Mergers, CEO Hubris, and Cost Stickiness

ABSTRACT

Hubris theory documents that bidder CEOs are overconfident about deal synergies without fearing the winner’s curse. We examine the role of bidder CEOs’ hubris over merger synergies on cost stickiness in the rapidly growing Korean market. Bidder CEOs who overestimate the merged firm’s growth retain more underutilized-capacity when sales decrease than do CEOs of stand-alone firms. Optimistic bidder CEOs induce greater cost stickiness through strong and irrational self-beliefs than do optimistic nonbidder CEOs. Given the learning and self-attribution effect, optimistic bidder CEOs who experience more successful operating synergies induce stickier costs than less successful CEOs with simply optimistic views. Implications for possible overslack and cost locking from bidder CEOs’ hubris are also discussed.

KEY WORDS:

• cost stickiness
• mergers
• miscalibration
• overconfidence
• self-attribution bias
• synergy

Notes

1. Yen, Chou, and Andre (2013) emphasize that emerging merger markets during the past decade demonstrated their potential to become the core of the global economy and reference South Korea’s and China’s merger markets.

2. By contrast, mergers were a trend in the global market during the 1960s and 1980s, with so-called merger waves occurring during these periods (Deo and Shah 2012).

3. The data for the world merger market are obtained from Thomson Financial; the data for the South Korean merger market are obtained from Korea Capital Market Institute.

4. The data on mergers are provided by a project of Kis-Line, a financial database, conducted solely for the purpose of this study and are not available to the public. In particular, we adopt distinct cases—mergers except for acquisitions from a legal point of view—because defining acquisition cases from a controlling point of view is difficult considering that anomalous acquisitions, such as cross shareholdings and family-controlled conglomerate ownership, have been pervasive in the Korean market.

5. The behavioral literature on finance provides evidence that overconfidence affects corporate policies, such as those on capital expenditures (Malmendier and Tate 2005), dividends (Cordeiro 2009), financing decisions (Malmendier et al. 2011), CEO turnover (Campbell et al. 2011), and research and development (R&D) expenses (Hirshleifer, Low, and Teoh 2012).

6. Choi and Hwang (2005), Kim and Kim (2007), and Song and Joo (1997) find operating synergy in the Korean merger market during the decades of the 1990s and 2000s.

7. Some studies on financial synergy show positive abnormal returns after mergers (i.e., Ben and Andre 2006; Berkovitch and Narayanan 1993; Goergen and Renneboog 2004; Gondhalekar and Bhagwat 2003; Healy, Palepu, and Ruback 1992; Kewei, Olasson, and Robinson 2000; Lin and Lee 2010).

8. In this case, sticky cost behavior relates to adjustment costs that arise when a firm reduces its committed costs. For example, adjustment costs related to human resources arise from layoffs (e.g., retirement pay), employment (recruitment and education costs), loss of morale, and so on. Anderson, Banker, and Janakiraman (2003) document that adjustment costs depend on human and capacity (or fixed) resources. Therefore, we analyze cost stickiness by focusing on labor and depreciation costs, both of which relate directly to human resources and fixed assets.

9. Santner and Weber (2009) also measure the biases of executives as a tight distribution of forecasts based on the survey results of CEO forecasts, following Ben-David, Graham, and Harvey (2007).

10. We attempt to capture CEOs’ hubris in a strict sense by bringing out general optimism bias in the second-step and third-step analyses, which may be distinct from simple hubris.

11. If a bidder CEO executes a merger without an optimistic view of the synergies, he may have another motive unrelated to hubris.

12. In the case of equity trading, Deaves, Lüders, and Schröder (2010) find that stock market forecasters are overconfident and become more overconfident with past successful forecasts.

13. To maintain the condition in which hubris theory is applied effectively, we need to intervene with optimism because a bidder CEO may have had motives other than hubris if he did not have optimistic views of the merger synergies.

14. $\mathrm{\Delta }COS{T}_{i,t}=\hspace{0.17em}{\beta }_0+{\beta }_1\ast \mathrm{\Delta }SAL{E}_{i,t}+{\beta }_2\ast \mathrm{\Delta }SAL{E}_{i,t}\ast D{D}_{i,t}+{\epsilon }_{i,t}$, and $\mathrm{\Delta }COS{T}_{i,t}={\beta }_0+{\beta }_1\ast \mathrm{\Delta }SAL{E}_{i,t}+{\beta }_2\ast \mathrm{\Delta }SAL{E}_{i,t}\ast D{D}_{i,t}+{\beta }_3\ast \mathrm{\Delta }SAL{E}_{i,t}\ast D{D}_{i,t}\ast Growt{h}_{i,t}+{\epsilon }_{i,t}$ (variable definitions are the same as those of the variables in Model (1), except for Growth, which is the percentage growth in real gross national product).

15. In the case of merger firms, ΔCOST_i,t indicates COST_i,t/COST_i,0 to compare with the fiscal year one year after a merger event (year t) and with the year of the merger (year 0).

16. We look closely at three traditional measures of managerial hubris: stock and stock-option behavior by Malmendier and Tate (2005, 2008), survey results on the distribution of CEOs’ forecasts by Ben-David, Graham, and Harvey (2007) and Santner and Weber (2009), and management forecast errors by Lin, Hu, and Chen (2005).

17. Although most Korean firms stopped disclosing data on the individual cost items of manufactured goods after 2004, we extend the sample periods by extracting labor and depreciation costs from the value-added data in the footnotes of financial statements.