Information Cascades cause all kinds of problems. Even when every participant acts rationally on his or her own behalf, they very frequently result in socially unfavorable outcomes. However, if a participant is able to recognize the existence of a cascade, acknowledges that it may lead to an unfavorable outcome, and blindly follows suit anyway, is he or she still acting rationally?

A private equity professional, in his blog Going Private, argues that such a participant isn’t acting rationally if he chooses to fall into a financial cascade. In his post entitled “Cascades are a Poor Excuse for Stupidity,” this investor claims that stock trending is a direct result of information cascades. Traders that see a stock prices climbing believe that the market knows more than they do, and so buy without any rational basis for doing so. This leads to a vicious buying cycle, and results in a stock price far higher than any individual’s valuation. Furthermore, the author contends that negative information cascades are used as an excuse for market collapses. Market experts try to reason how such a horrible outcome might have arisen through rationality, when in fact, the collapse was caused by collective irrationality. By the author’s logic, investors should have recognized the existence of a cascade, and taken the opposite positions in their portfolios.

This author’s logic can be applied to another area of finance: mergers and acquisitions. When one company decides to buy another, it submits a bid that, if accepted, results in a mutually beneficial outcome for both parties. The acquisition target is paid more than its shares are currently worth, and the buyer gains from the various synergies with the target. This system works quite well with a single bidder, but becomes distinctly more complicated when other bidders decide to enter their own bids.

If bids were entered using a sealed-bid second-price auction, all bidders would submit their true values, and the target would be awarded to the highest bidder at the second-highest bid. However, acquisition targets are smarter than that. In reality, the auction much more closely resembles an ascending-bid first-price auction, for the sole reason that the target may benefit from the bidders’ collective irrational exuberance. The reason this type of auction works better in this case is simple—bidders’ true values are somewhat dependent on other bidders’ valuations, since it is difficult to put an actual price on the target company. The value depends on both a common component (the company’s estimated value), and a private component (the estimated synergies to any particular company). Although the value of neither component is easily assessed, it is the common component that causes a cascade, and hence a bidding war, to occur.

In an ascending bid auction, participants should bid up to a price that is somewhat less than their actual valuations. The actual valuations, in this case, should be the company’s intrinsic value plus the net present value of the estimated synergies gained through the acquisition. However, bidding wars often cause bidding companies to (perhaps irrationally) bid more than this value, resulting in an unfavorable outcome for the winning bidder. This happens because as each bidder gets outbid, it perceives that the other bidders have higher valuations for the target company than it does. This bidder reasons that its financial model may have been flawed, and the company is actually worth more than it had originally thought. This bidding company may then submit a higher bid, ignoring its own financial model. This is the beginning of a cascade.

For example, let’s say that four bidders are bidding on one company. Bidder A, through its calculations, believes the company to be worth $8 million, and the NPV of its synergies with the target to be $2 million. Therefore, it should bid up to some value less than $10 million. Lets say that A bids first, at a price of $8 million for the target. However, he is outbid by B ($9 million), who is then outbid by C ($10 million), who is finally outbid by D ($11 illion). It is not rational for bidder A to make another bid, since he can only be made him worse off by doing so. However, seeing three signals from the other companies may outweigh Bidder A’s own signal, and so Bidder A submits a higher bid. Bidder B is faced with the same dilemma. He too may decide that the three external signals outweigh his own, and decides to outbid A. The resulting cascade may continue for some time, pushing up the target company’s sale price.

But is such behavior rational? Both students of finance and the author of Going Private would undoubtedly say it isn’t. If all of the bidders got together, shared their models, and discussed their actual valuations for the target company, they would find that they were being too optimistic. Each bidder would realize that it only continued to bid because it thought the other bidders placed a higher value on the target. The only real winner, in this case, is the target company, who sold its shares for more than they were worth. This is the reason acquisition targets often try to spur a bidding war, and why the stock price of an acquisition target jumps when a second bidder submits a bid. It is also probably safe to say that cascades are one of the main reasons for exorbitant acquisition prices, and are hence indirectly why acquisitions so often fail to create value for their parent companies.