Winner’s Curse

Synergy Fest has a series of interesting posts on Winner's Curse. I especially liked this one that relates the author's first hand experience with the phenomenon and its causes.

The commercial banking sector bought itself an expensive dose of the curse in the 1990s. As the industry consolidated, banks overbid for acquisition targets and hurt their balance sheets and stock prices. Exhibit A is usually First Union and Corestates, but there were many others.

What is interesting is that the banks who were hurt by overpaying in 1997-2000, were those who had been successful with an acquisition strategy from 1985-97: First Union, Bank One, NationsBank, etc.

I can think of several reasons why these banks stumbled:

1. Business as usual at an inflection point. In the late 80s, the bank acquisition market was not an auction. There were only a handful of regional banks doing the buying and numerous attractive targets. Under these conditions, winner's curse does not apply.

When conditions changed-- more bidders, fewer targets-- not many executives noticed. Growth by acquisition was still the strategy.

It's hard for any organization to reject a successful strategy based on the hypothesis that conditions have changed.

2. Go fever. Once top executives set their sights on an acquisition target, it is hard to hit the brakes. There is a powerful temptation to torture the numbers and make the pro formas support a higher price.

3. Grow or be eaten. When the assumption is that the industry is destined to have 3 or 4 megabanks, executives fear that standing pat means they will eventually become prey. This is a powerful incentive to justify a high bid for an acquisition which greatly enlarges their company.

While it is easy to see the problems today, most journalists and stock analysts promoted the acquisitions until the unfortunate results were manifest. One brave exceptions was Tom Brown who actually got fired because he spoke out against several expensive mergers. His company has a blog which makes for interesting reading for anyone interested in the financial services industry.

Side bar: Winner's Curse can also apply to the job market-- especially when firms hire outside executives for senior positions. The most enthusiastic candidates with the biggest promises is probably not the one with the best appraisal of the realities.