There can be many motives for corporate acquisitions. Consider the high-minded aim of creating a national champion or the much-touted justification of finding operating synergies. Sometimes the goal is more self-interested - eliminating competition.
Less commonly understood is that the acquiring firm can reap substantial benefits simply from post-acquisition accounting rules.
Once an acquisition is complete, the fair value of the target company’s individual assets and liabilities are consolidated with those of the acquiring company. Specifically, the pre-acquisition book values of the target are restated at their fair value at the acquisition date through so called “fair-value adjustments” (FVAs). These are typically assessed and certified by auditors. In other words, once a firm has been acquired, just like the flick of a switch, there’s a change in the accounting treatment of the acquired business’s assets.
What’s more, the great majority of FVAs result in an increase – rather than a decrease – in the reported value of the acquired company’s assets. The FVAs associated with the target’s tangible assets are economically large: they give a significant boost to the potential collateral available for lenders that provide debt financing. The point? Based on our study of the effect of FVAs on debt financing, we find that an acquirer’s larger collateral base is associated with bigger loans, which can be stretched for longer periods and at lower interest rates.
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.
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.
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.
We added a large number of controls to our calculation to account for the possible objection that deals resulting in high FVAs are ones that result in decreased credit risk – perhaps due to the combination of high-growth assets or other synergies. We also took account of other possible factors, including those specific to the industry or sector concerned as well as macro-economic factors. The impact of FVAs on debt financing activities remained strong.
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