Who Makes Acquisitions? CEO Overconfidence and the Market's Reaction

Abstract

We analyze the impact of CEO overconfidence on mergers and acquisitions. Overconfident CEOs over-estimate their ability to generate returns, both in their current firm and in potential takeover targets. Thus, on the margin, they undertake mergers that destroy value. Overconfidence also implies that managers view their company as undervalued by outside investors. Therefore, the impact of overconfidence is strongest when CEOs can finance mergers internally. We test these predictions using the merger decisions of a sample of Forbes 500 companies between 1980 and 1994. We classify CEOs as overconfident when, in spite of their under-diversification, they hold company options until expiration. We find that such CEOs are more likely to conduct mergers on average and that this effect is due largely to diversifying mergers. As predicted, overconfidence has the largest effect in firms with the most cash and untapped debt capacity. In addition, we find that the market reacts negatively to takeover bids and that this effect is significantly stronger for overconfident managers.