“[H]euristics are simple, efficient rules which people often use to form judgments and make decisions. They are mental shortcuts that usually involve focusing on one aspect of a complex problem and ignoring others. These rules work well under most circumstances, but they can lead to systematic deviations from logic, probability or rational choice theory. The resulting errors are called ‘cognitive biases’ and many different types have been documented. These have been shown to affect people’s choices in situations like valuing a house, deciding the outcome of a legal case, or making an investment decision.”  Wikipedia.

Much of my career has been spent on the merry-go-round of buying and selling petroleum assets.  The price dance usually starts with the buyer making the first offer—either in a competitive process (in which the seller solicits multiple offers) or a direct negotiation (in which one of the parties has approached the other).  I have noticed that dollar differences—rather than percentage differences—tend to predict whether the bid/ask range will be closed.  The greater than the gap in dollars (even if the percentage is relatively small), the less likely the price will be agreed.

All things being equal, why would a seller be willing to accept a 10% discount on a $50 million deal—but not on a $500 million deal?

“It isn’t that people are lazy or irrational, says Gerd Gigerenzer, managing director of the Max Planck Institute for Human Development and director of the Harding Center for Risk Literacy in Berlin. It’s that over the course of human history, people have typically encountered statistical information in ways they can count (say, seven instances out of 10), rather than contemplate in the abstract (as in 70%). People make better statistical projections, he says, when information is presented in concrete ways they can understand, such as a dollar amount. . . . Tell consumers the fee for a $100,000 investment is 1%, and they won’t think it’s very high . . . But say the fee for that $100,000 investment is $1,000, and they will think it’s much higher, even though the dollars involved are the same. . .”  Charlie Wells, Percentages vs. Dollars—a Battle for Investors’ Attention (Wall Street Journal July 6, 2014).

Offers in asset purchase agreements are expressed in dollars, and it may be harder for an executive to accept an eight-figure discount than, for example, a seven-figure one.

Large dollar gaps, irrespective of the percentage, also create other issues, including enhanced scrutiny by seller’s stakeholders. Large bid/ask spreads tend to arise from more valuable assets, which are material to the seller.  This means that the selling price for a major asset will be scrutinized by other executives, the board of directors, and investors.  Decision makers may fear that a big discount can be used by others (with the benefit of hindsight) to criticize their judgment.

A few years ago I was sitting with Lord John Browne (former CEO of BP) in his Riverstone London office. Browne said that the most valuable lesson he learned at BP was “do the biggest deals possible.” He went on to explain that if two deals yield the same percentage return, the larger will be more profitable.  He also noted that the transaction costs of big deals are often similar to those of smaller ones.

While Lord Browne’s observations were correct, he left out the risk of busted deals.  Of course, large companies such as BP can more easily absorb such costs.  But what about start-ups?  Even if they have private equity money backing them, PE may not start funding a management team until they have acquired their first asset.  This means the legal fees and other overhead for busted deals are absorbed by the management team.  PE-funded teams usually have a limited runway of savings with which to fund their ventures.  They may only get one or two shots at closing a deal before having to go back to work elsewhere.  As such, start-ups can improve their probability of success by pursuing middle-market acquisitions—where the bid/ask spreads are more manageable.

About the Gaille Energy Blog.  The Gaille Energy Blog discusses issues in the field of energy law, with weekly posts at http://www.gaillelaw.com.  Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, and the author of three books on energy law (Construction Energy Development, Shale Energy Development, and International Energy Development).

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