Is the decision maker isolated or in touch with reality of the M&A situation? One hears about the imperial CEO. Like the fabled emperor who had no clothes, the CEO might have a culture of “yes people” who simply endorse what the CEO proposes.
Does the decision maker operate under a governance system of monitoring and control? One of the benefits of good governance systems is to forestall problems of hubris. Chapter 26 discusses dimensions of governance.
Market Manias
A variant on the behavioral theme is the role of mass behavior that produces market bubbles, crashes, and fads. Kelly (1994) likened market movements to swarms of bees and flocks of geese. Others have sought to apply chaos theory to explaining the unpredictable movements in the market; see Gleick (1998). Robert Shiller (1998) discusses fads in financial markets as motive for takeover. He cites psychological literature on group behavior and gambling as parallels to merger fads. A variation on this point is the “I don’t want to be left out” factor for companies who are surrounded by acquisitive competitors. Investment bankers tell interesting anecdotes about “deal frenzy,” a kind of psychological momentum to get a deal done—on almost any terms—after an executive has been working toward the deal for some period of time. Toxvaerd (2002) models merger waves as the result of the attempt by managers to improve the strategic positions of their firms through preemption in the competition for scarce targets. The competitors would prefer to delay and retain the option to acquire. But in constant reference to their competitors, they all snap into action as the result of an industry shock or the release of some decisive bit of information: this produces a stampede to acquire, a type of rational frenzy.
The practical person will find it hard to know what to do with the mania explanation. Chapters 30 and 31 emphasize the influence of psychological effects on M&A outcomes. Our understanding in this area is still in its infancy. Still, the practitioner seeking to understand M&A activity should ask at least two questions:
1 Does the market, my industry, or my firm seem in the grip of “deal frenzy”?
2 What is the tendency of the “herd” in my industry with respect to M&A? What is the “lead steer” doing?
Both of these questions invite, at best, qualitative answers. Generally, the size of acquisition premiums relative to historical averages will give some sense of whether the deal flow is hot or cold. A close following of speeches, interviews, scuttlebutt, and, above all, M&A actions is the grist from which answers to these questions will be made.
Overvaluation of Stocks and the Asymmetry of Information
Five studies associate the appearance of waves with buoyant capital market conditions: a rising stock market and low or falling interest rates. M&A waves are procyclical; they occur in line with increases in stock prices.5 There is some disagreement about whether peaks in M&A lead or lag peaks in stock prices.6 Nelson (1959) suggests that rapid development of a capital market (in countries where it had been previously undeveloped) may spur M&A activity. Golbe and White (1988) argued that merger activity increases when bargains are available, as measured by a low ratio of market value to replacement costs (Tobin’s Q). Recent theories by Shleifer and Vishny (2001) and Rhodes-Kropf and Viswanathan (2003) consider an alternative explanation: that stock markets may overvalue stocks. Managers of firms have their own inside assessments of the intrinsic values of their firms. Because they know more than investors on the outside (economists call this “information asymmetry”), these better-informed assessments may vary from the prices in the market. When the prices in the market exceed the insider assessment of value, rational managers can enhance the wealth of their current shareholders by selling stock. Thus, equity issuance will tend to occur when stock prices are high, an idea advanced by Myers and Majluf (1984).
Recognizing that share-for-share deals were the equivalent of an equity issue by the buyer, Shleifer and Vishny (2001) modeled the behavior of buyer managers during “hot” and “cold” equity markets and found that merger activity (especially waves), form of payment, and who buys whom are driven by the relative valuations of the pairs of firms, synergies, and the time horizons of the managers. For instance, stock acquisitions are used by buyer managers who perceive that their shares are overvalued in the market—during buoyant stock markets, this would explain why we observe relatively more share-for-share deals; and it would explain the preponderance of cash deals in cold markets. They write, “Stock acquisitions are used specifically by overvalued bidders who expect to see negative long run returns on their shares, but are attempting to make these returns less negative than they would be otherwise. The examples of the acquisition of Time-Warner by AOL and of build-up of high valuation conglomerates with stock illustrate this phenomenon.” (Page 19) This would also explain the periodic appearance of momentum-style acquisition strategies (see Chapter 17 for more on momentum acquiring). Shleifer and Vishny conclude:
We do not assume that markets are efficient, but rather that the stock market may misvalue potential acquirers, potential targets, and their combinations. In contrast, managers of firms are completely rational, understand stock market inefficiencies, and take advantage of them in part through merger decisions. This theory is in a way the opposite of Roll’s (1986) hubris hypothesis of corporate takeovers, in which financial markets are rational, but corporate managers are not. In our theory, managers rationally respond to less than rational markets. (Page 2)
Rhodes-Kropf and Viswanathan (2003) (RV) build on this framework. While Shleifer and Vishny offer a rationale for the behavior of buyers, why should targets accept stock offers from buyers whose shares are likely to be overvalued? RV suggest that targets are canny enough to assess the misvaluation of the buyer and target, but not canny enough to correctly assess the value of synergies—this is because of an information asymmetry between the buyer and target in which the buyer has a better idea of the possible economic gains between the two firms. They write, “Thus, when the market is overvalued then the target is more likely to overestimate the synergies even though he can see that his own price is affected by the same overvaluation.” (Page 2) Ang and Cheng (2003) give empirical evidence in support of the overvaluation/information asymmetry theory. Based on a sample of 9,000 observations from 1984 to 2001, they find:
Acquirers are much more overvalued than their targets. Successful acquirers are more overvalued than the unsuccessful ones. The probability of a firm becoming an acquiree significantly increases with its degree of overvaluation, after we control for other factors that may potentially affect the firm’s acquiring decision. Since overvalued acquirers could only gain from their misvaluation by paying for the acquisitions with their stocks, we postulate and verify that stock-paying acquirers are substantially more overvalued than their cash-paying counterparts…. The probability of stocks being utilized as the payment method significantly increases with the acquirer’s overvaluation. Long-term abnormal returns of the combined firms in stock mergers are negative. (Pages 3–4)
The new theory of overvaluation and information asymmetry does little to explain the clustering of M&A activity in industries, but it advances our understanding of merger waves and lends a couple of practical implications. First, it helps explain the association between the buoyant stock markets of the 1960s, 1980s, and 1990s and the coincident large merger waves. Second, it presents a framework for thinking about the form of payment (about which more is said in Chapter 20). As a practical matter, then, this theory invites executives to consider three questions:
1 What is the level