Mergers and acquisitions explained.
Mergers and acquisitions are a multi-disciplinary field.
In this video, we will focus on several financial and strategic aspects of mergers and acquisitions,
by discussing the reasons for doing an M&A deal, the difference between the sale of assets
and the sale of equity, accounting for business combinations, measuring deal success or failure,
and examples of goodwill impairment
(a possible indicator of a merger or acquisition gone bad).
There are many different reasons to do an M&A deal.
One of the reasons that is very common for technology businesses (from biotech to software)
is based on the strengths of the company leadership or the business as a whole.
The seller might be great in the early stages of the lifecycle of a business: start-up and
prototyping, but lacking on the skills to grow and harvest.
The buyer might lack the skills for the early stages, but have strength in the area of scaling
up, commercial roll-out and standardization.
A deal that benefits both buyer and seller!
Here are some more reasons for an M&A deal from the perspective of the buyer: access
to products, resources or markets (skip the growth stage and buy existing sales and profits),
an opportunity to consolidate an industry (combining several smaller players into a
bigger player), vertical integration (upstream – moving up the supply chain towards raw
materials, or downstream – moving into finished products, distribution and direct customer
interaction), or simply to shut down a competitor (if you can’t beat them, buy them!).
Here are some reasons for an M&A deal from the perspective of the seller: monetize and
retire (accepting an offer that’s too good to refuse, and retire at age 55, 45, 35 or
even 25), the desire to start something completely new (due to boredom or changing interests),
declining revenues (selling a struggling business), the less virtuous reason of transferring hidden
risk to the buyer (which a buyer might detect during a thorough due diligence), or simply
lacking the resources to grow the business to its full potential.
When a deal is made and announced, the headlines are often dripping with euphoria.
The combination of the businesses creates opportunities for unprecedented growth.
The buyer expects to realize big revenue and cost synergies.
In short, by combining two businesses, 1 plus 1 promises to become 3.
One common way to design an M&A deal is a sale of assets.
This is the balance sheet of an incorporated company that owns a bunch of machines as its
assets, owes money to the bank for a loan, and is equity-owned by Jane.
If Jane sells the fixed assets of the company at book value, the machines leave the company’s
balance sheet, and are replaced by a big bag of cash.
Jane sells the assets of the business, but keeps the structure in place.
She can now start a new business activity in the existing legal entity, or pay down
the loan, or keep the entity dormant for now and available for possible future use, or
unwind the whole structure and take the equity out.
Jane might also be selling part of the assets in exchange for cash, and retaining part of
the assets for a smaller-sized operation.
Another common deal structure is a sale of equity: the assets and liabilities stay in
place, but Jane the owner is replaced (and compensated) by transferring the equity of
the business to a buyer.
The entire business itself, not just its assets, is sold along with its history.
How to account for a business combination?
US GAAP and IFRS are large converged in this area, meaning that the principles and language
in key accounting standards like ASC805 and IFRS3 are close (but not fully the same).
The accounting frameworks today are based on the acquisition method, also known as the
purchase method.
The starting point is that for a business combination to occur, an acquirer must obtain
control over a business.
US GAAP and IFRS define control differently, and both get quite technical in the requirements.
For this discussion, let’s highlight that one of the main criteria for control under
US GAAP is the power to direct activities.
Once you have established that a business combination is taking place, next steps are
to 1) identify the acquirer, 2) determine the acquisition date (the date on which the
acquirer obtains control), 3) measure and recognize the assets acquired and liabilities
assumed at their fair values, and 4) recognize and measure either goodwill or its opposite
a gain from a bargain purchase.
Let’s take a quick look at the definition of goodwill, as we need to understand goodwill
later on when detecting failed deals.
Goodwill is the excess of the purchase price paid for an acquired firm, over the fair value
of its separately identifiable net assets.
The business man in the blue suit and the business man in the red suit come to an agreement.
Red (the buyer) pays a large sum of money to blue (the seller), and in return blue transfers
the ownership of a factory to red.
If the purchase price is $3B, and the net assets are $2B,
then the difference of $1B is goodwill.
You could disrespectfully call goodwill an “accounting plug” in order to make the
journal entry balance: if $3B of cash leaves the door, and on paper I only get net assets
of $2B in return, then I need to “plug” $1B somewhere
in order for the debits to equal the credits.
Goodwill is the difference between what a company pays to buy an acquisition target,
and what that acquired company is worth “on paper”.
Goodwill is recognized only in a business combination, and goodwill is not amortized.
How can we measure the success or failure of an M&A deal?
Let’s discuss four possible outcomes.
The best outcome is for the euphoria of the deal announcement to become reality:
1 plus 1 actually turns out to be 3 over time,
the whole is bigger than the sum of the former parts.
It could be that 1 plus 1 turns out be just 2,
no value added or lost from doing the M&A deal.
Worse, 1 plus 1 could turn out be 1, the whole is smaller than the sum of the former parts.
The worst outcome is a blow-up: the combined business goes bankrupt.
An example is the K-Mart and Sears merger, which ended in a bankruptcy.
However, the question is whether this is a direct consequence of the deal, or whether
the individual companies would each have gone under anyway.
Both K-Mart and Sears were already on the downward spiral when they merged.
What happened was that pre-existing problems got pooled together instead of being fixed.
Let’s work our way up from bottom to top.
How about 1 plus 1 equaling 1?
In this category, the combined business has not gone bankrupt, but its financial performance
is signaling significant issues.
An indicator for deals that landed in this category
can be the announcement of goodwill impairment.
That doesn’t mean business combinations without a goodwill impairment are safe: there
could be a potential impairment building up.
At least companies that record a goodwill impairment decided to “bite the bullet”.
Here are some examples of large goodwill impairments in 2018 and 2019.
The $22 billion write-down by General Electric on the acquisition of Alstom’s power business.
The $8 billion impairment by Procter & Gamble for Gillette.
Verizon Communications’ $5 billion goodwill impairment related to its acquisition of Yahoo and AOL.
And CVS Health’s $4 billion goodwill impairment related to the acquisition of Omnicare.
Let’s dive into one of these examples in detail: P&G Gillette.
The one-time, non-cash accounting charge actually consists of $6.7B in goodwill, and $1.6B in
intangible assets.
It’s interesting to read the detail of the goodwill impairment testing in the annual report.
Two of the main reasons mentioned are grooming habit changes and competition.
In other words: a guy like this who has gone from using his Gillette razor almost every
day to once a week, and strong emerging competitors like Dollar Shave Club and Harry’s with
very different business models.
However, according to P&G, grooming continues to be a very attractive business, despite
the impairment now recorded.
Let’s zoom out to the bigger picture: P&G has done very well over the years, if you
measure the overall performance by the share price.
Procter and Gamble announced the $57 billion Gillette deal in January 2005, when P&G’s
share price was around $54.
The acquisition closed in October 2005.
Since then, P&G’s share price has moved largely in line with, or ahead of, the S&P500
and competitor share prices.
The announcement of the $8 billion impairment (a fraction of the total original deal value)
in the summer of 2019 hasn’t seemed to hurt the share price.
As the impairment was taken 14 years after the acquisition, it is probably safe to say
that it was an accounting entry due to evolving business and market factors, rather than judging
the Gillette acquisition as a “bad deal”.
To quote P&G executives in 2010, 5 years after the deal, “much of the deal's value is like
an iceberg: it's there, just obscured under water”.
So if P&G’s impairment for Gillette is not an indication of a deal gone bad, what data
do we have to judge the other impairment cases?
What we learned from looking at the P&G – Gillette case is that we need to look at deal closing
date vs goodwill impairment date, and size of the goodwill impairment versus size of
the deal.
GE announced the acquisition of Alstom’s power business in April 2014, the deal closed
after lots of regulatory discussions and deal structure changes in November 2015.
The impairment took place just three years later, and is enormous versus the deal value.
Verizon announced the acquisition of AOL in May 2015 and the acquisition of Yahoo in July 2015.
Both deals closed within months after the announcement.
The impairment of almost $5 billion was taken three and a half years after the deal closings,
for about half of the combined deal values.
A similar pattern occurred with CVS buying Omnicare: announced May 2015 for $13 billion,
closed August 2015, impairment three years later for a part of the deal value.
Now that we discussed negative outcomes of mergers and acquisitions, let’s ask ourselves
the question when we can conclusively decide that a deal was successful, or at least not
destroying value. That’s not so easy.
It is possible to detect failure and defeat (through “via negativa”), but we should
use caution or even abstain from declaring a definitive victory.
Here’s why.
Let’s say there are four paths for a combined business: great financial performance (strong
revenue growth, margin improvements, strong free cash flow generation), OK financial performance
(some growth in revenue, margins and cash flow), poor financial performance (a decline
in revenue, margins and/or free cash flow), and bankruptcy.
Each arrow represents one year of financial performance in the diagram.
The characteristic of bankruptcy is that it is an “absorbing barrier”, it’s game
over, once you are in there you exit the population as a company (even though your assets might
be purchased for a restart under a new label and with new capital).
A combined business might end in poor financial performance for a few years, if it runs into
integration and customer acceptance issues after the deal, but could recover and find
an upward trajectory over time.
At what point do we judge this as successful or unsuccessful?
After 3 years?
After 5 years?
After 7 years?
A combined business that starts off well could be in the great financial performance zone
for a few years, but then hidden risk suddenly materializes
and catapults the business into bankruptcy.
That’s why it’s so hard to declare the definitive victory of an M&A deal.
The best way to judge the performance in this case is to say that it has gone well so far!
The passing of time is great in detecting fragility!
I hope you enjoyed this discussion of various financial and strategic aspects of mergers
and acquisitions.
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Thank you.