Friday, November 9, 2012

Beware the Winner's Curse

Many acquisitions fail to create value for the acquirer and in most deals, the benefits go largely to the seller. This reflects the highly competitive nature of the M&A market. It also reflects the large concentrated investment bet at premium prices of M&A transactions. Buyers, in effect, are pre paying for uncertain future revenue and cost synergies. Frequently, buyers over pay for the expected synergies based on managerial optimism, overconfidence and the urge to beat competing bidders.  So it is understandable that the buyer’s shareholders react negatively to acquisition announcements. Many studies indicate that, on average, the acquirer’s share price falls once the transaction becomes public. (For alternative evidence see Ralph's blog on Anticipation). This overpaying is known as the winner’s curse or hubris-when the winning bid in an auction exceeds the target’s value. The absolute dollar loss of acquisition can be huge.  The loss can be estimated by looking at the level of goodwill paid and its subsequent write-off. Goodwill, the amount of the purchase price exceeding the target’s book value, represents a crude measure of over payment. Duff & Phelps estimates the amount of goodwill write offs, a proxy for overpayments which failed to materialize, for the 2007-2011 period to exceed $325B.

The key to avoiding this problem is to make an accurate assessment of the target’s value and to have the discipline not to bid more than that value. This requires establishing a walk-away, or reservation price, before making a bid.  The opening bid should be set at a fraction of that price based on competitive considerations. Ultimately, it is not just what you buy, but what you pay that determines an acquisition’s success. Overpaying for benefits received destroys acquirer shareholder value.

Distinguishing between cheap and frugal is needed when pricing an acquisition. Cheap refers to low value. Frugal, however, represents efficiency. You usually get what you pay for. Equally important is to avoid over paying for what you get. Complicating this matter is that price is fact, representing what the buyer gives up immediately. Value is an opinion concerning what you expect to receive in the future.

A target’s price has two components.  The first is the stand-alone, pre-bid minority ownership price.  It reflects the status quo value of its cash flow under the current strategy and management.  The second is the premium required to persuade the target’s shareholders to sell a control position.  The premium can be estimated from comparable transactions and can vary widely over time, reflecting the economic cycle.

Expected value includes the target’s status quo value plus potential synergy improvements. Value varies by owner depending on strategies pursued and execution of that strategy.  The acquirer’s net value added equals the difference between the expected synergies less the premium paid to acquire them. Buyers lose when the transaction premium exceeds the expected synergies. Thus, the buyer’s maximum price should be less than the seller’s status quo value plus expected synergies.

Projected synergies can represent a form of valuation Viagra used to justify excessive premiums.  As Warren Buffett notes, while deals often fail in practice, they never fail in projections. Buffett continues by noting that any business craving of the leader, however foolish, will be quickly supported by detailed rate of return and strategic studies. Avoiding this trap requires strong board of director oversight. Firms with weak governance and dominated by forceful CEOs are prone to the winner’s curse.

The board needs to consider the risk of an acquisition represented by the shareholder value at risk (SVAR), which represents the premium offered relative to the buyer’s market capitalization.  It measures the impact of failing to achieve the projected synergies. Larger, more competitively priced transaction with high SVAR should receive additional oversight.

Value additive acquisitions are difficult. Growth is not free. Furthermore, acquisitions are subject to behavioral biases like the winner’s curse that frequently override good analysis. Buyers need to exercise pricing discipline based on strong board oversight. There is no right way to do the wrong thing. Overpaying for synergies with an excessive premium is the wrong thing.  Bid wisely to avoid the winner’s curse. Keep in mind that bad bidders make good targets.


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