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Hubris or good business? The psychology of M&A

by James Phillipps on Feb 05, 2014 at 10:18

A number of theories have been put forward to explain this underperformance, which are commonly rooted in the psychology of the acquiring management team.

The hubris hypothesis

Often the acquiring company has had a strong period of corporate and share price performance in the period leading up to the bid.

In these cases, the management teams can become overconfident in their abilities and believe those abilities will enable them to turn around the acquired company,the so called ‘hubris hypothesis’.

Too often the prior outperformance has been partly due to cyclical or other external factors, and the acquiring management team struggle to meet their targets for the acquisition.

Having made the decision to acquire, if the bid becomes contested, with multiple interested parties, it becomes increasingly likely that companies will overpay.

The winner (if we can call them that) will be the company making the highest bid – the dreaded ‘winner’s curse’.

Having ‘won’ the bid, an insight into the management psyche can often be gleaned by the method of funding the acquisition.

If management teams, either consciously or unconsciously, perceive their own shares as expensive, and therefore a cheap source of funding relative to cash, this may encourage them to view the acquisition more optimistically and use shares as finance.

The evidence is that acquisitions financed by shares do worse than cash financed bids.

In light of these behavioural patterns, what can investors to do to protect against potential value destruction?

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