Auctions in M&A

Auction is a very important topic for all M&A practitioners for the following main reasons:

1. Auctions are widespread in business (e.g. hostile takeovers, privatizations of state-owned enterprises, sale of assets in bankruptcy, rights to exploit natural resources, etc.)

2. The auction process is a key element for negotiations and mastering this process often impacts on the outcome of the deal.

It is central to understand that the auction process involves strategic thinking. In fact auctions are a mix of behavioral finance, negotiations and clear rules.

The common definition of an auction is: a process by which an asset is sold by soliciting bids from buyers; the event is “public” and governed by rules of conduct that culminate in the sale to the highest bidder. Well, in M&A it might not be a single event, truly public, nor won by the highest bid. We can outline five auction methods (the first four drawn by McMillan):

· Beauty contest: Buyers are invited to present themselves to the target’s directors. The choice is made behind closed doors. If offers the seller a great flexibility (time, discovery of information, criteria on which a choice is made). However it often discourages potential buyers because of the opacity and the slow speed of this process.

· Lottery: The seller announces a sale at a specified price, invites potential bidders to participate and then a name is drawn randomly (e.g. from a hat). The disadvantage for the seller is that there is no price discovery and other considerations such as the technical competence of the buyer to operate the firm in the future are not taken into account. This method might be used by governments to sell some specific rights for example.

· First come, first served: The seller announce that the company is for sale and pursue a sale with the first buyer to show up. Once the potential buyer has discovered that there is no competition anymore, he will reduce the incentive to increase the bid and therefore the price discovery for the seller will be biased. Most of the SMEs use this kind of auctions.

· “True” auction: A true auction is run by rules and a schedule clearly expressed in advance. The clearer the rules and the commitment to those rules, the more the potential buyers will be motivated to participate to the auction. The process is transparent, goes fast and prices are revealed. The last one is the main difference with other types of auctions. It is often used for the sale of nonstandard items (e.g. a world-class athlete, great paintings or some companies).

· Friendly noncompetitive negotiation: The buyer persuades the target company to sell. This is a quite unstructured process and the buyer keeps quite a strong power during the negotiations. It is not directly an auction method, but it can become an auction, once other bidders come into the game.

Auctions differ from negotiations by the number of bidders, the structure and the speed of the transaction.

Furthermore, we can assume that there are more chances to close a deal with an auction process than with simple negotiations, because of the efficiency and focus of the auction process. There might be a back and forward between auctions and negotiations during a sale process (e.g. begin with auction and then negotiations with an exclusive bidder or negotiation with a potential buyer to test the market and then open an auction with other bidders, etc.). The main point to keep in mind is that auctions are competitive and negotiations are more or less exclusive.

There are four classic types of auctions, which have been described by McAfee and McMillan:

· English auction: this is the type of auctions used by art auction houses. Everyone can see the reservation price of the seller and then the price rises until no other bids are made. The asset is sold to the highest bidder.

· Dutch auction: this is mainly use in the sale of cut flowers in Netherlands. The auction begins with an arbitrary price determined by the seller and he then reduces it until a bidder accepts the offer.

· First price sealed bid auction: this works like an English auction, except that each bidder can only bid once and other potential buyers cannot see the bids. The bidder with the highest price gets the deal. It is used for example by governments for the sale of rights to exploit natural resources.

· Second price sealed bid auction: This is the same method as the first price sealed bid auction, but the winner pays the second-highest price, rather than the winning highest price. It mitigates the impact of the so-called “winner’s curve” among buyers (overpaying for an asset in an auction) and thus encourages more buyers and higher prices. This method is however rarely used in practice.

We can mention two main advantages of using auctions:

1. Price discovery: without auctions the buyer and the seller have each their own view on the intrinsic value of the asset and the price they would pay/accept. With an active and competitive auction, the different offers will help to determine the real (market) price of the asset.

2. Positive for the seller: auctions motivate buyers to bid in a desirable way for the seller, i.e. buyers want to go fast and will put the highest offer the can in order to get the target. An auction with clear rules and deadlines help also the buyer to assess the cost of acquiring the asset.

But auctions have of course some disadvantages, such as:

· By entering an auction, the target faces a confidentiality risk, i.e. by disclosing information to many bidders, the target’s business might be affected (e.g. if suppliers were to be informed about some conditions that the target grants to other suppliers, etc.).

· Potential buyers will try to avoid the auction process to come back to negotiations. They might threaten not to participate at all or simply asking the target to cancel the auction (so-called “bear hug” letter).

· The target has a reputation risk from canceling the auction or deviating from the rules, i.e. other potential buyers might think that the target is not as attractive as originally presented.

· Auctions might discourage some prospective buyers to participate, because of the maximizing price effect of auctions. They also might be afraid for their reputation if they lose.

There are some practical considerations to sellers in auctions. An auction will better work if the asset is unique. If it is not the case (e.g. fairly comparable independent companies are on the market), then use negotiations. Strive to increase the number of bidders, e.g. by setting clear rules and deadlines, putting in place a well-managed data room and due diligence process, etc. This increases the confidence of buyers. Allow different types of buyers to bid, i.e. strategic and financial and allow them to use their strengths.

Price is one aspect of auctions. But a seller often considers a lot of other aspects like strategic fit, contingent payment, incentives for the management in place, social issues, etc. All those aspects must be taken into consideration when comparing different offers from potential buyers and the highest price might not always win in M&As.