A New Era for Mergers and Acquisitions
By Robert McGarvey, Founder & Director of Strategic Performance
Mergers and Acquisitions, are they about to get more complicated?
Sir David Tweedie, Chair of the International Accounting Standards Board ("IASB"), is preparing to throw a regulatory 'spanner' into the international mergers and acquisition ("M&A") works. He and his team, toiling away quietly in their Cannon Street ivory tower are developing new, more rigorous international accounting standards. These new standards, particularly those linked to the recently issued International Financial Reporting Standards '3' ("IFRS 3(1)") , will impact the M&A game significantly by, amongst other things, formalizing the reporting requirements of 'intangible' assets in business combinations. To quote Bernard Kellerman writing in CFO magazine(2): "the effect of international financial reporting standards (IFRS 3) on business combinations - essentially the acquisition of control of one business by another - is fundamentally changing the way intangible assets are recognized, measured and treated..."
What does this have to do with hard-headed M&A activity? Well, everything. Corporate earnings and ultimately all significant corporate value are rooted in 'assets' of one kind or another. According to accounting theory, assets are those resources a company owns (tangible or otherwise) that can be linked to earnings; indeed assets are the very source of corporate earnings, and as a consequence heavily influence corporate share prices, market capitalization etc. So what's the problem? Well according to Simon Delgarno, associate director at Leadenhall Australia, "Intangible assets which would previously never have been capitalized now have to be...this means that Chief Financial Officers (CFO's, and everyone else involved in M&A) are going to have to manage an entirely new class of assets..."
As a rule the M&A process is about the accurate identification/valuation of assets and liabilities, and then (once negotiations and paperwork are completed) transferring or amalgamating those assets (earnings centres) within the new, acquiring or merged company.
The rise of intangible assets is complicating this identification-valuation-amalgamation process considerably. Today acquiring companies and their teams of lawyers, accountants and investment banking partners are faced with an uncomfortable reality, upwards of 70% of the value in modern corporations lies outside the comfortable confines of traditional tangible 'hard' assets(3).
This is quite a change from the recent past. A study conducted by the Stern School of Business at New York University (NYU)(4), comparing the market to book value of 3,500 U.S. companies over a period of two decades shows a dramatic decline in the relative importance of traditional 'tangible' assts (with a corresponding upward rise in intangible asset value). To quote Ben McClure: "In 1978, market value and book value were pretty much matched: book value was 95% of market value. Twenty years on, book value was just 28% of market value."
What are the implications of all this for M&A professionals? Well the rise in value and importance of intangible assets means that the experience, skills and norms that were, until recently, applied to the M&A process need to be supplemented by a suite of new skills, advanced know-how and unfamiliar risk factors associated with intangible assets. It all sounds like more work and a slower deal flow: something deal makers and their investment banking partners are not going to like.
Intangible Assets: International Accounting Standards (IAS 38)
The IASB with the U.S. based Financial Accounting Standards Board ("FASB") are formalizing accounting standards for intangible assets, building on FASB statement 141. International Accounting Standards document #38 ("IAS 38"), the IASB statement on intangible assets, recognizes a variety of intangible assets including many of the familiar forms of intellectual property, patents, copyrighted materials, trade marks, etc. plus a variety of conventional contracted services including marketing rights, franchises, licenses etc. But IAS 38 also identifies a number of unfamiliar customer-equity based assets including customer lists and a variety of critical customer and supplier relationships(5). IAS 38 mandates an enterprise to recognize an intangible asset if three critical criteria are met:(6) (1) the asset must be identifiable, i.e. the intangible asset is separable and has associated legal, contractual rights; (2) control, the controlling entity must demonstrate it has the power to obtain benefits from the asset and; (3) future economic benefits, the assets must have either associated present or future revenues or demonstrably reduce future costs.
The Impact of Intangibles on M&A
It is clear that the full impact of the knowledge asset revolution is only now beginning to make its presence felt in board rooms and in M&A deals. Consider the AOL-Time Warner merger of just a few years ago. America On-Line (AOL), an Internet service provider, merged in 2000 with media giant Time-Warner. At the time of the merger, (January 2001) AOL had a market capitalization of US$164 billion, while the much older and more established Time-Warner had a market capitalization of just over half that value, US$83 billion (which essentially made the deal an AOL acquisition). Much of AOL's market capitalization at the time was comprised of intangible assets, principally its high profile brand asset. AOL's brand asset value rested upon the assumption that customers would continue to find AOL attractive as an Internet service provider, and as a result advertising customers would continue to pay premium prices to advertise with AOL (the two principal sources of AOL's earnings). Unfortunately for shareholders, no one at AOL - Time Warner nor any of their highly paid investment banking advisors had sufficient skill or experience with intangibles to deal with such an unusual situation. As a result AOL's brand asset was never clearly or separately identified and therefore valued properly; consequently no attempt was made to consider what internal or external conditions might impair the AOL brand going forward(7). The events that followed - the collapse of AOL-Time Warner in the immediate aftermath of the merger - were, needless to say, disastrous for shareholders.
It is in response to events such as this that the IASB began developing new more vigorous standards in respect to intangible assets. Dealing with the new requirements will not be easy or simple, but given the growing importance of these assets and the need to protect shareholders and other investors, the accounting profession had to act, the integrity of the financial reporting system itself was at stake.
The new standards will create many difficulties for operating professionals in the M&A field, and will no doubt be resisted at many levels, but... one has to ask, could there be an upside to all this? It is quite possible that intangible assets may hold the key that unlocks one of the great mysteries in M&A activity. Many observers (and not a few shareholders) have been shocked by an imponderable yet observable reality that even as M&A activity has become more sophisticated over the decades with far greater access to data, employing ever more powerful analytical tools, success in mergers and acquisitions continues to be a hit and miss affair, to say the least(8). Perhaps a greater, more fulsome knowledge of the defined assets (both tangible and intangible) being exchanged, and appropriate management of those assets both before and after the 'deal', may go some way to resolving the question of why M&A success has been so difficult to come by in recent decades.
There are a variety of drivers and motivating factors at play in the M&A world. Apart from personal glory (or greed), M&A deals are often driven by many justifiable market-consolidation, expansion or corporate diversification motives. And, of course, ever present as an inspirational force in M&A is the old reliable financial, generally tax related motivation. But whether the deal is a horizontal merger designed to eliminate an unwanted competitor, a vertical merger to integrate the supply chain or indeed any other related motivation, deal makers can be depended upon ultimately to justify the deal based on anticipated 'synergies' of one kind or another. The landscape of M&A is littered with promises of operating synergies (saving from eliminating duplication in a variety of operational functions) or financial synergies (the larger combined entities may, for instance, reasonably expect to reduce their cost of capital). According to M&A specialists at McKinsey's, "these synergies can come from economies of scale and scope, best practice, the sharing of capabilities and opportunities, and, often, the stimulating effect of the combination on the individual companies.(9)"
Unfortunately many of these expected 'synergies' simply do not materialize to the extent anticipated after the 'deal'. Richard Thaler, Professor of Behavioural Science at the University of Chicago has termed this phenomena the 'Winner's Curse', while McKinsey's adds: "Our exploration of postmerger integration efforts points to the main source of the winner's curse: the fact that the average acquirer materially overestimates the synergies a merger will yield(10).
Soft issues left un-addressed
This would seem to beg the obvious question: why do deal makers focus so intently on synergies to justify a merger? To begin answering that question you would probably start by investigating management decision making and the rationale behind that thinking. You would probably not be surprised to find that M&A activity, like most management decision-making these days is driven by the 'numbers'; those apparently hard, quantifiable identifiers that are so easy to read and sit so elegantly on a spreadsheet. The 'numbers' generated by management and their accounting professionals systematize business, with all its vast human complexity, into quantifiable categories, revenues, expenses, gross profits, EBITA(11) etc. all of which helps simplify the hugely complex. When we understand this clearly, the answer to our question is obvious. Despite all the vigorous analysis that goes on in a M&A deal, 'synergies' and all that they imply are the only quantifiable factors that visibly appear in the financial models.
The problem with the 'numbers' is they don't tell the whole story. There are a host of 'soft' issues that are critical to merger success, that because they don't appear on the balance sheet, financial statements (or any of the many equations generated in M&A deals) tend to get lost in the shuffle. According to Ron Elsdon, director of retention services at DBM, a human resource consultancy in New York, "Mergers have an unusually high failure rate, and it's always because of people issues." In a similar vein, John Kelly, head of accounting firm KPMG's Mergers and Acquisitions (M&A) Integration division, suggests that many firms focus too much on the "hard mechanics" of the merger to extract value from an acquisition. Instead managers should concentrate more on "soft" issues like selecting the right management team and resolving cultural misunderstandings(12).
Has the Medium Determined the Message?
Could there be a link between what the IASB is attempting to do with accounting standards and the 'soft' issues that seem to play such a critical role in the success or otherwise of M&A? The answer, of course, is yes. The 'soft' issues identified by so many practitioners in the merger integration field are precisely the areas of intangible asset potential that IFRS 3 (and its successors) is insisting need greater attention and more precise definition. Unfortunately there is a big problem, modern management practices, rooted in traditional accounting customs, continue (despite guidance from FASB and other national accounting standards bodies) to underestimate or ignore this 'intangible' asset potential(13). Amongst the many 'invisible' assets to most organizations today are almost all internally generated forms of human capital, organizational know-how of employees, customer equity in the form of brand assets, as well as R&D and the more formalized intellectual assets, including copyrighted software, patents, trademarks etc. All are generally excluded from the balance sheet and/or treated like expense items on the financial statements. Its little wonder that 'soft' issues are a problem in M&A, they do not appear on the management radar screen. In this sense the paradigm - the accounting based 'financial' theory of management - has itself become a serious detriment to meeting the requirements of IFRS 3 and ultimately improving the success of M&A's.
Managing to a Balanced Asset Strategy
Companies involved in M&A have long histories of scrambling to meet synergy targets by hastily laying off head-office personnel and other staff as part of their restructuring plan; as a result many lose not only experienced staff but customers as well. So widespread is this 'scramble for synergies' in M&A that it breeds a kind of complacency and cynicism in precisely the areas of the business where trust is most needed in a period of transformation.
Consider a classic example in the customer industry, the Hewlett Packard (HP) - Compaq merger. This merger got off to a bad start in 2001 as a result of mismanagement of the organization's human capital. One thing can be said for mergers in the high tech field - employees will read the prospectus and do their own research. And while HP and Compaq staff heard management proclaim publicly that "our people are our greatest strength" they could also do the hard math. They all knew that the combined HP-Compaq would have to rid itself of approximately 15,000 employees in order to achieve the expected 'synergies'(14). Needless to say morale in the high tech firm collapsed post merger. As for the HP and Compaq customers, they voted with their feet. HP had always been known for its technical competency, and particularly for the reliability of its technical 'road maps' which played a key role building customer confidence and loyalty. After the merger the company struggled to find its direction, the 'road maps' lost credibility and it was no surprise to insiders when, on the first anniversary of the merger, arch competitor Dell surged to number one in the industry, surpassing HP-Compaq in key areas. As a result it is only now, five years and a new CEO later that the HP share price has recovered to its pre-merger values. Much of this damage might have been avoided if HP management had balanced its asset priorities, focusing their merger strategy on growth opportunities rooted in best use of the combined assets, as opposed to forging ahead with damaging and largely unachievable cost 'synergies'.
Programming for Success
The knowledge asset revolution today is simply overwhelming older standards, norms and systems. The accounting based 'financial' theory of management was ideally suited to an 'industrial' economy, where assets were predictable and predominately tangible. Despite a long history and sound pedigree, these traditional management tools have several structural limitations in an evolving knowledge economy. Because of how it formulates and presents financial data, the traditional accounting based system ignores the new classes of assets and focuses management's attention too intensely on cash flow, tax considerations and (shorter term) return on investment (ROI) priorities, as opposed to the longer term best use of, and return on, corporate assets (ROA).
The reasons for building competencies in identifying, valuing and managing intangible assets speak for themselves, but certainly the new IASB reporting requirements(15) will set a new, higher, standard of competency. Many M&A specialists will - no doubt - continue closing their eyes to intangible assets, lumbering them indiscriminately into goodwill (no doubt justifying it all with tax benefits). Increasingly, however, investors will demand that management at least be able to answer simple straightforward questions such as: "Exactly what assets are we buying? And has the analysis demonstrated that we're paying an appropriate price for these assets?" Furthermore, in this increasing litigious environment(16), investment bankers are going to find it increasingly difficult to signoff on an M&A deal that lacks a comprehensive asset inventory.
Despite the difficulties in meeting these new requirements, there is potential upside. The benefits of proper identification of intangibles can have significant financial impact. Knowing, for example, the differences between customers and customer 'equity' or the subtle distinctions between cost centres associated with preliminary 'research' which must be expensed in the year they were incurred or cost centres associated with legitimate asset building 'development' activities, which can be amortized over the useful life of an intangible asset, can obviously have a material impact on the size of your balance sheet, operating profits, EBIT and net earnings per share.
The new accounting standards will challenge management, investment bankers and other M&A specialists to achieve a greater balance in their priorities, and to identify the board asset potential of companies. This broader perspective should improve management decision making, provide a keener insight into the ultimate sources of market value and perhaps increase the likelihood of success in M&A activity - something that mutual funds, pension fund investment managers and other shareholders will no doubt welcome with open arms.
Robert McGarvey is Founder & Director of Strategic Performance at Beckett Advisors, Inc., a strategic marketing firm based in Los Angeles. He can be reached at email@example.com
- The International Accounting Standards Board, IFRS 3 Business Combinations was issued in March 2004 and is applicable for business combinations for which the agreement date is on or after 31 March 2004. It is presently in a review process; see June 2005 Exposure Draft and IAS 38 for more details.
- Hidden value increases New Accounting standards create risks and opportunities in management of intangible assets, Bernard Kellerman, CFO, 01 May, 2005
- The Knowledge Economy, Britain & Overseas Winter 2004, Robert McGarvey: in this article B&O readers may recall, the author discussed the nature of the knowledge revolution while examining the reasons why Economics as a science lacks the perspective to deal effectively with this new class of 'knowledge' assets.
- Ben McClure, 'The Hidden Value of Intangibles' January 6, 2003.
- A notable exception to this liberal interpretation of intangible assets is an 'experienced workforce' an important internally generated form of human capital, which remains out of bounds as far as accounting standards go, at least for the moment. So although organizational know-how is not yet considered an accounting grade 'asset' it nevertheless remains a critical form of capital for most organizations. It might be appropriate for management to begin treating this know how 'like' an asset (albeit informal) in anticipation of further developments in accounting standards.
- [IAS 38.8]
- Fools Rush In, Steve Case, Jerry Levin, and the Unmaking of AOL Time Warner, Nina Munk, HarperCollins New York, NY. p 179
- Where Mergers Go Wrong, Scott A. Christofferson, Robert S. McNish, and Diane L. Sias, The McKinsey Quarterly, 2004, Number 2 Research suggests that only 17% of all mergers added value to the combined company, while as many as 53% actually destroyed shareholder value.
- Where Mergers Go Wrong, Scott A. Christofferson, Robert S. McNish, and Diane L. Sias, The McKinsey Quarterly, 2004, Number 2
- IBID Where Mergers Go Wrong, For further details on this subject see Richard H. Thaler, The Winner's Curse: Paradoxes and Anomalies in Economic Life, published by Princeton University Press, 1992.
- EBITA is an accounting term = (Earnings Before Income Tax and Amortization)
- 'Most international mergers fail' http://news.bbc.co.uk/1/low/business/542163.stm
- As bad as this situation is for business in general, it is even worse in the case of official government statistics. See Business Weeks, Online article: Why the Economy is A Lot Stronger Than You Think, Feb 13, 2006 According to Business Week calculation's indicate that businesses in the US are investing about $1 trillion a year more in asset building enterprises than the official numbers (which only measure traditional hard assets) show. And if intangible assets were factored into conventional data the US domestic savings rate, far from being negative, is actually positive. The US trade deficit with the rest of the world becomes much smaller than advertised, and US gross domestic product may be growing faster than the latest gloomy numbers suggest.
- For more details see, HP/Compaq joint proxy statement/prospectus filed with the SEC on November 15, 2000. For a description of the interests of executive officers and directors in HP see the proxy statement for HP's 2001 Annual Meeting of Stockholders, this was filed with the SEC on January 25, 2001.
- According to the IASB Work Plan - projected timetable as at 31 March 2006, IFRS 3 the Statement on business combinations is scheduled for finalization and publication in the second half of 2007, the effective date for implementation is normally 12- 18 months later.
- See Ronald Perelman vs. Morgan Stanley, Mr. Perelman stunned the investment world when he successfully sued Morgan Stanley for offering advice in bad faith during the Sunbean-Colman merger. Although at the time of writing the case is still in dispute Morgan Stanley will likely have to pay Mr. Perelman hundreds of millions of dollars in compensation over its advisory role in this merger.