Purchase Price Allocation (PPA)
Understanding the M&A lifecycle
Signing the deal to buy or sell a company is often the most memorable moment for those involved in an M&A transaction. However, it is only one of the stages within the M&A lifecycle, in which each step impacts the other ones. In this article we will take a closer look at one of the steps that should be taken after the deal has been closed: the Purchase Price Allocation (PPA).
Integration of financial statements
The deal has been closed, the M&A advisors and lawyers have left the scene and the integration of the acquired business has started. Then the external accountant knocks at the proverbial door: the transaction needs to be properly recorded in the financial statements. After all, the consolidated annual report should now represent the acquired company. This may seem trivial – and maybe a bit dull – but this is an activity that needs to be dealt with as soon as possible with as little effort as possible. You only need the balance sheet of the acquired company, right? How hard can that be? Well, at times it’s actually not that simple...
Alignment of accounting principles
It may be that the acquired company adopts accounting principles that are different from the acquirer. Therefore, as a first step, the financial statements of the acquired company need to be aligned with the accounting principles of the acquirer. In case the acquired company is to switch from Dutch GAAP (RJ) to IFRS, this could be quite a significant exercise with, for instance, requirements of IFRS 15 (revenue recognition) or IFRS 16 (lease accounting).
Allocating the purchase price
Subsequently, the financial reporting standards (RJ and IFRS) require that the purchase price paid (in a business combination) needs to be allocated to the assets acquired and liabilities assumed, a process that is also referred to as a ‘purchase price allocation’ or PPA. This can be a tricky business. For starters, the purchase price may not have been paid exclusively in cash, but also partly in equity, or in deferred or conditional payments like earn-outs, which means that the definitive value of the purchase price might not be entirely clear at the moment the PPA is performed.
Fair value adjustments
An accurate and reliable estimate of the purchase price is required to determine the goodwill amount that is paid in the transaction. Goodwill is the difference between the value of the net assets acquired and the price paid for the shares. However, this goodwill amount may not be the figure that will be recognised in the balance sheet. The purpose of the PPA is to evaluate if the fair value of all assets and liabilities on the opening balance sheet is different from the stated book value. If there are material differences between fair value and book value, the asset or liability is revalued in the balance sheet to its fair value, with the goodwill amount as balancing item. The usual suspects for revaluation include real estate, machines and equipment, inventory, investments in associates, but possibly also long-term loans.
Identification, recognition and valuation of new assets and liabilities
In addition to potential fair value adjustments for existing items on the opening balance sheet, the acquired entity may also have assets and liabilities that did not meet the criteria for recognition before. For example, if a company has an internally developed reputable brand name for its product sold, this brand would not show on the balance sheet. When this company is acquired, the buyer will certainly have considered the brand in the purchase price he was willing to pay and will in turn have paid ‘goodwill’ for it. In that case, the reporting standards require the valuation and recognition of the brand name in the books. Other examples of such identifiable items are the customer relationships, databases or contracts, intellectual property, favourable or unfavourable contracts and contingent liabilities.
Goodwill and cash generating units
After allocating the purchase price as much as possible to all assets acquired and liabilities assumed, what remains is goodwill - the residual value that the company expects to monetise in the future from assets that do not exist today, such as growth from future customers or synergies effects. The reporting standards require that this goodwill amount is subsequently tested yearly to see if it can be recovered by the business. When it appears that the goodwill is not recoverable (in whole or partly), this results in an impairment of goodwill. To properly monitor the recoverability over time, and in the case of multiple cash-generating units – the smallest group of assets that independently generates assets from the rest of the business, such as a business unit or product segment – the final goodwill amount needs to be allocated to the cash-generating units.
Challenges for the controller
In many cases the person who is instructed to perform the PPA (the internal financial controller) has not been part of the M&A transaction team. The professionals who were on this team are now too busy working on a new deal. Also, a purchase price allocation is a rare event for many controllers; there is no need for most of them to specialise in this type of accounting as a PPA may only occur once in every few years. Can you imagine the challenge for this person?
With limited experience in the field of PPA, not having participated in the transaction process and often without support from the M&A transaction team and proper (internal) transaction documents, the controller has to – amongst others – find out what has been agreed in the share purchase agreement (SPA), to determine the actual purchase price, understand the assumptions underlying the financial forecast used as a basis for the purchase price paid, and to value newly identified assets.
An unpleasant surprise?
The PPA may have an impact on the future balance sheet as well. For instance, the amortisation of a newly recognised brand name will reduce the net profit and could therefore have a negative impact on the dividend capacity of the company. Also, (fair value) adjustments to inventory or the recognition of favourable contracts could have an impact on future EBITDAs. This can be a very unpleasant surprise post-transaction. Performing a pre-PPA analysis during the transaction phase could have revealed these effects beforehand.
How to focus on creating actual value
This is why it is so important to acknowledge that an M&A deal is in fact a cycle, where each step impacts the next ones. In an ideal M&A cycle, a pre-PPA analysis, focussing on the early identification of acquired assets and synergies, and on what the (consolidated) post-deal financial statements would look like, is performed before closing the deal. Also, the financial controllers who are delegated to perform the purchase price allocation require proper support and accurate documentation to swiftly prepare the work and obtain approval from the external accountant. This makes sure the company can focus on what actually adds value: delivering the promised returns after the transaction, which is the last step of the M&A cycle and the topic of our next article.
The M&A cycle in a nutshell
Below we have embedded a picture of the M&A lifecycle and a short description of each phase. In the coming months we will publish a series of articles on each step of the M&A lifecycle, sharing stories and thoughts about each of these phases of the M&A lifecycle to offer you insight in the entire process and help you benefit from the promised returns of a deal. In the lifecycle we will emphasise the integration of your steps and actions, and what might happen if you deal with every step in isolation.
Identify the Right Deal. Either through active selection of companies or business units, or by reacting to offers in the market (one-on-one or by auction). This phase involves setting corporate strategy, identifying growth areas or selling non-core activities.
Pricing and offer. Initial pricing of a company and assessing how easy or difficult integration or separation is going to be, as well as which legal and tax structure will be most suitable (and its impact on pricing).
Perform due diligence. What do we buy? It is crucial to assess the real value of the company, the presence of ‘skeletons in the closet’, financial aspects such as balance and cash flow as well as non-financial analyses (e.g. company culture, integrity, operational synergy benefits, and operational analysis of real estate).
Execution. After the due diligence phase, a Sales and Purchase Agreement is drafted, the relevant authorities are informed and consulted, and the ‘closing’ procedures are executed.
Deliver the Promised Returns. After the transaction has been completed, the expected results must be achieved – how to realise synergies and to prevent that in a future strategic re-assessment the new business will be considered as a non-core activity and be resold (without any added value).
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