FVAs: make your case
Should we worry about that? One immediate and entirely valid objection is that nothing has changed except the accounting method. The acquired firm is exactly the same the day after the takeover as it was the day before. The enhancement of its asset base is simply smoke and mirrors.
What are the effects of FVAs on the worth of acquired-company assets? Significant. On average, acquirers report a 43% increase in the value of a target company’s fixed assets, defined as total assets excluding cash and cash equivalents. This leads – again, on average - to a 29% increase in the collateralizable non-financial assets sitting in the total asset base of the acquirer after the transaction.
When it comes to valuing long-term tangible assets, standard accounting practices are conservative; so it’s unsurprising that when they are assessed afresh against the market, this typically leads to an increase in their value. The FVA process allows the acquiring firm to reflect the likely effect of current market conditions on its asset values, giving a more up-to-date picture than the traditional historic cost-based accounting methods.
Auditors give credibility to the revaluation process by signing off the new asset values. The result? Previously unrecorded economic value transfers to the books of the combined company. In theory, the firm can use this extra value as collateral for additional borrowing. Does this happen in practice? Our findings show that indeed it is.
In the three years following a takeover, we see an average 10% rise in the asset base after FVAs have been made, with a 5.84% rise in cumulative gross debt issuance. This debt figure includes the renegotiation of existing debt at more favourable rates and the issuing of new debt.
Interestingly, this increase is unevenly spread across the three post-deal years. Issuance in the second and third year usually shows an increase on that issued during the first year.
Not only can firms borrow more as a result of FVAs; they can also borrow on better terms. A 10% rise in the value of the asset base leads to a net decline in post-deal borrowing costs of about 10 percent. Furthermore, we found evidence that over the three-year post-acquisition period, merged firms can raise funds with significantly longer maturity dates.
It’s a similar story with corporate bonds: a 10% increase in the asset value of the combined group leads to a 5.61% relative fall in bond yields.
FVAs: defend your case
These results suggest that lenders are heavily reliant on balance-sheet values when making loan decisions. Is this naïve or sensible? One could argue that lenders are reducing their transaction costs by relying on the balance sheet alone instead of pursuing expensive independent valuations of the borrowers’ individual assets being used as collateral.
It may be surprising that banks, with their superior analytical skills, use only FVAs as a basis for lending decisions. Shouldn’t they have robust valuations in place even before the acquisition? If so, FVAs would provide no new useful information on top of that already available to the banks.
Another issue is that FVAs can be tweaked according to how information is interpreted, allowing managers to take account of market conditions and other factors. Arguably, this could leave room for opportunistic reporting, with managers producing numbers to suit their own objectives.
There is a further potential source of criticism: even when managers are reporting objectively, the FVA process still gives undue weight to current conditions, and conditions can change: they are subject to short-term shocks and other transient events.
Finally, the central argument must be that the target company remains exactly as it was before the acquisition: it seems bizarre that accounting rules insist that it is not. It’s like the same house going on the market the same day with two very different prices.
However, our aim was not to examine whether lenders should act on the basis of FVAs but whether they did, and the evidence seems conclusive.
We found that FVAs influence both access to debt markets for the acquirer after the transaction and the terms on which borrowing is secured. Lenders place considerable weight on FVAs: that much we know. This little-understood link between accounting and credit is intriguing. What’s next? We hope our work will encourage further study into how lenders use borrower-specific information to make credit lending decisions.