The Most Common Cognitive Biases In Life Sciences M&A

These common examples of narrow thinking can prevent decision-makers from coming up with more than one solution to a particular problem.

Base rate neglect

The base rate is a prediction based on prior data and probabilities, absent of information specific to a particular case. In transactions, the base rate is the likelihood that a transaction will close without considering the perceived probability of the specific transaction in mind. Statistical facts seldom come into consideration in decision-making. Instead, management tends to make big decisions based on little or no information and leap from little information to big conclusions. In our experience, management will almost always neglect to take the base rate into account and, as such, decisions are exposed to additional risk to closing. Base rates should be dominant in management’s thinking and their beliefs should be constrained by the logic of probability.

Fallacy of small numbers

A simple statistical reality is that large samples are more precise than small samples, and small samples yield extreme results more often than do large samples. Frequently, samples are too small to make any inference, but management is prone to jump to conclusions that have no bearing in reality. Executives often experience substantial difficulty adopting a statistical point of view and tend to imagine a causal connection between events. Given the central component of clinical data in life sciences transactions, management needs to engage in appropriate statistical reasoning and avoid falling into the trap of small numbers, thereby overvaluing, for example, Phase II clinical data of a small patient population. Similarly, when a transaction takes place at a particularly high valuation, it is important to acknowledge that it is likely an outlier, with little or no ramification on a particular company in the sector.

Narrative fallacy

Good stories provide a simple and coherent account of people’s actions and intentions. Narrative fallacies arise from our ever-present attempt to make sense of the world. Explanatory stories that people find compelling are simple and concrete, but assign a larger role to talent, planning, rationality and intentions while neglecting the contribution of random luck, happenstance or serendipity. These stories focus on the few known events that happened, rather than on the countless events that did not happen but could have caused a different outcome. In M&A transactions, however, reality emerges from the interaction of multiple agents and forces, random luck tends to play a role and the world is far less coherent and predictable than we would like to believe. As such, management is prone to overestimate the predictability of closing and fall victim into an illusion of understanding. It is thus wise to admit uncertainty, create multiple alternatives and address the downside risk of not completing a transaction.

Optimism and overconfidence

The role of hubris and overconfidence in decision-making has been extensively researched. Unrealistic optimism is rampant in the life sciences as this industry selects for inherently optimistic innovators and entrepreneurs. The base rate five-year survival of small business in the US is 35%, but over 80% of entrepreneurs put the odds of success of their venture at 70% or higher. Thirty-three percent of entrepreneurs say their chance of failing is zero – a statistical impossibility. Executives often make decisions based on delusional optimism rather than rational weighing of gains, losses and probabilities. They tend to overestimate potential synergies and underestimate risk associated with the transaction. Unfortunately, the evidence counts for little in comparison to unrestrained confidence. The confidence that management has in their beliefs depends on the narrative they tell about what they see, even if they see very little. Executives often fail to allow for the possibility that the evidence that should be critical to their judgment is often missing. Inadequate appreciation of the environment inevitably leads to CEOs taking risks that they should avoid. The lesson here is that errors of predication are inevitable because the world is unpredictable. As Charles Darwin succinctly said: “Ignorance more frequently begets confidence than does knowledge.” Thus, high subjective confidence should be treated with suspicion.

Illusion of control

Illusions of control are common even in purely chance situations. It is the phenomenon in which people overestimate their ability to control events and outcomes that they demonstrably have no influence over. Most of the founders and entrepreneurs that we encounter are convinced that the outcome of their company’s efforts is largely dependent upon their actions. They tend to be oblivious to the fact that outcomes depend as much on random or external events as on a company’s own efforts. This bias goes hand-in-hand with overconfidence and managerial optimism, all of which tend to have a negative impact on the decision-making process of senior executives in M&A transactions, consequently diminishing the probability of closing.

Confirmation bias

People seek data that are likely to be compatible with the beliefs they currently hold. One tends to see the world through a filter, noticing and looking for information that confirms existing preconceptions and ignoring data or evidence that contradicts them. This bias favors uncritical acceptance of improbable events, leading executives to fit the evidence to the theory rather than vice versa. They neglect data right under their nose, thereby distorting active pursuit of hard evidence and judgment. This bias transpires persistently and is a major obstacle in M&A transactions. One of many examples is when CEOs readily reject a buyer’s point of view pertaining to valuations supported by various market-driven methodologies, such as comparable transactions, trading multiples and discounted cash-flow analysis, the latter of which is invariably a source of endless debate.

Availability bias

Decision-makers rely on knowledge that is readily available, rather than taking the effort to examine other alternatives. It is the process of judging frequency by the ease with which instances come to mind. Executives tend to take into account whatever facts they know, while neglecting facts they do not know. CEOs must make the effort to reconsider their beliefs and intuition by asking themselves whether their estimated valuation is supported by a broad benchmark well beyond their immediate knowledge base. This bias often coincides with both the fallacy of small numbers and overconfidence, leaving executives underprepared for M&A decisions.

Affect

A consistent misconception is that M&A transactions consist of a formal process where companies have a set of well-defined acquisition objectives derived from an umbrella corporate strategy, and that buyers and sellers will evaluate the target companies based on a detailed quantitative analysis toward a rational decision, devoid of emotion, sentiment or self-interest. However, we often observe that executive decision-making is often irrational and driven by intuition, gut and instinct. This dominance of conclusions over arguments is most pronounced when emotions are involved. When people are favorably disposed toward a technology, a given for a sell-side life sciences CEOs, they rate it as offering large benefits and imposing little risk, which in turn, will fuel their overconfidence as to the successful outcome of M&A efforts.

Endowment effect

People ascribe more value to things merely because they own them. This is illustrated in a valuation paradigm where people will tend to pay more to retain something they own than to obtain something they do not own – even when there is no cause for attachment. The endowment effect violates standard economic theory, which asserts that a person's willingness to pay for a good should be equal to their willingness to accept compensation to be deprived of the good. This bias is apparent in M&A transactions where, by definition, sellers invariably overvalue their company (and buyers undervalue), regardless of objective data that points to the contrary.

Anchoring

People are typically over-influenced by a starting value, and their estimate stays close to the number initially presented although they do adjust that number to reflect new information or circumstances. Typically, however, those adjustments are insufficient relative to the initial number, thereby leading to an anchoring bias. Anchoring biases are most evident with respect to valuation and pricing of M&A transactions, particularly when buyers present a first offer, a negotiation advantage. Management should thus assume that any offered number has an anchoring effect and should mobilize to combat that effect by presenting arguments against the anchor.

Sunk-cost fallacy

A rational decision-maker is interested in the future returns of current investments. Justifying earlier mistakes or non-value-added activities is irrelevant. The sunk-cost fallacy in M&A transaction comes into play when venture board members insist on valuations that reflect their overall investments in the company. In many instances, common in the life sciences sector, past investments in endeavors that did not materialize and failed to create value are irrelevant. The continued commitment of resources to a failing project is a mistake and so is the expectation to garner value from a buyer.