undergraduate dissertation - antecedents of withdrawing from announced acquisitions

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Group No: 4907 NANYANG BUSINESS SCHOOL ACADEMIC YEAR 2010/2011 ANTECEDENTS OF WITHDRAWING FROM ANNOUNCED ACQUISITIONS 081629B51 088890G51 081643G51 A/P Kang Soon Lee, Eugene Applied Research Project submitted to the Nanyang Business School, Nanyang Technological University in partial fulfillment for the degree of Bachelor of Business.

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Authored by: Loh Tai Yuan Berne; Woo Kai Zhi; Koh Hui Chan Joyce Supervisor: Kang Soon Lee, Eugene (NBS)

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Page 1: Undergraduate Dissertation - Antecedents of withdrawing from announced acquisitions

Group No: 4907

NANYANG BUSINESS SCHOOL

ACADEMIC YEAR 2010/2011

ANTECEDENTS OF WITHDRAWING FROM ANNOUNCED

ACQUISITIONS

081629B51

088890G51

081643G51

A/P Kang Soon Lee, Eugene

Applied Research Project submitted to the Nanyang Business School, Nanyang Technological University in partial fulfillment for the degree of Bachelor of Business.

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ACKNOWLEDGEMENT

We would like to express our heartfelt gratitude to Assistant Professor Kang Soon Lee,

Eugene, for his guidance and patience throughout the whole course of this project. This

project will not have been possible if not for his valuable advice and insights on the topic.

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ABSTRACT

This paper investigates the impact of board characteristics and CEO hubris on the

withdrawal of acquisitions, an event less extensively investigated. Prior research indicates

that board characteristics are associated with a firm’s financial performance, which is a

direct consequence of the firm’s strategic decisions. Furthermore, executive hubris is found

to influence corporate investment decisions such as acquisitions. Hence, we posit that board

characteristics and executive hubris should have an effect on strategic decisions,

specifically, acquisitions and their subsequent withdrawals. Using a conditional logistic

model, we carried out the study on publicly traded U.S. firms. The results suggest a positive

relationship between presence of a strategic committee and the likelihood of withdrawal

from announced acquisitions. We also found a negative relationship between CEO hubris

of acquirer and target firms with the likelihood of withdrawal. We conclude by discussing

the implications of this study for practice and suggesting avenues for future research.

Keywords: withdrawal from acquisitions, strategic committees, CEO-directors, strategic

persistence, hubris acquirer CEO, hubris target CEO

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CONTENTS

ABSTRACT ................................................................................................................................ 2

1. INTRODUCTION ............................................................................................................... 5

1.1. Research Motivation .................................................................................................... 5

1.2. Research Objectives ..................................................................................................... 5

2. LITERATURE REVIEW ................................................................................................... 7

2.1. Strategic Actions .......................................................................................................... 7

2.2. Board Characteristics ................................................................................................... 8

2.3. Hubris ......................................................................................................................... 10

3. THEORETICAL DEVELOPMENT ................................................................................ 13

3.1. Proportion of CEO-directors ..................................................................................... 13

3.2. Strategic committee ................................................................................................... 15

3.3. Hubris of Acquirer CEO ............................................................................................ 17

3.4. Hubris of Target CEO ................................................................................................ 21

4. METHODOLOGY ............................................................................................................ 23

4.1. Sample ........................................................................................................................ 23

4.2. Dependent Variable ................................................................................................... 23

4.2.1. Withdrawal ......................................................................................................... 23

4.3. Independent Variables ............................................................................................... 24

4.3.1. Presence of Strategic Committee ...................................................................... 24

4.3.2. Proportion of CEO-directors ............................................................................. 24

4.3.3. Hubris of CEO of Acquirer................................................................................ 24

4.3.4. Hubris of CEO of Target ................................................................................... 25

4.4. Control Variables ....................................................................................................... 25

4.5. Conditional Logistic Regression ............................................................................... 27

5. RESULTS .......................................................................................................................... 28

6. DISCUSSION AND CONCLUSION .............................................................................. 33

6.1. Discussion................................................................................................................... 33

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6.2. Implications ................................................................................................................ 34

6.3. Limitations and Future Research .............................................................................. 35

7. REFERENCES .................................................................................................................. 37

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1. INTRODUCTION

1.1. Research Motivation

An acquisition represents a major strategic action that is undertaken by a firm and will

necessitate a huge commitment on the part of the firm (Porter, 1987). It is mandatory under

the federal law of the United States of America to file and to announce acquisition intent

(SEC, 1934).

Some scholars have examined the strategic persistence to an acquisition decision

even though it may lead to unfavorable outcomes for the firm (Hayward et al., 2006).

However, firms may also recognize a previously announced acquisition to be a poor

decision. The executives of these firms may then choose to withdraw their acquisition

intent before the transaction is completed. Most studies have concentrated on factors

leading to a divestiture after the completion of the acquisition (Shimizu, 2007). However,

we believe that studies focused on events leading up to the acquisition could yield more

benefits. This is because even though firms can choose to divest a recently acquired unit

due to poor performance, costs to acquire and integrate the unit would have been incurred.

If a firm withdraws from an announced acquisition, it will be able to save on such

additional costs that will be incurred should the deal proceed.

1.2. Research Objectives

This study investigates certain factors influencing a firm’s withdrawal from an announced

acquisition. Specifically, this paper addresses two questions. Firstly, what is the influence

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of a firm’s board characteristics on the likelihood of withdrawal from an announced

acquisition? Second, what is the influence of CEO hubris of both the acquirer and target

companies on the likelihood of withdrawal from an announced acquisition? This research

adds to the existing literature on strategic persistence, specifically, on the influence of

board characteristics and CEO hubris in relation to acquisition withdrawal decisions. This

will aid our understanding of why firms choose to renege on a significant strategic act

previously communicated. The study makes use of firm-level data on publicly traded firms

in the United States.

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2. LITERATURE REVIEW

2.1. Strategic Actions

Decisions on a firm’s merger and acquisition activities are highly critical to its strategic

success. Such activities require the acquiring firm to make significant investments and the

outcome may not necessarily be favorable (Porter, 1987). Hence, due diligence needs to be

conducted by management before the firm continues in its endeavor of acquiring another

firm (Pautler, 2003). Therefore, in typical decision-making processes, top management

teams initiate and execute strategic actions whilst the board of directors ratifies the

decisions made (Carpenter et al., 2001).

Acquisition decisions impact various stakeholders. In particular, they are perceived

to reduce shareholder wealth (Porter, 1987). Hence, acquiring firms generally post negative

cumulative abnormal returns following acquisition announcements (Byrd et al., 1992;

Pautler, 2003). Despite this apparent signal to management to convey shareholders’

disagreement over the proposed acquisition, many firms will choose to continue with their

acquisitions on the belief that the acquired units will be able to increase their competitive

edge. The loss context arising from acquisition announcements may exert pressure on the

actors of a firm and influence their choice of subsequent strategic actions.

Prior research has focused mainly on the performance of the post-acquisition entity

and results showed that these entities have failure rates of about 50% (Saxton et al., 2004).

The high failure rate demonstrates the difficulty of successfully integrating acquired entities

into firms. Firms can choose to divest the acquired unit that is performing poorly or they

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can withdraw the acquisition bid if it is discovered that the target was no longer viable

before the transaction has been completed. Should a proposed acquisition be unviable, the

latter course of action will allow the acquiring firm to avoid the high sunk costs necessary

to acquire and integrate the acquired entity into its corporate structure. Hence, studying the

factors influencing the likelihood of withdrawal from announced acquisitions will greatly

benefit firms in their merger and acquisitions decisions. To the best of our knowledge, the

act of withdrawing from an announced acquisition has not been studied. Extant studies have

only studied corrective actions after the acquisition has been finalized (Hayward et al.,

2006).

2.2. Board Characteristics

Board characteristics comprise of the structure of the board and the characteristics of the

individual directors of the board. Boards of directors were established to resolve agency

issues. Agency theory asserts that agents entrusted to look after the interests of their

principal, may use the authorities and powers granted to them for their personal benefit.

Similarly, the separation of ownership and control in a firm results in conflicting interests

between shareholders and management. As a result, the traditional role of the board is

primarily of a monitoring nature. Their duties include managing the compensation of top

management and auditing major financial transactions of the firm (Fama et al., 1983).

Corporate governance is the set of mechanisms used to audit the decisions made by

management due to the separation of ownership and control (Larcker et al., 2007). The

purpose of establishing a code of corporate governance is to provide some assurance that

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decisions undertaken by a firm’s management are properly monitored and evaluated by the

board (Holm et al., 2010).

Research has established that corporate governance influences strategic decisions

(Larcker et al., 2007), which encompass mergers and acquisitions. Certain theories have

suggested how corporate governance might influence corporate strategy, such as the upper

echelon theory (Cannella et al., 1997). Upper echelon theory suggests that there is a

significant relationship between the strategic preferences of corporate board members and

their demographic characteristics (Hambrick et al., 1984; McDonald et al., 2008; Wiersema

et al., 1992). In relation to this study, researchers have suggested that CEOs are more likely

to undertake acquisition activities (Avery et al., 1998). This phenomenon is due to CEOs’

belief that higher number of acquisition bids will improve their prestige and competence in

the business community (Rao et al., 1999). Thus, it is useful to investigate whether CEOs,

who are serving on the board of directors (or CEO-directors), will exhibit any influence on

the firm’s strategic actions, in particular, acquisition activities.

Corporate governance has come under intense scrutiny with the passing of the

Sarbanes-Oxley Act. However, the Sarbanes-Oxley Act only focuses on the monitoring

nature of the board of directors (Akhigbe et al., 2008). In recent years, other functions of

the board have received greater attention, such as providing strategic advice and direction

to top executives (Chalhoub, 2009; Pugliese et al., 2009). Corporate boards in a modern

firm also bring business expertise and contacts that are potentially valuable to the firm.

However, the combination of monitoring and strategic roles for corporate boards may result

in a paradox of approaches to corporate governance (Sundaramurthy et al., 2003). It

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remains difficult to identify what is the optimum level of control and collaboration that is

required by the board of directors. In order to make decision-making a more rigorous

process, some companies have set up strategic committees specifically for the ratification

of strategic decisions.

Various studies have established the relationship between board composition and

characteristics with a firm’s financial performance (see Dalton et al. (1998) for a meta

analysis). However, there is a lack of research investigating the corporate governance-

related reasons which encourage or discourage withdrawals from an announced acquisition.

In particular, it will be useful to study whether the proportion of CEO-directors on the

board and the presence of strategic committees influence a firm’s withdrawal from

acquisitions.

2.3. Hubris

Past research has established that the majority of consummated acquisitions result in an

eventual loss of value (Berkovitch et al., 1993; Bradley et al., 1988). Despite such findings,

mergers and acquisitions are still undertaken by acquiring firms. Research has established

three main underlying reasons for the decline in value, namely, ineffective management of

target firm, lack of synergistic gains and hubris (Berkovitch et al., 1993; Hayward et al.,

1997).

As the first two motives linked to strategic considerations are insufficient to explain

the phenomenon, a third factor, hubris was proposed. Roll (1986) established the “hubris

hypothesis” to explain the phenomenon whereby acquisitions are consummated despite

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bidders having knowledge that there are no actual gains because of the bidders’ hubris and

overbearing presumptions that their valuations are accurate. In particular, CEO hubris plays

an integral role in the acquisitions undertaken by an acquiring firm (Haspeslagh et al.,

1991). Hambrick and Hayward (1997) found that CEO hubris is positively correlated to

acquisition premiums which are used to measure what acquiring firms’ perceive to be the

additional value that can be realized. Hence, this finding suggests that CEOs with higher

hubris believe in their competence and abilities to extract greater value from the acquisition,

hence this may potentially affect the likelihood of withdrawal from an acquisition. While

current studies have looked into how hubris affects the likelihood of acquisition initiation

and the premiums paid, there is a lack of research investigating its impact on withdrawals

from an announced acquisition. Examining whether hubris plays a role in the likelihood of

withdrawing an announced acquisition thus provides an interesting research endeavor.

The construct of CEO hubris is also relevant because scholars have observed

seemingly irrational behavior of pursuing inappropriate strategies or decisions, i.e.,

strategic persistence (Westphal et al., 2005a). Hubris results in overconfident individuals

overestimating their abilities, resulting in a higher tendency to engage in perceptive biasing,

escalation of commitment or other irrational behaviors, known collectively as strategic

persistence. Strategic persistence has been explored via two streams of research, escalation

of commitment (Lant et al., 1992) and perils of excellence (Miller, 1997). Escalation of

commitment refers to the fact that individuals base their decisions either on their past

actions or the need to justify an action done in the past (Staw, 1981). Actors of a firm who

have invested a significant amount of time and effort into a particular acquisition will find

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themselves persisting in a particular course of action though evidence points to the loss of

viability of the strategy for the firm. Conversely, perils of excellence refer to the sense of

self efficacy developed by the manager based on his past successes (Miller, 1994).

Executives who have successfully concluded numerous deals are likely to be boosted by

their perceived success and lead the firm to persist in the current acquisition intent. Hence,

it will be useful to study how hubris, related to strategic persistence, influences the

likelihood of withdrawal of acquisitions.

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3. THEORETICAL DEVELOPMENT

3.1. Proportion of CEO-directors

CEO-directors are directors who concurrently serve on the board and hold CEO positions at

other firms. There are a few schools of thought with regards to how the proportion of CEO-

directors on the board may affect the likelihood of withdrawing from an announced

acquisition. Extant studies suggest that corporate leaders share similar characteristics

(Hambrick et al., 1984; McDonald et al., 2008; Wiersema et al., 1992), such as similar

informal access to information through personal networks. CEO-directors are likely to

receive additional information and insights on an ongoing acquisition, more so than non-

CEO-directors. The additional access to market intelligence renders CEO-directors more

sensitive to market changes, and hence strategically, more astute. When the viability of an

announced acquisition decreases during the execution phase, CEO-directors are more likely

to spot the rot and hit the brakes. The argument that corporate boards demographically

filled with more CEOs are more likely to withdraw from an announced acquisition is

consistent with the upper echelon perspective.

In addition, CEO-directors are often seen as accomplished business people expected

to guide the firm’s strategic direction. Therefore, CEO-directors are expected to exercise

strategic prudence in upholding their reputation as good monitors of the company and

competent business people (Fama et al., 1983). With their business reputation on the line,

CEO-directors are less likely to stay committed to an acquisition that is no longer viable

(Simonson et al., 1992). This is consistent with the loss aversion attitude (Tversky et al.,

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1991) supported by the regret theory (Boyce et al., 1992; Loomes et al., 1982). The theory

suggests that an individual, in anticipation of a negative outcome, will adopt a course of

action that minimizes the potential downside. In the context of an announced acquisition, a

withdrawal effectively sidesteps the potential pitfalls of an unviable announced acquisition.

Hence, the upper echelon and regret theories suggest that the higher the proportion of CEO-

directors on the board, the higher the probability of withdrawal from an announced

acquisition.

The opposing school of thought argues that all human beings have limited attention

(Gladstones et al., 1989) and CEO-directors are no different. As leaders of their own

corporations, CEO-directors generally have limited time and attention available to the

board they are serving on than non-CEO-directors, ceteris paribus. Since it will take a

substantial amount of effort to challenge an agreed-upon strategic decision (Westphal et al.,

2005b), CEO-directors are more likely to allow an ongoing acquisition to continue.

Therefore, based on this argument, a higher proportion of CEO-directors should be

associated with a lower likelihood of acquisition withdrawal. However, selection of board

directors today is a rigorous process (Shivdasani et al., 1999). In addition to their

experience and expertise, new board members are expected to demonstrate their

commitment to the firm. Regardless of whether they are CEO-directors, most legal

jurisdictions require directors to devote sufficient time and energy to their board duties. As

fiduciaries of a firm, directors are expected to commit their resources in ensuring the firm’s

optimal growth and development. Therefore, with stringent selection procedures and

regulatory controls in place, CEO-directors are not expected to commit less time and

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attention than their non-CEO counterparts. Hence, we do not expect a higher proportion of

CEO-directors to result in a lower likelihood of withdrawing from an acquisition. In other

words, we expect the arguments of the upper echelon and regret theories to hold

Hypothesis 1: Firms with a higher proportion of CEO-directors on the board are

more likely to withdraw from an announced acquisition.

3.2. Strategic committee

A strategic committee is a board subcommittee that is formed by virtue of a firm’s code of

corporate governance. The main responsibility of the committee is to ratify the strategic

direction that a firm will take. Executive decision to undertake an acquisition usually lies

with the CEO and top management during the strategic formulation stage of the decision

making process. For proper control, an acquisition decision proposed by top executives

should be ratified by the entire board at the ratification stage of the process. However, this

two-stage process limits top executives from leveraging on the expertise of the board

during the strategic formulation stage. If the entire board were involved in the strategic

formulation stage with the top executives, then cognitive biases such as self-serving bias,

may prevent the board from reneging on an earlier decision during the ratification stage.

Thus, to better balance collaboration and control for acquisition decisions, a strategic

committee should be established to allow a clearer segregation of duties. This reduces the

board’s cognitive biases, thereby increasing the likelihood of walking away from an

unviable acquisition when needed.

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Another function of the strategic committee is to act as an independent thinking unit

from the rest of the board so as to minimize the occurrences of groupthink. Groupthink

refers to a mode of thinking that people who are deeply involved in a cohesive in-group

engage in, when the members’ strive for unanimity overrides their motivation to appraise

alternative courses of action (Whyte, 1989). The segregation of duties reduces the incentive

of conforming to the initial decision by top executives since there are two separate groups

responsible for the entire strategic action. As a result, groupthink is reduced and it is more

likely for the firm to walk away from strategic actions unbeneficial to the firm.

Board members have a personal and professional incentive to maintain their

reputations as good monitors of the company and competent business people (Fama et al.,

1983). Since the strategic committee may be held accountable personally for strategic

decisions ratified and are likely to be evaluated on the basis of these decisions, they will be

less willing to escalate their commitment to poor quality decisions (Simonson et al., 1992).

This results in less strategic persistence. This is consistent with the regret theory, which

states that an individual will choose a less negative course of action when they consider the

anticipated regret of different alternative courses of action. The continuation of an

acquisition that may no longer be viable may incur huge costs for the firm, thus they are

more likely to adopt the less negative course of action, which is to withdraw from the

announced acquisition.

The loss aversion effect of prospect theory may also be applied to explain the

likelihood of withdrawals. The loss aversion effect suggests that, the psychological impact

of losses are twice that of gains and an individual will strongly prefer avoiding losses than

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acquiring gains of the same magnitude (Brenner et al., 2007; Tversky et al., 1991). Given

that acquisition announcements generally result in negative abnormal returns, corporate

boards make subsequent decisions in a loss context and are thus under pressure to abort

these acquisitions. As directors in a strategic committee are more personally invested in the

decision-making process, this may lead to cognitive biases distorting their objective

judgment. Comparatively, directors who are not members of the strategic committee are

less likely to escalate their commitment and undertake risks. Hence, they are more likely to

halt the acquisition process to avert losses.

Hypothesis 2: Firms with strategic board committees are more likely to withdraw

from announced acquisitions.

3.3. Hubris of Acquirer CEO

Hubris is the exaggerated pride, self-confidence or arrogance of an individual (Hayward et

al., 1997). Managerial behaviours reflecting hubris include undertaking overvalued

acquisitions or growth initiatives for the sake of merely growing the firm size (Kroll et al.,

2000). CEOs may be overconfident in their abilities to derive synergistic gains from

acquisitions, though in practice, synergy is often difficult to attain (Davis, 1985; Hartley,

1994; Haugen et al., 1975). These overconfident CEOs may wish to exhibit mastery

through successful acquisitions, resulting in an underweight of potential risks and

difficulties, and an overweight of their capabilities (Rovenpor, 1993). Furthermore,

takeovers occur as acquiring managers perceive themselves as superior (Hambrick et al.,

1993). Despite their overconfidence, Hambrick and Hayward (1997) found no evidence that

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executives with high hubris were superior to those without, in terms of recovering the high

premiums paid. Having the belief that their decisions are correct, overconfident managers

unconsciously turn away from negative signals pertaining to potential consequences of their

decisions (Hayward et al., 1997). Consistently, Duhaime and Schwenk (1985) argued that

executives with an “illusion of control” undertake vertical integration and unrelated

acquisitions deals. Hence, it can be posited that overconfident CEOs tend to overestimate

their competencies, thus reducing the likelihood of walking away from an acquisition.

CEO hubris may result in greater escalation of commitment towards a losing course

of action, such as an acquisition deal. Since CEOs play a pivotal role in acquisition deals

(Haspeslagh et al., 1991), they are likely to feel personally responsible for the negative

consequences of their actions, which is a pre-condition necessary for perceptual biases to

occur, resulting in escalation of commitment (Staw, 1976). Overconfident CEOs who

initiated or self-endorsed acquisitions which subsequently lose value are likely to

experience ego-defense mechanisms, in a bid to regulate their strong self-esteem (Banaji et

al., 1994; Brown, 1997). Hence, it is likely that overconfident CEOs have a greater

probability to engage in self-justification processes such as denial and rationalization, thus

escalating their commitment in a value-destroying acquisition, thereby decreasing the

likelihood of their ability to walk away from unprofitable acquisitions.

Furthermore, once the acquiring firm’s initial bid has been accepted, the acquirer is

allowed to conduct additional due diligence. However, CEOs may suffer from judgment

biases such as anchoring on a set number (Tversky et al., 1974) and sunk cost fallacy due to

their hubris. In an acquisition, it is postulated that the initial valuation may be treated as an

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anchor and overconfident executives are unlikely to adjust the initial price adequately even

in the face of new unfavourable information (Garbuio et al., 2010). Due to the sunk cost

fallacy, it is likely that CEOs consider sunk costs incurred, instead of only prospective costs,

in corporate investment decisions, leading to inefficient resource usage (Garbuio et al.,

2010). Overconfident CEOs are likely to be entrapped by such judgment biases due to their

psychological predispositions, which cloud their objective judgments. This thus diminishes

their ability to walk away from the acquisition.

A strong need for power and sense of superiority may also underlie CEOs’ desire to

acquire. The need for power is referred by Winter (1987) as an individual’s desire to obtain

prestige and impact through the attainment of formal socialized power and rash acts, such

as taking extreme risks. It is likely that CEOs who enter into expensive acquisitions share

this need for power, desire prestige, and domination over others. It has been established by

Rovenpor (1993) that the greater a CEO’s need for power, the greater the firm’s merger and

acquisition activities. Acquisitions may be made due to managerial desire to control and

supervise more employees or build their reputation as aggressive managers, astute in

identifying potentially good deals (Goldberg, 1983). Hence, this need for power underlying

the acquisitive behaviours of CEOs infected with hubris may result in their reluctance to

withdraw from acquisitions.

Furthermore, there is a high propensity for leaders and CEOs to be credited with

success even though the success may be attributed to external factors (Meindl et al., 1985).

CEOs with higher hubris are more likely to credit these favourable attributions to their

personal capabilities. Such favourable self-attributions in turn, lead to growth of prestige

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within the firm (D'Aveni, 1990), hence increasing the likelihood of management and other

board members concurring with the CEO’s actions without an objective and independent

assessment. Hence, self attribution theory suggests that heightened hubris levels of the

CEO may possibly result in an overly-optimistic and less objective assessment of an

acquisition’s potential, hence decreasing the probability of withdrawal of these acquisitions.

This is consistent with the model of institutionalization of power (Boeker, 1989; Salancik et

al., 1977). The board’s confidence in the CEO grows after he proves his leadership

competencies, which may lead to reduced board vigilance, thus increasing the CEO’s

discretionary power further (Lorsch et al., 1989). This is consistent with findings that the

CEO’s power becomes institutionalized within the company such that no one questions his

decisions and authority (Ocasio, 1994). With no one to challenge his decisions,

overconfident CEOs are thus less likely to walk away from an acquisition.

Lastly, CEOs have been found to be motivated by personal incentives to see

acquisitions through. Research has found that CEOs’ desire to undertake empire building

has led to mergers and acquisitions. Empire building relates to the CEOs’ wish to expand

their span of control and grow their firm size. CEOs derive personal benefits from their

control over larger firms, such as higher remuneration, higher power and prestige enjoyed

as well (Bliss et al., 2001; Jensen et al., 1990; Shleifer, 2003). Consistently, CEOs holding

greater power enjoy higher bonuses and are inclined to enter larger acquisitions as

compared to CEOs holding less power (Grinstein et al., 2004).

To further build on the above argument, upper management of firms plagued with

poor performance may feel threatened with regards to their job security, leading to personal

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incentives to go into new businesses that they possess stronger expertise over (Shleifer et

al., 1988). This is consistent with management pursuing growth as a strategic means to

ensure the survival of the company independently in the long run (Donaldson, 1984). CEOs

with greater hubris seek to be at the helm of companies they control for as long as possible,

hence entering acquisitions to entrench their managerial positions, leading to lower

likelihood of withdrawal of acquisitions despite negative shareholder value creation

prospects.

Hypothesis 3: Acquirer firms whose CEOs have higher hubris are less likely to

withdraw from announced acquisitions.

3.4. Hubris of Target CEO

The previous hypothesis examines the hubris of acquiring firms’ CEOs, hence similarly, we

expect the hubris levels of target firms’ CEOs to also influence the likelihood of withdrawal

from announced acquisitions. We posit that target CEOs who have high hubris tend to

believe that they will be valued and retained should their companies be taken over. It has

been found that the CEOs of target firms, who remain employed subsequent to an

acquisition, experience increases in their salary, bonus and total compensation (Agrawal et

al., 1994). Hence, this financial incentive coupled with the CEOs’ confidence in being

retained, serves as a motivation for them to put the acquisition through.

Further, it has been studied that CEOs of target firms, whose firms are acquired, are

more likely to resurface in top leadership positions comparable to their previous positions

(Park, 2007). Since they face no risks of unemployment, these CEOs stand to lose little

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despite the acquisition of their firms. The ease of finding a job of similar stature to their

previous one will likely reaffirm the CEOs’ sense of self-importance. This leads to lower

resistance and hence, likelihood of withdrawal from announced acquisitions.

Hypothesis 4a: Target firms whose CEOs have higher hubris are less likely to be

withdrawn from an announced acquisition.

However, it can also be argued that CEOs with high hubris are too proud to allow

their firms to be acquired. Research has shown that target CEOs experience high turnover

rates at the time of the acquisition. However, for those who remain employed, they tend to

remain employed for several years thereafter (Hartzell et al., 2004). The position of CEO is

a symbol of power to those CEOs with high hubris. Losing their stature as the CEO will

thus dent their self esteem and pride. Hence, these CEOs will be less likely to continue with

an announced acquisition and are more likely to resist any acquisition offers.

As mentioned earlier, a strong need for power and sense of superiority underlie the

acquisitive behavior of overconfident CEOs (Winter, 1987). Faced with the risk of losing

his controlling stake in the firm following an acquisition, a CEO infected with hubris is

thus more likely to resist and reject any such acquisitions.

Hypothesis 4b: Target firms whose CEOs have higher hubris are more likely to

withdraw from announced acquisitions.

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4. METHODOLOGY

4.1. Sample

The initial sample size consisted of 341 publicly-listed U.S. firms that withdrew from a

significant announced acquisition from 1998 to 2007. These firms were then matched with

a control firm that did not withdraw from an announced acquisition to form a paired

observation. We selected the control firm based on the following criteria; their industry

codes, year of announcement of acquisition, form of acquisition, acquirer size and ratio of

target size over acquirer size. After accounting for confounding announcements, such as

announcements of new product offerings and earnings reports, and removing firms with

incomplete data, we were left with 172 usable observations.

4.2. Dependent Variable

4.2.1. Withdrawal

The dependent variable represents a dummy variable of withdrawal which is coded as 1 if

the acquiring firm withdraws from an announced acquisition and 0 otherwise. This

information was retrieved from the SDC database.

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4.3. Independent Variables

4.3.1. Presence of Strategic Committee

This is a dummy variable coded as 1 if a firm has a board committee that makes decisions

on strategic issues and 0 otherwise. The information is retrieved from a firm’s proxy

statements.

4.3.2. Proportion of CEO-directors

This is a ratio of the number of outside directors who are active CEOs to the total number

of directors on the board. The information is retrieved from a firm’s proxy statements.

4.3.3. Hubris of CEO of Acquirer

This is obtained as a ratio of the total compensation received by the CEO of the acquirer

firm to the total compensation received by the next highest paid executive (Hayward et al.,

1997). One way to measure hubris is to quantify the compensation of the CEO relative to

the next highest paid executive in the company. It is believed that the amount of

compensation received by an executive reflects the skill sets and unique competencies

possessed by the executive (Hayward et al., 1997). Hence, the CEO may use this relative

compensation as a yardstick of the value of his capabilities. A CEO’s hubris can thus be

gauged through the compensation of the CEO relative to the next highest paid executive

(Brenner, 1986). The information is retrieved from a firm’s proxy statements.

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4.3.4. Hubris of CEO of Target

This is similarly measured as a ratio of the total compensation received by the CEO of the

target firm to the total compensation received by the next highest paid executive. The

information is retrieved from a firm’s proxy statements.

4.4. Control Variables

Several control variables were included so as to exclude alternative explanations. Firstly,

the cumulative abnormal returns (CAR) from a financial-event study analysis were

included as a measure of investor reactions to an announced acquisition. The abnormal

stock return is computed after determining the normal return from the market model. The

normal return is defined as the expected return if the event of interest (i.e., announced

acquisition) had not taken place. The computation of the normal return requires an

estimation window that is typically prior to and does not overlap with the event window

(McWilliams et al., 1997). The estimation window was set at 200 trading days starting

from 10 days prior to the event window and the CRSP Value-Weighted Index was used as

the market portfolio in the market model. We computed the CAR for Day -1 (i.e., one day

before acquisition announcement) to Day 0 (i.e., on the day of the acquisition

announcement). The abnormal stock returns for each day in the event window is summed

up to arrive at the CAR over the event window. To ensure that the financial-event study

analysis only captures investors' reactions to an announced acquisition, confounding

announcements one day before, on, and one day after the event date were excluded from

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the analyses (McWilliams et al., 1997). All stock price and index data for the study were

extracted from CRSP.

Second, various common corporate governance variables were included in the

model. For example, we included the variable, Independent Chair, which is a dummy

variable with a value of 1 if the chair is an independent director of the firm and 0 otherwise.

Next, we included proportion of independent directors, which is measured as a ratio of

independent directors over board size. In addition, we measured proportion of equity held

by independent directors, which is a ratio of the shares owned by the independent directors

over the total number of shares of the firm. We also measured proportion of equity held by

inside directors, which is a ratio of the shares owned by the inside directors over the total

number of shares of the firm. Data for these governance variables is extracted from the

proxy statements.

Certain characteristics of the transaction were also controlled for. Hostile

acquisition is a dummy variable that has a value of 1 if the bid was unsolicited and 0

otherwise. Competing bid is a dummy variable that has a value of 1 if there were competing

bids for the same target and 0 otherwise. These dummy variables were collected from the

SDC databases. In order to control for firm size, we included the natural logarithm of the

total assets of the firms. Profitability of the acquiring firm is controlled by including return

on equity. These financial data are extracted from COMPUSTAT. Lastly, we included the

year of withdrawal announcement and industry dummies as control variables. The year of

announcement was extracted from the SDC database and verified via the LexisNexis

Database. Industry dummies were computed from SIC codes in COMPUSTAT.

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4.5. Conditional Logistic Regression

Conditional logistic regression was used to test our hypotheses for two reasons (Agresti,

2002; Hosmer et al., 2000). First, the dependent variable, Withdrawal, is binary as a

matched-pairs design was employed, where each pair contained one firm that withdrew

from an acquisition post-announcement and the other firm did not. Second, the matched-

pairs design employed a conditional distribution, where the distribution of the dependent

variable is fixed and subject-specific instead of marginally distributed and population-

averaged (O'Connor et al., 2006). The conditional logistic regression does not have an

intercept term since having the term would interfere with the estimates of the other

parameters (Agresti, 2002).

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5. RESULTS

Table 1 shows the correlation matrix and the descriptive statistics used in the study. The

proportion of CEO-directors is negatively correlated with the dependent variables (r=-0.16,

p<0.05). Several control variables also have significant correlations with other variables in

the model. This suggests that multicollinearity may be present in the empirical model.

Variance Inflation Factor (VIF) is used to further determine if multicollinearity is an issue

(Chatterjee et al., 2006). The VIF for the reported regression model ranged between 1.32

and 9.78, with a mean of 2.93, which suggests that multicollinearity is not a concern.

Table 2 shows the results of the analysis. The overall model is significant and the

pseudo R2 value of 0.37 is significant, which suggests a good fit with the model (χ2=63.85,

p<0.05). One tailed p-values are used to test the independent variables while two tailed p-

values are used for the control variables.

Hypothesis 1 states that a firm with a higher proportion of CEO-directors is more

likely to withdraw from an announced acquisition. This hypothesis is not supported. The

coefficient for proportion of CEO-directors is positive and not significant (b=0.22, p>0.1).

Hypothesis 2 states that a firm with a strategic committee is more likely to withdraw

from an announced acquisition. This hypothesis is marginally supported. The coefficient

for strategic committee is positive and significant (b=1.59, p<0.1).

Hypothesis 3 states that a CEO at the acquirer firm who has higher hubris is less

likely to withdraw from an announced acquisition. This hypothesis is strongly supported.

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The coefficient for hubris of CEO from the acquirer is negative and significant (b=-0.39,

p<0.01).

Hypothesis 4a states that a CEO at the target firm who has higher hubris is less

likely to withdraw from an announced acquisition. This hypothesis is supported. The

coefficient for hubris of CEO from target is negative and significant (b=-0.26, p<0.05).

Hence, hypothesis 4b which states that a CEO at the target firm who has higher hubris is

more likely to withdraw from an announced acquisition is not supported.

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Table 1 Descriptive statistics and correlations among study variables

Variable Mean S.d. 1 2 3 4 5 6 1 Withdrawal 0.50 0.50 2 Proportion of CEO-Directors 0.12 0.13 -0.16* 3 Strategic Committee 0.04 0.19 0.05 0.13 4 Hubris of Acquirer CEO 2.00 1.57 -0.05 0.16* -0.04 5 Hubris of Target CEO 1.83 2.01 -0.06 -0.01 0.02 -0.09 6 Abnormal Returns of Announced Acquisition -0.02 0.08 -0.06 -0.05 -0.08 -0.10 -0.10 7 Independent Chair of Acquirer 0.13 0.34 0.01 -0.02 0.15* 0.01 -0.10 -0.04 8 Proportion of Independent Directors 0.70 0.16 -0.12 0.27*** 0.15* -0.17* -0.03 -0.01 9 Proportion of Equity Ownership by

Independent Directors 0.03 0.07 0.17* -0.11 -0.02 -0.05 -0.08 0.10

10 Proportion of Equity Ownership by Inside Directors

0.01 0.06 0.01 -0.16* -0.05 -0.13 -0.02 0.01

11 Hostile Acquisition 0.06 0.24 0.18** 0.06 -0.05 0.10 -0.03 0.06 12 Competing Bids 0.19 0.39 0.30*** 0.09 0.03 0.05 0.06 0.05 13 Natural Logarithm of Firm Size 7.18 2.03 -0.20** 0.31*** 0.14* 0.09 -0.04 0.01 14 Return on Equity of Acquirer -0.15 2.44 -0.08 0.08 0.02 -0.05 -0.03 -0.20*

*p < .05; **p < .01; ***p < .001

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Variable 7 8 9 10 11 12 13 8 Proportion of Independent Directors 0.28***

9 Proportion of Equity Ownership by Independent Directors

0.15* 0.13*

10 Proportion of Equity Ownership by Inside Directors

-0.09 -0.31***

0.03

11 Hostile Acquisition -0.03 -0.10 -0.03 -0.03 12 Competing Bids -0.03 0.14* 0.03 -0.02 0.18** 13 Natural Logarithm of Firm Size 0.03 0.27*** -

0.15* -0.32*** 0.06 -0.00

14 Return on Equity of Acquirer 0.03 0.14 0.02 -0.06 0.03 0.04 0.25***

*p < .05; **p < .01; ***p < .001

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Table 2

Conditional Logistic Regression Results Model 1

Variable Coefficient

Robust Standard Error

Abnormal Returns of Announced Acquisition -0.51 4.40 Independent Chair -0.09 0.81

Proportion of Independent Directors -5.80 1.90 ** Proportion of Equity Ownership by Independent Directors 16.19 8.44 † Proportion of Equity Ownership by Inside Directors -12.35 4.64 ** Hostile Acquisition 3.77 1.50 * Competing Bids 4.00 0.89 *** Natural Logarithm of Firm Size -0.42 0.18 * Return on Equity -1.41 0.99

Year of Acquisition Announcement dummies Included Industry Dummies Included Proportion of CEO-Directors 0.22 2.35

Strategic Committee 1.59 1.05 † Hubris of Acquirer CEO -0.39 0.15 ** Hubris of Target CEO -0.26 0.13 * Number of observations 172 Wald Χ² (df) 63.85 (45) * Pseudo R² 0.37 †p < .10; *p < .05; **p < .01; ***p < .001

z-tests are one-tailed for the independent variables and two-tailed otherwise.

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6. DISCUSSION AND CONCLUSION

6.1. Discussion

For hypothesis 1, the results showed that there is a non-significant relation between the

proportion of CEO-directors and probability of withdrawal. The result is unexpected based

on theoretical corollaries drawn from the upper echelon and regret theories. One possible

explanation is that CEO-directors in general do not play as significant a role in the

completion of an announced acquisition as compared to other directors with designated

positions. Since a previously announced acquisition was a decision made by the entire

board, only directors with specific designations, such as CEO and strategic committee

members, hold sufficient power and authority to subsequently change the acquisition

decision.

Hypothesis 2 is supported as, the results showed a significant positive association

between the presence of a strategic committee and the likelihood of withdrawal from an

announced acquisition. This is largely consistent with the hypothesis developed earlier. The

segregation of duties reduces the influence of cognitive biases on the decision ratification

process of the board and thus increases the likelihood of the firm reneging on its previous

decision. Moreover, outside directors not members of the strategic committee are less

involved in the strategic decision making process and less committed to the strategy, thus

increasing the ease of withdrawal. Firms may consider segregating the responsibilities in

the board of directors to better structure the decision making and decision control

responsibilities of the board. The segregation of duties may help firms reduce potential

costs due to poor acquisitions or strategic persistence tendencies of corporate boards.

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For hypothesis 3, the hubris of acquirer CEOs showed a negative association with

the likelihood of withdrawing from an announced acquisition. Consistent with the

hypothesis developed earlier, the results support that CEO hubris may lead to

overconfidence in personal abilities to derive synergistic gains, as well as, escalation of

commitment and perceptive biases against withdrawals of announced acquisitions.

Judgment biases such as anchoring and sunk costs fallacy may also kick in. In addition,

CEOs with high hubris are likely to possess a strong need for power and domination,

leading to acquisitive behavioral tendencies. Lastly, personal incentives, such as empire

building and self-entrenchment may also prevent the withdrawal from an announced

acquisition.

Lastly, hypothesis 4a is supported (i.e. Hypothesis 4b is not supported). The hubris of

target CEOs has a significant negative association with the likelihood of withdrawing from

an announced acquisition. As earlier explained, it is hypothesized that the hubris of target

CEOs results in them being overconfident, thereby leading them to believe that they will be

retained even after their firms have been taken over. Hence, they are less likely to oppose

an acquisition by another firm.

6.2. Implications

The results of our study have several implications relating to the influence of the board and

CEOs on the outcome of announced acquisitions.

Firstly, CEO-directors are found to be insignificant in influencing the completion of

an announced acquisition, while strategic committees seem to play a more significant role

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in reviewing ongoing strategic activities. This implies that the specific designation of a

director on the board tends to have an overriding effect on the external background of the

director. Firms should thus establish strategic committees in their corporate boards in order

in improve the firm’s strategic decision-making process, and thus the performance of the

firm.

Furthermore, high-hubris CEOs may be less prudent in making acquisition

decisions, as they have been found empirically to be less likely to withdraw from

announced acquisitions than their lower-hubris counterparts. High-hubris CEOs are also

less resistant to takeover bids. Depending on the nature and objectives of the company,

such propensity could make or break the business. This implies that shareholders and

nominating committees should consider the hubris level of individuals when selecting their

ideal corporate leaders.

6.3. Limitations and Future Research

One limitation of this paper is that it focuses solely on firms in the United States. Hence,

some of the recommendations in this paper may not be fully applicable universally. More

research can be carried out on firms from other countries and regions to determine if these

results remain substantively similar. Second, more research may be carried out to

investigate whether there are other factors that will contribute to the withdrawal of an

announced acquisition. Third, the hubris variable was measured using the relative

compensation of the CEOs to the next highest paid executive. However, other hubris

proxies such as media praise can be examined as well. Fourth, future research can also

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investigate whether other characteristics of both the target and acquirer firms’ boards have

a discernible effect on the results of this study.

Finally, future research can examine the sources of CEO hubris. CEO hubris has not

been widely researched upon. It has been suggested that CEO overconfidence can be traced

to self-attribution bias. CEOs attribute success of past acquisitions to their own capabilities,

developing their overconfidence to derive gains, hence leading to more acquisitions, even

value-destructive ones (Billett et al., 2008). Furthermore, CEOs have been found to

increase their equity holdings in the firm preceding acquisitions that eventually had

negative wealth effects, which displays their overconfidence in future firm prospects due to

self-attribution (Billett et al., 2008).

While the current paper looks into the relation of CEO hubris of acquiring firms

with the likelihood of withdrawal, a potential area of research would be to investigate the

sources of CEO hubris, in particular, the number of past successful acquisitions

consummated. Such specific findings will provide deeper insight into the sources leading to

CEO hubris, hence allowing firms to take actions to identify and mitigate potential issues in

advance.

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