Deal-Maker Adverse Incentives in a Hot Market
As we pass a full decade of strong market performance I find it interesting to reflect on the decision-making process for M&A. It strikes me that you have a dual adverse incentive when you combine a CEO or GM with a corporate development leader. The CEO is always looking to grow their business. By definition almost being the CEO of something bigger is better. There are many paths to growth but M&A can look deceptively easy. The beautiful shortcut that doesn’t require years of product innovation new market expansion hiring and operational excellence.
Of course we all know that it’s a false premise. M&A comes with its own set of equally daunting challenges. The opportunity for value distraction in integration is huge. The incomplete information you have when assessing an acquisition target creates gigantic risk for mistake. And the opportunity to radically overpay for An asset based on either that or incomplete information or a frothy market is ever present. That said it’s clear that there is a huge incentive for CEOs to grow through acquisition. Ironically this is more true in a hot market where the growth rates of competitors accelerate and the need to keep up may come at the expense of wise choices with the balance sheet. While the entire executive suite is involved in an acquisition decision the corporate development leader has a unique position. They are the experts in how to execute some transactions but also how to value them.
Valuation is at the very least a mix of art and science. In a frothy market you can find lots of data to support even very rich valuations. While the entire executive suite is involved in an acquisition decision the corporate development leader has a unique position. They are the expert in how to execute some transactions but also how to value them. Valuation is at the very least a mix of art and science. In a frothy market you can find lots of data to support even very rich valuations. The corporate development officer and to some extent the CFO are in a unique position to either validate or invalidate the level of valuation for an acquisition. The challenge is that the corporate development officer has the same adverse incentive. Perhaps even more so. When you have a hammer everything is a nail and proper development officers too often are judged by the volume and scale of acquisitions that they have done rather than by the bad acquisitions they have killed. In a down market few companies have the appetite to be aggressive requires. Therefore the cop corporate development officer knows that their opportunity to build their brand and the resume is largely in a strong market. That creates an adverse incentive to kill off deals and since they are anointed the expert on valuation there is an adverse incentive to support even frothy valuations to get deals done. I’m not saying that all CEOs and corporate development officers abandon their fiduciary duty’s to pursue a rash of bad deals. Throughout my career I have worked with CEOs and corporate development leaders who are assiduous in focusing on their long-term fiduciary duty to shareholders and resisting the “shiny object” temptation to buy at unreasonable prices. But I am saying that we have structured the economic incentives of these two roles to create a strong adverse incentive toward untenable purchase prices in hot markets.
This is clearly not the primary driver of a frothy market but I think at the very least a contributor. I wonder if there’s a way of structuring both compensation and career acceleration for these two critical roles to ensure that this incentive is not quite as powerful. Perhaps a good conversation for any board of an acquisitive company to have.
