Monday, August 4, 2014

The Curses of M&A: Winner’s and Seller’s

The buyer related Winner's Curse is well known. It involves overpaying for targets relative to the benefits received. Essentially, you do the deal you should have passed - a type I error of commission. The seller’s curse-sometimes known as Seller's Remorse, although less discussed, is equally dangerous. It occurs when sellers overvalue themselves and reject an offer they should have accepted - a type 2 error of omission. Both curses are based on over optimism. For buyers this means that they can obtain the needed improvements to justify the price. For sellers it means that future returns justify forgoing a current offer.

Firms go thru life cycles. The best owner of a business changes for each stage of the cycle. As firms age they, like cottage cheese, reach a sell by date. New owners can extract more value thru better execution of higher valued strategies. This is important in rapidly evolving industries like big phrama where value chains are changing, making current asset combinations obsolete. Current owners find this fact hard to accept due to emotional ties to their organizations.

These ties are difficult to overcome unless you have a disciplined process to determine if you have reached your sell by date. This requires comparing retained value from not selling with your private market price in the M&A market. Retained value, the floor or refusal price below which the firm should not be sold is analogous to the reservation or maximum price a buyer can offer without diminishing shareholder value. The retained value is the potential seller’s expected cash flows discounted at its cost of capital. Private market value is based on recent comparable transactions.

If the private market value is greater than the retained value, then the firm is worth more to someone else than to the current owners. M&A is based on differences between actual and potential value. There is no one true value. It depends on the owner-management team’s chosen strategy and execution ability. Sellers can capture the upside of selling to a higher valued owner through the buyer’s bid premium. Even if you elect not to sell, you at least know the opportunity cost of that decision.

Seller’s reluctance to sell, like the related winner’s curse, reflects a behavioral bias. Sellers are prone to the Endowment Effect, whereby, they ascribe more value to something they already own than what they would be willing to pay to acquire it. Thus, you develop unrealistic pricing expectations, and fail to execute a sale you should have completed by pricing yourself out of the market. Inexperienced first time sellers are prone to seller’s reluctance. Repeat sellers like private equity firms are less likely to suffer from this bias.

Overcoming seller’s reluctance requires an external review of the firm well before the actual exit to ensure objectivity and commitment. It involves thinking like an investor by asking ‘If you were not already the entity’s owner would you invest in it and if so at what price?’ An annual appraisal process to determine whether to sell, and at what price, should accompany a firm’s strategic plan update. It provides the basis to begin discussions with qualified buyers. Selling should be viewed as a valid aspect of strategy and not a last resort.

Seller’s reluctance is just as dangerous for sellers as the winner’s curse is for buyers. Knowing when to sell and at what price is as important as knowing when to buy. Any fool can buy. A wise person knows when to sell. Sell when you can and not when you must. Sometimes you have to let go. It is being smart not giving up.


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