Much more on incentives next week Managerial attention Warren Buffett is a

– Much more on incentives next week • Managerial attention – Warren Buffett is a serial acquirer but somehow has committed not to pay much attention to his acquisitions – he lets his managers operate without much interference. – Seems somewhat unique in this – very difficult to avoid the temptation to meddle 32

33 Some arguments to be skeptical of • “Mergers diversify shareholders’ portfolios” – People often argue that a merger will reduce risk through diversification – In well-functioning capital markets, however, shareholders can do this themselves – i.e. if business A is pro-cyclical and business B is anti-cyclical, an investor could buy shares of both without them merging – Financial diversification will generally be much less costly than a merger

34 Some arguments to be skeptical of • “I am good at identifying undervalued firms” – In this case, the price they will pay will be less than their expected profits. – But do we really think they have better information than all other potential investors? – Overwhelming evidence from psychology, finance, etc. that managers tend to be overconfident in their own judgment.

35 An argument that needs clarification • “The merger will create $X in synergies” – On its own, a vacuous claim – Essentially saying the merger will increase revenues or lower costs … – Always be sure to clarify what exactly the “synergies” are

36 Managerial incentives for mergers • Our discussion has been framed as: when do mergers increase shareholder value • A different question: when do mergers make CEOs happy? • Since corporate governance is generally weak, we would expect private incentives to play a role

37 Managerial incentives for mergers • Possible incentives: – Like running larger companies – Like to be on the cover of magazines – Want to diversify away personal risk (legal limits on ability to hedge in financial markets) – Want to ensure firm’s survival to protect own job / human capital – Want to ensure growth so that subordinates can continue moving up the ladder

38 Managerial incentives for mergers • We would expect these incentives to play a large role in mergers... – Where merging companies are unrelated – Where target companies are growing fast – Where managers have performed poorly in the past • Morck, Shleifer and Vishny show that exactly these kinds of mergers tend to lead to adverse stock market reaction at announcement

39 What does the empirical evidence show? • Mergers on average create shareholder value (at least a little) • All of the gains accrue to target firms (acquiring firms may actually lose out on average) • This evidence comes mainly from event studies, but is supported by studies of profitability. Long-run stock market performance provides some contrary evidence.