"A Man Hears What He Wants to Hear and Disregards the Rest"

The title comes from lyrics to one of my favorite songs by my favorite singer-songwriter, The Boxer by Paul Simon.  It also describes the subject of today's post: confirmation bias and how it might relate to acquisitions.  "Confirmation bias" is the tendency to overweight evidence that supports our views.  No sooner do you read the definition than you think of the countless ways this could apply to mergers and acquisitions.

First and foremost, consider the CEO determined to grow the company.  A possible target opportunity is identified and before beginning the analysis, the CEO has a favorable view. Being prudent, he or she state, "But let's see what the numbers say."  The danger is that he or she will overweight evidence that supports a positive  position.  It doesn't take much manipulation to change a negative net present value to a positive result.

While the CEO is generally not the person doing the analysis, we all know that when mangement asks "How much is 2 + 2?" the safest answer is "How much do you want it to be?"  That kind of bias leads to disastrous acquisitions.   Synergies, often used to justify deals,  are easy to imagine and tougher to realize.  

Confirmation bias can also be related to the frequency illusion, the odd feeling that some new thing you have just learned about is suddenly catching your attention more far more than seems probable.  Frequency illusion is thought to occur because we all have selective attention.  There are often far more sensory inputs occuring than we can process.  Consequently, our mind focuses on some pattern of interest and records that, ignoring much of the rest.  The pattern of interest, is likely to be the recently learned 'new thing' or information that conforms to our hopes and expectations.  Each new occurrence of the item increases our belief that our analysis and ideas are correct.

The solution, in the case of mergers or in any business decision is to ruthlessly challenge all assumptions, to stress test all analyses, to encourage and nurture dissenting views and to be constantly aware of they types of biases that can distort our thinking.

(For other posts on behavioral bias, see Behavioral Biases in Acquisitions - The Anchoring Effect and Roll's Hubris Hypothesis and Behavioral Bias.)

All the best,

Ralph

Behavioral Biases in Acquisitions - The Anchoring Effect

This post is one in a series where we continue to explore how behavioral biases can affect merger decisions.  Joe started this discussion over a year and a half ago in a post entitled, Behavioral Bias, the Hidden Risk in Mergers and Acquisitions.  For years, economists have assumed that men and women were rational in their decision making and that markets were efficient.  To quickly come to the defense of economists (because on my better days I resemble one), these assumptions are not necessarily in place because we thought they were true.  Rather, they present a meaningful standard for testing alternate hypotheses.  After all, I can explain virtually anything but just telling you the decision maker was irrational.  So too can I explain any movements in the stock market by simply throwing up my hands and declaring markets are inefficient.  There is not much value in those two statements.  

There is value in carefully documenting empirical regularities in decision making.  The advancements in the field of behavioral finance have occurred simultaneously with two phenomena: 1)  the growth of experimental economics where subjects are presented alternate choices  in a controlled setting and researchers are able to carefully measure and calibrate the tests and 2) an increased appreciation in the field of finance for the psychological sciences.  

The literature on behavioral biases has been voluminous in recent years and we can only hope to start the dialogue and acknowledge some of the issues in these short posts.   Today, I just want to talk a bit about one of these biases: anchoring.  

The anchoring effect occurs when we give too much weight to some value presented early in the decision making process.  Research shows that final values are influenced by this initial number, even if it is irrelevant.  An interesting article in by Edward Teach in (see CFO magazine, Avoiding Decision Traps) gives many excellent examples.  In one, researcher Dan Aerily asked his MBA students to write down the last two digits of their social security number. Subsequent to this, they bid on bottles of wine and boxes of chocolate.  Students whose SS numbers were higher placed bids that were 60 to 120 percent higher.  Obviously, one's SS number has no relation to the actual value of the item, yet it had a major influence in the bidding.  

In many cases the anchoring number is presented to us as with the list value of a car, or the stated value of an item at a department store.  When we purchased the item at a lower price we feel that we obtained a bargain.  In fact, the initial number may have been grossly overstated or irrelevant.  Similarly, when a bidding or target firm suggests an initial value an anchor is created, one that often influences the outcome.

The price at which we purchased a stock can create an anchor even though (except for tax purposes) that value is irrelevant today.  I don't feel good about the Apple stock I purchased at $700 and I might be irrationally reluctant to sell below that price even if the true value is less.  

Other times, investors will anchor at the recent 52 week high value of a stock or its book value even though these numbers can bear little resemblance to true value.  

The lesson is to be aware and wary of the anchoring phenomena and where possible estimate values on your own without initial regard to other estimates.  

We will continue with other observations.  

All the best,

Ralph

Rolls Hubris Hypothesis and Acquiring Firm Returns

I've heard management professors and some consultants throw around comments like "Seventy percent of all acquisitions fail."  I don't believe it and the statistical evidence doesn't support that claim.  True, there is a lot of evidence that suggests bidders break even or lose a few percent at the announcement of a bid.   The combined returns to bidders and targets, appropriately weighted for size, are positive.  The typical deal creates value.   What I might believe is that 70 percent (or more) of mergers fail to realize their potential.  But that is typically a problem of integration and the subject of other posts. 

So what do we make of the continuing story that bidders tend to lose or break even?  After all, bidding activity continues to be quite popular (even if currently dampened).   There are many explanations in the literature to explain bidder returns.  Today, I will mention two.

The first is the possibility that we, as researchers, are not measuring returns correctly.  In a recent paper published in the Review of Financial Studies we present evidence that the typically measured bidder return doesn't adjust for anticipation.   When returns are measured correctly bidder returns are positive.  See (Anticipation, Acquisitions and Bidder Returns.)  

But let's return to the fact that some deals, however measured, do result in the loss of value to the acquiring firm.  Even in our sample this occurs as much as 40% of the time.  Why? A good place to start looking for the answer is in the price paid for the target.  As we have noted, Every deal is a bad deal at some price.  Not every deal is a good deal at some price.

In an efficient market, the value of a firm's shares are priced correctly.  Why would bidders typically add 20-40% to the market price in their bids?  Why would bidders pay more than this? The obvious, and always cited reason is synergies.  Synergies, of course, can be easily overestimated and in other posts we note that you should always challenge the assumption of synergies.  Why are they available to your firm and to no one else?  

Another reason to explain high bid prices is behavioral - the hubris factor. Roll (1986) was the first to point this out in the finance literature.  

Anyone who has bid for an object on Ebay understands that it is easy to overpay, to go beyond the rational limits we might set in advance on our bids.  We get caught up in deal fever or a desire to 'win' regardless of price.  The same behavior must certainly be true of at least some acquiring managments.  One can imagine the psychological pressures on management in certain bidding wars.  Multiple sides express multiple views with many unkind words and suggestions.  If psychological factors lead bidders to go beyond pre-determined boundaries (or equivalently if management directly or indirectly causes their own analysts to overestimate the gains to mergers in setting those boundaries) shareholders lose.  As we have noted, some of the best deals are those not attempted or in this case, not completed.  

One of the best illustrations of the hubris phenomena are found in the words of Warren Buffett, quoted in a previous post,

"Many managers were apparently over-exposed in impressionable childhood years to the
story in which the imprisoned, handsome prince is released from the toad's body by a kiss
from the beautiful princess.  Consequently, they are certain that the managerial kiss will
do wonders for the profitability of the target company.  Such optimism is essential.
Absent that rosy view, why else should the shareholders of company A want to own an
interest in B at a takeover cost that is two times the market price they'd pay if they made
direct purchases on their own?  In other words investors can always buy toads at the
going price for toads.  If investors instead bankroll princesses who wish to pay double
for the right to kiss the toad, those kisses better pack some real dynamite. We've observed
many kisses, but very few miracles.  Nevertheless, many managerial princesses remain
serenely confident about the future potency of their kisses, even after their corporate
backyards are knee-deep in unresponsive toads." 

(Warren Buffett in the 1981  Berkshire Hathaway Annual Report)

We'll continue this discussion in two ways in the future.  One will be through an analysis of other factors related to bid premia and to bidding and acquiring returns.  A second avenue of analysis will continue to explore the role of behavioral factors in mergers and acquisitions.

All the best,

Ralph 

Risk Appetite: Eating Well or Sleeping Well

Ralph and enjoyed teaching the December 4-6 Acquisition Finance Course at the Amsterdam Institute of Finance-despite enduring the worst storm in over 60 years while in Amsterdam. The attendees raised some interesting questions, which I will attempt to address in this and upcoming posts.

Readers of MergerProf will note one of the reoccurring themes is how changes in investor risk appetite trigger changes in buyout volume, capital structure, financing instruments and structuring. The attendees inquired about what causes risk appetite changes. This is an important issue for trying to understand markets.

Risk appetite is based on Keynes’ notion of Animal Spirits and included in behavioral finace. My understanding of risk appetite is as follows:

1)   Risk Appetite is driven by changes in investor wealth. When wealth increases it encourage investors to risk their winnings on more adventurous activities. When wealth decreases, in a downturn or market crash, it make us more cautious. This is especially true when the wealth decreases are large enough to cause solvency and liquidity problems which breach our budget constraints.

2)   Risk appetite changes, both up and down, are amplified by leverage and liquidity. Leverage allows us to invest more thereby lifting asset prices and collateral values. This creates a virtuous circle or positive feedback loop. As we all know, when this reverses, the downward price movement can be unpleasant.

3)   Liquidity is driven by rising asset prices and increased credit. It tends to be ephemeral and is never there when you need it as investors learned during the credit crisis. Hence the need to hold negative return assets like cash and treasuries as an insurance policy.

4)   Liquidity shifts as asset correlations change. All asset correlations, except for cash and treasury insurance policy assets, go to one in a crisis. Diversification evaporates just when you need it the most. As prices decline, we tend to liquidate our most liquid assets first, to make margin calls, to minimize capital losses. This triggers a vicious circle further reducing prices, credit and liquidity.

Currently, central bank Quantitative Easing efforts with their massive liquidity injections and falling yields have spurred investor risk appetite-more so in the United States than Europe given the improved domestic economy. Thus, U.S. buyout volume is strong, fueled by investor demand for higher yielding high risk instruments like “CCC” rated debt, high yield bonds, second lien loans, and covenant lite loans used to fund more aggressive higher priced buyouts. Interestingly, we are also seeing more PE sponsored IPO exits like Blackstone’s Hilton Offering. This is a reflection of an exuberant stock market compared to a more subdued M&A-trade sale exit.

We all know how this will end. We just do not know when it will end. We need to structure transactions able to withstand abrupt market changes. Of course, this comes at a cost.

j

Experience Matters: The Impact of the Financial Crisis on M&A

I have been stumped by the continued low level of M&A activity. Despite improving fundamentals, strong stock market performance and the need for many industries to consolidate, M&A remains stuck in low gear. I understand macro headwinds and political uncertainty still exist. Nonetheless, something else seems to be dogging managerial animal spirits. My concern is the 2008 Financial Crisis may have a long term damping effect on management risk appetite.

The Financial Crisis represented a near death experience for many firms. Stock prices fell by 50%.  Although they have largely recovered over the past 5 years the cumulative return over that period remains flat. The collective memory of this experience may take years to dissipate.   Experiences matter - sometimes even more than fundamentals. Risk tolerance is time varying. Thus, the financial crisis is likely to have a long term negative impact on managers’ willingness to engage in M&A.  See a book chapter I authored on this subject chapter_24_post_crisis_investor_behavior_-_rizzi_-_final_-_05-18-13.pdf.

J