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M&A and Gresham's Law

If a government or central bank issues two distinct types of silver dollars, one containing half as much silver as the other, the lighter-weight, overvalued silver dollars will circulate whilst the heavier-weight coins will be hoarded, assuming each coin is legally pegged at a par. Bad money drives out good. That is Gresham’s Law. At its very core, it relies upon the fact that some goods are often traded at a face value which may not represent their intrinsic value. When such goods are overvalued due to government decree or carry the risk of being overvalued due to information asymmetry, they drive out the good goods.

For example, in the market for used cars, “lemons” drive out the good cars. Sellers have a natural incentive to market their cars as quality goods, independently from the actual quality of their cars. Buyers are unable to fully due diligence the products they purchase for practical reasons. They will thus apply a discount to any used car as a hedge against poor quality items. High quality cars are pushed out of the market since their owners cannot expect to obtain a fair price for them. As a cost to society, this reduces the size of the marketplace and thus affects the efficient allocation of resources in the economy.

The same phenomenon is applicable to advisory services. Here is my take on the analogy: The information is asymmetric since the quality of the seller’s advice is unknown at the time of the purchase. In that context, advisors have an incentive to market certainty with a high degree of conviction – independently from their actual level of knowledge – since it signals quality of insights from a client point of view. Strategic consultants who have a clear perspective on a market scenario and propose a precise course of action which is readily usable for a board meeting have a higher chance of being hired than those who acknowledge uncertainty and recommend some strategic flexibility. A real estate agent who expresses confidence in selling a house at a premium within a record time has a higher chance of being picked than a competitor acknowledging difficult market conditions and expecting a potentially lower valuation. In both cases, bad advisors tend to be hired whilst good advisors are driven out of the market.

In fact, the same bad (or dishonest) agents would advise to purchase a house during boom times by promising fast increasing value. Good (or honest) agents who do not are quickly out of work (which creates a situation akin to a prisoner’s dilemma). Gresham’s Law is thus at the very origin of the Great Financial Crisis. It is also blamed for intelligence failure: CIA agents who provide a clear perspective on any given situation which forms the basis for military action are rewarded at the expense of those who establish facts in a more nuanced fashion. Wars got started because of the Gresham dynamics. To sum up, bad advice is overvalued and “drives out good advice […] because it offers certainty where reality holds none.” Note that the Gresham Law is also relevant to politics. Politicians make grandiose statements, but what are their genuine positions? Here again the information is asymmetric since the truth, if there is any, is in the pudding. Great campaigners displaying a vision with confidence drive out good politicians, a fundamental flaw of any democratic system noted by Aristophanes in 405 BC already.

Closer to home, are there any implications for M&A? I would argue so. Auction processes are akin to a market for used cars. Sellers, aided by their advisors, portray their targets in the best possible way, typically to the cynicism of the buy-side. Potential buyers have a strong incentive to discount inflated business plans in a rather indiscriminate fashion. As a result, high quality assets are driven out of the broad market. Instead, they require truly bespoke processes outside of the main market “by invitation only”.

Beware though. Tailored-made processes are not necessarily optimal for average or lower quality assets. They are in fact often at the origin of failed processes. With a view to maximizing value and minimizing execution risk, it is therefore critical for the seller to assess whether it is about to sell a high quality asset or not. Since beauty is in the eye of the beholder, the owner requires the input from a financial advisor. But, given Gresham’s Law and its implications for advisors, who are you gonna call? Sources:


“Yea for these, our sterling pieces, all of pure Athenian mold, All of perfect die and metal, all the fairest of the fair, All of workmanship unequalled, proved and valued everywhere Both amongst our own Hellenes and Barbarians far away, These we use not: but the worthless pinchbeck coins of yesterday, Vilest die and basest metal, now we always use instead. Even so, our sterling townsmen, nobly born and nobly bred, Men of worth and rank and mettle, men of honorable fame, Trained in every liberal science, choral dance and manly game, These we treat with scorn and insult, but the strangers newliest come, Worthless sons of worthless fathers, pinchbeck townsmen, yellowy scum, Whom in earlier days the city hardly would have stooped to use Even for her scapegoat victims, these for every task we choose. O unwise and foolish people, yet to mend your ways begin; Use again the good and useful: so hereafter, if ye win 'Twill be due to this your wisdom: if ye fall, at least 'twill be Not a fall that brings dishonor, falling from a worthy tree.”

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