M&A Activity: Back with a WhimperPublished: December 17, 2003 in Knowledge@Wharton
To some market watchers, such transactions signal a comeback for the M&A market, which has been in a slump for the past few years. But Wharton faculty and other experts say the M&A frenzy of the 1990s is unlikely to be repeated this time. Instead, they suggest, valuations and expectations that reflect reality, not desire, will drive this round of activity.
Wharton management professor Harbir Singh, who has done extensive research on mergers and strategic alliances, believes that the recent uptick in M&A deals reflects the release of pent-up demand. "Transactions slowed down after the Sept. 11 attacks. In part, this was because stock prices fell, so companies that were using stocks to make deals were unable to do so. Since then, the economy seems to have improved, interest rates are still low, and stock prices are rising, so the economic drivers of M&A deals have returned."
Singh explains that in addition to the improving economy, two long-term factors are driving the resurgence of M&A. The first is industry consolidation. "It is clear to companies in industries ranging from retail banking and insurance to specialty chemicals and telecommunications that the minimum size to be a meaningful player has increased," he says. Second, globalization is redrawing the economic and political boundaries of almost every industry. "Globalization is like a form of deregulation," says Singh. "Companies are looking beyond national borders to seek growth in global markets, and mergers offer an effective way to expand into new regions."
Despite the uptick, M&A activity is unlikely anytime soon to scale the giddy heights it reached during the boom. During the period from 2000 to 2002, for example, the value of M&A activity retreated from a record $1.33 trillion to $441.3 billion, according to Mergerstat, which tracks merger and acquisition activity. Mergerstat reckons that overall deal value added up to $194.2 billion in the first half of 2003, compared to about $182.0 billion in the first half of 2002. Mergerstat's website lists this year's deal flow in the U.S. at $487.3 billion compared with $428.3 billion last year. In Europe this year the deal flow was $531.2 billion compared with last year's $525.4 billion.
If M&A markets are still sluggish compared with the boom years, it is because the factors that contributed to the fall haven't gone away. “Corporate scandals and uncertainty about the economy played a large part in the decline,” says Wharton accounting and finance professor Robert W. Holthausen. “Although the economic reasons for mergers and acquisitions – including faster access to new products and markets – did not disappear, uncertainties drove more companies to sit on the sidelines instead of taking action.”
The shaky economy also multiplied the inherent risks of M&As, he adds. “Acquisitions or mergers are complex transactions. First, there’s a need to determine the strategic fit of the companies, decide who will run the business, and agree on how compensation will be aligned. Other issues include tax and legal implications, and board makeup. As we have seen, there are a lot of things that can go wrong.”
Singh adds that in distinguishing failure from success in M&A “it is not so much what you buy, but what you do after you have bought it and how well you do it.” Executives need to have a “realistic outlook” at the time of the initial transaction, and maintain that objectivity while the newly acquired business is integrated into existing operations. Executives sometimes “fall in love” with an acquisition and want it to work at any cost, notes Singh, who along with Holthausen, teaches a Wharton executive education course on developing and implementing M&A strategies.
Rewriting the Rules
The economy aside, a pair of June 2001 pronouncements issued by the Financial Accounting Standards Board (FASB) may have contributed to the slowdown in M&A activity, according to Shaun Kelly, KPMG’s national partner in charge of transaction services. FASB is the industry organization that establishes standards for financial accounting and reporting.
“FAS 141 and 142 rewrote the rules on the way that goodwill was treated,” explains Kelly. “After they took effect, the premium (the excess of purchase price over fair market value of the acquired company’s assets) in an acquisition is no longer charged to expense over time. Rather, that premium, or goodwill as it is called, is tested for impairment, with indicated impairments charged to expense when known. This creates a kind of scorecard that lets investors in on how successful or unsuccessful the transaction was.”
Impairment generally occurs if the fair value of the underlying goodwill is less than the carrying value (or amount reflected on the balance sheet). When it comes to goodwill generated from a merger or acquisition, impairment might occur when the current value of the acquisition is significantly lower than it was when the acquisition was first made, and has remained lower for an extended period of time.
Before FAS 141 and 142 were issued, companies that made acquisitions often accounted for them under the “pooling of interest” method, which made it difficult for outsiders to calculate the premium.
But in the wake of FAS 141, called “Business Combinations,” companies can no longer use pooling of interest accounting treatment for acquisitions. Instead, assets have to be recorded at fair market value and the premium is charged to goodwill. Meanwhile, FAS 142, called “Goodwill and Other Intangible Assets,” eliminates the amortization of goodwill, which means companies are generally required to keep premiums on the books indefinitely.
Although that might seem to be favorable, companies are also required to review their goodwill on an annual basis to determine if it has permanently declined in value. If it has, the goodwill must be written down to reflect the current value.
Kelly notes, though, that as companies learn to cope with the reporting requirements of FAS 141 and 142 and with other challenges, the M&A market will continue to pick up. “It’s not a sharp, hockey stick kind of increase,” he reports, “but it does represent steady growth.”
That’s because, according to Kelly, “mergers and acquisitions are still a key part of corporate strategy,” offering access to new markets, technology and customers. But he’s quick to add that valuations today are more realistic. “M&As are now more likely to be part of a well-thought-out strategy instead of a spur of the moment transaction,” he says. “Top management and the board of directors are likely to first ask questions” such as: How does the deal fit in with the company’s strategy; what are the advantages, if any, of buying technology through an acquisition instead of developing it internally; how will the firms be integrated, and was sufficient due diligence performed?
Today’s methodical approach is a sharp contrast to the purported style of some famous companies, like WorldCom, observes Holthausen. Several reports have suggested “that a number of boards did not play much of an oversight role during the acquisition boom of the 1990s. Some of the findings on WorldCom indicate that the board sometimes spent only 20 to 30 minutes reviewing a multibillion-dollar acquisition.”
There are reasons for increased scrutiny on the part of boards. For one thing, the pullback in stock prices (compared to the late 1990s) means that it’s not as easy for a buyer to use inflated stock as currency for an acquisition. More deals call for at least some cash, which may spur directors to engage in a higher level of review before blessing a transaction.
But Holthausen says that regulatory legislation, like Sarbanes-Oxley, is another reason. “Sarbanes-Oxley has nothing that specifically addresses the responsibility of the board in a merger or acquisition,” he notes. “But it does call for greater accountability on the part of management and the board, which tends to nudge directors in the right direction.”
Trend, or False Start?
The ingredients may indeed be in place for a resurgence of M&A activity. But Tom Butler, a partner in the transaction services practice of PricewaterhouseCoopers, isn't about to declare the start of a trend. “There's certainly been an upsurge, but we have seen false starts before,” he cautions. “However, I think this uptick will have legs because of the hot high yield debt market. If that debt market cools off, then the M&A market may also cool, and we would have had just another false start. But this one looks more real than the others.”
He adds that the last two months have been very busy. “For now, the banks are back in the market, even though many got burned in the last surge of M&A volume,” he reports. “No one knows whether that activity involvement will continue, however. This time around, banks want EBITDA (earnings before interest, taxes, depreciation and amortization) to be scrutinized carefully, and they want to be comfortable that the buyers can improve EBITDA and not just rely on run ups in the valuation multiples.”
Luis Acosta, managing director of GE Corporate Financial Services, also has some concerns. In a recent presentation he gave at the M&A East conference, titled "You've Signed The Deal - Now How Do You Get It Financed?" he noted that buyout fund raising in 2002 reached only $17 billion, less than half of the 2001 level and a far cry from the $63.3 billion peak reached in 2000. Through the first half of 2003, only $4.1 billion was raised. But Acosta is quick to point out that despite a decline in capital raising, the inventory of buyout equity capital and venture capital remains healthy.
"The deal market continues to be challenging due to economic uncertainty," he says. "In addition, lender consolidation continues, which limits choice and availability, and lenders' portfolios remain challenged, with 8.7% of the issuers in the S&P/LSTA (Loan Syndications and Trading Association) Index in payment default or bankruptcy in 2002."
Despite his concerns, Acosta is hopeful. "Private equity sponsors continue to be attracted to high quality properties, and deals are being carefully structured and priced to gain market acceptance," he observes. "There's more caution, but opportunities are still available in the middle market segment."
In the long run, says Holthausen, there’s a good chance the M&A market will continue its comeback. “We have been through a rough patch, but as we gain distance from the corporate scandals of the past few years, people will be more comfortable,” he suggests. “And there are still sound reasons for M&As. The activity has a history of being cyclical – there are waves of mergers and acquisition, and then things slow down a bit, and then they resume.” Singh, too, is optimistic. "It is a good thing that many M&A deals these days are cash-based, and that stocks are now valued appropriately," he says. "That forces discipline on companies."