When faced with short deadlines, shareholder pressure, impending costs and increased competition, we fall back on preconceived notions or cognitive biases to help us make decisions quickly. Cognitive bias is ingrained in every part of our daily lives, and M&A transactions are no different. However, leaning too heavily on these can create blind spots for strategic decision-making.

Cognitive bias is ingrained in every part of our daily lives, and M&A transactions are no different. The human brain is complex and multifaceted, and sometimes it falls back on mental shortcuts that lead us to choices based on preconceived notions or cognitive bias. To date, a mammoth 185 known cognitive biases have been identified. When faced with short deadlines, shareholder pressure, impending costs and increased competition, we fall back on these biases to help us make decisions quickly. However, leaning too heavily on these can create blind spots for strategic decision making.

The good news is that by recognising our biases and accepting the role these inherent preconceptions play in our decision-making processes, it is possible to change behaviours or at least mitigate their adverse effects.

Step Advisory works extensively with transaction teams, so we are keenly aware that there are many external factors currently creating pressure in the local deal environment, including suppressed economic performance due to Covid-19 and uncertainty around the political landscape in South Africa. Furthermore, with organic growth stalling, many companies are now turning to acquisitive opportunities to drive growth and shareholder returns. This combination of factors creates increased pressure on transactions to deliver positive returns and drive sustainable growth.

As a result of the present economic environment, we are currently seeing a shortage of attractive deals that deliver on expectations for appropriate value within a reasonable period as everyone competes over fewer opportunities. This translates into shorter deadlines, more pressure, all of which play into cognitive biases as a means of coping with the competitive, pressure cooker situation.

When analysing the transaction process, we’ve noted that the following cognitive biases are the most prevalent to consider:

The anchoring bias within a transaction stems from holding too tightly onto information revealed early in the process, such as value estimations, growth vectors, or the original investment thesis. Relying too heavily on this information can result in a reluctance to modify the perceived value of the transaction or a hesitance to change and plan effectively for value creation after the deal. This can lead to over-investing or missing out on deals through unwillingness to review pricing or the probability associated with growth vectors that underpin the value in the target.

Confirmation bias affects individuals who interpret new information or analysis to prove an existing investment thesis. This bias is most prevalent when evaluating a deal’s strategic rationale and potential synergies. It emerges when a greater focus is placed on analysis supporting existing beliefs rather than the analysis contradicting them. This focus can cause blind spots to possible unforeseen risks or other opportunities that could drive increased value. This type of bias can cause the limitation of value creation post-transaction if synergies or growth vectors prove unrealistic compared with the initial targets set.

The availability bias entails making judgements based on mental shortcuts or similar past experiences and examples. Individuals can rely too much on previous experiences, causing them to skew how they manage the situation. This bias has become increasingly more frequent due to shorter deal timelines and time pressures. While learning from experience and past transactions is incredibly important, if we do not take sufficient time to understand the deal’s nuances, certain intricacies may not be identified and planned for until the transaction is closed.

Attentional bias is the tendency to pay attention to selected aspects while overlooking others. Within an M&A deal, this could be an overt focus on management’s view of potential growth. When dealing with tight deadlines, this focus on the critical elements of the investment thesis put forward by management can help efficiently evaluate a transaction given a defined thesis. However, it does not consider unknown or innovative growth vectors outside of management’s current paradigms, which are generally risk-averse in the existing macro-climate. This bias can significantly impact value realisation and planning after the fact.

This bias causes individuals and companies to act rashly to avoid pain or loss. Loss aversion is rife with companies underperforming and economies under pressure in the current climate. Companies are focussed on unloading underperforming assets to prevent further losses on a consolidated or fund level. Businesses that still have a strong growth story or good fundamentals are often disposed of prematurely based on underperformance driven by the current macro-climate. This urgency to sell and prevent loss can lead to businesses being undervalued if the focus on loss outweighs the evaluation of the business’s strategic strength and growth story if they manage to weather macroeconomic storms.

This bias is the ultimate iteration of not letting go. Individuals stick with a plan or transaction simply because time, effort, or money has already been invested. Even if the risk is above an objective threshold and it seems the right decision is to walk away from the potential transaction, this bias keeps teams locked into a process as a way of justifying the effort already made, even in the face of adverse outcomes. Results often include signing on the bottom line with less than favourable terms and an anticlimactic level of return.

Cognitive biases are not necessarily wrong or unhelpful, and in many instances, we rely on them to help us make split-second decisions. We need to be aware that they exist and know when they are detrimental to our decision-making process. As we can see in the M&A space, which will always live in an environment with tight timelines and pressure to deliver significant returns, these biases can cause teams to miss potential risks or even potential opportunities to create additional value.

One can limit the impact of cognitive bias by following these four steps:

1. Be aware and acknowledge they exist when discussing the deal
2. Provide the space in the process to reflect and test whether biases may be influencing the decision
3. Create diversity in the team to bring in different experiences
4. Allow for independent thoughts to be expressed to prevent individual biases from dominating

Independent and objective teams can help combat these biases in the deal-making process. This team plays a valuable role in alerting you to cognitive bias and are not tied to the deal’s outcome. Independent and objective involvement, whether internal or external, can help you become aware of these biases, test assumptions and help you make better decisions.

As we mentioned above, these six cognitive biases are just the tip of the iceberg, and there are many more to understand and consider. While these biases make our decision-making process easier and more efficient by relying on previous experience and understanding, we need to be cognisant that we may very well be blind to the nuances of the situation at hand. It is essential to be aware of these biases, understand their impact on your decision-making abilities, and use a trusted team that can mitigate the adverse effects these biases might have. Only then can we set ourselves up with the best chance of limiting risk and maximising value.