make acquisitions, but perceived undervaluation and perceived financing constraints can prevent them from doing so. Overconfident CEOs are, however, unambiguously more likely than rational CEOs to undertake value-destroying acquisitions. And, they are more likely to make acquisitions when their firm has abundant internal resources. Because they do lower quality deals, on average, and tend to overpay, the market discounts their acquisitions relative to those of other CEOs.
They find empirically that CEO overconfidence boosts the number of takeovers - even on average and despite the mitigating impact of cash constraints. Further, overconfident CEOs undertake more diversifying mergers, which are unlikely to create value. In addition, overconfidence has a strong positive impact on the probability of conducting mergers (and particularly of diversifying mergers) among the least equity dependent firms and has no effect among the most equity dependent firms.
The market's assessment of overconfident CEOs, as reflected by press coverage in major business publications and the stock price reaction to merger announcements, corroborates the authors' findings. The authors' findings hold true using both exercise of stock options and press coverage as measures of overconfidence. Finally, they find that the market prefers the bids of rational managers: cumulative abnormal returns around overconfident bids are roughly 100 basis points lower on average than for rational bids.
The authors' findings also have implications for organizational design and leadership. Because overconfident CEOs believe they are maximizing value, standard compensation incentives are unlikely to correct their suboptimal decisions. However, overconfident CEOs do respond to financing limitations, proving the constraining role of capital structure. The authors suggest that independent directors may need to play a more active role in project assessment and selection to counterbalance CEO overconfidence.
-- Les Picker