For Buyers Only: The Overpayment Trap

The factors that contribute to M&A failure have been a topic of a growing number of studies conducted over the last few decades. The results of these studies have appeared in the financial press as well as materials prepared by consultants. The source, methodologies used and specifics of these studies are a subject in and of itself. For our purposes here, there seems to be four fundamental, root causes of M&A failure:

1. The buyer bought the wrong company (strategy).
2. The buyer paid too much for the company (price).
3. The transaction was poorly executed by the buyer’s team (implementation).
4. The buyer did everything right but just had bad luck (unknowns).

Each root cause contains a number of issues and complexities that can snare an unwary buyer. Of these four career-killing-value-destroyers, the most unforgiving is paying too much. It is sometimes referred to in business literature as the winner’s curse. We call it the overpayment trap.

An otherwise brilliantly conceived and implemented deal can become a challenge because of overpayment. Falling into the overpayment trap adds cost and increases risk. It also compounds the pain caused by buying the wrong company, poorly implementing the acquisition and/or being side-swiped unforeseen circumstances.

The first and most important steps in avoiding the overpayment trap are to recognize that it exists and to make a commitment to avoid failing into it. The next step is to understand the various ways in which a buyer can get ensnared. It can be argued that the entire system of M&A is geared to net top dollar for the seller. Consider the following:

1. Many sellers hire investment bankers and brokers to market the company. Most of these hired guns work on a contingent or commission basis and specialize in selling companies. While a buyer might think of them as financial professionals, intermediaries are also salesmen. They act as buffers between the buyer and seller and as agents with limited authority; they provide the seller with a negotiating edge.

2. A good broker will put the law of supply and demand to work. They have a number of techniques to develop a multiple of interested parties. The objective is to create an auction effect. An auction effect occurs when buyers get into a “gotta have it” mindset that can pressure them into paying more than they should. Along the same lines as an auction effect, there is a tendency to pay more for a company if a buyer is concerned that a competitor might buy it and gain an advantage in the marketplace. What will the buyer do if T-H-E-Y get the company? (Time Warner now probably wishes that the competition bought AOL.)

3. The company will be dressed up for sale. The selling memorandum will look good, the outlook will look good, with fresh paint the facility will look good and everyone will be wearing clean knickers. A spotlight shines on the positives and, if the intermediary is good, reasonable explanations are offered for any negatives.

4. The recast, normalized and adjusted EBITDA will be touted on a silver platter. The financial press and conventional wisdom often talk in terms of multiples, usually multiples of EBITDA. Our recommendation: go easy on EBITDA. The preferred earnings base is Free Cash Flow because it more closely indicates the returns that could be distributed to shareholders or re-invested in the business.

5. The seller has probably already figured out how much the company will make in the coming years and has priced the company to keep as much of those earnings as possible.

6. If the company is publicly traded, the stock might already include a built-in premium in anticipation of the company being acquired by a party with deep pockets and great vision. So, the lucky buyer will sometimes pay a premium on top of a premium.

7. If the price seems too high, a buyer may be initiated into the arcane mystery of synergy. There are two kinds of synergy: conceptual synergy and tangible synergy. Conceptual synergy is based upon a “grand business theory” such as convergence or becoming a major force in the marketplace. Such theories often fail in the laboratory of business. On the other hand, tangible synergies are based upon situations as they exist. An example would be the use of productive capacity or cost efficiencies. The buyer knows that capacity is available and can be put to work. The buyer knows that certain costs can be eliminated. Tangible synergy is rooted in economic reality. When a buyer is willing to buy and pay for what can’t be measured, they are buying into a concept and there’s a good chance that they will overpay.

8. Big deals and big multiples make a big splash in the press. They create buzz and provide a nice massage to one’s ego. In the dealmaking arena, hubris can be a major-league liability and can tack an unrealistic premium to the purchase price. Although emotionally appealing, research indicates that ego and glamour seldom make money.

9. It’s a generally recognized negotiating truth that the more time, money and attention a buyer has invested on a given deal, the more psychologically engaged they become. The process starts to take on a life of its own. Closing the deal becomes the objective instead of furthering the financial objectives of shareholders.

10. Overall, the efficient market theory would suggest that in the long run, sellers will receive the highest price that will meet the buyer’s minimum required return on investment. Any failure by the buyer to properly estimate the cost of capital and cash flows to be derived from the acquisition investment can be considered a breakdown in the efficiency of the transaction. To the extent that capital costs are underestimated and cash flows overestimated, the buyer will overpay.

The final step in avoiding the overpayment trap is to install and use a formal, standardized and disciplined approach to valuation and pricing. Even if a buyer relies on outside professionals to provide guidance on value and price, it is prudent to have an internal means to run these numbers.

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