Thursday, April 19, 2012
Facebook's billion dollar bet on Instagram is one of those deals that keeps me up at night. A billion dollars for a company with no revenues, hmmmm... I am even more worried now that reports indicate that the Facebook board was essentially absent in advising Zuckerberg on the decision to purchase Instagram.
Acquirer overpayment often occurs in these large transactions. While some papers connect these losses to classic agency cost problems, numerous finance scholars have studied the role that non-economic forces, such as ego and hubris, play in corporate transactions (for just some of these pieces, see here and here). Several of these studies find that empire-building preferences and overconfidence predict heightened managerial acquisitiveness, including acquisitions that result in losses in acquirer shareholder wealth. This is particularly true when managers have significant internal resources. Ulrike Malmendier and Geoffrey Tate demonstrate how CEOs can overestimate their abilities to generate returns and create value. In particular, they illustrate how overconfident CEOs are associated with an increased likelihood of conducting M&A transactions, and also poorer deals for their shareholders as measured by bid announcement returns. Simlilarly, Mathew Hayward and Donald Hambrick examined hubris as a determinant of the size of premiums that CEOs will pay for acquisitions. In their examination of 106 large acquisitions, Hayward and Hambrick find “losses in acquiring firms’ shareholder wealth following an acquisition, and the greater the CEO hubris and acquisition premiums, the greater the shareholder losses [following an acquisition].” Moreover, the study also indicates that the relationship between acquisition premiums and CEO hubris is stronger in cases where board vigilance is lacking, i.e. when the board has a high proportion of inside directors and a CEO who also serves as chair of the board. More recent papers build on these results. In an unpublished manuscript, John, Liu, and Taffler find that overconfident CEOs pay higher bid premiums and that this effect is reinforced when the target CEO is also overconfident. Similar findings are reported by Chatterjee and Hambrick who show that narcissistic CEOs in the computer industry carry out more and larger acquisitions.
None of this bodes well for Facebook's Instagram deal. It may be that at the end of the day the deal turns out ok. But I would be cautious when a young star CEO runs around spending the company's resources without any board involvment.