By: Dexter Braff
You go to B-school. You learn about discount rates, cost of capital, multiples, discounted cash flow, capital structures, tranches (oh, the bankers go ga ga over tranches) – enough numbers and data to make a spreadsheet jockey swoon.
You’ve got this whole mergers and acquisitions thing figured out.
But then you realize you have to factor in people. People with feelings. Agendas. Biases. Egos.
That in the real world of M&A, the numbers will only get you so far.
And deal making isn’t quite as logical as you thought.
Kirk rules, and Spock drools.
Economists call this behavioral economics.
We call it M&A pixie dust.
Here’s just a few of our favorite sprinklings:
The Don’t Hate Me Because I’m Beautiful Oxymoron. Compared to profitability typically expected in a sector, the higher the margin, the lower the valuation multiple.
Why? Because many buyers get the willies when purchase prices rise above one times revenues. So, if a company has a high margin – say 30% – even if the risk-return economics of the deal justify a six multiple (which at 6 x .30 computes to 1.8 times revenues), they will often skinny it back to bring the revenue multiple down.
The Marginal Margin Anomaly. Companies with marginal losses frequently capture higher values than those with marginal profits.
With marginal losses, buyers often think, “the company should be making money, and we can fix it.” But, if it’s marginally profitable, the thinking morphs to “hmmm, they’re making money, but not much. It may be tough to squeeze out additional earnings.”
Ipso facto, even though they’re both around breakeven, buyers will pay more for the company losing money.
The Rule of Thumb Paradox. Comparatively speaking, formulaic buyers will often overpay for an underperforming company, and underpay for those that are more attractive.
In determining valuation multiples, certain buyers focus more on the macro-economics of a sector versus company specific attributes, gravitating to “rules of thumb” that companies in a space are worth at X times EBITDA.
Now this multiple may, in fact, be a reasonable assessment of a sector’s risk profile and growth opportunities.
But it’s a generic average for generic providers.
Consequently, these multiples tend to over value underperforming acquisition candidates. Worse yet, when competing with other buyers for deals, it can lead to a dynamic where rule of thumb buyers disproportionately succeed in buying poor performers.
Oops.
There are many other examples where behavioral economics intrude on the logic of a deal.
It’s up to buyers and sellers alike to either deflect – or exploit – them.
Live long and prosper.