The New Deal: Negotiauctions
|Guhan Subramanian is the H. Douglas Weaver Professor of Business Law at Harvard Business School and the Joseph Flom Professor of Law and Business at the Harvard Law School|
You've held your own while negotiating dozens of successful deals. Even so, you want to take your game to the next level. What's the next step?
There are plenty of guides that offer tips on negotiation strategies. As useful as these are for a grounding in the fundamentals, they don't always fit the complex, ever-changing deal situations that occur in today's business environment. Harvard Business School professor Guhan Subramanian fills that gap by examining complex deals where negotiators are fighting on multiple fronts—across the table for sure, but also on the same side of the table with known, unknown, and potential competitors.
In February 2010, Subramanian will publish Negotiauctions: New Dealmaking Strategies for a Competitive Marketplace, a book that draws on his experience studying and advising on complex corporate transactions and high-stakes personal transactions such as buying a home or car. The first Harvard faculty member to hold tenured appointments at both Harvard Business School and Harvard Law School, Subramanian is the faculty chair for the new HBS Executive Education course Managing Negotiators and the Deal Process (November 8−13, 2009).
Julia Hanna: Talk a little about what you mean by "negotiauctions."
Guhan Subramanian: If you put aside fixed-price mechanisms, such as buying lettuce at the grocery store, negotiations and auctions are the only two ways in which assets get sold in any market economy. There's a deep literature on each of these mechanisms but very little on the interplay between the two—that messy, murky middle ground where most deals happen in today's world. The term itself, negotiauction, is just a term—you can take it or leave it. But the phenomenon of across-the-table competition, as exists in a negotiation, and also same-side-of- the-table competition, as exists in an auction, is pretty ubiquitous in our increasingly competitive marketplace.
Q: How did you come to this insight?
A: Back in 2001, I wanted to test some theoretical predictions about negotiations versus auctions. At the time I was co-course head for the first-year required course on Negotiation at HBS, so I designed an elaborate experiment that used all 900 first-year MBAs as my subjects.
Each team of three to four students was given four assets to sell to classmates, and I constrained the deal process so that they would have to either auction or negotiate. But despite my efforts to keep the two mechanisms pure, auctions regularly devolved into private negotiations with the top two or three buyers, and negotiations regularly culminated with the seller going from buyer to buyer extracting successively higher prices. The students adhered to the letter of my rules, but the auctions looked a lot like negotiations, and the negotiations looked a lot like auctions.
At around the same time, I started teaching a course called Deal Setup, Design & Implementation, first at the Law School and then across HLS and HBS with my HBS colleague Jim Sebenius. In each class, we studied a different real-world deal in considerable detail, and brought in a practitioner who was centrally involved to comment on our analysis. Over five years of teaching the course, I realized that what I was seeing in my experiment back in 2001 wasn't just an artifact of the classroom setting. Many high-stakes negotiations have significant auction elements to them, and many auctions have important negotiation elements.
So my thinking started to change. Rather than trying to shoehorn the world into these separate buckets, why not think about the proper buckets that would be useful in analyzing what I was seeing?
Q: What are some of the defining characteristics of a negotiauction?
A: An example might help illustrate what I'm talking about. Imagine that you are looking to replace the fence around your backyard, as my wife and I were a couple of years ago. What do you do? You talk to several fence contractors, and you get bids from a few who you think would do a reasonable job. Then you might go back and forth a bit among them to try to get a better price. So it's a negotiauction.
One defining feature is that there are only a few "process takers" (the fence contractors, in my example). If there are more than three to five process takers, it's hard to have meaningful negotiations with each, and it starts to look more like a full-blown auction.
Another defining feature is that there are multiple interests—in the fence example, price is important but so are quality and timeliness. A third feature of a negotiauction, and maybe the most important, is that the process is unclear. Are you going to go back and forth five times among the contractors to get the best possible price? Or does each contractor get just one chance to put a best offer on the table?
In a typical auction, like what you might see at Christie's or Sotheby's, the rules are very precise. But in a negotiauction, the rules are never perfectly pinned down, which creates both opportunities and challenges. Sophisticated dealmakers are able to take advantage of the ambiguity to shape the game to their advantage.
Q: How do sophisticated dealmakers shape the game to their advantage in negotiauction situations?
A: What's interesting to me is that when you look across hundreds of negotiauction situations—across industries, across countries, across cultures—you start to see common patterns.
In my analysis I find that there are three kinds of moves that repeatedly appear: set-up moves, which establish terms of entry into a negotiauction situation; rearranging moves, which reconfigure the assets or the parties or both; and shut-down moves, which prematurely cut off same-side-of-the-table competition.
When I was a consultant at McKinsey in the early 1990s, we used the term MECE—"mutually exclusive and collectively exhaustive." Is our framework for thinking about a problem MECE? The taxonomy of set-up moves, rearranging moves, and shut-down moves is a MECE framework. It's a helpful roadmap that tells you where to look to shape the game to your advantage.
Q: In what situations is your framework useful?
A: Most of my technical and academic writing over the past decade has focused on mergers and acquisitions, which are typically negotiauction situations. But one of the main messages in the book is that the deal strategies and structures that have developed in M&A are applicable to virtually all high-stakes, complex deals.
Take buying a house, which for many people is the most important transaction in their lives. In the United States, a house purchase is a very "tight" deal—once the seller commits to a particular buyer, the seller can't (legally) sell the house to someone else, even if the person offers a substantially higher price. In many cases, that's the right deal structure, because the buyer needs certainty in order to arrange the financing, prepare for the move, etc. But in some cases both the buyer and the seller might prefer a "looser" deal—for example, a deal in which the seller can back out at any time between the signing and the closing by paying the buyer a "breakup fee," which might compensate the buyer for out-of-pocket expenses. The seller gets the ability to shop around. The buyer might not mind renting for another year, or buying the house down the street instead, particularly if he gets a big breakup fee out of it.
If all this sounds too crazy to work, it's actually the default in the British system. In the United Kingdom, the seller has the right to sell the house to someone else up to the moment of closing. So it's an incredibly "loose" deal, in which the buyer engages in a mad dash from signing to closing in order to avoid getting "jumped." The British even have a term when someone else jumps your deal—it's called "gazumping." You can even buy gazumping insurance against getting gazumped.
The point isn't that the UK system is better—in fact, gazumping can wreak havoc on people's lives. But the point is that deal protection, which is a kind of shut-down move, should be a highly negotiated point in the U.S. housing market, but it's not. In the book I offer some explanations for why, ranging from "boilerplate" to the agents' incentives to just lack of creative thinking and willingness to push the boundaries of what's done. One of the goals of the book is to put these kinds of moves on the table for people to consider.
Q: In your opinion what's changing about the dealmaking world today?
A: Well, one of the benefits, if you want to call it that, of a downturn in the economy is that people start challenging the conventional way of doing things. So I think my book might be timely in the sense that dealmakers today are generally receptive to new and creative ways of thinking about the deal process.
To go back to the example I offered a minute ago, I'm slowly beginning to hear about more creative deal structures in the residential real-estate market. Take a seller who believes that he can get $1 million for his house, but a buyer who is only willing to pay $800,000. The typical approach to this impasse would be to split the difference or the parties walk away. But I'm now hearing about loose deals—for example, $850,000, but the seller has the right to walk away between signing and closing by paying the buyer $25,000. Basically the buyer is betting that $850,000 is the best that the seller can get; but the seller, who believes otherwise, gets the chance to test whether he is right.
Another thing that's changing in the dealmaking world today is increasing price pressure, which often manifests itself through auction-like mechanisms. The subtitle of my book, New Dealmaking Strategies for a Competitive Marketplace, is a reference to this phenomenon. Companies are telling their marketing managers, "Get your advertising spend down by 20 percent over the next 12 months," and so the marketing manager then puts pressure on the advertising agency to lower its fees, sometimes with a threat of putting the business "out to bid." Yet there are opportunities to shape the process that could give both sides a better outcome than a put-out-the-gavel auction in which the price goes down but quality is lost due to a lower head count on a project, for example.
The current economic crisis is putting a lot of pressure on cost reduction—and that's certainly important—but there are often other factors in the mix. If you focus solely on one metric, like price, you're potentially causing long-term problems. Something can be worked out in a more fluid process that isn't captured in a pure auction. The negotiauction approach is a more nuanced mechanism that can result in a better outcome for both parties.
The recent back-and-forth on the deployment of the TARP [Troubled Asset Relief Program] illustrates how even very sophisticated parties can get it wrong in terms of deal process design. Back in October 2008, when the EESA [Emergency Economic Stabilization Act] was passed by Congress, the Treasury Department intended to buy back the so-called toxic assets through a reverse auction mechanism. The idea was that Treasury would specify a class of asset that it was willing to buy, and then the banks that held that class of asset would bid the price down in an effort to sell their toxic assets back to the government. Auctions work great when the Treasury Department is trying to sell U.S. Treasuries, and maybe that's where the idea came from.
But the problem is that the toxic assets are incredibly heterogeneous, even within an asset class, unlike U.S. Treasuries, which are homogeneous. The result would have been a huge adverse selection problem, to the detriment of the U.S. taxpayer. Luckily, Treasury officials eventually realized this and backed away from the idea. But the case study illustrates how deal process design matters a lot, and has to be thought through very carefully. Currently, Treasury officials are trying to design a mechanism for selling TARP warrants—the securities that the troubled banks gave to the government in exchange for TARP funding. It's going to be a $120 billion auction over the next few months. Hopefully, we will get it right the first time around in this auction.
Q: What spurred your interest in this area?
A: When I was a JD/MBA student at Harvard back in the mid-1990s, I wrote a case study about the Conrail-CSX-Norfolk Southern deal that was happening around then. To understand the case better, I wrote a letter to Bruce Wasserstein (HBS MBA 1971), who at that time was running Wasserstein Perella in New York City and who was advising CSX in the deal. I asked if I could come down to New York and interview him, and he graciously agreed, spending 90 minutes talking with me about the deal and about dealmaking more generally.
I learned a tremendous amount from that conversation, and it certainly fueled my interest in understanding corporate dealmaking from an academic perspective. I began to recognize that sophisticated dealmakers play the game at a different level—like a chess game instead of trying to scream and yell louder than others in the room. Rather than a frontal assault, sophisticated dealmakers engage in a carefully thought-through sequencing strategy: get all the pieces lined up, to the point where when you go in the room, it's basically a done deal.
[This article has been reproduced with permission from Harvard Business School Working Knowledge, the online research journal of University of Harvard Business School http://hbswk.hbs.edu/.]
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