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Over-confident CEOs can lead to disastrous M&A deals Back  
There are major lessons to be learnt from behavioral finance, a rapidly growing area that applies psychology to financial decision making, says Hersh Shefrin. And financial executives are not immune. Psychological phenomena provide the major explanation for why the majority of merger and acquisition activity has destroyed value for shareholders.
A study by KPMG International of the seven hundred largest acquisitions during the period 1996 through 1998 found that over half destroyed value. Acquisition activity peaked at $1.8 trillion in 2000, more than triple the level in the mid-1990s. Between 1995 and 2000, the average acquisition price in the U.S. rose 70 percent, to $470 million.

History is rich in failed M&A endeavours, though the same cannot be said for shareholders. Examples abound. In 1991, AT&T purchased computer firm NCR for $7.6 billion and lost $3 billion over the next three years. In 1994 the pharmaceutical firm Eli Lilly paid $4 billion for PCS Health Systems, and after two years sold it to the drugstore chain Rite Aid for $1.5 billion. WorldCom, now MCI, engaged in seventeen acquisitions using $30 billion of debt, and in 2002 became the largest corporate bankruptcy in U.S. history. The largest acquisition in history was AOL’s takeover of Time Warner in 2000. It proved to be a disaster.

The executives who engineered these deals are typically very intelligent. Yet their actions lead to disaster more often than not. What are the psychologicaal phenomena that drive these very intelligent executives to make huge errors in judgment?

The answer has three parts. To understand the first part, think about the following question. Relative to all the executives in your industry, how would you rate yourself: above average, average or below average? For those who feel they need a statistical definition of average, please use the median.

If you answered below average, you belong to a rare species indeed. Almost everyone answers either above average or average. Of course statistically, roughly half lie above average and half lie below average. However, most people hate to think of themselves as below average. Most people like to think of themselves as at least average. In this respect, psychologists have concluded that most people are overconfident.

Being human, financial executives also fall into the overconfidence trap. Chief executives are especially overconfident. Ask a roomful of chief executives the question and they all answer above average. Overconfidence is the first part of the three-part answer to the question of what drives judgmental errors on the part of executives.

The second part involves what financial economists call market efficiency. Most textbooks in corporate finance advise managers to trust market prices as representing intrinsic value. Proponents of behavioral finance offer somewhat different advice. They suggest that prices and intrinsic values sometimes part company, and that managers need to know when to trust market prices.

In practice, most financial executives do not trust market prices. Being overconfident, most believe that their own firms are undervalued. Even during the super bull market of the 1990s, most chief financial officers surveyed in the United States expressed this sentiment. Overconfidence also leads the typical acquirer to overestimate the value of the synergy in the deal. As a result, most acquiring firms overpay, and suffered what is generally known as ‘the winner’s curse.’ Because overconfidence on the part of acquiring executives is the chief culprit in driving overpayment, the effect is also known as the ‘hubris hypothesis.’

The adjective ‘hubris’ has frequently been applied to Steve Case, the AOL chief executive behind AOL’s disastrous acquisition of Time Warner. Headlines from press writings of the time explicitly identified hubris as the problem. Typical headlines ‘Doomed relationship forged in hubris’ and ‘How executive hubris destroyed the AOL-Time Warner merger.’

A major problem for the shareholders of Time Warner was that Steve Case did not trust market prices, he knew AOL’s stock was overpriced. The problem was that Time Warner’s CEO Gerald Levin did trust market prices, and agreed to the deal.

Cisco Systems has been one of the most active acquirers in the world. Its experience offers important lessons. Cisco’ acquisition activity began in 1993 when one of Cisco’s senior vice presidents, John Chambers, developed a plan to grow the firm through acquisitions. That year, Cisco acquired Crescendo Communications Inc. for about $95 million in Cisco stock.

Six and a half years later, in 1999, Cisco’s market capitalisation stood at more than $220 billion, and John Chambers was its CEO. Crescendo’s switches, along with products from more than thirty-five acquisitions, were at the heart of a unit that had nearly $7 billion in annual sales. Crescendo had been a very successful acquisition, and John Chambers talked about it proudly.

In 1999, Cisco became interested in acquiring Cerent Corp., a closely held firm that made devices to route telephone calls and computer traffic on and off fiber-optic lines. Despite its sales success, in July 1999 Cerent reported that for the first half of the year it lost $29.3 million on revenue of $9.9 million. Indeed, since being founded in 1997, Cerent had reported cumulative losses of $59.7 million.

Moreover, the firm indicated that it was expecting to incur negative cash flow in the future. Cerent had consumed $17 million in cash during the first half of 1999, and was holding less than $6 million in cash, and $10 million in available debt. At the time Cerent had two hundred and sixty-six employees.

Cisco did acquire Cerent. How much did they pay? Most of Cisco’s valuations were less than $500 million. However, Cisco made four acquisitions for which it paid more than two billion per acquisition. And there was one outlier, a $6.9 billion tail event. That outlier was Cerent, a $7 billion example of winner’s curse.

What compelled Cisco Systems to pay $7 billion for a tiny firm with few assets and negative cash flow prospects for the foreseeable future? The answer is that the price of publicly traded networking firms had been soaring. For example, Juniper Networks Inc., had recently gone public and was valued at nearly $11 billion.

Like Time Warner, Cisco trusted market prices, and thought that Cerent would be like Juniper. Cisco’s executives did not make a single present value computation in respect to buying Cerent. They were overconfident in their own subjective judgment about identifying value.

The third part to the three-part explanation involves being in the domain of losses. Psychologists have concluded that people tend to seek risk when they view themselves in the domain of losses, hoping to beat the odds and break even.

Managers of firms that are in trouble often view themselves in the domain of losses, and take a chance on breaking even by gambling through M&A. That was the case in 1991, with AT&T’s decision to acquire NCR, and also ten years later in Hewlett-Packard’s decision to acquire Compaq Computer. In both cases, the acquiring firms were experiencing serious business challenges, and relative to past successes viewed themselves in the domain of losses. AT&T’s acquisition of NCR turned out to be a fiasco. The jury is still out on H-P’s acquisition of Compaq. The psychological elements that underlie executives’ vulnerability to the winner’s curse in M&A are extremely powerful.

Overconfidence, misjudging market prices, and aversion to sure losses are very compelling. Resisting those elements takes considerable self-control, and self-control begins with awareness.

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