We discuss how investors assess and monitor acquisitions.
I lead on valuation and accounting issues across all sectors, reviewing recommendations, challenging existing holdings and developing valuation frameworks. I believe that financial reports, if interpreted carefully, can reveal a lot about both a company’s strengths and weaknesses, and the quality of management. The goal of my forensic reviews is to distil all the numbers into a few differentiated investment questions which can help lead to high-quality investment discussions with our fundamental analysts and with companies.
- Assessing an acquisition when a deal is announced is a key skill for any investor. We look at some indicators to help separate the good from the bad.
- Monitoring acquisitions over subsequent periods is very challenging because of limited financial disclosure. We consider five ways accounting information can help.
Assessing an Acquisition
Dickens opens his historical novel, A Tale of Two Cities, with the famous line, “It was the best of times, it was the worst of times”, with brilliant concision setting a scene of coexisting extremes. Likewise in investing, when an acquisition is announced it could be the best of deals, supporting prosperity for years to come, or the worst of deals, potentially destroying the company.
As a long-term investor, I want to be confident that management is good at allocating capital. An acquisition should be compared against other options, including other acquisitions, internal projects, reducing liabilities or returning money to shareholders.
Many studies have concluded that most, but not all, acquisitions destroy value. How can we separate the good from the bad?
A potentially good deal has a clear investment rationale and a low risk profile.
Clear Investment Rationale
An acquisition means taking control, so the most fundamental question is whether the premium paid for control is justified. I want to be confident that the target company will be more valuable under new management: perhaps the target company is poorly run and can be improved, or perhaps there are cost savings when the target company is integrated into a larger group.
I once analyzed a large industrial company which specialized in growing profits by shrinking revenues! While this sounds counter-intuitive, it was simply applying the Pareto principle, in this case that 80% of the profits came from 20% of the customers. It had advanced methods of measuring customer profitability and observed that there was typically a long tail of marginal and loss-making customers. By cutting off this tail in the businesses it acquired, it increased profits.
You don’t necessarily need to run the target better for a deal to have a clear investment rationale; it can simply be that you can acquire at an attractive price.
One business-services company employed a very successful acquisition strategy of consolidating its market. It was able to purchase lots of small privately held businesses at attractive valuations, but the market was willing to value the publicly quoted group at a much higher valuation, reflecting the overall lower risk profile and better liquidity.
Low Risk Profile
The phrase ‘bolt on’ reassures me that the risk profile is low. Operationally low risk means that the target business is well known to the acquirer, selling related products or services in the same geographies.
I covered an aerospace company which was built over years from lots of small acquisitions. Management spent years, and sometime decades, nurturing relationships with potential targets, getting to know their businesses. When these founder-led businesses were ready to sell, this acquirer already knew most of the strengths and weaknesses.
A potentially bad deal has an unclear investment rationale and a high risk profile.
Unclear Investment Rationale
Sadly, there is very often scant quantitative detail as to why a target is more valuable under new management. Labelling a deal ‘strategic’ or ‘growth-oriented’ is often a sign that there is no proper investment rationale.
So why are there so many bad deals? One explanation is that executives are incentivized on short-term key performance indicators (KPIs) which may not align with long-term value creation. If management is paid on adjusted earnings-per-share growth, virtually any deal will end up being accretive (i.e. resulting in a higher adjusted earnings-per-share number). A non-executive director once referred to the period following a large acquisition as an “accounting honeymoon”, obliquely referring to the range of possibilities a chief financial officer (CFO) has in order to manage adjusted earnings for several years after the deal closes, including judgements in purchase-price allocation, the application of new accounting policies, and adding back merger-related and restructuring costs.
High Risk Profile
The label ‘transformational’ often suggests a high risk profile. It could mean that the business is not known well to the purchaser, perhaps because it sells different products or services, or operates in a different geography.
I recall discussing an unsuccessful acquisition with a management team, trying to understand what went wrong and how I could identify the signs to avoid the same situation in future. I was surprised to hear just how limited their due diligence was: they had just a few days in a data room to review the management accounts and major contracts.
Even if an acquisition initially appears to be a good deal, I want to track the subsequent performance, ideally to calculate the return on investment to check that capital was well allocated. Unfortunately, the reported accounts are of limited help, but here are five ways accounting information can be used.
(1) Segmental Disclosure
If the acquired business is disclosed as a newly reported segment, the subsequent performance is relatively clear, although comparability with historic performance is trickier if accounting policies have changed and there are material purchase-price allocation adjustments. However, it is more common for an acquired business to be combined into an existing segment, making it extremely difficult to track subsequent performance. If the rationale for the acquisition was to integrate the target business, it is legitimate to present it in such a way, but if the target is being run separately it would be helpful to disclose it as a separate segment.
(2) Management Commentary
Management often shares progress on cost synergies with shareholders as part of its management commentary. Unfortunately, this is of limited value as achieved cost synergies are almost always better than what was shared as initial guidance, but this does not necessarily mean everything is going well. I recall one example of an acquisition where there was a huge focus on cost synergies – so much so that new customer opportunities were ignored, and growth suffered terribly as a result. With hindsight, the important number to track was employee attrition in the acquired business, as this was a sign that things were not going well under the new ownership.
(3) Purchase-Price Allocation Adjustments
When a business is first consolidated, estimated fair values are assigned to the acquired assets and liabilities. However, these estimates can be subsequentially adjusted by management if better information is available after having run the business for a while. For example, if after six months management realizes that a lot of the customers from the acquired business are unlikely to pay, it may write off receivables.
(4) Changes in Contingent Consideration
Instead of paying for a business upfront, some of the consideration may be paid later, contingent on performance. Contingent consideration is sometimes called an ‘earn-out’. This type of deal structure is common in the pharmaceutical industry, where payments are often contingent on the revenues for specific drugs. From an accounting perspective, the value of this contingent consideration is estimated and recognized as a liability. Each year the estimated liability is updated: if the liability decreases, this suggests that expectations have deteriorated.
(5) Goodwill Impairments
Another indication of how an acquisition is doing is whether goodwill is impaired. If goodwill is impaired, this is normally an indication that the acquisition has gone badly and is worth less than the initial investment. However, the converse is not true: if goodwill is not impaired it does not necessarily mean that the acquisition is going well. Part of the problem is that goodwill is tested for impairment at the level of a cash-generating unit (CGU) in the combined business, rather than at the level of the acquired entity. This means that poor performance of the acquired business can often be shielded by good performance of the other businesses in the CGU. I will discuss goodwill accounting in more detail in my next blog.
Acquisitions are an important part of capital allocation for many companies; however, investors have very limited information on the risks and returns on these acquisitions.
When a deal is announced, I look for a clear rationale explaining why the target company is worth more under new management and indications that the deal has a low risk profile. Monitoring subsequent performance is not straightforward, but there is useful information in the accounts; investors just need to look closely.
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