Avoiding Lemons in M&A Deals

With the recent rise in corporate share prices, swelling cash accounts and a weak dollar, prognosticators are heralding the return of strong mergers and acquisitions activity, particularly in the high-tech, pharmaceutical and banking sectors. Yet if history provides any guide, many of these deals will fail to generate any real value for the shareholders of the acquiring company, and a good number will ultimately become wealth-destroying propositions.

New insights into why this happens have come from seemingly unrelated markets, including those for used cars, labor and insurance. In 2001, George A. Akerlof, A. Michael Spence and Joseph E. Stiglitz shared the Nobel Memorial Prize in Economic Sciences for their work on these markets and the failures that can arise when buyers and sellers possess different information about the goods or services being exchanged (Stiglitz, 2000). Strategic management researchers and financial economists have used these insights to understand why some M&As perform poorly and to identify ways that managers can cope with the challenges presented by knowledge discrepancies across bidders and targets.

The fundamental problem lies in two inherent features of many M&As: the acquiring company’s struggle to value the target’s resources and the need for the parties involved to agree on a price. The process of due diligence provides a useful starting point for obtaining detailed and reliable information about the quality of the resources to be acquired, yet often fails to unearth the sort of deep, and often tacit, knowledge about the target’s resources that can ultimately determine the success or failure of an acquisition. Moreover, time pressures, organizational complexity, unfamiliar product or geographic markets and the challenges surrounding the appraisal of intangibles can hamper a suitor’s valuation and negotiation efforts. Sellers often face problems in conveying the true value of their resources and capabilities to a buyer in a credible fashion. This is because sellers have natural incentives to inflate their representation of the quality of the offering in order to command a higher sale price, while acquirers already assume that sellers are presenting their best face. When suchinformation asymmetries exist across bidders and sellers, attractive deals may simply fall through; but for those deals that are completed, acquirers are likely to overpay. In other words, acquirers run the risk ofadverse selection, or winding up with a “lemon.&