CEO overconfidence and corporate performance

Laura Hermes

2022-11-05 11:32:00 Sat ET

CEO overconfidence and corporate performance

Malmendier and Tate (JFE 2008, JF 2005) argue that overconfident CEOs are more likely to initiate mergers and acquisitions that erode shareholder value. The odds of initiating mergers and acquisitions increase by 65% if the CEO is viewed as overconfident in terms of late option exercise (Longholder and Holder 67) or press portrayal. The effect of CEO overconfidence on M&A likelihood is more pronounced if the deal involves firm diversification and does not require external finance. CEO overconfidence tends to drive M&A and capital overinvestments to the detriment of outside shareholders (Jensen, AER 1986; Stulz, JFE 1990; Lang, Stulz, and Walkling, JFE 1991; Harford, JF 1999). The 3-day cumulative abnormal return is significantly more negative for acquirers with overconfident CEOs (–90 basis points) than for acquirers with non-overconfident CEOs (–12 basis points). The negative impact of CEO overconfidence on bidder returns complements the behavioral hypothesis that CEO overconfidence complicates corporate investment distortions (Malmendier and Tate, JF 2005). CEO overconfidence significantly correlates with a greater cash flow sensitivity of capital investment, especially among equity-dependent firms. These results reflect the dark side of CEO overconfidence on M&A and capital overinvestments.

 

In terms of its dark side, CEO overconfidence complicates corporate investment distortions (Malmendier and Tate, JF 2005, JFE 2008; Ben-David, Graham, and Harvey, QJE 2013), financial fraud and earnings management (Schrand and Zechman, JAE 2012), and financial misstatement (Hribar and Yang, CAR 2015). Malmendier, Tate, and Yan (JF 2011) empirically find that prior life experiences such as military service and adulthood in the Great Depression affect the relative degree of CEO overconfidence. CEOs with a military background tend to maintain high leverage while CEOs with some Great Depression experience tend to use debt conservatively relative to the other CEOs. Overall, overconfident CEOs seem to follow the pecking order and so prefer to first use up internal finance and available debt capacity before their firms tap into external equity. Ben-David, Graham, and Harvey (QJE 2013) find that overconfident CEOs make suboptimal investment decisions because these CEOs have miscalibrated conditional expectations of stock return distributions.

 

In this context, a major puzzle arises from why firms employ overconfident CEOs in the first place. Hirshleifer, Low, and Teoh (JFE 2012) suggest the bright-side story that overconfident CEOs are better R&D innovators. Firms with overconfident CEOs invest more in R&D innovation, yield more patents and patent citations, and achieve greater innovative efficiency per unit of R&D expenditure. The empirical corporate finance literature is replete with examples in support of both the bright and dark sides of CEO overconfidence.

 

Cai and Sevilir (JFE 2012) find that both first-degree and second-degree board connections significantly correlate with positive 5-day abnormal bidder returns (2.45% and 1.84%). First-degree board connections help enhance the information flow and communication between the bidder and target firms. Second-degree board connections lead to an improvement in industry-adjusted ROA of about 2% in the post-merger period. In comparison to Cai and Sevilir's study of the effect of professional connections on M&A bidder returns, Ishii and Xuan (JFE 2014) study the effect of social ties through school or prior employment on M&A bidder returns. Because better social ties correlate with a high probability that the target-firm executive directors and managers remain in their respective positions post-announcement, the market reacts negatively to the presence of these social ties. The bidder-firm incumbents tend to receive hefty bonuses or some other cash windfalls for completing M&A deals through their social ties with the target-firm executive directors and managers. These empirical studies provide complementary evidence in light of the different effects of professional connections versus social ties on M&A bidder returns.

 

Deng, Kang, and Low (JFE 2013) apply 2SLS regressions to address the potential endogeneity of bidder CSR performance and merger performance. The religion rank of the state of the bidder's headquarters, and the blue-state dummy variable, serve as relevant and exclusive instrumental variables for these 2SLS regressions. These instruments correlate with the bidder's CSR engagement but not the merger outcome variables such as bidder stock return performance and merger default likelihood. The use of several control variables for product market competition, corporate governance, and managerial compensation accords with the prior corporate finance literature (e.g. Masulis, Wang, and Xie (JF 2007); Edmans, Gabaix, and Landier (RFS 2009); Harford, Humphery-Jenner, and Powell (JFE 2012)). High-CSR bidders yield higher abnormal bidder returns around deal announcements, higher bidder-target portfolio returns around deal announcements, and greater increases in long-run operating performance post-announcement. The bidder's CSR performance is a major positive determinant of both bidder stock return performance and merger success likelihood.

 

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