Board bias: Setting acquisition premiums

March 11, 2010

To be a fly on the wall in the board rooms of corporate America would be worth a mint. To understand the social psychology behind boards' strategic decisions would be priceless. David H. Zhu has done that.

Zhu, an assistant professor of management at the W. P. Carey School of Business, studied one important aspect of corporate decision-making: how boards price acquisitions. Acquisition premiums -- paying more to acquire a company than its pre-acquisition stock price -- are typical; the average is 38 percent. But Zhu found that group discussions lead boards to approve more extreme acquisition premiums than the average prior premium experienced by directors.

Amplifying pre-meeting positions

As with most people, corporate board members' opinions are informed by past experiences. When considering complex and uncertain decisions such as corporate acquisitions, a member's preference for relatively high or low premiums is largely a factor of his experience with acquisitions in the past.

If the member sat on a board in the past that approved a higher-than-average premium, he is more likely to favor a higher-than-average premium in the current acquisition discussion. The reverse is also true: if in the past a member approved a lower-than-average premium, he is more likely to favor a lower-than-average premium in the current acquisition discussion, too.

Yet in his research Zhu found that acquisition premiums approved after board discussions were even higher (or lower) than the average premium previously experienced by board members when members paid above-average (or below-average) premiums in prior deals.

For example, when Abbott Laboratories acquired i-STAT Corp. in 1998, board members had in the past approved an average acquisition premium of 20 percent. After discussion, the board approved an even lower premium -- 11 percent -- for the i-STAT acquisition. When American Express acquired Rockford Industries in 1998, board members had in the past paid a 92 percent premium, on average. Yet after meeting, the board approved a 138 percent premium for the acquisition.

Why is the outcome of board meetings an even higher (or lower) acquisition premium than members favored before getting together? It's the result of a fundamental decision-making bias that arises during the board's discussion.

"Biases in group information exchange and processing caused directors to systematically amplify their average prior premium experience in board decision-making processes," Zhu writes in "Group Polarization on Corporate Boards: Theory and Evidence on Board Decisions about Acquisition Premiums," a paper that has garnered him a number of awards.

The phenomenon is called group polarization, which, in academic research, refers to differences across two types of groups -- in this case, board members with low prior premium experiences tend to approve an even lower premium following board discussions while board members with high prior premium experiences tend to pay an even higher premium after board discussions. Group polarization is best understood as an amplification of board members' pre-meeting positions.

"Group polarization is said to occur when the pre-meeting average member position is amplified in the group's post-meeting collective decision. For example, when group members are initially inclined to take risks, their post-discussion collective decision tends to become even more risky; but when group members are initially inclined toward a conservative position, their post-discussion collective decision will be even more conservative," Zhu writes.

Jumping on the bandwagon

One aspect of the decision-making bias that skews information exchange during board discussions is the muting of counterarguments. According to Zhu, "As group discussions reveal the prevailing position supported by most members, individuals may tend to avoid expressing concerns about the prevailing position because of social risks of voicing minority opinions."

 "A major motivation for directors to join boards is to make favorable impressions on fellow directors," Zhu writes. But "directors who voice minority opinions can receive less positive assessments from peers, experience social distancing, and potentially lose important opportunities and positions." It's not surprising, then, that board members are inclined to keep quiet when theirs is the minority opinion.

In addition, Zhu writes, "individuals tend to emphasize position-consistent arguments in group discussions and avoid expressing counterarguments so that they can present the self favorably and confidently before others."

Another aspect of the decision-making bias is the amplification of prevailing arguments. As arguments in favor of a high (or low) premium prevail in the discussion, they become increasingly understandable, and increasingly salient,Zhu said. That makes it even easier for board members to support them, and the perception that the arguments are shared by others grows.

At the same time, members tend to think that others support the prevailing argument (say, paying a high premium) because they are confident that paying a high premium is best. Yet in reality, a member may voice support for a high premium just because he doesn't want to express a dissenting opinion.

So once the board members meet to discuss the acquisition, the minority opinion tends to be muted and the majority opinion is amplified. That leads boards to approve acquisition premiums that are even more extreme than individual members favored before meeting.

Measuring the implications

The implications of that polarization -- toward either higher or lower-than-average premiums previously experienced by board members -- are significant. According to Zhu, "In an average-sized acquisition directors with the average level of prior premium experience will pay $24 million more than the price that they would pay without group discussions."

"The question when a board overpaid in an acquisition is 'Could they have paid less and still closed the deal?'" Zhu can't answer that question, but he does say that closing the deal itself should not be the whole purpose and there is evidence that high premiums are problematic. "There is evidence that high premiums are not good for the shareholders of the acquiring company, though they are good for the target company's shareholders," Zhu said.

Lower-than-average premiums can have important consequences, too -- including the failure of the acquisition. "Low premiums are problematic when a company's executives and board members regret not offering a higher premium if they weren't able to acquire a valuable target," Zhu said.

Mitigating group polarization

According to Zhu, board leaders and corporate executives can proactively address decision-making bias on their boards. He found that a number of factors might mitigate group polarization; one is the acquisition experience of the directors who support the minority position.

"The expertise of the minority can grant their arguments more credibility, making arguments that challenge the prevailing position especially salient, and reducing the dominance of arguments that support the majority's position," Zhu writes. In fact, on boards where the minority has much more experience with acquisition decisions than the majority, group polarization can be muted.

A second mitigating factor is the homogeneity of the board, especially in terms of board members' backgrounds. "When board members have common backgrounds," Zhu said, "they share a common vocabulary, which makes members trust each other more and feel more comfortable speaking up for a minority opinion."

Yet Zhu admits that homogeneity on corporate boards is not always positive. "Certainly we hear, 'Boards need to be diverse,' but diversity on a corporate board is really a two-edged sword. If the group can't fully utilize its members' diverse knowledge -- because information exchange is impeded by a lack of shared 'culture' -- then board diversity isn't helpful."

Ultimately, it's a lack of open communication and mutual trust that leads to decision-making biases. Yet social cohesion, which fosters the kind of mutual trust and open communication that good decision-making desperately needs, is not typically at a very high level on America's corporate boards. According to Zhu, board members, on average, rank their relationships with fellow members above the level of acquaintance but below the level of friendship.

"It's really important for executives and board leaders to encourage open communications and build up mutual trust and social cohesion in order to reduce group polarization," Zhu said. "If they care about improving decision quality, CEOs and board leaders should encourage members to share their diverse opinions."

The first step is simply understanding that group polarization exists and that it comes from a bias in group information exchange and processing. "When I conducted interviews with these Fortune 500 board members, few had heard of group polarization," Zhu said. "Decision makers need to be aware that it exists, so they can take steps to counteract it."

Zhu's findings about the causes of group polarization could be applied to other areas of board decision-making -- from diversification strategies to CEO compensation. They could be applied outside the boardroom, as well -- to decision dynamics among jurors and in online chat rooms, for example, or in civic or religious governing organizations.

Wherever the discussion, whatever the decision, Zhu's research makes clear that fundamental biases in a group's information exchange and processing can lead to group polarization. His research also makes clear that an organization's leaders can do something about it.

Bottom Line:

  • Acquisition premiums are typical, as is board members' reliance on past experience to inform their position on current acquisitions. Yet W. P. Carey Assistant Professor of Management David H. Zhu found that approved acquisition premiums were even higher (or lower) than the board members favored before they met to discuss the acquisition as a group.
  • According to Zhu, "Biases in group information exchange and processing caused directors to systematically amplify their average prior premium experience in board decision-making processes." The phenomenon is called group polarization.
  • Group polarization is the result of a decision-making bias that skews information exchange and processing during board discussions. One aspect of that bias is the muting of minority opinions. Another is the amplification of prevailing arguments.
  • A number of factors might mitigate group polarization. One is the acquisition experience of the directors who support the minority position. Another is the homogeneity of the board, especially in terms of board members' backgrounds.
  • Ultimately, it's a lack of open communication and mutual trust that leads to decision-making biases. According to Zhu, "It's really important for executives and board leaders to encourage open communications and build up mutual trust and social cohesion in order to reduce group polarization."