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.
 
M&A 'Synergies'
 
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.