One of the key factors determining the success or failure of an M&A deal is the mindset of the CEO.
Few direct actions of the CEO can have as much impact on the future of a company as the decision to make an acquisition. For Chinese companies that have decided to buy a foreign company, the stakes may be even higher.
Unfortunately, it’s not only lonely at the top; often, there’s not much oxygen. One of the biggest risk factors in a merger is that the CEOs involved pursue the deal based on a less-than-rational reading of its merits. Overconfidence, ignorance, greed—almost every human foible that may be only personally destructive in a mid-level manager can lead to the loss of thousands of jobs and billions of dollars in value in a CEO in the grip of a merger mania.
The Buck Drops Here
In 2010, on the 10th anniversary of the disastrous $164 billion AOL-Time Warner deal of 2000, former Time Warner CEO Gerald Levin said that CEOs like himself who made big merger mistakes needed to acknowledge their role and say, “You know what, I’m solely responsible for it. I was the CEO; I was in charge; I’m really very sorry about the pain and suffering and loss this has caused. I take responsibility. It wasn’t the board; it wasn’t my colleagues. It wasn’t the bankers and lawyers.”
Unfortunately, Levin wasn’t exaggerating about his degree of responsibility for this particular debacle, which erased $200 billion in shareholder value. As Nina Munk wrote in her 2005 history of the merger, Fools Rush In, “Despite the rules set by the Securities and Exchange Commission and other regulators, the company’s own stakeholders—its shareholders and employees—didn’t count for much.”
Deals are often complex, but the factor most often to blame for a deal going bad is the simplicity of the deal-maker-in-chief. The problem, according to Donald C. Langevoort, a professor of law at Georgetown University Law Center, who has written an article on the behavioral economics of mergers and acquisitions, is that CEOs often end up in the top job precisely because they had taken big risks earlier in their career and won “as skill levels become more concentrated up the ladder, the winner of a contest among managers is the one willing to risk the most—and lucky enough not to have it blow up on him or her.” As a result, he writes, they tend to have diminished risk perception.
One 2004 study by Ulrike Malmendier, now a professor of economics at the University of California at Berkeley, and Geoffrey Tate, now an associate professor of finance at the University of North Carolina at Chapel Hill’s Kenan Flagler Business School, found that the odds of making an acquisition were 65% higher if the CEOs were overconfident, taking as a proxy of confidence their portrayal in the press and the amount of their personal wealth they had left in the company. Malmendier and Tate estimated that the 10.8% of the CEO population they could classify as overconfident were responsible for 44% of the value destruction.
Not surprisingly, the more money they have, the more damage they can do, according to another 2006 study by Malmendier and Tate. They found that arrogant chiefs are more likely to execute deals when they have access to debt or cash. The pair theorize that thanks to their rose-colored glasses, overconfident execs not only estimate their return on investment, but the value of their stock, which makes equity deals seem too expensive.
Nor is this behavior unique to Western companies. Chinese hubris seems just as likely to lead to risk taking in private Chinese companies, according to a 2010 Hong Kong University of Science and Technology study (Li & Tang). The scholars also found that firms with more experienced CEOs, better-educated CEOs, and founder CEOs were all somewhat more likely to take risks than the average CEO. However, state-owned companies and companies where the CEO was not the chairman as well remained risk averse even when they were led by an overconfident CEO.
Somewhat less often, personal motivations may also play a role. For example, CEOs who become focused on the fact that the chiefs of larger companies tend to earn more money and decide to push for a deal, according to Edward Hess, a professor of business administration and Batten Executive-in-Residence at the University of Virginia’s Darden School of Business.
Pay itself seems to be a risk factor. One recent analysis (Cooper 2014) of the performance of the 1,500 largest market cap companies between 1994 and 2013 found that companies led by CEOs who were in the top 10% for pay were more likely to make a merger than the lowest-paid 10% (19% versus 13%), and their average return on the merger was much lower for the first three years of the deal (negative 1.38% compared to negative 0.51%).
Blind spots in the CEO’s understanding can also have a negative impact. “If the CEO is too focused on sales or just a bean counter, only about finance, they can get hit by blind spots,” says Robert Sher, founder of CEO to CEO, a consultancy to mid-sized companies.
CEO’s should try to keep themselves from getting overly enthusiastic about a deal. “Don’t identify yourself by whether the deal gets done,” advises Darden’s Hess. “Be very disciplined and have skeptics on the due diligence team and really listen to them and consider their views.”
“Many companies either lose focus of the original intentions, or lose focus of the financial ceilings that should be adhered to,” warns Russell Brown, Managing Director of LehmanBrown, a Beijing-headquartered accounting and corporate advisory firm.
All the way through the process, Hess advises, the CEO should try to maintain a sense of skepticism about the deal. “Up front, assume you bought the company and it was a big failure. List all the reasons how or why that could occur. And then frequently review your processes—are you looking to see if the facts that would lead to that bad outcome exist? Are you looking for reasons not to buy or just looking for facts that confirm your thought that you should buy? Under what conditions would you walk from the deal?”
Processes in Place
However, the CEO can’t do it alone. “It’s important to make sure the company has many processes in place to mitigate cognitive biases, sloppiness, and becoming too emotionally invested in doing the deal,” says Darden’s Hess.
Boards also need to play an important role in disciplining the leader—which in turn depends on whether the CEO sees the directors as having knowledge and experience and the best interests of the CEO and the company at heart, Langevoort points out.
“In that setting, there can be a candid and useful conversation built around precisely why the CEO thinks the deal will succeed, whether these beliefs are realistic, and whether the CEO has considered the lessons from the many acquisitions that fail to meet expectations,” Langevoort says. “In other words, play devil’s advocate.”
The deal, however, is only the beginning. In fact, it’s not even half the battle, according to Sher. “The people that get their egos carried away, often CEOs, love the idea of buying a business, like buying a ship or buying a jet. People too often think that an acquisition is doing the deal,” says Sher. “They sign on the dotted line, they hand over the check, and they say, ‘I’m done, I bought a business.’ That’s like a third of it… most of the wreckage happens after that point.”
Paradoxically, at that point, the game changes. The caution that serves executives well in the beginning isn’t useful once the papers are signed. After the deal is closed, the CEO needs to be a quick, courageous and decisive leader. “You have to be ready to handle the heat and react quickly and make quick decisions,” Sher says.
To read all the articles in the When East Buys West series, please click here.