Behavioral Effects in M&A: A brief reference.

Importance given to behavioral finance has increased considerably in the 21st century.

“Breaking with the neoclassical finance framework allows for decision-making biases of economic agents. Such biases could play an important part in explaining both the volume and the outcome of merger activity”, p. 385.

For instance, legal provisions in M&A determine a great deal of the attitude of a company towards a capital restructuring transaction. Corporate law theory posits that the degree to which capital markets investors are legally protected determines the volume of merger activity.

Irrational Managers.

“The hubris hypothesis of takeover activity” proposes that executives overestimate their own ability to identify and realize potential gains from a merger. As a result, acquiring firm managers have a habit of overvaluing the equity of a target firm. Consequently, disappointing firm performance in a post-merger scenario is the product of unrealistic expectations (on the side of the bidding firm’s executives).

Overconfident executives, convinced of the positive outcome of their actions, suffer from cognitive bias. Hence, this executive hubris diagnosed by Roll leads to good-faith mismanagement mergers.

This theory is firstly developed by Richard Roll in “Roll, Richard, “The hubris hypothesis of corporate takeovers”, Journal of Business, 1986, 59:2, 197-216.”. Warren Buffet implicitly alludes with acid irony to this hypothesis in the following quote:

“Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial skills will do wonders for…profitability…We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses-even after their corporate backyards are knee-deep in unresponsive toads”.

"Letter to Shareholders of Berkshire Hathaway Inc.", 1981.

Irrational investors.

Executive overconfidence solely is unable to explain merger waves and activity. If we were to diagnose an irrational impulse behind these transactions, the fair business is to diagnose it in both sides of the picture. Irrational managers very frequently are substituted or complemented by irrational investors. As a matter of fact, the biased investor approach in behavioral finance underpins various well-known stock market anomalies such as the January effect, the momentum trading, etc.

The author stresses that, ultimately, “once acknowledging the presence of irrationality in merger-related decision making, there is no reason to presume that such behavior will be restricted to a single party in the merger transaction”, referring to the delusional attitudes that some investors also perform in their decision making.

Executive compensation and Behavioralism.

“If pay is sensitive to firm size but greatly insensitive to firm performance, managers are incentivized to engage more in growth-enhancing acquisitions than in value-enhancing ones (…) Essentially, the argument is that excessive compensation may breed managerial overconfidence (…) Higher pay, therefore, equates to overinvestment in the market for corporate control”, pp. 393-394.

Reference: KENT BAKER, H.; KIYMAZ, Halil (editors); The art of capital restructuring. Creating shareholder value through M&As., John Wiley & Sons, New Jersey 2011, pp. 339-398.

Some defensive (behavior-related) strategies in Takeovers.

A preventive defense tactic has the goal of incorporating several procedures in a company’s bylaws that can be made effective once a hostile takeover attempt is made. These tactics are also aimed at retaining corporate value during the course of the takeover battle. Among these strategies we can find the very well known “parachutes”; which can be distinguished as golden, silver or tin:

a.    Golden parachutes refer to severance agreements for top-level management and thus only cover a small number of people.

b.   Silver parachutes apply to a larger number of employees who are not part of top-level.

c.    Tin parachutes contain provisions that grant monetary benefits to every employee following a change of control.

Another widely used and very effective preventive strategy is staggering a company’s board of directors, also known as “classifying” a board. An effective antitakeover provision can prohibit electing all board members in one setting. If a staged board is in place, a hostile investor cannot replace the board members in one shareholder assembly regardless of the amount of votes held.

As a mere curiosity, we can sometimes find a peculiar defense, frequently referred to as the “Pac-man defense”. The “Pac-man” defense describes a strategy in which the target itself makes a hostile bid for the acquirer in order to “eat it up” before it can be “eaten up”. A pretty discussed corporate practice. In the other hand, a “white knight” defense refers to a company that rescues a potential hostile takeover target by acquiring a controlling share of stock in the target. It can also be the case of companies saving financially distressed companies from liquidation.

Jaime Stein González

M&A Intern

Prospective Corporate Lawyer