Tuesday, May 26, 2009

My Kid Could Do That!

In a flash bulletin this morning from The Department of the Obvious Department—otherwise known as The Wall Street Journal—I was gobsmacked to learn that a crack team of Harvard and NYU academics has cracked the code to M&A valuations.

As I hastily toweled coffee off my keyboard and computer monitor, it occurred to me that, if said news were true, it could revolutionize the practice of corporate mergers and acquisitions, not to mention put a serious damper on my plans for early retirement to the Côte d'Azur with a couple hundred large and a stable of pliant young confidential secretaries. Naturally, I read the article with bated breath.

Having read the piece, however, I am pleased to report that investment bankers, private confidential secretaries, and French Riviera purveyors of vintage champagne, high-priced real estate, and paid police protection can all heave a gratified sigh of relief. There is nothing to see here. Move on, folks.

Of course, there will always be some number among my Worshipful Audience who will affect a slightly more skeptical air and demand to know names, dates, and the particular measurements of any confidential secretaries involved. For these tiresome busybodies, I will take valuable time away from my Tuesday afternoon pedicure to make the following remarks.

* * *

Sadly, the concierge for this little spectacle, the WSJ's own Dennis Berman, did not link to the original report by our intrepid researchers, so your Dedicated Bloggist is limited to commenting on the news article alone. Fortunately, there is adequate supply of folly in said piece to provide ample amusement for all.

For instance, Mr. Berman opens his piece with a sop to the cheap seats, taking a swipe at the supposed hypernumeracy of the media's current favorite whipping boys:

With their spreadsheets and teams of math geeks, investment bankers like to show their deal work as a kind of deep science.

While pithy and provocative, this little dig suffers from the slight rhetorical handicap that it simply is not true.

First of all, the mathematics used in M&A valuation, while admittedly more complicated than balancing the average American's checkbook, is decidedly not complex and bears absolutely no resemblance to the scary agglomerations of obscure Greek letters, self-referential operators, and nested gobbledygook in which the true "math geeks" of the investment banking world—derivatives structurers and traders—traffic. Sure, there is the all-important concept of the time value of money, the calculation of which is best handled within the confines of a computer spreadsheet, but most M&A valuation entails simple grade school math: addition, subtraction, multiplication, and division.

Second, any M&A banker worth his or her salt knows that valuation is an art, not a science. There is no one right answer to the valuation of anything as complex as a business. For one thing, while the mathematics of the relatively simple models investment bankers traditionally use to value companies—comparable company trading multiples, comparable transaction multiples, and discounted cash flow projections—are uncontroversial, their input assumptions are not. Which publicly traded companies do you designate most comparable to the firm you have on offer? Which valuation multiples do you weight most heavily in deriving an "appropriate" public valuation? Which M&A transactions do you pick to compare the proposed deal to, and why? Which discount rate do you use for your discounted cash flow analysis of the company's projected future results? What is the basis for the operating assumptions which underly those projections? Etc., etc.

Every single one of the important assumptions an investment banker makes in his or her valuation of a company can and will be challenged by the banker on the other side of the table. And this conflict over assumptions does not spring solely from the antagonistic positions the opposing bankers hold as advocates for their different clients. Even among bankers on the same side of a deal, honest disagreements can arise over the proper assumptions to make. Valuing a company is not like solving the Pythagorean theorem: there is no one right answer.

Given this, and given the competing objectives of the parties to a deal, it is clear that the determination of "value" in an M&A transaction—the purchase price to be agreed upon—is driven not by the unchanging precepts of cold, emotionless science or mathematics. It is determined by negotiation.

M&A bankers know this. I have written so, at length, before:

There is no "right" number in merger negotiations, just as there is no one, right number in valuing any for-profit enterprise. Valuation, whether in the market or in a deal, is well and truly—and ineluctably, now and forever—an art, not a science. But such gut instincts—rather more accurately described as carefully considered judgments—on the part of M&A advisors are or should be based on a mountain of careful, well-judged analysis, comparison, and argument. You never go to your counterparty in an M&A deal and say your offer of $100 million for his pissant company is based on gut instinct; you give him reasons. You show him where his company's peers are trading in the marketplace, you show him the levels at which other companies in his industry have been bought and sold, and you share your assumptions of the future value of his business enterprise with exhaustively analyzed and justified discounted financial projections. He, if he is not an idiot, will counter with his own exhaustive analysis showing why his gem of a company is really worth $500 million. And you're off to the races.

Therefore, I find Mr. Berman's transparent attempt to criticize an M&A straw man made up of imagined scientific rigor from the perspective of behavioral economics flatly unconvincing.

In other words, boards and bankers are just like the rest of us. They set aside their rational mind in favor of those anchors -- arbitrary and emotional points of concentration. It's the same process that we use when ordering dinner at a restaurant: That $50 steak can influence how we perceive the $25 chicken.

Of course M&A is subject to all sorts of emotional and psychological quirks. What person who actually does M&A for a living ever said it wasn't?

* * *

For another thing, I find the article's purportedly dramatic conclusion that there is a surprisingly high correlation of completed merger prices with the 52-week high stock price of the target company seriously underwhelming, on many levels.

First, there is the question as to whether Boards of Directors and investment bankers are in fact "fetishistic" about it:

The 52-week high stock price has always had a fetishistic role in merger discussions. By custom, boards are insulted if a merger offer doesn't breach this price level. Banker presentations focus on whether an offer is greater or lower than the 52-week high.

Well, look at it this way. The 52-week high, by definition, shows a demonstrable, concrete valuation for the target company, one validated in the public market sometime within the past year. It is a "real" price that directors can point to easily, unlike the smoke and mirrors valuations based upon a mountain of assumptions which their investment bankers assault them with in the boardroom. It is a price the other side cannot reasonably dispute. It is a clear, unequivocal, publicly-available reference point which the Board can direct their shareholders to, without making Aunt Millie or Cliff Asness dig through a 500-page proxy statement to find it. As anchors go, it is a damn convenient one: good, solid, and indisputable.

Second, unless the company has fallen on seriously hard times, or its directors believe its future prospects have been permanently impaired, their default starting point should be that they will not consider selling the company for anything less than a premium to the 52-week high. After all, even if the company is not trading at that level, it was worth that much less than a year ago (see above), and generally accepted corporate finance theory contends that an acquirer should be willing to pay a premium to the publicly-traded price of a widely held company to reflect the value of control for that asset. Therefore, it strikes me as no great surprise that the 52-week high holds such attractive power when it comes to M&A transactions.

The academics' study itself supports this idea with some rather unsurprising results of its own, results which Mr. Berman oddly chooses to characterize as "oddities":

Consider these oddities. More deals priced at exactly the 52-week-high than at any other price. About three-fifths of deals fall above the 52-week marker. And each deal that is priced above the high has a 76% chance of shareholder approval, while deals falling below the high succeed 69% of the time.

What's odd about any of this? (In particular, I fail to get excited that exactly 60 out of 7,500 transactions studied show final prices equal to the target's 52-week high, more than any other price. Sixty out of 7,500? Stop press!) Almost none of these results are remotely odd if you consider that there are probably tons of offers to purchase companies at prices well below their 52-week highs where Boards of Directors politely tell the suitor to go pound sand before the deal is even announced. Hostile suitors, of course, can announce offers well below their targets' highs, but such deals remain a substantial minority among all M&A deals even today.

Frankly, I find the study's results rather reassuring that Boards of Directors may in fact be less driven by emotion and unexamined behavioral tics than the authors seem to conclude. The mere fact that 69% of announced deals priced below the 52-week high water mark actually close demonstrates to me that directors (and shareholders) can make economically rational decisions quite often. For all the reasons the 52-week high acts as a positive benchmark for the selling company in negotiating a deal, it also imposes an extra burden on the selling company's directors to explain and justify the sale of the company for less to their shareholders and the market. I find the fact they pull it off more than two thirds of the time somewhat of a minor miracle.

* * *

For all this, there may actually be something there there. One could perform an interesting analysis with the professors' data that looks at anchoring around the 52-week high during different market environments. In particular, I would expect the correlation to be stronger—the 52-week high to be a stronger anchor to final pricing—during sellers' markets, when the selling company arguably has the upper hand in negotiations, and weaker during buyers' markets. Our intrepid academics would have to fine grain their analysis much more than their base period of 1984 – 2007 to pick up those patterns, though.

In the meantime, I would urge you to heavily discount the article's suggestion that anyone can take this study and go do M&A.

You don't need Goldman Sachs to do this math. Dr. Phil will probably do the trick: If you want to get a deal done, beat that 52-week-high. "These are the largest transactions that take place in the economy. If there's any place where psychology should be absent, it's here," said Mr. Wurgler. "But it's not."
Dr. Phil might actually be an asset at the negotiating table, but I guarantee you that completely clueless ivory tower M&A virgins like Professor Wurgler would not.

If there is any form of economic transaction where psychology does and must take center stage, large scale corporate M&A is it.

© 2009 The Epicurean Dealmaker. All rights reserved.