Comment: The unconscious biases that affect deal success

Plenty of consideration is given to the technical aspects of corporate finance transactions and the commercial, financial and legal analysis that should be undertaken by buyers as part of the transaction process. But what about the psychological aspects of private equity investments and M&A deals, particularly the unconscious influences that impact decision making?

Royds Withy King, together with PCB Partners, have teamed up with Professor Scott Moeller, director of the M&A Research Centre at The Business School (formerly Cass), City, University of London, to explore some of the biases which are most prevalent in corporate finance transactions and the impact that they can have. Particularly, overconfidence, confirmation bias and the illusion of control.

So what are these biases and how do they manifest themselves?

Overconfidence bias

People make mistakes more frequently than they believe, invariably view themselves as better than average and overestimate how frequently they will experience favourable outcomes. Research shows that what people think will happen 98% of the time only actually happens 60% of the time. Management teams are not immune to this and overconfidence bias often comes into play when reviewing investment opportunities and making decisions about longer-term value creation.

Confirmation bias

Overconfidence isn’t the only psychological bias impacting deals. It is common for people to seek information that agrees with their existing beliefs, giving more weight to information that confirms their preconceptions and dismissing other data that is contrary to those existing views. This is confirmation bias in practice. Good or confirming information is given too much importance whilst bad news is ignored. This can be particularly prevalent in the due diligence process, with the risk that decisions about information supplied can be influenced by the time investment made to get to that point and emotional attachment to a deal.

Illusion of control

People often overestimate the extent to which they can control events, believing that they can “beat the odds” and control outcomes over which they really have no influence. This factor overlaps with the overconfidence bias where despite information to the contrary, the influence of external factors that can have a significant impact on a deal may be downplayed.

Mitigating the risk

Whilst access to data may already reduce the effect of biases in areas such as deal origination, there is also a need for advisers to have an understanding of the psychological factors in play so they can be an effective ‘control’ on biases. The due diligence process, in particular, should be the moment where assumptions are tested and unexpected issues identified and advisers should be proactive in challenging assumptions, emphasising key risk areas and identifying solutions.

Knowing that decisions can be influenced by psychological factors inherent in the relationship driven nature of private equity is an important first step in understanding how better to address their negative effect. There are, of course, many other factors that affect deals. But it will be interesting to see if the increasing use of sophisticated data solutions and technology in private equity can further alleviate, at least to some degree, the negative impact of biases and give deals the best prospect of success.

Click here for a copy of the white paper produced by Royds Withy King, PCB Partners and The Business School, City, University of London.