Boards: Beware the 'winner's curse': firms with weak governance are prone to this trap.

• Author: Rizzi, Joe
• Position: COMPETITIVE EDGE

MANY ACQUISITIONS fail to create value for the acquirer, and in most deals the benefits go largely to the seller. This reflects the highly competitive nature of the M&A market. It also reflects the large concentrated investment bet at premium prices of M&A transactions. Buyers, in effect, are prepaying for uncertain future revenue and cost synergies. Frequently, buyers -overpay for the expected synergies based on managerial optimism, over-confidence, and the urge to beat competing bidders.

7 So it is understandable that the buyer's shareholders react negatively to acquisition announcements. Many studies indicate that, on average, the acquirer's share price falls once the transaction becomes public. This overpaying--when the winning bid in an auction exceeds the target's value--is known as the winner's curse, or hubris.

The absolute dollar loss of acquisition can be huge. The loss can be estimated by looking at the level of goodwill paid and its subsequent write-off. Goodwill, the amount of the purchase price exceeding the target's book value, represents a crude measure of overpayment. Duff & Phelps estimates the amount of goodwill write-offs, a proxy for overpayments that failed to materialize, for the 2007-2011 period to exceed $325 billion.

The key to avoiding this problem is to make an accurate assessment of the target's value and to have the discipline not to bid more than that value. This requires establishing a walk-away, or reservation, price before making a bid. The opening bid should be set at .a fraction of that price based on competitive considerations. Ultimately, it is not just what you buy but what you pay that determines an acquisition's success., Overpaying for benefits received destroys acquirer shareholder value.

PRICE IS A FACT. VALUE IS AN OPINION.

Distinguishing between cheap and frugal is needed when pricing an acquisition. Cheap refers to low value. Frugal, however, represents efficiency. You usually get what you pay for. Equally important is to avoid overpaying for what you get. Corn pl icati in this matter is that price is a fact, representing what the buyer gives up immediately. Value is an opinion concerning what you expect to receive in the future.

A target's price has two components. The first is the standalone, pre-bid minority ownership price. It reflects the status quo value of its cash flow under the current strategy and management. The second is the premium required to persuade the target's shareholders to...