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Explaining the premiums paid for large acquisitions: evidence of CEO hubris

Administrative Science Quarterly, March, 1997 by Mathew L.A. Hayward, Donald C. Hambrick

The famed investor, Warren Buffett, once said that many corporate acquirors think of themselves as beautiful princesses, sure that their kisses can turn toads into handsome princes. The acquirors pay substantial premiums over market value, believing that they can release the imprisoned princes. But, as Buffett said, "We've observed many kisses but very few miracles" (1981 Berkshire Hathaway Annual Report).(1) With acquirors making record numbers of takeovers at prices far above market levels, the comment Buffett made in 1981 has not lost its relevance for managers and students of organizations today. In fact, more acquisitions were announced in 1995 than in any prior calendar year. And between 1976 and 1990, 35,000 corporate acquisitions were completed in America, with a combined value of $2.6 trillion (Jensen, 1993). Yet, for all this activity, executives of acquiring companies generally fall to effect acquisition miracles. Acquisitions sometimes yield positive returns for acquirors (Lubatkin, 1987), but generally acquisitions have been found to have a neutral to negative effect on the shareholder wealth of acquiring firms (Bradley, Desai, and Kim, 1988; Jarrell, Brickley, and Netter, 1988; Berkovitch and Narayanan, 1993). Commonly, investors mark down the stock of acquirors following takeover announcements, indicating their belief that acquiring managers have overpaid (Shleifer and Vishny, 1991). This adverse market reaction is reinforced by findings that acquisitions lead to declines in the acquiror's longer-term profitability (Fowler and Schmidt, 1988 Herman and Lowenstein, 1988; Ravenscraft and Scherer, 1987, 1988) and shareholder returns (Agrawal, Jaffe, and Mandelkar, 1992). Acquisitions are often resold later at a loss (Porter, 1987).

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Acquisition premiums, defined as the ratio of the ultimate price paid per target share divided by the price prior to takeover news, have generally been ignored by strategy and organization researchers (Haunschild, 1994, and Sirower, 1994, are exceptions). Premiums are major statements by acquiring managers of how much additional value they can extract from the target firm. Premiums underscore acquiring managers' convictions that the target's preexisting stock price inadequately reflects the value of the firm's resources and its prospects and that in the right hands -- their hands -- more value can be created. For example, in paying a 110 percent premium for Paramount Corporation, Viacom Corporation managers expected to extract al least 2.1 times more value from Paramount than could Paramount's incumbent managers, a belief the stock market summarily dismissed. And such substantial premiums are common: Between 1976 and 1990, premiums averaged 41 percent, with many over 100 percent (Jensen, 1993).

Premiums are important not just as statements of pricing and acquirors' expectations but because they affect ultimate acquisition performance. Sirower (1994) found that acquisition premiums inversely affected acquirors' shareholder returns for up to four years following the acquisition date. Ceteris paribus, it is axiomatic that the higher the premium paid, the lower the ultimate returns to the acquiror from a given acquisition. Sometimes excessive premiums can be devastating: One year after Campeau paid a 124 percent premium to acquire Federated Department Stores, Campeau declared bankruptcy, unable to cover the debt it incurred for the deal (Kaplan, 1989; Haunschild, 1994). If substantial premiums often damage acquirors' shareholder wealth over the short and long term, why do so many acquirors pay them? The answer, we believe, is that acquiring managers overestimate their ability to extract value from acquisitions because of their hubris (Roll, 1986).

THEORY AND HYPOTHESES

Acquisition Motives

Three main motives for takeovers have been advanced: poor target company management, synergy, and hubris (Walsh and Seward, 1990; Berkovitch and Narayanan, 1993). Advocates of the poor target management perspective, which is rooted in agency theory, claim that inefficient, self-serving incumbent managers who fail to maximize stockholder value will be forced out of office by acquirors attempting to extract such value (e.g., Fama, 1980). Premiums paid thus reflect the value that can be gleaned from eliminating the target company's inefficiencies. Implicit in poor-management explanations is that the acquiror's stockholders will benefit from takeovers through improved management of the acquired firm. But even if beliefs about poor management initially motivate transactions, two factors suggest that acquirors generally overestimate their ability to extract improvements: the common adverse market reaction to acquisition announcements and the poor subsequent performance of many acquisitions.

Tests of poor target performance in affecting premiums have been inconclusive. Although Varaiya (1987: 182) found some evidence that the target firm's poor performance within its industry caused higher premiums, he concluded that there was only "weak support for the predicted effects of ex ante gains" and "the undermanagement variables are uniformly insignificant." Slusky and Caves (1991) did not directly examine the underperformance hypothesis, but they found that premiums were not as large when the target's stockholdings were relatively concentrated, presumably a condition in which managers were already closely monitored and less able to sustain poor management.

Business Services Industry

Explaining the premiums paid for large acquisitions: evidence of CEO hubris

Administrative Science Quarterly, March, 1997 by Mathew L.A. Hayward, Donald C. Hambrick

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