Definition - What does Winner's Curse mean?
Winner's curse refers to when one participates in an auction for the purchase of a business and he/she tends to overpay if the winner. The winning bid exceeds the value of the auctioned asset and, in absolute terms, the winner is worse off. The value of the asset is less than that anticipated by the bidder, so the bidder may have won the auction but will still be worse off than anticipated.
Divestopedia explains Winner's Curse
The severity of the winner's curse increases with the number of bidders. The winner's curse can be experienced by both financial or strategic buyers. Each potential buyer in an auction will individually estimate the value of the firm before bidding. Buyers, in effect, are pre-paying for uncertain future revenues and cost synergies. In an urge to beat competing bidders, the winners tend to overpay. This overpayment is known as winner's curse or hubris.
The level of goodwill is a crude measure of the loss incurred. In an effort to grow their firms, competitive and overly confident managers with high compensation packages make rash decisions. Therefore, firms must exercise caution to not join in on the bandwagon without strategic purpose and a clear road map for integration.
The most common reasons for destruction of value are overestimation of a target firm’s growth/market potential, overestimation of cost/revenue synergies, or failure of integration of the two firms.
To avoid this winner's curse, buyers must perform comprehensive due diligence and establish walk-away prices that they are willing to stick to in the heat of an auction process.