Deals Without Delusions
IF YOUR FIRM IS LOOKING TO ACQUIRE, how can you tell whether a given deal is advantageous? Unfortunately, you can never be sure that any large organic or acquisition investment will pay off, which may explain why many firms shy away from purchases that might otherwise afford them important growth opportunities. The good news is that you can stack the odds in your favor by examining a psychological phenomenon that most executives never consider when making deals - the degree to which their own biases influence decisions.
Before we disentangle the biases, let's consider some facts about M&A nowadays. A typical large corporation derives 30% of its revenue growth through acquisitions. For a $10 billion company growing by 10% annually, that's $300 million in revenues a year. Our work has shown that companies that aggressively leverage acquisitions for growth are at least as successful in the eyes of the capital markets as those that focus on purely organic ways to grow. Nevertheless, recent research from McKinsey & Company reveals that approximately half of acquiring companies continue to pay more for acquisitions than they're worth. Certainly, firms are getting better at M&A - 2006 was almost a ten-year high in the percentage of shareholder value created through takeovers - but there's still plenty of room for improvement.
Many scholars have attributed the largest M&A mistakes to executive hubris in decision making, but having studied the psychology of the deal for over a decade, we believe this is only a small piece of the problem. Our insights have been confirmed by a recent McKinsey survey of executives responsible for M&A at 19 top U.S. firms. Each firm had derived at least 30% of its market value from acquisitions; the market rewarded some of these companies (their returns to shareholders exceeded those of peer firms) but did not reward others. Our analysis of responses from executives at these firms demonstrates how a variety of cognitive biases - systematic errors in processing information and making choices - can affect each step of the M&A process.
As we will show, when executives take a targeted debiasing approach to M&A, deals can be more successful. The approach requires executives first to identify the cognitive mechanisms at play during various decision-making steps and then to use a set of techniques to reduce bias at specific decision points, thereby leading to sounder judgments. (See the exhibit "How to Overcome Biases That Undermine the M&A Process.")
Preliminary Due Diligence: Five Biases
The preliminary due diligence stage of the M&A process is when biases are most likely to cause damage. They can, for example, lead a potential acquirer to overestimate enhancements to stand-alone values as well as revenue and cost synergies between the acquirer and the target. In addition, they can cause a deal maker to underestimate the challenge of integrating two corporate cultures. In this section, we explore five biases that tend to surface during preliminary due diligence. We also provide strategies for overcoming them and thereby avoiding their potentially costly consequences.
Confirmation bias. People have an overwhelming tendency to seek out information that validates an initial hypothesis. This bias is particularly pernicious during M&A preliminary due diligence, because the main outcome is a letter of intent (LOI) with a price range that's enticing enough to move a deal forward. The need to provide an acceptable initial bid often biases all analyses upward. Instead of synergy estimates guiding the price, as would be appropriate, the LOI often guides the synergy estimates. In effect, this seeds the entire due diligence process with a biased estimate, even before much factual information has been exchanged.
During the price-setting stage, deal makers also sometimes use current market multiples as evidence to confirm the wisdom of a deal, in lieu of a compelling business case. In 2003, for example, Career Education Corporation (CEC) paid $245 million - 14 times its annual operating earnings - for Whitman Education Group. (The historical multiple in this industry is six to eight times earnings.) CEC executives justified the high price by arguing that the sector was undergoing a period in which high prices were the norm. This convenient logic - in no way an independent test of the appropriate price - may explain why the executives opted to pay a high price, but it doesn't show whether that price should have been paid. Subsequently, stock prices for the industry receded to historical norms.
The best way to counteract confirmation bias is to tackle it head on - by actively seeking disconfirming evidence. Consider one company that did not do that. The firm sought to acquire a sizable firm that had a complementary technology. The acquirer hoped that the combined technology platform would enable significant new product development and fuel revenue growth. Since the quality of the technology was the driving force behind much of the due diligence, the acquirer didn't take into account the target's slowing growth rates, which should have signaled the deteriorating attractiveness of the target's markets. A harder look might have raised red flags earlier. Of course, most companies examine potential pitfalls at some point during the M&A process, but often not with the same degree of insight and strategic rigor that they build into their initial case for a deal.
Overconfidence. The ubiquitous problem of overconfidence is especially insidious when it comes to identifying revenue and cost synergies. Since revenue synergies are less likely to be realized than cost synergies are, heavy reliance on the former may signal a problem. For revenue synergies to work, there must be a specific integration plan that involves new investment in growth initiatives. This plan should complement a balanced assessment of the entire competitive environment. One way to avoid overconfident synergy estimates is to use reference-class forecasting, which involves examining numerous similar deals that your firm and others have done, to see where the current deal falls within that distribution. It provides a top-down sanity check of typical bottom-up synergy estimates (see "Delusions of Success: How Optimism Undermines Executives' Decisions," HBR July 2003).
Leading serial acquirers, such as GE, Johnson & Johnson, and Cisco, draw from past experience when contemplating mergers. Companies that don't have rich M&A histories can often use analogous situations in other companies as benchmarks. To estimate synergies, firms look at a detailed business case from the bottom up; they also make top-down estimates on the basis of comparable deals. Recently, a banking firm examined more than a dozen comparable deals on three continents to make an accurate assessment of realized synergies. It is not necessary to calculate the exact value of the synergies in comparable deals; grouping them into a few performance categories - good, bad, or disastrous, for example - often suffices. Watch out if your firm's expected synergies are skewed toward the high end of, or beyond, what comparable deals have yielded and your performance with your current assets is not similarly skewed (see the sidebar "Eight Red Flags in M&A").
Underestimation of cultural differences. Unanticipated cultural conflicts are well known to cause merger problems; less well known is the idea that conflict can arise even in the most anodyne situations. In a simulation experiment performed in 2003, Roberto Weber and Colin Camerer showed how conflict between merging firms' cultural conventions (the codes, symbols, anecdotes, and rules that bind cultures together) can substantially diminish performance. Participants were assigned to either an acquiring or an acquired firm and given time to develop, within each group, a common language for describing generic photos of employees doing various kinds of work. When the firms were "merged," participants from the acquiring company who role-played as managers were able to communicate much more effectively with subordinate participants from their own firm than with those from the other firm. Sometimes, the person in the manager role grew impatient with the subordinate from the acquired company. The researchers concluded that "the more deeply ingrained firm-specific language is, and the more efficient the firm, the harder the integration may be." They also noted that employees of both the target and the acquirer tended to overestimate the performance of the combined firm and to attribute any diminished collective performance to members of the other firm - outcomes that are often evident in real-world mergers.
One way to prevent cultural conflicts is to perform cultural due diligence (see "Human Due Diligence," HBR April 2007). According to the previously discussed McKinsey survey, companies that had been rewarded by the market were 40% more likely than unrewarded companies to perform this due diligence at least "most of the time." We have also found that network analysis maps, which describe the connections among people in an organization, provide some insight about the similarities between company cultures and can help identify the key people to be retained during integration. (See "A Practical Guide to Social Networks," HBR March 2005, and "How to Build Your Network," HBR December 2005.) For one pharmaceutical client, McKinsey used network analysis to identify whether the target's scientists really were world-class research leaders in the area where the acquirer wanted to build capabilities. The results showed that the target's scientists were not essential for doing cutting-edge research on a key chemical, so the client decided to build the skills organically.
We believe that network analysis holds huge promise for refining the work of cultural due diligence. In the future, companies will be able to use this method to help identify which types of networks are easiest to integrate. The analysis should highlight places where the target's network is dependent on too few key capabilities and may even shed light on the target's quality of work.
The planning fallacy. People have a tendency to underestimate the time, money, and other resources needed to complete major projects, including mergers and acquisitions. We believe that reference-class forecasting, mentioned in our discussion of the overconfidence bias, has great promise as a tool for anticipating how much time and money will be needed for M&A integration. The American Planning Association, a nonprofit organization that helps communities plan infrastructure projects, routinely recommends this type of forecasting, and it is used to plan infrastructure development throughout the UK and Switzerland.
Firms that are successful at integration also formally identify best practices and use them to improve future integration efforts. For example, GE Capital applies the principles of Six Sigma to drive continuous improvement in its integration practices, just as it does for its other core business processes. Started more than 20 years ago, this approach has developed as the company has faced challenges in its various acquisitions. The firm's executives discovered that mergers go more smoothly if integration begins early in the deal-making process and if detailed written plans include clear objectives that are to be met immediately after the deal closes. GE Capital also surveys its own employees and those of the other company to compare cultures, sets up structured meetings to address cultural integration, and works to solve actual business problems based on shared new understanding. Most important, the firm has put in place a process for learning from deal-making experience. It also sponsors conferences to foster idea sharing and improvement of best practices, and it constantly updates materials for leaders in the newly acquired company to use. This commitment to learning, codification, and continuous improvement has helped make GE Capital a world-class integrator across the globe.
Conflict of interest. Although advisers generally earn more business if deals they work on actually go through, the good advisers understand that the best way to secure a reputation is to provide objective recommendations that stand the test of time. Firms that do deals infrequently should be especially careful to stay clear of people who are driven by one-shot profit motives. Building a network of trusted advisers who are interested in the long haul goes far toward avoiding the conflict-of-interest bias.
Conflict of interest is an even bigger concern when a deal sponsor in charge of due diligence evaluates a merger or acquisition without obtaining any external input. Recent research by Don Moore and colleagues indicates that the judgment of internal partisans, and even of external advisers, is unconsciously influenced by the roles they play. Accordingly, they are likely to reach the same conclusions as their sponsor, unintentional as that outcome may be.
Private equity firm partners have proved very successful at reviewing one another's deals to ensure analytically rigorous due diligence. Even more important, they practice humility - that is, they approach each deal as if they didn't know anything about the relevant industry, even though they may buy multiple companies within it. They ask for expert advice; they question anyone who's willing to talk; they listen genuinely to the answers they receive. Corporate buyers, on the other hand, usually evaluate deals episodically, and certainly less often than private equity firms' investment committees, which tend to have weekly rhythms. As a result, corporate boards and management teams do not develop the skills they need to critically evaluate deals. This results in a conservative bias either to kill most deals or to take management's word and provide a rubber stamp. If your firm does deals infrequently, consider seeking out objective external expertise beyond that of the advisers assisting on the deal. (Also see the sidebar "Aversion to M&A: Two Biases.")
The Bidding Phase: Avoiding the Winner's Curse
If there are multiple bidders for an M&A target, a well-documented phenomenon called the winner's curse can come into play. Someone bids above an item's true value and thus is "cursed" by acquiring it. Bidding wars often lead to above-value offers.
One bidding war broke out recently over Guidant, which makes heart devices such as defibrillators, pacemakers, and stents. Johnson & Johnson offered Guidant shareholders $68 a share in late 2004, which wasn't much of a premium over the stock's trading price. In early 2005, though, reports of problems with some of Guidant's defibrillators began reaching the public. When J&J subsequently dropped its offer to $63 a share, Boston Scientific offered $72 a share in late 2005. The bids increased over a couple of days in January 2006, until Boston Scientific decided to make a bid so strong that it ended the contest: $80 a share (with a collar) and an agreement not to walk even if the government objected or further recalls came to light. Soon after the deal closed, however, additional product recalls were issued and the value of Boston Scientific's stock fell by about half, although this deal may have not been the only cause of the drop. Boston Scientific's failure to protect itself from future changes and its rushed offer to end the bidding war made it fall prey to the winner's curse. Of course, this doesn't mean the company won't derive value from the deal in the long term.
The previously discussed McKinsey survey suggested that successful acquirers are much more likely to exit when competitors initiate a bidding war: 83% of the rewarded companies withdrew at least sometimes, compared with only 29% of the unrewarded companies. Staying in a bidding war doesn't necessarily lead to a poor acquisition, but if your company doesn't evaluate whether to drop out when others enter the bidding, that's a red flag.
One technique for avoiding the winner's curse is to tie the compensation of the person responsible for the deal's price to the success of the deal - for example, to the percentage of estimated synergies realized. An even better strategy is to have a dedicated M&A function that actively generates alternatives to the deal under consideration and sets a limit price for each deal. (Companies that don't proactively maintain a deal pipeline are often forced to overpay for what seems to be their only alternative.) This method isn't a guarantee against the curse, since your maximum price still might be greater than the target's true value, but it can prevent you, in a fit of auction fever, from increasing your bid above the level you initially deem prudent.
If the acquiring firm's limit price changes during the bidding, someone in the firm should wave a warning flag and stop the negotiations. If the acquiring firm doesn't have a limit when it starts bidding, the bidder should be struck with the flagstaff.
The Final Phase: The Perils of Clinging Tightly
Once an initial bid is accepted, the acquirer has an important opportunity for additional due diligence, since it now has much greater access to the target's books. The final negotiation phase also encompasses the deal's legal structuring (for example, the exact composition of payment cash or stock). In this final phase of due diligence, the goal is to honestly evaluate the investment case in light of the more detailed information now available from the target. Two biases can come into play.
The first stems from a tendency to underreact to surprising news. A simplifying heuristic called anchoring is operative here. Specifically, people tend to anchor onto an initial number and then insufficiently adjust away from it, even if the initial number is meaningless. In a classic article in Science magazine from 1974, Amos Tversky and Daniel Kahneman described how anchoring works. In one experiment, subjects witnessed the spinning of a roulette-type wheel emblazoned with numbers from 1 to 100. Then the subjects were asked what percentage of African countries were members of the United Nations. The random numbers generated by the wheel biased the subjects' answers. For example, when the spun number was 10, the median answer was 25%; when the spun number was 65, the median answer was 45%.
Initial valuations, such as the price range in the LOI, can also act as anchors. Many acquirers fail to adjust sufficiently from a price, even in the face of surprising new evidence. For example, one energy company pursued a deal in part because the target had a futures contract with Enron. Even when Enron collapsed soon afterward, the would-be acquirer remained anchored to its original estimates of the deal's value. After the deal went through, it spent an additional $30 million - beyond an initial price of approximately $75 million - to keep the deal in play. The deal never succeeded because the acquirer eventually ran into its own problems with regulators. Likewise, anchoring can occur in the process of bidding. Confronted with unfavorable information, the acquirer may not lower the price sufficiently. It's rare to be able to bargain down the LOI price, so stepping away is almost always the only way to avoid paying too much.
When people feel that they've sunk a lot of time, money, effort, and reputation into making a deal happen, they aren't willing to surrender, even if the costs are unrecoverable. The sunk cost fallacy can cause an acquirer to continue pursuing the target even when it shouldn't. This phenomenon probably was operative in Boston Scientific's pursuit of Guidant. The best way to free your firm from both final-phase biases is to hire fresh, dispassionate experts to examine the relevant aspects of the deal without divulging the initial estimate. Some private equity firms use this technique. The independent team simply is asked to make its evaluation of the new information uncovered during the detailed due diligence - data that were not available before the initial bid was accepted.
Just as important, your firm should always entertain multiple M&A possibilities as part of a broader backup plan, and should know when to stop bargaining and walk away. When you have multiple offers in play, you aren't emotionally attached to one deal. Having a few options on the table also allows you to shift to another deal with a better price-value ratio as the bargaining continues. Of course, the ability to juggle several options at once requires a disciplined, ongoing M&A process and the attention of a much larger M&A team.
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M&A is a vital component of any company's growth options, but doing it well means identifying the red flags. Taking a targeted debiasing approach can help the acquiring team make better, more accurate value estimates and can help mitigate the influence of cognitive biases. By improving the decision-making process in this way, companies increase the chances that their acquisitions will lead to success rather than to post-merger disaster.
Harvard Business Review; Dec2007, Vol. 85 Issue 12, p92-99