The 'Winner's Curse' Hypothesis and Corporate

Takeovers
Hypothesis
The winners curse hypothesis states that in any bidding situation, a party which
unknowingly overestimates the value of an asset tends to bid higher than its
competitors, and thus win the auction. In case of takeovers, the magnitude of
curse is the difference between the bid premium of the winner and the maximum
offerable premium conditional on the capital markets expectation.
In the paper The 'Winner's Curse' Hypothesis and Corporate Takeovers by
Nikhil P. Varaiya published in the Managerial and Decision Economics, the author
relates the magnitude of curse with:
Divergence of opinion amongst acquirer with respect to size of takeover
gains
Degree of competition for control of target firm, and
Pre-acquisition profitability of the winning bidder
The main testable hypothesis that emerge from the paper are thus
Ho1: The winning Buyer in a corporate takeover auction will, on average,
pay more than the value of expected takeover gains.
H02: The likelihood and magnitude of the winner's curse, i.e.
overpayment, will increase with an increase in the divergence of opinion
among buyers with respect to the value of expected takeover gains
H03: The likelihood and magnitude of the winner's curse, i.e.
overpayment, will increase with an increase in the degree of competition
among Buyers for control of Seller.
H04: The likelihood and magnitude of the winner's curse (i.e.
overpayment) is positively related to the magnitude of the pre-acquisition
abnormal performance of the winning Buyer
Methodology
A sample of acquisitions was taken from a mergers and acquisitions database
provided by Kidder Peabody & Co. The time period in consideration is 1974-83
and the value of the deal exceeded $15 million. The final sample set contained
91 acquisitions (51 mergers and 40 tender offers). The following filters were
used:
The acquisition was successful (completed), i.e. the identity of the winning
Buyer was known
The winning Buyer financed the acquisition with an offer of cash, of
common stock or a combination of cash and stock (including preferred)
only
The acquisition was not a leveraged buyout; and
The availability of sufficient information enabled measurement of the
announcement date, the winning bid premium, the degree of competition
and the estimate of expected takeover gain in each acquisition.
Hypothesis 1: The magnitude was defined as difference between observed
premium and maximum offerable premium. The overall calculations were

influenced by sellers excess return on the day of announcement and sellers and
buyers total equity value.
Hypothesis 2: For divergence of opinion, a proxy was used based on variation in
the EPS estimate of the sample companies by the leading brokerage houses.
Hypothesis 3: The degree of competition was measured as well as regression
was run where 2 or more actual/potential competitors were present. In case
where there was only one bidder, a proxy was generated which would measure
the increase in competition had there been more bidders.
Hypothesis 4: The pre-acquisition profitability and cash flows of the winning
bidder was measured for the 12 months preceding the deal. It was expected that
these companies generated excess cash flows and thus would fund their
acquisitions through these.
Conclusion
The empirical results show that the magnitude of overpayment is positively
related with all the determinants stated. In our sample set, 67% of the
acquisitions have the winning bid premium more than the maximum offerable
premium conditional on the market's estimate of the expected takeover gain.
Only in 33% of the acquisitions the winning Buyers could be argued to have fully
incorporated the winner's curse. The regression result supported the positive
relation of magnitude of winners curse with dispersion of opinion and preacquisition profitability, but nor degree of competition.