“Be careful what you wish for”…sound advice for any situation, especially in business.
Case in point: our firm was recently asked to assist in the auction of a notable music publishing catalog. The auction ran like most others – bidders were given a period of time for due diligence, which included reviewing the catalog’s financial performance.
While our client, the seller, was pleased with the financial outcome, something fascinating occurred.
The winning bidder did what you or I might do in a similar situation, especially if we really wanted the asset being auctioned: he outbid the nearest competition by close to ten percent.
But the winner’s victory dance was short-lived due to a phenomenon in game theory known as the winner’s curse. This occurs when a winner’s bid exceeds the intrinsic value of the asset purchased.
Think of it as a type of buyer’s remorse, but on steroids.
How did this happen, especially when the winning bidder had scores of executives, lawyers and accountants pouring over the asset prior to the auction?
There are two key reasons for succumbing to the winner’s curse: first, there’s always going to be a level of incomplete information, especially in auctions. In this case, the value of exploiting the catalog’s songs over time is, at best, an informed guess; and second, emotions can run high, especially in ultra-competitive situations where revenues, and egos, are on the line.
During our auction, both of these factors served to cloud the ability of the winning bidder to determine the catalog’s true intrinsic value. Not only did the winner’s curse reveal a flaw in the winner’s approach to auctions, but it provides a framework for us to understand why winning is not always the best outcome, and in this particular case, it would likely prove an unprofitable one.
Adverse Selection, a Song Sung Blue
Music catalog sales often operate as common value auctions. The rights to the music contained in the catalog have a common value to all of the bidders, which is equal to the current revenue its commercial exploitation generates. However, bidders will also estimate future earnings and do so differently, depending on what strategies they employ to exploit songs. Perhaps these songs will be featured in an upcoming movie or part of a Coca-Cola or Apple media campaign.
In our case, each bidder interpreted the available information in their own particular way, but not a single bidder had all of the information to know for sure how much money the rights to the catalog would eventually earn. After all, the appeal of songs is fickle at best, especially over the long run.
Moreover, competition for this catalog was fierce. It included a number of chart-topping songs, which attracted over a dozen bidders including music publishers and venture capital firms.
In the end, the winner forked over an amount other bidders likely thought preposterous. His overly inflated notion of projected returns from the exploitation of the catalog represented a form of valuation Viagra, which he used to justify such an excessive premium. Even though he won the catalog, he ended up overpaying for it.
Clearly the market (the other bidders) didn’t see the value of this catalog at his price. So his win proved too costly. If he were a more rational bidder, he would have anticipated this adverse selection, so that even though his information would still have been overly optimistic when he won, he wouldn’t have paid so much on average.
Getting a Hit, Shading your Bid
To avoid this type of mistake, make a more accurate assessment of an asset’s value and have the discipline not to bid more than that value. This requires establishing a walk-away price before making a bid. One way to accomplish this is to shade your bids. This means setting your opening bid at a fraction of your walk-away price based on competitive considerations. This will help account for the risk of overpaying.
Whether you are purchasing a music catalog, a new house, paid search on Google, or bidding on players in your Fantasy Baseball league, auctions can be profitable and fun. But the phenomenon of the winner’s curse can ensure that sometimes winning comes at too high a price.
So if you are not careful, you may get exactly what you wish (bid) for.