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.

j

"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 

Goodwill Hunting Revisited

An earlier Post focused on goodwill Impairments as a measure of M&A value destruction. Duff & Phelps has released a new Study which contains some interesting results:

1)   Goodwill impairment surged 76% from the prior year to $51B.They still remain below the peak 2008 crisis related levels which were centered in the financial services industry.

2)   Buyers paid the lowest premiums in nearly 20 years, less than 20% v a historical 30%+.

3)   Impairments were concentrated in industries and firms undergoing structural change. IT was the industry experiencing the largest share of impairments. Two firms in that industry, Hewlett Packard (HP) and Microsoft (MS) had the largest impairments at $13.7B and $6.2B respectively representing nearly 40% of total annual impairments. HP’s impairment concerned its Autonomy acquisition while MS’s related to aQuantive.

The biggest source of M&A value destruction is overpaying. No matter how good the fit, how good the target, how flawless the integration, or the amount of due diligence, if you overpay, reflected in the amount of goodwill created or earnings and book value dilution, your shareholders will suffer.

Conceptually, the target’s pre bid share price plus the premium equals price paid. The value received is the target’s standalone value (reflected in the pre bid price) plus any synergies. Thus, the acquirer’s net value received is synergies less the premium. Premiums are, however, a fact while synergies are an opinion subject to behavioral bias.

As a rule of thumb, premiums exceeding 40% are prima facie evidence of overpayment. Think about it, a 40%+ premiums means you have to improve the target’s performance by over 40% just to breakeven. Unless, the target was grossly mismanaged, this will be difficult in a low growth highly competitive market.

The HP and MS acquisitions were grossly overpriced with premiums of 64% and 85% respectively. Such actions reflect desperate buyers gambling for redemption (AKA Hail Mary pass). Both HP and MS are former growth stars experiencing slumping sales growth and eroding margins. Their management teams, both of which have or will be replaced following their disastrous acquisitions, believed large transformational acquisitions would serve as a growth elixir. Unfortunately their shareholders were forced to drink from the poisoned chalice of value destruction.

j

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.

Behavioral Bias-The Hidden Risk in Mergers and Acquisitions

 Mergers and acquisition decisions are made by humans, not mathematical models. Humans have biases and make mistakes when fear or greed overrides their analysis. Richard Roll noticed this in his 1986 hubris hypothesis. These systematic deviations from rational calculations lead to substantial value destruction. As Warren Buffett notes, any CEO business craving will be quickly supported by detailed financial and strategic studies. Thus, it is better to start our review at the top with the CEO. The issues are understandable given the infrequent nature of acquisitions, limited feedback and the delay between upfront benefits and later costs. The errors can be both failing to make the good acquisition and making the wrong acquisition. Our focus here is on the latter.

Some major senior management biases are as follows:

1) Herding: mindlessly imitating peer actions - the “I have to have one because all the other kids have one” excuse. It gets especially bad as the merger cycle peaks resulting in buying at a high price.

2) Anchoring: overweighing certain information such as the original bid price or locking on to the 52 week high of the target’s shares for the opening bid.

3) Over Optimism and its cousin Over Confidence: this is the “we can do it” attitude to justify any synergy estimate needed to defend the price.

4) Confirmation: over weighting confirming evidence to the exclusion of contradictory facts.  These lead to a win at any cost approach known as the winner’s curse in which the “winner” overpays.  A practical way to handle the winner’s curse problem is to set a maximum price before the bidding starts.  Attempts to increase the price after the bidding starts should be questioned.

Remember we are often:

•       Guided by selective memories 
•     Often fail to consider what we believe to be false
•     Influenced by the actions of others
•     Confusing preferences with predictions
•     Engaging in self serving attribution
•     Denigrating non conforming views

Hopefully, forewarned is forearmed.

Joe