Behavioral biases and their effects on M&A transactions

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Although we have, here at Investing, readers more interested in trading on the stock exchange, I thought it would be interesting to bring the perspective of behavioral biases from within M&A transactions.

It is true that selling a company requires a more time-consuming and complex process than selling a share on the Stock Exchange, but at the end of the day, both converge in relation to dependence on people for decision-making.

People who, in turn, are subject to the nuances and weaknesses of human behavior, often far from the rationality and pragmatism predicted in classical economic theories.

We live in an increasingly volatile, uncertain, complex and ambiguous world (characteristics usually combined in the acronym “VUCA”), which reinforces the importance of recognizing and understanding the limitations of the rationality of beings for evaluating and making increasingly complex decisions.

There are many articles here on Investing that deal with the subject of behavioral biases, so I’ll go straight to examples of the pitfalls and challenges that surround company negotiations. But, before that, I cannot fail to recommend reading the book: “Fast and slow”, best seller by Daniel Kahnemann, which summarizes much of the research of the Israeli-American psychologist and economist, winner of the Nobel Prize in Economic Sciences in 2002 , together with Amos Tversky Source, for the development of “Prospective Theory” and “behavioral economics”.

In my opinion, these are the most frequent biases in M&A negotiations:

Anchoring: the decision maker often uses a price reference that may not be consistent anymore. It is common in situations where the seller has already received a higher proposal in the past and wants, at the very least, an equivalent proposal — even after the deal has deteriorated and no longer deserves the previous valuation. Another recent example involved a businessman who insists on selling the business, at least, for the amount invested, even without forecasting a return on that investment. This bias is also called the “sunk cost fallacy”.

Loss aversion: the pleasure of a gain is less than the pain of a loss, even for symmetrical results, which can lead to hasty decisions. Hard to argue when a customer prefers to secure cash in their pocket rather than the chance to receive potentially greater value in the future. The phrase “a hand is better than two in the bush” usually has its merits, but sometimes ends up inducing sub-optimal decisions. I’ve experienced some situations where a small improvement in the payment method was more valued than a relevant increase in the total price.

Confirmation bias: we usually seek comfort in the signs that confirm our beliefs and move away from situations that challenge them, avoiding the inconvenience of revisiting an opinion. A strategic buyer often thinks he already knows everything about the sector without first knowing the company in more detail. We can use this bias for good or bad, depending on which side of the table we are on.

Halo Effect: it’s when we evaluate the whole by just one part. A bias similar to the previous one. I’ve had a boss who wanted to end a negotiation just because the target was located in a smaller city in the northern region, even though he was a local leader and outperformed his peers in São Paulo. Coincidence or not, this former boss retired early. Intuition has its uses, but it also has its flaws.

Illusion of Control: happens when we have the erroneous impression that externalities are predictable and controllable. An example that struck me was the sudden death of one of the shareholders of the selling company in the final stretch of the negotiation. The transaction eventually went through, but not before being delayed by several weeks and nearly being discontinued.

Overconfidence: This bias needs no explanation. Unfortunately, excessive ego is a recurring problem among my professional colleagues. Humility is always good, it avoids embarrassment and reduces the chance of losing money.
Framing effect: the first impression is not the only one that lasts, but it certainly has a lot of relevance. Nothing like a good powerpoint to decorate the bride.

Availability Heuristic: This is a complicated way of saying that we tend to believe that known events will be repeated in the future. It is the infamous “drag the cell” in projection worksheets. Another acronym linked to this bias is WYSIATI (what you see is all there is).

Possession effect: everything that is ours has greater value than what is not in our hands. Difficult to convince businessmen that their company is not more valuable than others just because they want to. The opposite is also true, as sometimes we increase the importance of a risk beyond belief, even having already seen precedent cases or formed jurisprudence on the subject.

Social Proof: also confused with the FOMO effect (fear of missing out) or the famous “heartache”. As collective beings, we are disproportionately motivated by comparison with peers. There are times when it is enough for a businessman to announce that he got rich selling the company to make all competitors move.

We often joke that we don’t have to worry about being replaced by machines. As long as we have people ahead of the negotiations, we will always have to deal with the biased and subjective decision-making process, difficult to be predicted only by algorithms. Those who work with me often hear this phrase: “human beings are animals”. It seems obvious, but I always need to reinforce the existence of instincts and reactions full of biases — often far from the rationality we idealize.

Original text published in investing.com.

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