Thursday, March 13, 2014

Rolls Hubris Hypothesis and Acquiring Firm Returns

I've heard management professors and some consultants throw around comments like "Seventy percent of all acquisitions fail."  I don't believe it and the statistical evidence doesn't support that claim.  True, there is a lot of evidence that suggests bidders break even or lose a few percent at the announcement of a bid.   The combined returns to bidders and targets, appropriately weighted for size, are positive.  The typical deal creates value.   What I might believe is that 70 percent (or more) of mergers fail to realize their potential.  But that is typically a problem of integration and the subject of other posts. 

So what do we make of the continuing story that bidders tend to lose or break even?  After all, bidding activity continues to be quite popular (even if currently dampened).   There are many explanations in the literature to explain bidder returns.  Today, I will mention two.

The first is the possibility that we, as researchers, are not measuring returns correctly.  In a recent paper published in the Review of Financial Studies we present evidence that the typically measured bidder return doesn't adjust for anticipation.   When returns are measured correctly bidder returns are positive.  See (Anticipation, Acquisitions and Bidder Returns.)  

But let's return to the fact that some deals, however measured, do result in the loss of value to the acquiring firm.  Even in our sample this occurs as much as 40% of the time.  Why? A good place to start looking for the answer is in the price paid for the target.  As we have noted, Every deal is a bad deal at some price.  Not every deal is a good deal at some price.

In an efficient market, the value of a firm's shares are priced correctly.  Why would bidders typically add 20-40% to the market price in their bids?  Why would bidders pay more than this? The obvious, and always cited reason is synergies.  Synergies, of course, can be easily overestimated and in other posts we note that you should always challenge the assumption of synergies.  Why are they available to your firm and to no one else?  

Another reason to explain high bid prices is behavioral - the hubris factor. Roll (1986) was the first to point this out in the finance literature.  

Anyone who has bid for an object on Ebay understands that it is easy to overpay, to go beyond the rational limits we might set in advance on our bids.  We get caught up in deal fever or a desire to 'win' regardless of price.  The same behavior must certainly be true of at least some acquiring managments.  One can imagine the psychological pressures on management in certain bidding wars.  Multiple sides express multiple views with many unkind words and suggestions.  If psychological factors lead bidders to go beyond pre-determined boundaries (or equivalently if management directly or indirectly causes their own analysts to overestimate the gains to mergers in setting those boundaries) shareholders lose.  As we have noted, some of the best deals are those not attempted or in this case, not completed.  

One of the best illustrations of the hubris phenomena are found in the words of Warren Buffett, quoted in a previous post,

"Many managers were apparently over-exposed in impressionable childhood years to the
story in which the imprisoned, handsome prince is released from the toad's body by a kiss
from the beautiful princess.  Consequently, they are certain that the managerial kiss will
do wonders for the profitability of the target company.  Such optimism is essential.
Absent that rosy view, why else should the shareholders of company A want to own an
interest in B at a takeover cost that is two times the market price they'd pay if they made
direct purchases on their own?  In other words investors can always buy toads at the
going price for toads.  If investors instead bankroll princesses who wish to pay double
for the right to kiss the toad, those kisses better pack some real dynamite. We've observed
many kisses, but very few miracles.  Nevertheless, many managerial princesses remain
serenely confident about the future potency of their kisses, even after their corporate
backyards are knee-deep in unresponsive toads." 

(Warren Buffett in the 1981  Berkshire Hathaway Annual Report)

We'll continue this discussion in two ways in the future.  One will be through an analysis of other factors related to bid premia and to bidding and acquiring returns.  A second avenue of analysis will continue to explore the role of behavioral factors in mergers and acquisitions.

All the best,


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