M&A deal flow beat the odds last year. Here comes the reckoning.
By Justin Schack
March 2001
Institutional Investor Magazine
As is said of second marriages, corporate couplings are a triumph of hope over experience. More than two thirds of all mergers and acquisitions fail to increase shareholder value, yet they continue at a record pace.
Corporate America was not supposed to break an all-time record for M&A activity last year - a major change in accounting rules was expected to dampen deal flow. And, by April, it became evident to everyone that the soaring stock values driving the late 1990s merger frenzy were quickly melting away.
But when all the deals were tallied, U.S. corporations had engaged in $1.8 trillion of mergers and acquisitions in 2000, handily beating the $1.56 trillion of deals in 1999 and the record $1.61 trillion in 1998, according to Thomson Financial Securities Data. What's more, deals financed entirely with the acquiring company's stock represented 44 percent of overall volume, up from 32 percent in 1999.
How did the M&A market manage to stay so robust? For one thing, the Financial Accounting Standards Board's scheduled date for elimination of pooling-of-interests accounting, a favored method for all-stock deals, was pushed back several times. This accounting treatment ignores the creation of goodwill - the difference between the price paid and the acquired company's tangible net worth. Pooling encourages overbidding with high-priced stock because it has no impact on reported income.
Indeed, from 1993 to 2000, acquirers in pooling transactions paid an average premium of 35.4 percent over the stock market values of their targets, according to J.P. Morgan Chase & Co. In purchase deals that figure was 28.2 percent.
The new rules, which ban pooling and require companies to take charges against earnings under certain circumstances to reduce goodwill, are expected to take effect in July. Requiring companies to use purchase accounting, which requires goodwill to be amortized over several years, is a deterrent to stock-financed deals. But it may have accelerated the pace last year, as some companies rushed to get in under the wire.
"There probably were some sellers who came to market a bit earlier than they envisioned, thinking they could get a higher price in a pooling," says Frederic Escherich, head of M&A research at J.P. Morgan Chase. Because the FASB rule has been watered down, companies will not be required to write off goodwill unless it becomes "impaired," a subjective judgment that means the value created by the acquisition has withered. Consequently, even when the new rule finally does take effect, it isn't likely to put a big dent in the deluge of stock-financed deals.
But a bear market could.
Because stock valuations remained sky-high through April and didn't begin to fall precipitously until late summer, high-growth companies were able to announce huge deals early in the year, even though the value of those deals fell along with the market by the time they closed.
Consider America Online's acquisition of Time Warner. The deal was valued at $182 billion when it was announced in January 2000 and only $106 billion when it closed a year later. Or take JDS Uniphase Corp.'s purchase of SDL, which fell in value from $41 billion to $18 billion between its July announcement and closing last month.
This same time lag may portend a dry spell in 2001, with the Nasdaq composite index in a deep bear market that now threatens to engulf the broader equity universe. In fact, the portion of all M&A volume paid for in stock stood at only 31 percent in January, according to J.P. Morgan Chase, compared with 58 percent for all of 2000. And concern about a slowing economy may keep companies from getting involved in the kinds of big deals that helped set last year's record.
"The M&A dialogue is still very strong," says Escherich. "Some sectors may be a little bit off, but there's lots of looking and talking going on. In general, decision makers want to feel fairly certain about the future before they do something very large, and the economic outlook right now may be holding them back."
