MACR/U1 Topic 5 Hubris Hypothesis of Takeovers
Hubris hypothesis suggests that the management of the acquirer is sometimes over-optimistic in evaluating potential targets because of information asymmetry, and in most cases, because of their own misplaced confidence about their ability to make good decisions. Their over-optimism eventually leads them to pay higher bid premiums for potential synergies, unaware that the current share price may have fully reflected the real value of this target. In fact, acknowledging that takeover gains usually flow to shareholders, while employee bonuses are usually subject to the size of the firm, managers are encouraged to expand their companies at the expense of shareholders (Malatesta, 1983). The hubris theory suggests that takeover is both a cause of and a remedy for agency problems.
Through takeover, management not only increase their own wealth but also their power over richer resources, as well as an increased view of their own importance. But a weakness in this theory is the assumption that efficient markets do not notice this behavior. According to Mitchell and Lehn (1990), stock markets can discriminate between “bad” and ”good” takeovers and bad bidders usually turn to be good targets later on. These empirical results imply that takeover is still a device for correcting managerial inefficiency, if markets are efficient.
Of course, good bidders may be good targets too, regardless of market efficiency. When the market is efficient, a growth-oriented company can become an attractive target for more successful or bigger companies who wish to expand their business. When firms are inefficient, a healthy bidder may be mistaken for a poor one and the resulting negative reaction will provide a chance for other predators to own this newly combined company. In these cases, the treatment directed towards target management may be different since the takeover occurs because of good performance not poor. In either case, Mitchell and Lehn (1990) admitted on the one hand that managers’ pursuit of self-interest could be a motive for takeover but on the other they still argue that this situation will be corrected by the market mechanism.