The CFO's approach to analysing an M&A transaction
An Expert Insight by Johann de Lange, founder of M&A advisory firm Pollination Capital*
M&A transactions are game changers for companies. They are usually large transactions when compared to other capital investments and tie up substantial resources and focus. They are normally also closely tied to the strategic direction of a company. The many unknowns represent an increased risk environment for the acquirer.
This is when a good CFO needs to rise to the occasion, as it his/her job to look at the viability of the M&A deal and to calculate the impact on shareholders' returns.
How should this be done? It depends on the approach taken. The conventional measurement of fair value is based on the value of free cash flows discounted at a fair rate of return for all funders. This is also commonly referred to as the DCF valuation method. It implies that a fair value was paid if the forecast on which the valuation was based is achieved.
However, will value be created by such an M&A transaction? The fair rate of return, at which forecast free cash flows are discounted, is essentially risk weighted and, as such, market related. Investors can therefore earn a similar return when investing in a similar asset elsewhere. Therefore, if the forecast cash flows are achieved, the investment is essentially a value break-even scenario: A principle amount is exchanged for equivalent risk-weighted cash flows in the future. No value was therefore created.
It may be argued that the acquirer can create value if it trades at a higher earnings multiple than the transaction multiple for, say, a smaller and unlisted entity. This lower transaction multiple is because the target trades at a marketability discount, and a higher fair rate of return is expected because of a small stock premium included in the fair rate of return. This may be true, but has to be weighed against the management focus and resources required to integrate the smaller entity. A different risk profile also has to be managed. There will in all likelihood be a value offset given the relative sizes of the acquirer and target.
Synergy creates value
The realisation of synergy benefits is the only way to create value for shareholders from an M&A transaction, i.e. the future incremental cash flows have to exceed the forecast cash flows. These incremental cash flows have to offset transaction costs and integration costs before they can add value for shareholders. This is not something that automatically happens. It is usually the result of meticulous strategic planning and the execution of such a strategy. This requires the selection of the right company with the required fit, executing the transaction according to pre-determined parameters, managing the integration process and engineering the synergies after this.
The greater the synergies are, the greater the value added for shareholders. These synergies should ideally be estimated at an early stage of evaluating all the possible acquisition candidates. As a minimum, the synergy benefits should offset the transaction costs and resources applied to integrate in order to achieve a value break-even. Acquisition targets should be compared to one another to determine which transaction would yield the greatest synergies and, as such, generate the greatest return for shareholders. The selection of the target that does not yield the highest return represents an opportunity cost to shareholders.
CFO is critical
The CFO has a critical role to play in developing a framework within which the synergy benefits are to be estimated, compared and measured throughout the transaction process. A set of synergy key performance indicators (such as investment repayment period, increase in group value, return on investment) need to be applied as the benchmark against which future estimates for the acquisition (including its synergies) need to be measured. Estimates should be adjusted for anomalies identified in the due diligence report.
Synergies should be measured after the transaction to identify any variances from the plan. This is a valuable tool to drive towards original goals and to refine the manner in which synergy benefits are estimated, contributing towards an ever-improving acquisition skill set.
The CFO's responsibility stands central in the pursuit of generating value for shareholders through M&A. This can be executed by simply measuring the fairness of a transaction or by applying a strategic, synergy-driven approach. Which of the two do you think will create the most value for shareholders over the long term?
*Johann de Lange is the founder of Pollination Capital, an advisory firm focussing on facilitating and designing M&A transactions bearing synergy benefits for clients. He has extensive corporate finance experience, spanning over the last 16 years of his career. He is also a renowned and frequent speaker on corporate finance topics, having presented more than 50 seminars, workshops and conferences over the last 6 years.
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