To participate in an auction process, interested parties must pay an entry cost equivalent to purchasing an option. The cost of the option (the option premium) amounts to the due diligence work to be carried out and the opportunity costs. This investment allows them to assess a target’s underlying value. If the winning bid (the exercise price) is below the value of the target, the option is exercised.
A pre-emptive offer has profound implications for auction dynamics if its existence is known to competing parties. This occurs in public takeovers and, more subtly, when a private auction process is triggered by a pre-emptive approach or accelerated after its launch.
The pre-emptive strike is designed to act as a deterrent for competitors: the existence of a highly motivated buyer increases the expected exercise price, which in turn reduces the value creation potential for all bidders, to the point where the cost of the option may become uneconomical for potentially competing bidders.
In ‘Acquisition as a Real Options Bidding Game’ (2005), the authors mathematically demonstrate that this is particularly true when the buyer universe is highly homogenous (e.g., a pure consolidation opportunity in a narrow industry segment) since the target will have a similar value to all of them.
Interestingly, the same is true when the buyers’ universe is highly heterogenous.* In that case, the strong signal of confidence sent by a pre-emptive party suggests a high value to that party which potential bidders with a different strategic angle may find challenging to achieve.
Based on the above considerations, seeking to pre-empt a process when the buyer universe is neither highly heterogenous nor highly homogenous has a relatively low probability of success; and seeking to pre-empt at a low value is futile.
The option analogy also helps illustrate why pre-emptive moves are more likely to be effective during times of elevated M&A activity. When investment opportunities abound, such as today, the opportunity costs of participating in a process increase dramatically. Even if capital is plentiful, the number of professionals capable of deploying it is constrained. As a result, the cost of the option skyrockets and cannot be justified by the value creation potential if the exercise price is driven through the roof by competitive dynamics. Confronted with a pre-emptive bid, competing bidders struggle to engage.
Separately, the authors of ‘Initial Offer Precision and M&A Outcomes’ demonstrate that a precise offer (e.g., $1,020,000 vs. $1,000,000 for a house) can tilt the bargaining power to the bidder’s advantage. This is because the offer can be viewed as more informed and thus more credible than otherwise – which is particularly relevant in conjunction with pre-emptive offers.
While M&A can be mathematically modeled, transactions rely on specific circumstances which require expertise and psychology. Much like driving, most individuals think their M&A skills are above-average – a case of ‘superior illusion.’ Yet, when it is dark, snowing and the road to a mountain peak is icy, it pays to have an expert who has done it time and time again to safely reach a destination. And don’t Uber it.
* For example, when various strategic parties approach the target from a different angle (consolidation, vertical integration, diversification) and/or private equity players are involved
‘A Theory of Preemptive Takeover Bidding,’ Fishman (1985)
‘Preemptive Bidding, Target Resistance, and Takeover Premia,’ Dimopoulos/Sacchetto (2008)
‘Merger Negotiations and the Toehold Puzzle,’ Betton/Eckbo/Thorburn (2009)
‘Bidding strategies and Takeover Premium,’ Eckbo (2009)
‘Bidder Contests in International Mergers and Acquisitions’, Bessler/Schneck/Zimmermann (2014)