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The primary inference from this research is that any explanation of the sources of M&A activity will tell a complicated multicause story. Consider a division of explanations for M&A activity based on the rationality of markets and buyers’ managers. This creates a matrix of four camps of explanations for M&A activity, as shown in Exhibit 4.5.⁸

1 Rational managers and markets. In the northwest corner of the table is the “base case” of economics, which assumes that markets and the decision makers within those markets are rational. In this quadrant, share prices fairly reflect intrinsic value. Managers take effective action to maximize share prices. Economics offers the richest set of explanations for M&A activity here: Both waves and industry clustering can be rationalized. But assumptions of widespread rationality have become the piñata for business critics and reregulation advocates. Even the friends of M&A would have to admit, following the experience of 1995–2000, that bubbles happen.

2 Rational managers, irrational markets. The northeast corner accommodates the possibility of bubbles and assumes that individual managers can and will act rationally. This approach gains good traction on the explanation for why the form of payment in M&A varies with the market cycles. But it has less to say about industry clustering of M&A activity.

3 Irrational managers, rational markets. In the southwest corner is the world of managers who do stupid things for which the market reacts and penalizes them and their firms. Hubristic M&A is possible in a world with poor governance systems. But hubris says virtually nothing about M&A waves or industry clustering.

4 Irrational managers and markets. Economics has little to say about this world. When you assume away rationality, you sacrifice considerable traction from modeling and empirical research. Here, the best one can say is, “We don’t know what’s going on, but it’s probably bad.”

EXHIBIT 4.5 Explanations for M&A Activity Vary with Assumptions about Markets and Managers

Buyer’s Managers Are:	Markets Are:
Rational	Irrational
Rational	Managers and firms pursue competitive advantage within constraints of antitrust. With external shocks markets, firms, and managers respond rationally. It is difficult to determine whether negative returns to buyers are due to merger or the shock. Firms conduct M&A to exploit profitable opportunities and avoid losses. This may include exerting capital market discipline to correct agency problems and improve governance.	With overvaluation markets express irrationality. With information asymmetry managers are able to respond rationally on behalf of shareholders. Firms conduct share-for-share M&A to exploit overvaluation of their shares. Explains why we see many share-for-share deals near market peaks, and cash deals in the troughs.
Irrational	Managers make decisions based on hubris and markets punish the managers’ firms. Explains why firms do bad deals and why buyers’ share prices fall after the deal is done.	Managers and markets exhibit swarm behavior and market mania. Market prices regularly overshoot or undershoot intrinsic values. Managers display deal frenzy. Buyers’ shareholders approve acquisitions consistent with the prevailing mania, even though the deals may destroy value.

Where in this space would you position your view? It helps to reflect deliberately on this question because how you approach the tools and concepts in the rest of this book will be colored by your fundamental assumptions about what drives M&A.

My own view is that, on average and over time, markets and managers are rational (the operative phrase here is on average and over time). In the main, this encourages the use of tools and concepts founded on assumptions of rationality—these tools give a special benchmark for assessing deals as if markets and managers were rational. Periodically, markets and managers can lose their moorings. When they do, my practice is to cling to a value-style focus on intrinsic values and make decisions accordingly. This follows the philosophy that one must retain one’s fundamental discipline regardless of market conditions (for more on this, see Chapter 9).