Letter number 19 of October 2006


News : IFRS one year after

Ernst&Young have just published the results of a study of the first application of IFRS by listed European companies, since 2005 was the first year in which such groups were required to publish their financial statements in accordance with IFRS. This analysis (1) sets out and illustrates using examples, the different practices of the main European groups, and seeks to isolate a best practice that could be used as a reference. 
We highly recommend this study, which is to be published on an annual basis, to anyone interested in the application of IFRS.  This is the best way of keeping up to date on this often complex and rather vicissitudinous topic.   And the publishers are considerate enough to bring it out in time to ensure that you’ll have some riveting reading matter to keep you busy over the summer! 
We won’t go over those IFRS issues that in our view are irrelevant, counter intuitive or debatable (accounting for stock options, assumptions relied on for applying the DCF method to impairment tests, accounting for convertible bonds, etc.).  We’ll just summarise what we see as the most important issues in the practical application of IFRS. 
We'd all agree that although changes in substance had been anticipated (2), the impact of changes in form, which admittedly are less important than the former, were overlooked.  A reading of the 2005 accounts shows that IFRS has had a big impact on the presentation of financial statements.
Firstly, there is no sign of the main benefit that European groups were expecting from the introduction of IFRS.  Contrary to what we had been led to expect, IFRS does not (or not yet) make it possible to compare the accounts of one company with another. There are several reasons for this:
• The way some of the standards have been drafted leaves a lot of room for interpretation
• IFRS does not provide a model for presenting accounts
• Some standards intentionally leave options open
• IFRS does not currently cover all of the issues encountered in drawing up accounts
•Finally, because they anticipated the application of recent standards or because of deadline extensions granted for the implementation of others, companies have not all applied the same set of rules in practice.
We should bear in mind that IFRS does not provide a model for presenting accounts.  So, European groups have not presented their accounts in a standardised manner and they have not used standard terminology either.  They have had to make choices, especially about what they put on the income statement.  These choices have often been influenced by previously existing standards in the different countries.  For example, French groups generally used a concept that closely resembled résultat exceptionnel (a form of extraordinary gains) under French standards, that isn't covered by IFRS. 
The terminology used is very varied.  At least, eight different terms have been identified to refer to the concept of current operating income, EBIT, current income from operations, operating income, income from operations, operating profits, profits on operations, operating income from activities, and even contribution of activities. Furthermore, the lack of a clear cut model sometimes means that accountants had to wing it when deciding what should be included under this heading and what should be left out.  This is especially the case for interest costs related to pensions(3), allocation of stock options, non-recurring items and income from companies accounted for under the equity method.
We have to acknowledge, however, that the notes to the accounts are generally very comprehensive (there has in fact been a substantial increase in the volume of annual reports).  Following a close scrutiny of the notes, the informed investor will be able to understand exactly what most of the figures provided in the income statement or on the balance sheet refer to.  However, reading the accounts has now become a very complex exercise for students and for budding analysts.
The option of whether to revalue assets on the opening balance sheet under IFRS or not, has resulted in major differences between the financial statements of European groups.  It seems obvious that the balance sheet of a group that revalues all of its real estate will not look the same as that of a group that leaves its real estate assets at their historical depreciated value.
As they currently stand, the IFRS do not deal with all of the issues faced by companies like the acquisition of minority interests or concessions. Let’s take concessions.  Unlike some local GAAPs, which classify concessions as tangible fixed assets, IFRS seems (the standard has not yet been finalised) to recommend booking them either as intangible fixed assets or as financial fixed assets.  You can understand then how companies had some problems drawing up their accounts! It would appear that there is still a lot of work to be done before IFRS provide companies with a body of comprehensive rules. 
One naïvely humorous comment, expressing surprise at how so many groups elected to use current operating income, when this term no longer has any meaning or existence under IFRS, says it all.  The problem is that for those reading the accounts, it still carries a lot of meaning, whether the IASB likes it or not.
So, it should come as no surprise that a lot of companies have elected to present their performance using non IFRS concepts and/or figures.  This is especially the case of UK groups which have almost systematically used non IFRS aggregates in MD&A discussions.  This is clearly not the greatest compliment that could be paid to the IFRS, but the IASB does rather deserve it.  Sad, but true.
(1) Première Application des IFRS, les pratiques des groupes européens, Ernst & Young, CPC, 2006.
(2) For more details see Vernimmen.net Newsletter n° 5 April, 2005.
(3) See chapter 7 of the Vernimmen.

Statistics : Recovery rates for defaulted debts

A few weeks ago, Fitch Ratings published a report which shows that recovery rates can vary significantly across sectors. Although, on average, a debt holder can hope to recover 45c in the dollar, the figure is a low as 7c in the transport sector and as high as 68c for food and beverage companies.  
Even though the number of rated companies that have recently defaulted is near its historical low, ignoring default risk and recovery rates is not really an option for the wise investor:

Research : Family ownership and performance

The relationship between shareholders and management is one of the issues frequently examined by researchers into corporate governance.  The seminal work by Berle and Means (1932) (1) highlighted the problem of agency between the shareholder and the company manager (agency problem n°1) as the former may not necessarily share the interests of the latter. 
In 1986, Schleifer and Vishny (2) explained how another problem of agency could exist between the majority and minority shareholders (agency problem n°2). Although the existence of a majority shareholder could mean tighter control over management and accordingly, reduce problem n°1, this shareholder could divert (whether legally or illegally) some of the company’s profits for his own benefit and to the detriment of the minority shareholders.
One agency problem replaces another.  Generally, will the existence of a majority shareholder increase the value of the company?  In other words, is problem n°2 less serious than problem n°1 for the shareholder community, and in particular, the minority shareholders?  The study on family-run businesses, i.e., businesses in which the main shareholder is a single person or a family, helps to provide answers to this question.  When the main shareholder is an institutional shareholder, more often than not, it will own several stocks. It will thus be less inclined to seek control and to expropriate the minority shareholders.   Studies of family-run businesses highlight the typical impacts that a majority shareholder has on a company.
In a study of the biggest US family-run businesses between 1994-2000, Villalonga and Amit (2004) (3) show that family ownership enhances a firm’s value only when the founder himself is a member of the management team.  The authors studied the valuations of the largest US listed companies between 1994 and 2000.  When the founding shareholder is involved in running the company, this reduces agency problem n°1, which results in a higher Tobin’s q ratio (4). On the other hand, when the founders’ descendents take control of the company, agency problem n°2 becomes a bigger issue.  In addition to the expertise provided by the founder, you now get excessive family control, to the detriment of the minority shareholders.  The problem becomes more serious when there are mechanisms in place that strengthen control, such as different classes of shares.
Maury (2005) (5) studied the impact of family ownership on listed European firms.  The author draws a distinction between the firm value (estimated using Tobin’s q ratio) and profitability (estimated on the basis of return on assets).  It demonstrates that family ownership systematically and substantially increases the firm’s profitability (thanks to the reduction of agency problem n°1).  However, this increased profitability will not result in a higher value if the family has a large majority and if minority shareholder protection is weak.  Part of the profits could easily be “diverted” in one way or another by the majority family shareholder (agency problem n°2).  Finally, the author shows how family ownership is good for all shareholders when shareholder concentration is not excessive and when the environment is well regulated.

(1) Berle A. A. and Means G. C., 1932, The Modern Corporation and Private Property, Harcourt, Brace & World, New York.
(2) Shleifer A. and Vishny R., 1986, Large Shareholder and Corporate Control, Journal of Political Economy, 94, pages 461-488.
(3) Villalonga B. and Amit R., How do Family Ownership, Control and Management Affect Firm Value?, Journal of Financial Economy, 80, pages 385-417.
(4) Ratio between the value of a firm’s stock and that of its assets.
(5) Maury B., Family Ownership and Firm Performance: Empirical Evidence from Western European Corporations, Journal of Corporate Finance, 12, pages 321-341.

Q&A : What are mix and match offers?

Bidders launching a takeover bid usually choose between a cash offer and a share exchange offer (1).  For bidders wanting to make a combined cash and paper offer, there are the following options:
• Mixed offer: for every target share tendered in the offer, the shareholder receives consideration in the form of a cash payment and a fixed number of shares in the offerer’s company
• Alternative cash or exchange offer: shareholders tendering their shares in the offer elect to tender them either in the cash or the exchange offer
• A primary cash offer and a secondary capped exchange offer (or a primary exchange offer and a secondary capped cash offer):  the shareholder elects either of the two options but if the cap on the secondary offer is reached, the shares can be deemed to have been partially tendered in the primary offer
• A mix & match offer
Mix & match offers include a primary mixed offer (cash and paper) and two secondary offers, one cash only and the other shares only.  A mechanism whereby shares tendered in either of the secondary offers can be deemed to have been tendered in the primary offer is used to fix the ratio of cash to shares paid by the offerer in the end. 
Before the offer closes and the shares tendered in the different offers have been counted, it is impossible to tell which secondary offer will be reduced.  Shareholders tendering their shares in one of the secondary offers know that, at the worst, they will get the same ratio of cash to shares as for a mixed offer.  Shareholders tendering their shares in the primary mixed offer know exactly what the cash/share ratio of their consideration will be.
For example, the final Mittal Steel offer for Arcelor was broken down as follows: 
• a primary mixed cash and exchange offer, €150.60 in cash and 13 Mittal Steel shares for 12 Arcelor shares tendered
• a secondary cash offer of €40.40 for each Arcelor share tendered
• a secondary exchange offer of 11 Mittal Steel shares for7 Arcelor tendered
The two secondary cash and exchange offers were subject to a proration and allocation procedure in order to ensure that the ratio of the total consideration paid under the offer by Mittal Steel in the form of shares and cash was 68.9% to 31.1%.
Imagine that you had tendered 600 Arcelor shares in the cash offer.  If all Arcelor shareholders did likewise, all of these shares would be deemed to have been tendered in the primary mixed cash and exchange offer, and you would receive 650 (600 × 13 / 12) Mittal Steel shares and €7,530 (150.6 × 600 / 12).
However, if by chance 31.1% of the shares tendered in the secondary offers had been tendered in the cash offer (which would mean 68.9% tendered in the exchange offer), you would have been paid all of your consideration in cash (600 × €40.4 = €24,240). Between these two extremes, you get a ratio of cash to shares of between 31.1% and 100% (but always approximately the same value, if you use the Mittal share price announced before the offer as the benchmark).

This type of offer makes it possible to meet the requirements of all of the target’s shareholders, who may not always have the same goals (some may want to cash in their shares while others may want to become shareholders of the new entity).  It also provides the buyer with an advance guarantee of the cash/shares ratio of the consideration.
There may also be tax breaks for shareholders in mix & match offers. Capital gains tax on shares received in the exchange offer can be carried forward, while in the case of a mixed offer, capital gains tax must be paid on all of the shares tendered (even if part of the consideration is in shares).
(1) For more information, see chapter 42 of the Vernimmen.