Setting/negotiating the Bid Premia in Acquisitions

It is easy to set the likely minimum and maximum prices that should be paid for a target firm.  It is more difficult to adhere to these values in practice.  Without such boundaries, however, we don't have a chance for a disciplined bid.  As we've said many times, there is not better time to create or destroy value than when paying for the deal.  Value is created (destroyed) as we underpay (overpay) for a particular company.

From the bidder's point of view, the maximum that should ever be paid for a target is the NPV of the acquisition to the bidder.  That is, calculate the incremental value expected to be obtained from a deal.  This is the maximum dollar bid premium.  But if you pay this amount, you will break even and no value will be created for your shareholders.

From the target's point of view the minimum that would likely be accepted in a deal is the current market price.  Although one can create scenarios in which a target would take less because of liquidity issues, such scenarios are rare.  In practice, the mimimun for which a firm can be acquired is its current market price and as more shares of the target are sought, higher premia must be paid.

The actual price paid generally falls between these two boundaries and is a function of the bargaining power of each party.

Factors increasing the bargaining power of the bidder include the existence of unique synergies available only to this bidder, a toehold in the bidder, and the ability to pay cash to facilitate a speedy transaction.

Factors favoring the target include multiple bidders (usually a function of synergies available to many), a high level of target managerial ownership and the necessity of target management for continued success of the venture.

The actual price paid will be a function of the various estimations implied by these concepts and the negotiating ability of each party.  It takes a disciplined bidder to not overpay.  It takes a disciplined target to know which deals to reject.  Understanding one's boundary points is the start to this discipline.

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

Hell or High Water Deals

I enjoy reading the M&A Law Professor blog, and often find it quite relevant to the types of things we think about at MergerProf.  Such is the case with last weeks link to another post about Hell or High Water Deals - deals that are designed to close no matter what - once they are signed, they close.  No major MAC clauses, etc.  The post contains a cute animated video illustrating some of the concepts involved and noting some of the great problems from the sellers point, of a deal not closing (loss of morale, loss of employees, uncertainty, etc.) [I know it is a link to a link, but let's give credit to the place where I read this.] The post also notes that deals that close 'no matter what' are extremely rare.  Well, maybe.  It seems to me that the Dow Chemical - Rohm and Hass deal came pretty close.  After the financial crisis Dow tried to walk away from the deal and found that they couldn't.  But anyway, enjoy the post.  You can find it here.

May the Odds Be With You

This blog has highlighted the difficulty for acquirers to create value for their shareholders. This is due to a variety of factors ranging from behavioral biases to governance breakdowns. This does not mean that all M&A is bad as some do succeed. Those success stories share some common characteristics. A key is the establishment of an appropriate process with effective procedural safeguards.

This process incorporates many of the following steps (my Ten Commandments) :

1)     Avoidance of large transformational transactions-especially when proposed by a new CEO seeking to make a reputation for himself. He usually succeeds in making the reputation-unfortunately, not the one he intended. HP’s Leo Apotheker stands out as the poster boy example with the disastrous Autonomy acquisition.

2)     Actively engage the board in the process from the beginning rather than just asking them to approve a fully cooked deal under a tight deadline.

3)     The board should establish a subcommittee chaired by a knowledgeable outside director to challenge management concerning, inter alia, pricing, valuation, synergies, and alternatives.

4)     Establish a firm up front walk away price before the negotiations begin. Beware having to adjust your price to “win”-AKA the winners curse. This reservation price should reflect your best alternative to a negotiated agreement (BANTA). This protects against accepting an unfavorable agreement compared to a better alternative outside of the negotiations. To paraphrase Warren Buffett-there are no called third strikes in M&A. There is always another opportunity.

5)     Carefully consider the “whole deal” and not just price. Remember, you can name the price if I can name the terms, and I will win every time.

6)     Ask yourself if you are honestly the best owner of the target. This means you can extract the highest value through an optimal mix of strategy and execution. If not, then you are unlikely to extract the premium paid in a competitive bidding situation. As my favorite Chicago mayor Richard Daley Sr. eloquently stated-“don’t play no games you can’t win”.

7)     Make sure you get what you thought you were buying through extensive hands on due diligence(DD). DD is not glamourous and is frequently out sourced to consultants by executives who do not want to get their hands dirty. This leads to failure like those at HP in their failed acquisitions program. The seller enjoys an informational advantage over the buyer. Since they are unlikely to tell, it is up to the buyer to find out. A useful supplement to DD is using the reps and warranties in the sales and purchase (merger agreement) to flesh out matters you should explore more deeply.

8)     Develop a detailed integration plan updated by DD results covering the first 100 days after the closing. You need quick victories and must consider the complex social issues.

9)     Tie management’s incentive compensation to the target’s post close performance.

10)  Conduct a post mortem a year after closing to uncover lessons to be learned.

Of course, there are no guarantees, but the odds for success can be increased through an appropriate process.

Good luck

j

Social Terms in Mergers, US Air, American, Office Max and Office Depot

We've noted before on this blog the importance of negotiating on all aspects of the deal, not just price. (See, The Interrelated Nature of Deal Design.) The recently announced  mergers of US Air and American Airlines and also Office Max and Office Depot  are good examples of the importance of social terms.  

Social terms include things like the name of the merged firm, where it will be headquartered, who will be the CEO and how the board of directors will be constructed.

Consider the US Air - American Airlines merger.  Although US Air pursued this deal vigorously and is the acquiring firm, the combination retains American's name and will remain headquartered at its Fort Worth location.  Doug Parker, CEO and Chairman of US Air becomes CEO and board member of the new firm and after one year, Chairman of the Board.  Thomas Horton, Chairman, President and CEO of American Airlines will be Chairman of the Board for only one year.  

The Board of Directors of the combined firm will consist of 12 members, three from American Airlines,   four from US Air, and five from the creditors of American Airlines.   I'm a bit surprised that US Air doesn't dominate the board.   

Think that board composition isn't important?  Recall the merger of Duke Energy and Progress Energy that closed in July 2012.  Bill Johnson, the former CEO of Progress was to be CEO of the new firm, but was fired within 24 hours.  Replacing him was Jim Rodgers, the former CEO of Duke.  Under the merger terms, Rodgers was supposed to have been Chairman of the Board.  Reportedly, both of these CEOs had suffered errors in their stewardship as CEO.  Why did Rodgers survive?  One possibility has to do with board composition: the combined firm had 18 board seats, 11 from Rodger's Duke Energy and 7 from Johnson's Progress Energy.  

And then there is the merger of Office Max and Office Depot announced yesterday.  According to the announcement (which was, incidentally inadvertently leaked on Wednesday) the name and headquarters will be announced after the company appoints a CEO?

Huh?  Social terms are important components of any deal determined in the give and take of normal negotiations.  And social terms are costly - they involve real changes with real economic effects.  But not knowing the social terms?  That, would seem to be even more costly.  Not knowing these items as a deal is announced does not seem like the start of a prudent, coherent strategy.  Integration is fraught with uncertainty in the best of deals.  Starting out without  knowing the basic game-plan can only increase integration costs.  

Knowing your social terms? Important.  

Not knowing your board (if you are a new CEO)?  Courageous or some other adjective. 

Not knowing your CEO or name or headquarters? 

Priceless.  (Not.)

Just a thought,

Ralph

Position, Flexibility, Power, and Knowledge: Chess Moves for Acquisition Success

Sunday's New York Times contains an interesting discussion about bargaining by Robert H. Frank.  The context of the discussion is politics and how, in Frank's view, the Republicans are in a weakened position to bargain.  While one might take issue with some of the political viewpoints, the discussion of bargaining is unassailable.  Knowing the bargaining strengths and weaknesses of each side is crucial in negotiations.  In particular, know the BATNA - the Best Alternative To a Negotiated Agreement.  

Frank writes:

"The Warner Brothers 1999 hit comedy 'Analyze This' portrays a mob boss (Robert De Niro) and his psychiatrist (Billy Crystal), who share a passion for the recordings of Tony Bennett. With the film almost completed — and with Mr. Bennett already an integral part of the plot — the studio finally got around to approaching the crooner with an offer of $15,000 to sing 'I’ve Got the World on a String' in the movie’s closing scene. But as Danny Bennett, the singer’s son and business manager, later explained, the executives made a fatal mistake by not scheduling this conversation sooner: 'Hey, they shot the whole film around Tony being the end gag and they’re offering me $15,000?'

Had studio officials made their offer at the outset, they would have had much more leverage. If the Bennetts demanded an unreasonable sum, the filmmakers could have rewritten the script and used some other singer. At the 11th hour, however, Warner Brothers’ best alternative to a negotiated agreement was to spend hundreds of thousands of dollars reshooting the film. In the end, the studio paid Tony Bennett $200,000 for a brief cameo appearance."

The same thing occurs in mergers and acquisitions.  When we know the strengths and weaknesses of both sides of a deal, we are better able to strike favorable terms.  In part, this ties back to synergies, strategies and necessity.  What are the synergies in this deal?  How many are unique?  That is, how many are available to one particular bidder?  To the extent this occurs, that bidder is in a stronger bargaining position.  In situations where any bidder can achieve synergies, the power flows back to the target.  

What are the strategic needs of both sides?  Does one side need the deal to prosper - or to survive?  The bargaining power of each side increases with their own BATNAs. 

There are numerous implications for this.  We'll mention just a few.  First, always be thinking strategically.  Strive to be 'anticipating and acting' - thinking proactively rather than 'reacting' to some exogenous shock to your firm.  Thinking ahead could have reduced the amount paid to Tony Bennett.  It can also result in more favorable terms in acquisitions.  Try to place your firm in a position of strength.  Second, enter the negotiations with as much information as possible.  As we've written elsewhere, negotiate on multiple fronts, not just price.  

The essence of a BATNA is simple - it is our opportunity cost - what we could be doing if we were not doing this deal.  Position, Flexibility, Power, and Knowledge.  They work in chess - and in acquisitions.

The Interrelated Nature of Deal Design

Point 3 of our 14 keys to acquisition success states:

3.     Negotiate the deal on all aspects (price, form of payment, contingencies, etc.)

In a previous post, we commented that any deal is a bad deal at some price.  But a deal is so much more than price.  If we think about just a few of the decisions made in an acquisition it is clear that any deal involves a busy menu of detailed choices.  One of the things we discuss in the acquisition finance class is the interrelated nature of these choices.  Each deal is a system and each of the choices we make and negotiate has the potential to influence the others.  Wise negotiators consider the whole deal and bargain on multiple fronts.

Let's take just a few factors: price, form of payment, accounting choices, ownership structure, risks to the acquiring and biding firm and the length of the deal.  The price or bid premium over market is known to be related to form of payment.  Premia are known to be higher in cash deals, ostensibly to compensate for the immediate tax effects to the seller - and tax obviously affects the 'real' premia that target shareholders receive.  But form of payment also determines the accounting choices we make and even the form of organization.  And, of course, price and form of payment are related to financing.

A choice of stock as a form of payment affects the resulting ownership structure of the combined firm.  It also affects risk to all parties.  If the stock of the acquiring firm or the target change before the deal is closed the price that is paid and received is different from that originally negotiated.  (One way around this is the use of collars, but more on that in another blog.)  And remember, in terms of risk, who bears the risk ultimately affects the returns of the parties.

The choices we've just described also affect the length of time until a deal closes.  Cash offers tend to be faster (which is why hostile offers favor cash bids); stock bids involve more regulation and tend to take longer and so on.

We begin to see the complications and interdependencies from just the factors we've considered and we haven't even talked about social terms of the deal: where will the firm be headquartered?  What will it be called?  How many directors from the target firm shift to the acquiring firm's board.  Nor have we talked about target management: will they stay with the firm? etc.  etc.

The point is to take a whole deal approach, to recognize the myriad of interrelated choices and to bargain on multiple fronts.  Structuring the most effective deal requires no less.

Ralph