17 September 2018
This week’s column by Luke Johnson in the Sunday Times focuses on the intricacies of buying or selling a business. As always, we think it’s a beautifully written and thought-provoking piece; if you’d like to discuss it with us, feel free to drop us an email or call us on 020 8530 0720.
Why are auction prices so often set by buyers who overbid? This question holds significance for purchasers of companies — which are usually auctioned. While there is no exact science to valuing businesses, I would say that “winners” of auctions often pay too much.
Psychologists suggest that people overbid because of a powerful fear of losing. Normally rational business executives can suffer from an emotional state, termed “competitive arousal”, fuelled by adrenaline. Instead of deciding to buy an asset based on logical analysis, the goal mutates, and becomes all about beating an opponent. In such circumstances, the successful bidder can end up burdened with the winner’s curse — lasting regret over the excessive price paid.
The classic case was the mad acquisition of ABN Amro by Royal Bank of Scotland, Fortis and Santander in 2007. The joint bidders caught auction fever after Barclays tried to gatecrash their deal. Subsequently, both RBS and Fortis needed government bailouts — RBS alone lost £20bn on the transaction. The board were disgraced, shareholders lost 95% of their investment, and the taxpayer had to inject almost £40bn into the banking sector to prevent collapse.
Advisers who orchestrate auctions make sure there is a tight timetable in order to maximise competitive tension. This can help tempt bidders to overpay. Deadlines are designed to put pressure on participants. Interestingly, research suggests that competitive spirits are most ferocious when bidders face only one serious rival. I suspect this is because bidders think they have better odds of triumphing in such circumstances.
We have sold four companies for decent prices this year. Easily the best price came from an auction that ended up with two very keen rival bidders.
There is a delicate game played by bankers acting for sellers. In my experience, they will not knowingly lie to would-be purchasers about the existence and level of rival bids, but they will desperately try to maintain the asymmetric level of information between the selling and buying parties. This issue is relevant only in disposals of private businesses, since bids must be disclosed in disposals of public companies. Of course, the fact that public-company bids are carried out under the bright spotlight of media coverage means competitive excitement can be even more intense. No one wants to lose publicly.
Moreover, bidders can justify to themselves paying whatever it takes because of sunk costs, in terms of time and fees. Of course, this is usually a terrible reason to pay more. Advisers generally earn far more from the winning bidder — yet face no negative consequences if their client overpays. So, inevitably, they will encourage a bidding frenzy, working up ever more ludicrous rationalisations to support higher prices.
This applies to the lawyers and accountants as much as the bankers. They can fuel the overconfidence of a bidder, allowing them to think they understand the target better than they do. The professional who should stay sober, independent and aloof from the fray is perversely incentivised to see a deal happen at almost any cost to their client. Commitment escalates as the auction wears on, until bidders risk losing all perspective and paying a price they would never have contemplated at the outset.
Most buyers who overbid are not paying with their own money. Either they are managers using corporate cash or, in the case of private equity, partners whose funding comes from banks and outside investors. Humans are far more cautious about risking their personal resources. I tend to spend mainly my own cash when buying companies — and so I frequently lose out in auctions. Of course, I can get carried away, and I have certainly overpaid for businesses. However, paying more than you should, simply because someone else is willing to fork out a higher price, is a stupid idea. Other bidders may be fools or enjoy merger synergies unavailable to you. You should set your own price limits and stick to them.
Wild prices have become standard in the past 10 years because of ultra-low interest rates, quantitative easing and a financial system awash with liquidity. Thanks to luck or smarts, bidders with big balls have paid silly prices only to see asset prices rise even further. I cannot believe that trend will continue.
Luke Johnson is chairman of Risk Capital Partners and the Institute of Cancer Research.
If you’re thinking about selling your business – or buying a new one, we’d love to chat with you about your options. Call us on 020 8530 0720 or email firstname.lastname@example.org.
You can read the original article here.