M&A and Management Due Diligence: Lessons from NBA Draft Picks

Back in 2007, the Houston Rockets were testing a mathematical model to assess potential draft picks. That year, the model favored a young player named Marc Gasol, a seven-foot-one center. As it happened, a shirtless photo of Marc circulated amongst the Rockets scouts. The photo revealed Marc’s pudgy torso and earned him the nickname “Man Boobs”. The scouts’ ridicule of Marc and his “Man Boobs” was pervasive, and eclipsed the model’s positive outlook about his potential. Team manager, Daryl Morey, who had developed the mathematical model, decided not to fight the scouts and Gasol went to The LA Lakers on the 48th draft pick. In 2008, Gasol was traded to the Grizzlies and has since been a three-time NBA All-Star, as well as winning the 2013 NBA Defensive Player of the Year Award. This and other incidents, including one involving the Chinese American shooting guard Jeremy Lin, who became a star after the Rockets (and most of the NBA) passed, led Morey to conclude that human judgment was heavily skewed by preconceptions[1].

The Science of Skewed Judgment

Morey’s view is validated by the findings of two renowned (in academic circles) Israeli psychologists, Danny Kahneman and Amos Tversky[2], whose ground-breaking work included revelations about how cognitive biases skew human judgment. What Morey observed in the NBA draft picks, where scouts made judgments and predictions based on preconceived notions of what they saw as a good basketball player, Kahneman observed in the selection process for Israeli army officers.  While working in the army, Kahneman saw judgments and predictions that were based on preconceptions about what a “good officer” looked like.  Often, however, the outcome did not align with the prediction. Ultimately, Kahneman and Tversky’s work led them to conclude that we humans rely on a limited number of decision-making tools which allow us to process information.  Unfortunately, those tools, with their intrinsic cognitive biases, can lead to “severe and systematic error”.[3]

But what does any of this have to do with M&A and management due diligence?

Descriptions of the current M&A environment often feel like clichés: ubiquitous statements about heightened competition for quality targets, sky-high valuations, and all that dry powder. But that’s the way it is, now and for the foreseeable future.  So it’s critical that buyers know what they’re buying (rigorous due diligence matters more than ever) and maximize the value of their acquisitions.

A recent study by Kilberry, a Toronto-based leadership advisory firm, reveals that private equity (PE) investors believe management team capability makes a significant contribution to the success of an acquisition, ranking closely with operating model/fundamentals and product/service offering. But while firms do rigorous due diligence on the latter two factors, for example, by bringing in a top accounting firm to do a quality of earnings report, management due diligence tends to be treated less formally. Of the firms surveyed by Kilberry, 28% did not do an external assessment of target management, relying instead on more casual evaluation methods.

Dr. Richard Davis, a management psychologist and CEO of Kilberry, suggests that utilizing a scientific assessment of management mitigates the likelihood that human bias will skew the diligence process:

“There is substantial evidence that we have a really poor ability to understand ourselves and our own biases,” Dr. Davis says. “We have anchored in our mind what ‘good’ looks like, and we evaluate people based on that anchor. But when a buyer is assessing a management team, there shouldn’t be a fixed idea of ‘good’, as different growth strategies will require different attributes.”

Dr. Davis also points out that, as management diligence can occur well into the deal process, an external assessment can help manage the effects of “emotional interference” or attachment to a deal. He analogizes this to buying a house, where a prospective buyer sees lots of options and takes plenty of time to check off his or her requirements. After going through all the work and finally making an offer, that buyer may overvalue the positive attributes about the house and underplay the flaws. “The external assessment is like the home inspection,” he says.

Kahneman and Tversky would likely agree with Richard Davis. Through the course of their work, they established that people allow stereotypes to skew their judgment. Well-educated individuals or experts in their field were not exempt – the pair found that this tendency applied to individuals ranging from teenagers to professors.

Given the evident flaws in human judgment, and considering current valuations and the vital role that a target management team plays in contributing to an acquisition’s success, there is good reason for prospective buyers to consider a more scientific and rigorous approach to management due diligence. Just remember, if the Houston Rockets had stuck with this approach back in 2007, they might have scored themselves a three-time NBA All-Star!

Further Reading

For more on the role of human biases in M&A, check out the recent report: M&A Valuation: Trends, Challenges and Horror Stories.

[1] I have borrowed these basketball anecdotes from Michael Lewis’s most recent book, The Undoing Project: A Friendship That Changed Our Minds.

[2] In 2002, Danny Kahneman was awarded a Nobel prize for the groundbreaking work that he did with Amos Tversky, who died in 1996 (and was thus precluded from receiving a Nobel prize).

[3] D. Kahneman and A. Tversky, Judgment under Uncertainty: Heuristics and Biases (1974).

Karen Fisman

Karen Fisman is a freelance writer, covering finance and deal-making with a focus on Canada. Her current assignments are with FirePower Capital, an independent Canadian investment bank and private capital firm, and with a finance-focused content marketing firm.  She was previously the publications lead at a Toronto-based M&A advisory firm, and has years of experience as an equities analyst covering the media and entertainment sector. Karen has an LLB from the University of Toronto and an MBA from the Rotman School of Business.