Understanding How Psychology Drives M&A Decisions

Wednesday, April 14, 2004

Edward Teach, CFO - January 2004, Pgs. 55-57, http://

Abstracted from: Watch How You Think

Judging mergers and acquisitions.
Researcher after researcher has shown that too many mergers and acquisitions destroyed rather than created shareholder value. So why do executives continue pursuing M&A deals, Edward Teach asks. According to behavioral finance theory, the lure of M&A springs from the overconfidence or hubris of chief executives. Headstrong CEOs chase risky deals and overpay because they overestimate the returns, say advocates of behavioral finance. One example is the AOL/Time Warner merger. Time Warner's Gerald Levin did not seek the advice of the board, the CFO, or the general counsel before committing the company to this $163 billion catastrophe. In the aftermath, $200 billion in shareholder value has vanished.

Behavioral finance comes of age.
Over the past two years, academics and executives have shown increasing interest in applying the principles of behavioral finance to economic decisionmaking, reports the author. This discipline, which involves the application of psychology and sociology to finance, emerged in the 1970s, largely through the efforts of Amos Tversky and Nobel Laureate Daniel Kahneman. Known principally for their work on prospect theory, the two theorists conducted studies showing how loss aversion and other psychological factors can distort one's financial judgment. Richard Thaler and Robert Schiller added to the new field by solving oddities of economic behavior such as why people resist high deductibles in insurance policies and by revealing the market's irrational volatility. Although some might argue that behavioral finance is purely theoretical, it relies heavily on real-world data. Academics at Stanford and University of Chicago are studying behavioral corporate finance and the effects of managerial optimism and overconfidence. The first textbook in the field will be published in 2005.

Emphasis on overconfidence.
Much of the behavioral psychologist's work focuses on the effects of overconfidence in today's CEOs. It helps, say the behaviorists, if CEOs and CFOs understand the psychological issues associated with reaching decisions and incorporate this understanding in their decisionmaking process. The cognitive bias that leads to flawed decisions can take several forms. For example, executives with confirmation bias overweight the evidence that supports their views and underweight any contrary evidence. The author outlines tactics that can temper the influence of a perennially overconfident CEO, such as raising awareness in the boardroom that a problem exists; teaching executives how to restructure or reframe business problems; and creating an effective, group process to assess major deals. The group can avoid "groupthink" responses by including managers from different corporate areas, who should also have accounting and financial literacy. The directors should serve as the final devil's advocate, to counterbalance the CEO.

Abstracted from CFO, published by CFO Publishing Corp., 253 Summer Street, Boston, MA 02210.

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