November 29, 2019 //
We all know the thrill of finding an item vastly on sale. “It was a steal!”, we exclaim to our friends.
In the world of M&A, buyers are always cautioned about the dangers of overpaying. In the classic Harvard Business Review article “Are You Paying Too Much for that Acquisition?”, Robert Eccles et al warn, “there’s a systematic way for senior managers to think about pricing acquisitions. … Even experienced acquirers, who should know better, sometimes get too attached to a deal. When that happens, it’s essential to have organizational disciplines in place that will rein in the emotion. A combination of analytical rigor and strict process discipline will help senior executives and board members guide their companies toward the right acquisitions at the right price.”
We at Stillwater regularly help acquirers research and approach targets that are not already in the market, in order to avoid prices inflated through competitive bidding. We have also written extensively about the art of valuation and the importance of disciplined pricing.
But do “disciplined pricing” and “the right price” mean “the lowest price”? Not necessarily. Let’s look at why grabbing bargains isn’t always the best strategy.
Why do we love finding a bargain? A RetailMeNot survey of over 2,000 Americans’ shopping habits reveals that “spending money on expensive items generally makes people feel bad. In fact, when asked if they had ever experienced any feelings of guilt after purchasing an expensive item only 28% of people had no regrets. …. Saving reduces the ‘neural pain’—the sense of loss as cash is spent.” Furthermore, demonstrating that you’ve got a bargain is “also a way to defend and justify the purchase against any criticism.”
And yet, who among us hasn’t grumbled, as our spouses or kids head out to the Black Friday or Boxing Day sales, about a bunch of unnecessary purchases coming into the house?
In M&A, a parallel situation can occur. When do opportunities to buy a company at bargain prices cross your path? Rarely when you have done your analysis, crafted a tight strategy and business case, and set out in search of your next acquisition. More commonly, it’s when a seller comes to you. You weren’t really looking, but the case is plausible and the price is terrific.
When this happens, it’s important to look at your company’s existing strategy and growth plans. Ask yourself the following questions:
• Does your current plan call for organic growth or acquisitions? If organic, why? Has this opportunity fundamentally changed your rationale? The right acquisition can accelerate growth, give access to new products and markets, or provide a platform for industry disruption. But acquisitions and their subsequent integration are still costly and often disruptive, drawing heavily on leaders’ time and attention. Large ones especially may change your corporate culture in unforeseen ways.
• If you were going out to look for an acquisition, is this the company you’d choose? Why or why not? Does it further your existing strategy, or shift it toward some markets you may not have prioritized, and away from others that you had? If it changes your focus, is this new direction better long-term?
• What would making this acquisition prevent you from doing? What’s the opportunity cost? Strategy is as much about the opportunities you say “no” to, the directions not taken, as it is about the ones you pursue. Given finite time, capacity, and financial resources, is this acquisition necessary, or at least beneficial?
Do you know any bargain-hunters with closets full of clothes, but “not a thing to wear”? Or a basement crammed with electronics that don’t work properly with each other? It’s no secret that when the price is “too good to pass up”, we often buy things that don’t fit with our bodies, our lifestyles, our previous investments.
Why does this happen? As business and consumer psychologist Dr. Dimitri Tsivrikos explained to the BBC, “when one looks at the brains of consumers excited by a bargain, it becomes clear that considering savings makes it harder for consumers to determine whether or not they are actually getting a good deal on the item, independent of the sale price. Bargain hunting creates dopamine rushes in consumers, as they feel an increased sense of control of the transaction.” And retailers amplify that feeling by limiting quantities and the duration of sales.
In M&A we see companies seduced into poorly fitting acquisitions by this same combination of excitement at a low price and urgency driven by the fear that if they don’t take advantage of the opportunity, a competitor will. Specifically, this causes acquirers to:
• Short-circuit or bypass the rigorous strategic planning that forms the foundation of any successful acquisition program
• Compromise on some of the criteria dictated by their strategy and growth plans that they would ordinarily use to assess a target
• Overestimate their ability to shape the target into a business that will fit with their existing organization and future vision
Another strong psychological bias called anchoring tricks us into viewing a lower-priced item more favourably than we otherwise would after seeing a higher-priced one. Anchoring is why we walk out of Best Buy with a $1,499.99 75” tv, even if it doesn’t fit on the wall, because the one beside it cost $3,999.99. Anchoring is also why the price tag on the more expensive tv helpfully states that its regular price is $5,299.99 and you are saving $1,300.
This bias can lead acquirers to choose a cheaper target company over a more expensive one, even if the latter is a better strategic and cultural fit. It can also mean that the opportunity to acquire a business at a reduced price is viewed through a more favourable lens than would otherwise be the case.
Everyone knows somebody who got a used car at an amazing price, only to learn that it would need a new engine. Once hidden costs were factored in, the car wasn’t a bargain at all.
The factors that cause companies to make an ill-fitting acquisition also have an adverse effect on their due diligence. Driven by excitement and urgency, acquirers in pursuit of that low price often:
• Conduct a quicker or lighter due diligence investigation than would otherwise be the case
• Miss or dismiss “yellow flags”
• Be reluctant to spend time negotiating their usual reps and warranties protection
• Fail to properly examine why the company being offered at such a low price
Bargain-hunting is essentially a “taking” mentality. It asks how we can get more, while giving as little as possible. But as Roger Martin, writing in the Harvard Business Review, says, “companies that focus on what they are going to get from an acquisition are less likely to succeed than those that focus on what they have to give it.”
Why is that? The answer lies in how to create real value and competitive advantage. Says Martin, “as long as the acquisition can’t make that enhancement on its own or—ideally—with any other acquirer, you, rather than the seller, will earn the rewards that flow from the enhancement. An acquirer can improve its target’s competitiveness in four ways: by being a smarter provider of growth capital; by providing better managerial oversight; by transferring valuable skills; and by sharing valuable capabilities.”
An acquirer overly focused on getting the lowest price, may entirely miss the thinking about what it can or must give to create the most value with the target company.
As noted in Are You Paying Too Much for that Acquisition, “the relationship between the size of the premium and the success of the deal is not linear.” Deals with low premiums (i.e., bargains) often fail, and those with high premiums often succeed, as measured by total ROI one year later. “The question, then, is not whether an acquirer has paid too high a price in an absolute sense. Rather, it’s whether an acquirer has paid more than the acquisition was worth to that particular company. …. Ultimately, the key to success in buying another company is knowing the maximum price you can pay and then having the discipline not to pay a penny more.”
You see that Eccles is talking about “the maximum price you can pay”, not the minimum. It’s a subtle distinction, but it matters.