Do Envious CEOs Cause Merger Waves?

In our paper, Do Envious CEOs Cause Merger Waves?, which was recently accepted for publication in the Review of Financial Studies, we develop a theory which shows that merger waves can arise even when the shocks that precipitated the initial mergers in the wave are idiosyncratic.

We start with a simple premise: CEOs have preferences defined over both absolute and relative consumption, with relative-consumption preferences characterized by envy. Whenever we refer to a CEO, we mean the CEO of a bidding firm, and by envy, we mean that an individual’s utility is increasing in the difference between his consumption and that of the person he envies. There is now a large literature on the biological, sociological, and economic foundations for envy-based preferences, and substantial empirical evidence that preferences display envy. Assuming envy-based preferences generates a simple yet powerful intuition for why mergers come in waves. If CEOs envy each other based on relative compensation and CEOs of bigger firms get paid more, then a merger in the industry that increases firm size for one CEO will cause other envious CEOs to be tempted to undertake value-dissipating but size-enhancing acquisitions, thereby starting a merger wave.

To refine the intuition and extract additional testable predictions, we develop a formal model. The CEO of a firm within a size and/or industry cohort receives a possibly idiosyncratic shock that justifies an acquisition. This increases both the size of the firm and the CEO’s compensation, which is increasing in firm size. In the absence of envy, the story would end right here if the shock is purely idiosyncratic. Envy, however, induces a correlation in merger activities by making other CEOs in this cohort envious of the larger firm size and compensation now linked with the CEO of the firm that acquired first. Consequently, even if their own synergies do not warrant acquisitions, these CEOs acquire in order to diminish the utility-sapping impact of their envy. Moreover, as more firms merge, the effects of envy get stronger for the CEOs who have not joined the fray.

Thus, the model predicts that the envy-induced cross-sectional correlation in mergers is generated by the sequential decisions of firms, which then leads to results about how the gains from mergers vary depending on the timing of the merger within the wave. In particular, assuming that CEOs care both about firm value and envy-induced comparisons with other CEOs, we get the result that it takes smaller synergies to induce the later acquirers in the merger wave to seek acquisitions. Hence, another prediction is that bidder gains for later acquisitions in a merger wave are smaller than those for earlier acquisitions in the wave. Moreover, the increase in the total compensation of the acquiring firm’s CEO and top management team is higher in earlier acquisitions than in later acquisitions, and targets in earlier mergers are smaller than in later mergers. An additional related prediction is that more envious CEOs are more likely to engage in acquisitions and pay higher premiums. Our tests provide strong empirical support for all predictions.

The full paper is available for download here.