In the Classroom
The Heat of the Moment: Why Do Acquirers Overpay?

When AT&T Wireless went into play in early 2004, a bidding war ensued between Cingular and Vodafone. Vodafone's CEO went to bed in London with a deal in hand, thinking he had won a hard-fought battle. But Cingular's investment bankers put together a sweeter offer; and by the time Vodafone's CEO woke up in London, the deal was in Cingular's pocket.

Cingular had won, or had it? When the smoke cleared, Cingular's $41 billion bid was about 10 times 2004 earnings. This translated into a cost of about $1,800 per subscriber, about twice what they were estimated to be worth. Vodafone's stock, which dipped during the bidding war, jumped 7 percent on the announcement that it had lost, while share prices of Cingular's parent companies, SBC Communications and BellSouth, went down.

"The market was saying, 'you guys overpaid.' What is the rationale to justify this deal when the market said you overpaid?" asked Wharton Professor Harbir Singh, during a recent session of Wharton's Mergers and Acquisitions executive education program. How could the company justify paying roughly twice what the customers were worth? Were the two companies simply caught up in the heat of the moment? On the other hand, it was one of the last great unclaimed wireless assets in the industry. Could Cingular afford to let it get away?

Roots of the Problem

In deal making, the value that is determined by the valuation process is one thing, but the value paid is the result of a number of factors, including:

  • Ego: Pure and simple, CEOs are used to winning, and they hate to lose. When they have a deal on the hook, they don't like to let it get away. What will it mean for their reputations? Will they be remembered as the CEO who lost the big fish? The repercussions of overpaying for an acquisition may take a long time to show up, but losing a hot deal will have an immediate impact on the leader's career. "CEOs get caught up in the battle," Singh said. "They think: I've announced this, and I'm going to have this or otherwise I'll look weak and ineffective."

  • Publicity: Publicity puts more pressure on the CEO to close the deal. Research shows that more press attention leads to higher prices. "What it seems to indicate is that CEOs and management teams somehow become more involved in the transaction when it has public visibility," Singh said. "Real money is being paid just because of press attention. When you are committed to something publicly, it is harder to walk away."

  • Overconfidence: Even when managers see the odds, they are sometimes overconfident about their ability to beat these odds. This is particularly true when companies purchase unrelated businesses. Instead of the lack of knowledge of the business making the acquirer more conservative, it often makes them more overconfident and more likely to overpay.

Why Smart MBA Students Get Caught Up in Overpayment

One might expect to see more rational decision making in a simulation in a business school classroom. After all, students are removed from the life-and-death career implications of the decisions. There is no media attention. They have the luxury of making decisions in the purified atmosphere of a classroom. They are bright, and they have been studying M&A and business analysis. But, even with all these advantages, they still tend to overpay.

Singh conducted a simulation with the MBA students (who had had the full set of core courses but were early in an elective on M&A) in which they were asked to prepare a bid for a company to acquire. On the second round, whatever their price, the students received information that meant they should have clearly dropped the value of the target firm about 5 percent below their offer price. In this exercise, students did not have the option of revising the offer. In a rational world, they all should have walked away from the deal at that point. It didn't happen. In fact, only 15 percent of the students left the deal table.

On the next round, the professors hit the students with even more serious bad news arising from due diligence (a process of inspecting the assets of the firm after a serious bid has been made). Now the majority of the students woke up and walked. But even after this devastating news, 36 percent of students remained in the game. "This meant that 36 percent had made what would have been a career-ending decision," Singh said, "and only 15 percent actually got a good answer. The rest were in between."

What was the explanation for the results? During a class discussion, some students said they stayed because they felt they could achieve synergies (although these were already factored into the original valuation). They said they were entrepreneurs, and would make it work. But how could they believe that when the chance of succeeding was just 0.5 percent? The most humorous answer was the student who said that because it was a class in M&A, how could they divest?

None of the answers was rational, in terms of creating shareholder value. In fact, in modeling the role of managers, the students had become caught up in the process of bidding. Students knew the number where they should have walked away, but they ignored it. Too small a group walked away after a round of significant bad news, and too many stayed in the game even after receiving further bad news about the value of the assets under negotiation. This finding is consistent with other exercises, where similar dynamics were observed. What makes this particularly problematic is that the real pressures of publicity and time compression can only distort these decisions further. It clearly demonstrated how hard it is for managers to stay the course in the heat of negotiations.

Knowing When To Walk

How can managers avoid overpaying? Singh offered a number of strategies:

  • Plan ahead to counter time compression: "One of the big issues in bidding is time compression," Singh said. "So you have to combat time compression by doing all the 'what-if' scenarios well before. Once you are in the negotiations and bidding, your thinking changes. You start to become biased by the fact that someone else is interested. You think: 'Maybe these guys know something I don't.' All it needs is a little change in discount rate or growth rate, and now you can afford it." Engaging in this advance preparation — and following its results — can help to avoid the wishful thinking and redefined assumptions in the heat of the moment.

  • Define a walk-away price, and stick to it: Singh said that companies need to perform careful analysis that goes beyond creating a single value for the offer. Managers should create a distribution of values based on different assumptions and scenarios of the world after the deal. With this bell curve, managers will be able to see more clearly the sweet spot in the center of the deal where it is likely to pay off. Before going to the table, managers should decide where to draw the line. Some might walk away at the point where there is a 40-percent chance of losing money. Some might go to 50 percent. Few would decide at the outset to pursue a deal that has a 90- or 95-percent chance of losing money — but this is where they sometimes end up.

  • Modify the price only if there is material information: The only time this analysis and the exit price should be tinkered with is if there is new information. When this happens, as it often does in the course of a deal, the new information should be put into the model, and a new set of bidding parameters should be created.

  • Know your alternatives: There should always be a plan B, so the deal doesn't become a "must have." Sometimes the alternatives can be better, particularly if the price runs too high. For example, Daimler-Benz might have gained many of the benefits of its merger with Chrysler through an alliance strategy. Managers should carefully assess the implications of building versus buying versus partnering to achieve their strategic objectives.

Above all, while mangers often recognize the immediate impact of losing a desired acquisition target, they also need to pay attention to the downside of overpaying. WorldCom's purchase of MCI demonstrates the risks of overpaying, while Comcast's ability to walk away from its bid for Disney shows the benefits of a more disciplined approach. "Comcast put a good price on the table initially but did not get into a protracted battle. They refused to budge and walked away," Singh said. "If you walk way, you may look bad now. But if you stay and you pay too much, you may look much worse later."

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