Tuesday, December 4, 2012

Acquisition Hubris: Over confident CEOs and Compliant Boards

In my last post, I noted that acquisitions are more likely to destroy value for acquiring firm stockholders than to add value, and that there is little evidence that companies learn from history. That is puzzling, given the manpower, data power and model power that is brought into the acquisition process. How can all these smart people working with sophisticated models and updated data be so wrong so often?

The answer I think lies in a simple fact: in most acquisitions, the decision to acquire is made first and the analysis follows, and all too often, the decision is not only made at the top of the organization, but at the very, very top by the CEO. That is not the way organizations are supposed to work. Big ideas, no matter who originates them, are supposed to be discussed honestly and openly, analyzed fully and then vetted by an independent, well informed board of directors to make sure that stockholder interests are being served. That may still happen in some organizations, but consider this alternate reality. In a moment of inspiration (insanity) or brilliance (lunacy), the CEO decides to do an acquisition of a target firm for strategic (empire-building) reasons. The managers around him or her, recognizing that the die has been cast, choose not to voice their opinions, get bulldozed when they do, or decide to join the CEO in pronouncing the acquisition a great idea. An investment banker is found to affirm that the deal is, in fact, a great deal and the rest as they say is history. Reminds you of this fairy tale, right? If you find this scenario to be absurd, start by taking a look at James Stewart's article on the HP/Autonomy deal and especially at the back story on how Leo Apotheker, HP's then CEO, pushed for the deal even as there were plenty of doubting voices (both within and without the firm), and how the board essentially went along with his wishes. Then, move on to take a look at these stories about Eisner's role in Disney's acquisition of Capital Cities in 1995 and Zuckerberg's role in Facebook's purchase of Instagram earlier this year to see how much head-strong CEOs can influence the acquisition process.

If the acquisition process is prone to failure, as the evidence suggests that it is, there are many potential culprits that you can blame. The investment bankers who facilitate the deals for huge advisory fees are an easy target and the accountants/auditors who dress up the books are a close second, but the primary culprit has to be the top management (and particularly the CEO) of the acquiring firm. After all, once a CEO gets set on doing a deal, he can go about picking the facilitators (the investment bankers and accountants) to make the deal look good. As we bring behavioral finance into play, the evidence suggests that over confident CEOs  play a key role in greasing the skids for large (bad) acquisitions. To measure confidence, Malmendier and Tate, who have a series of interesting papers on how over confident CEOs manage, developed two measures:
  1. Insider holdings in the companies that they manage: Rather than diversify and spread their risks by investing in other companies, over confident CEOs seem to double up and invest their wealth/income back into the companies that they manage.
  2. Press reports: Looking across financial news stories for mentions of the CEO in question, they looked for the words "confident" or "optimistic" in descriptions of the CEO   opposed to words such as "cautious", "frugal" or "steady". If the former exceeded the latter, the CEO is classified as an over confident CEO, whereas if the latter dominated, the CEO was classified as a cautious CEO.
They then looked at a sample of 394 large US firms and found that over confident CEOs were 65% more likely to do acquisitions than cautious CEOs, though they were also less likely to draw on external financing; their over confidence led them to believe that the market was underpricing their stock and thus made them more reluctant to use stock in acquisitions. They were also more like to acquire just to diversify, and the market reaction to their acquisitions is more negative than to acquisitions by cautious CEOs.

Can no one stop a headstrong CEO? There is a counterweight built into the system, the board of directors, and it can act as a restraint on a CEO embarking on a value-destructive path. Unfortunately, one common feature shared by value-destroying acquirers is a compliant board, that shirks its responsibility to protect shareholder interests. It is not surprising that it HP, which has had issues with corporate governance and board oversight, was the ill-fated acquirer of Autonomy.

In summary, then, a headstrong, over confident CEO, combined with a compliant board creates a decision making process where there are no checks on hubris and large, value destroying actions often follow. If investors want to prevent their firms from embarking on deals like the HP/Autonomy deal, they need to pay attention to corporate governance, and not just at the surface level. After all, the board at HP met all the Sarbanes/Oxley requirements for a "good" board and may even have scored high on the corporate governance scores in 2010. The problem with corporate governance watchdogs, legislation and scores is that they are far too focused on what the board looks like and far too little on what it does. In my view, it matters little whether a board is small or large, whether it is filled with luminaries or unknowns, experts or novices and whether it meets the criteria for independence. It does matter whether the board acts as a check on the dreams and acts of imperial CEOs.

The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset


The Contrarian Individual Investor said...

When acquisitions occur they are typically shrouded in secrecy during the critical pre-deal stages of identification, evaluation, synergy estimation, pricing and offer stages making it easy for an overconfident CEO to lead a campaign to acquire. Information is scarce and controlled, boards usually only see highly distilled projections that can easily be manipulated by adjusting underlying assumptions and very small tweaks to rates.

Lenders who are often called upon to finance the deal are too often behind the screen the investment bankers provide the overconfident CEO.

Aswath Damodaran said...

The boards should follow the 1980s prescription" and "Just say No", until the shroud is removed and the facts see the light of day.

Alex said...

This post is incredibly timely. Even today with Freeport-McMoran (http://dealbook.nytimes.com/2012/12/05/freeport-to-buy-plains-exploration-and-mcmoran/) - seems to be a decision driven by CEO relationships. Be interesting to see if the moves are accretive, the market today has agreed with your sentiment and voted accordingly.

Felix said...

I think an important component is the incentives and compensation plan for the CEO and other executives. They may often have compensation linked to performance metrics e.g. revenue growth.

MikeJake said...

To follow what Felix said, just what opportunities for notable growth exist for big corporations like HP other than through M&A? It's much easier to purchase increased revenues than it is to grow them organically. We would be much better off if big corporations were evaluated over periods 5 years and longer, rather than annually and quarterly. The incentives for truly strategic leadership just aren't there.

guz said...

It's a pity that this phenomenon still spread all over the word. Today, Siemens is trying to overcome the underperformance over the last few years by cutting cost and performing acquisitions such as the one of Invensys' rail division for £1.7bn. It's like a never ending history.

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