PLAYING AT ACQUISITIONS P L A Y I N G A T A C Q U I S I T I O N S B E H AV I O R A L O P T I O N G A M E S HAN SMIT AND THRAS MORAITIS Princeton University Press Princeton and Oxford Copyright © 2015 by Han Smit and Thras Moraitis Requests for permission to reproduce material from this work should be sent to Permissions, Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW press.princeton.edu Jacket Design by Jessica Massabrook All Rights Reserved ISBN 978-0-691-14000-1 British Library Cataloging-in-Publication Data is available This book has been composed in Kabel LT Std & Adobe Caslon Pro. Printed on acid-free paper. ∞ Printed in the United States of America 1 3 5 7 9 10 8 6 4 2 CONTENTS LIST OF FIGURES vii LIST OF TABLES ix PREFACE xi About This Book xi Who Should Read This Book? xii A New Strategic Valuation Approach as a Bridge between Theory and Practice xiv Academic Contribution and Features xvi A Guide through the Book xviii CHAPTER 1. LEARNING TO SEE, TO ADAPT TO, AND TO VALUE UNCERTAINTY 1 Learning to See Uncertainty 3 Learning to Adapt to Uncertainty 8 Learning to Value Uncertainty 11 Summary 15 PART I. LEARNING TO SEE UNCERTAINTY 17 CHAPTER 2. HOW TO DE-BIAS VALUATION OVER THE CYCLE 19 Problem Diagnosis: Why Acquisitions Occur in Go/No-Go Waves 20 Avoiding Irrational Infection of the Valuation Analysis 22 A Remedy for Uncertainty Neglect: Broaden Your Narrow View 25 Examples of Appropriate Real Options Thinking in Hot and Cold Deal Markets 32 Conclusions 41 CHAPTER 3. PLAYING AT SERIAL ACQUISITIONS: THE CASE OF VODAFONE 43 Six Potential Pitfalls in the Execution of a Serial Acquisition Strategy 44 Can Rational Analysis Discipline Strategy? 57 Dual Valuation of Growth Option Value to Avoid Irrational Infection 61 How to Use Option Games to Overcome Bidding Pitfalls 65 Conclusions 68 vi • Contents PART II. LEARNING TO ADAPT TO UNCERTAINTY 73 CHAPTER 4. STRATEGY AS OPTIONS GAMES 75 Classifying Acquisition Options under Competition 78 Expressing a Buy-and-Build Strategy as an Option Portfolio 81 Competition in the Bidding Game 87 Play Poker against Rivals Who Overshoot or Fall Asleep 93 Conclusions 95 CHAPTER 5. DUAL REAL OPTIONS VALUATION: THE XSTRATA CASE 101 Illustrative Example of the Dual Approach: Xstrata’s Journey 103 Bottom-Up Framework: Xstrata’s Serial Acquisitions 106 Top-Down Framework for Listed Companies: How Finance Can Enlighten Strategy 112 General Implications and Limitations 117 Conclusions 118 PART III. LEARNING TO VALUE UNCERTAINTY 121 CHAPTER 6. OPTION GAMES VALUATION 123 Designing and Solving an Option Bidding Game 124 Quantifying the Optionality of the Falconbridge Episode 133 Conclusions: How Option Games Can Deliver Their Potential 147 CHAPTER 7. CONCLUSION AND IMPLICATIONS 151 Biases and Options Are Everywhere 152 The Problem: Selected Pitfalls in Acquisition Decision Making 154 The Solution: How Executives Can De-bias Their Acquisition Decisions 158 Selected Implications to Deal Rationally with One’s Own Biases, Financial Markets, and “Irrational” Rivals 163 Empirical Evidence 166 Promising Future Research Directions 169 Broaden Your View with Option Games 171 BIBLIOGRAPHY 173 INDEX 185 LIST OF FIGURES Figure 1.1 The Ponzo Illusion: How Perspective Can Bias Vision 4 Figure 1.2 Perceived Uncertainty in the Payoff of Acquisitions (Inner Distribution) Is Lower Than Actual Uncertainty (Outer Distribution) 5 Figure 1.3 Learning to Adapt to Uncertainty: Optionality Generates a Positively Skewed Distribution 10 Figure 1.4 Components of Company Value 11 Figure 2.1 A DCF Valuation That Derives a Significant Part from Its Horizon or Terminal Value May Reinforce Hot and Cold Deal Framing 23 Figure 2.2 A Real Options Analysis May Promote Cautious Venturing 28 Figure 2.3 How a Real Options Approach Can Counter Executive Framing Biases 33 Figure 2.4 Decision Tree for Offshore Oil Development 37 Figure 2.5 Restructuring a Business as a Portfolio of Options 40 Figure 3.1 Staged Decisions in Vodafone’s Buy-and-Build Acquisition Strategy 59 Figure 4.1 The Real Options Approach to Classifying Acquisitions 80 Figure 4.2 Staged Decisions for a Buy-and-Build Strategy 85 Figure 4.3 Different Competitive Strategies Following “Buy” or “Build” Expansion in a Value Enhancement or a Value Capture Game 90 Figure 4.4 Timing Strategies Based on the Consolidator’s Market Position 93 Figure 4.5 Executive Summary: Conceptual Implementation of Bottom-Up Option Games 99 Figure 5.1 Xstrata’s Market Value as It Evolved into a Major Mining Company 104 Figure 5.2 Xstrata’s Acquisition Paths as a Series of Platform and Asset Options 111 Figure 5.3 Summary for Implementing Top Down Valuation 119 Figure 6.1 Simultaneous versus Sequential Bidding 141 Figure 6.2 Strategic Option Value of a Minority Stake 145 Figure 6.3 New Players Scramble for Global Mining Assets 146 Figure 7.1 Potential Biases, Pitfalls, and Solutions at Each Phase of the Acquisition Process 155 Figure 7.2 Summary Scheme of Behavioral Option Games 159 LIST OF TABLES Table 3.1 Biases That Affect Company Strategy 49 Table 3.2 Biases That Affect Company Valuation 52 Table 3.3 Biases That Affect Bidding 54 Table 3.4 Summary of How to Overcome Pitfalls in Serial Acquisitions 69 Table 5.1 Xstrata’s Rapid Growth Trajectory through M&As in Early Years 105 Table 5.2 Common Corporate Real Options in Acquisitions 108 Table 5.3 Global Diversifieds Have a Higher Proportion of Growth Option Value (PVGO) to Equity 115 Table 6.1 Scenarios Influencing the Shared or Proprietary Nature of the Option 140 Table 7.1 Industry Average of the Market Value of Growth Opportunities, Modified Growth Opportunities, and Mispricing 167