A tough challenge for M&A markets

It is common knowledge that most merger and acquisition deals fail. It is also accepted wisdom that one of the principal reasons for their failure is managerial hubris, or “chief executive ego”. Boards and management teams are similarly infected by exuberance, which causes them to overestimate their own ability to manage the new and larger company after the deal.

These same chief executives also overpay for such acquisitions. This results in large premiums being paid to target company shareholders, negative market reactions on the announcement day and thereafter, and subsequent poor performance of the newly combined firms.

There are some winners in this scenario: the target’s shareholders; managers who have a larger responsibility in the new combined company; and corporate advisers, who do their best to set things right. Clients, most employees, suppliers and the buyer are left behind. Just look at the events that followed Kraft’s triumph over Cadbury.

But there are other “behavioural” factors that contribute to deal failure and are likely to have important implications for the M&A market outlook in 2010 and 2011.

First, let us look at what drove the M&A market down in 2007 and 2008. Undeniably, there were the interrelated issues of the declining stock market, the lack of credit and the disappearance of financial sponsor buyers such as private equity firms. What else was going on, especially in the boardrooms where deals are born?

There is extensive evidence that people are overconfident most of the time, and this is most likely to extend to successful managers. One study shows that what people think with 98 per cent confidence will happen, will only happen 60 per cent of the time in reality. Similarly, people are generally overly optimistic and have an unrealistically positive view of their own abilities and prospects. Another study shows 90 per cent of people surveyed felt they were above average.

An additional behavioural factor driving the M&A market up before mid-2007 was another human bias: sample-size neglect. After 2003, there had been several good years of rising markets, both in terms of stock prices and M&A deal volumes. Some very smart people thought this was a continuing trend, ignoring the predictable and volatile cycles observed in markets every decade or so.

Taking these drivers together, it is easy to see how hubristic managers came to be busy buying overpriced assets in 2007. When their overconfidence and optimism was destroyed and they saw the trend changing, as it did in late 2007, the deals disappeared and it was tough to get started again. No wonder only the boldest chief executives were willing to propose deals in 2008 and 2009.

Now the M&A market is stuck in neutral, albeit with the engine revving and ready to go. For the same reason that the psychological factors drove the market up in the years before mid-2007, psychological factors will make the market “sticky” at lower levels for the next few years, until confidence and optimism return and there is compelling evidence that the economy and stock markets are not going to plummet again.

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There are other psychological factors at play that will contribute to the stickiness of the markets at a lower level. These follow the old Wall Street adage that “bull markets climb a wall of worry”.

People hold on too long to cherished opinions, otherwise known as “belief perseverance”. In fact, studies show people are reluctant to search for evidence that goes against their beliefs, even when shown overwhelming contrary data, and will anyway treat that information with intense scepticism.

In addition, they will anchor their projection of the future on an arbitrary or unrelated value. Thus, if M&A volumes were high in one year, the tendency is to look on those as expected values (at a minimum) for the following year.

Volumes really are not linked – except psychologically – from one year to another, as each deal is a unique event. Admittedly, some mergers will create follow-on divestitures if there are non-core businesses that need to be sold to finance the deal or for strategic reasons.

Last, there is the bias of placing more weight on recent events – which now are very negative – even if it would be more logical to look at the average of, say, the past five or six years.

What does this mean for M&A markets? It is not good news. Deals need confidence in boardrooms and executive corner offices. M&A activity is driven by chief executive overconfidence, unbridled optimism, a rising market and evidence of other recent deals that have made money for their shareholders. This will be hard to achieve in 2010.

The writer is the director of the M&A Research Centre at Cass Business School and author of ‘Surviving M&A: Make the Most of Your Company Being Acquired’ (John Wiley, 2009)