Acquisition

What is an Acquisition?

An acquisition is when one business buys a majority ownership (equity) stake in another business. Companies make acquisitions for various reasons such as increasing market share, reducing costs (synergies), acquiring new talent or technology, etc.

Acquisitions are often complicated and long processes involving many professionals such as investment bankers, accountants, and lawyers. Under the accounting rules if you acquire a controlling stake (typically over 50% of the shares outstanding) in another company you must consolidate 100% of the assets and liabilities, revenues and expenses even though you might not own 100%.

Accounting for Acquisitions

A key criterion to determine the accounting methodology used is whether control has been achieved. Normally control means owning over 50% of the shares outstanding, however technically the definition of control is more nuanced. Both IFRS and US GAAP have extensive guidance on what constitutes control. But the fundamental principles are based upon an understanding of who:

• Makes the key decisions that the business then follows
• Is exposed to the main risks associated with the business
• Receives the benefits generated by the business

Two factors can help in determining whether control has been achieved:

• Percentage purchased by the acquiring company
• The involvement of the investor in the decision making of the acquired business

Most M&A transactions are straightforward in this regard. The buyer prefers to buy 100% of the target equity. In the absence of any information to the contrary, the % of equity bought is used to determine the level of involvement. So, if a company has acquired 100% of the equity in another company, it can be assumed they have full control over the business’s strategic and operational directions. Situations where control definition is more complex include where the acquirer must keep one of the subsidiaries at arms-length for anti-trust (competition regulations) requirements. In that situation even though the acquirer may own over 50% of the common equity they would not fully consolidate the subsidiary (they might use equity method accounting, or cost accounting).

Control Achieved – 100% Acquisitions

When a parent company purchases 100% of the target company, it becomes the sole shareholder in each subsidiary. The shareholders of the parent are the shareholders of a family of corporations, via subsidiary relationships. While the accounting makes it look like there is only one company, legally there will be a web of subsidiaries. When control is achieved, a parent-subsidiary relationship is created. The parent is then required to produce consolidated accounts. Now, the parent and all subsidiaries are reported in one set of financial statements, as if it were a single trading entity. An example of a relatively simple group structure is Fevertree Plc:

Factset – Fevertree Drinks Plc

Control Achieved – 100% Acquisitions – The Numbers

Let us look at what happens to the numbers in an acquisition. We are presented with two balance sheets for different companies:

A Inc. buys all the equity of B Inc. for 35 in an all-cash deal. Here is how the consolidated balance sheet of A Inc. would look like.

Notice that we have added all the assets and liabilities of both A Inc. and B Inc. We have deducted cash to account for the financing of the deal. And the difference between B Inc.’s equity and cash paid of 5.0 is shown as goodwill. Goodwill is not really a plug number but is calculated comparing the price paid minus the fair value of the net assets acquired: 35 – (140-50-60) = 5.

Control Achieved – Non-Controlling Interest Created

In some cases, the parent company achieves control of the acquired company, but without 100% ownership. Here, the parent is not the sole shareholder in the subsidiary corporation. The non-parent shareholders are called non-controlling interests or NCIs. In such acquisitions, there are two distinct groups of owners involved, the parent and the NCI. Each has a stake directly in a subsidiary. The non-controlling interest is a third-party ownership of the subsidiary, not the holding company. Below is an extract from Nestle’s list of stakes in German entities:

The whole list apart from the last three will be 100% consolidated. The entity in which they own 80% they will fully consolidate 100% of the assets, liabilities, revenues and expenses and create a non-controlling interest for the 20% they don’t own. For the entity in which they own 50% they can choose whether they use equity method accounting (or under IFRS they can elect to use proportional consolidation) For the entities in which they own 25% they must use equity method accounting.

Nature of an Acquisition:

Any merger analysis is highly dependent on the nature of the acquisition. There are two things one must consider:

• Whether the target is a public company or a private company
• Whether the acquiring company is acquiring the assets or buying the shares of the target company [start here]

Acquiring Assets:

In this case, it doesn’t make a difference whether the target company is a public or a private company. The acquisition gets incorporated into the acquirer’s balance sheet, like the purchase of any other asset. Financing items change (cash, debt, and equity), and the asset and liability accounts rise. No new subsidiary gets created. The pricing is based on the enterprise value (EV) of the target company.

Buying Shares:

If the acquisition involves buying the target’s shares or equity, then it makes a difference whether this target is a public or private company.

If the target is a private company, each party will sign up to a Sale and Purchase Agreement. The acquired company becomes a subsidiary of the acquirer. Both balance sheets are fully consolidated. The pricing can either be based on the enterprise value or an equity value basis.

If the target is a public company, the process is similar to buying a private company but highly regulated. For example, things like making an offer or collecting responses should be done in a timely manner. The pricing is on a per-share basis because the acquisition process involves acquiring shares from public shareholders. Also, we can measure the control premium (the difference between the offer price and the unaffected price.) For example, if the offer price is $5 and the unaffected price is $4, then the shareholders would receive a premium $1 per share to give up control of the business.

Financing for Acquisitions

Debt and equity are the two main sources of finance for an M&A transaction. Cash balances can also be used, but usually acquirers don’t have large amounts of cash on their balance sheet.

Debt

The amount of debt that can be raised to fund the acquisition will depend on the acquiring and target companies’ consolidated debt capacity after the deal. The LTM EBITDA multiple (using a credit methodology) can help in calculating the maximum debt capacity of a company. Once you understand the maximum consolidated debt capacity, you deduct the pre-deal debt of the two companies. For example, a maximum consolidated debt capacity is 800, and the pre-deal debt is 500, this will give a debt capacity of 300 to finance the acquisition. The interest rate attributable to the debt will depend on the risk of the two companies on a consolidated basis.

Equity

Usually, equity funding is more expensive than debt. Also, issuing new shares will dilute the ownership of existing shareholders, and synergies will be shared between the new and old shareholders. Equity funding is usually used where there is limited debt capacity or where the existing capacity is already used up. The volatility of share prices can impact the amount to be paid for the acquisition. For example, in an all equity financed acquisition if the acquirer’s share price falls then either the target shareholders will have to accept lower value, or the acquirer will need to issue more shares and accept greater dilution.

Evaluating acquisitions

Acquisitions are evaluated in different ways:

• Most common for a public company is looking at the change in the acquirer’s forecast diluted earnings per share. Does the acquisition result in the earnings per share pricing or falling? This analysis is known as accretion / dilution.
• Increasingly companies are also looking at the comparison of the Return on invested capital versus the target’s Weighted Average Cost of Capital. The invested capital is the acquisition Enterprise Value plus any acquisition fees, and the return is the target’s Net Operating Profit After Tax (NOPAT) plus any after-tax synergies.
• For public target companies, we can calculate the control premium using the equity acquisition price less the unaffected equity price. We can then compare this to the present value of deal synergies. The value of the synergies should be significantly higher than the price paid in most circumstances.