In general terms, the winners curse phenomenon occurs when the winning bid in an auction exceeds the intrinsic value or true worth of the item. This difference in the value paid and the intrinsic value is often ascribed to one (or a combination of) the following factors
- incomplete information
- incorrect information
- emotions – hubris
Bidders often face a difficult time determining and rationalizing a target firm true intrinsic value. This is despite there being numerous accounting methods such as EBITDA to judge the value of a firm. As a result, the largest overestimation of the value of the target firm ends up winning the auction. Bidders tend to interpret signals differently about this value and subsequently the winner is the bidder with the most optimistic evaluation and subsequent valaution of the asset. This leads to overestimation and overpayment.
The winners curse can be observed in one of two ways:
This second point is especially true when integration costs and issues have been underestimated by the acquirer.
If during the closing period fo the deal there was a severe market downturn, the acquirer will see the level of overpayment exposed and may try to exit the deal. Therefore, traders using a merger arbitrage investment strategy must be aware of the dangers of overpayment and must consider it a a reason for a deal break or renegotiation.
An Example of the Winners Curse
If perfect information was available to all acquirers and all these acquirers were able to accurately use this information and, they were completely rational in their decisions, a strong efficient market would exist. In this case, no overpayments or arbitrage opportunities would ever occur and prevent the winners curse phenomenon existing. When an acquirer bids more than a rival for the target, there is a strong possibility they will end up paying more than they had wished. Often, it is only after the transaction has taken place that this becomes apparent. A classic case of overpayment by a private equity firm was the Kohlberg Kravis Roberts (KKR) purchase of RJR Nabisco as detailed in Barbarians at the Gate by Bryan Burrough.
