Letter number 2 of January 2005


News : Purchase accounting or when financial common sense overcomes dogmatism

In December 2001 option for pooling of interests was suppressed in US merger accounting, thus leaving purchase accounting and nothing else.

Three years later, US groups are beginning to use this method, and the financial markets are getting a firmer grip on its repercussions.

The IASB has adopted a position similar to that of the US accounting regulators. Purchase accounting has thus become the global standard in merger accounting (1).
Broadly speaking, purchase accounting consists in writing down on the buyer’s balance sheet all the assets and liabilities of the target company, on the basis not of their book value but their fair value estimate. Any difference between the acquisition price of the assets and their fair value when deducted for assumed liabilities is called goodwill. This is written on the buyer’s consolidated balance sheet under intangible fixed assets.

This goodwill is assessed each year to ensure that its value is at least that of the value at which it is written down on the balance sheet. This assessment is called an impairment test. If the fair value is below book value, a provision for goodwill depreciation is written down.

As an exemple, Pfizer estimates that it paid $56bn for Pharmacia, vs. a book value of just $7bn. Of the remaining $49bn:

  • $37bn was assigned to identified intangibles ($25bn for patents depreciable over three to 13 years, $10bn for brands with no specific life span and $1bn for technologies depreciable over three to 20 years;
  • $21bn was considered to be goodwill;
  • $5.5bn was assigned to current research & development, but which is nonetheless fully charged off against income for the 2003 financial year, in accordance with accounting standards;
  • there was some deferred tax and various items;
  • $1.6bn was assigned to revaluation of inventories to their sale value.

Note that by virtue of this revaluation of inventories to their market value, i.e. the sale price or something close to it, the normal process of selling the inventories will generate no profit. So how relevant will the profit and loss account be in the first year after the merger...? Say somebody took over Rémy Cointreau. Since cognac inventories would have an average life span of seven years, that would mean several lacklustre years for the profit and loss account!

As a result, Pfizer decided to report on the basis of “adjusted income” and “adjusted diluted EPS”, which fully neutralised the P&L impact of purchase accounting. It was as if the entire difference between the acquisition price and book value was booked under goodwill. Naturally, a P&L account is drawn up under normal standards, but it carries an audited table showing the impact of the switch to adjusted income…

For 2003, Pfizer reported net attributable profit of $3.9bn, down 57% from the $9.1bn figure of one year earlier. On an adjusted basis, net profit rose 42% to $9.9bn. Not exactly in the same ball park, is it? The adjustments reflect the reversal of the 100% depreciation of the cost of acquired R&D, the reversal of Pharmacia’s depreciations, which were revalued at the acquisition, and the reversal of the reappraisal of Pharmacia’s inventories, net of tax impact.

To the extent that Pfizer is one of the biggest US market caps (the seventh biggest, in fact, at $200bn), its practice is likely to be copied. Sanofi has already announced it will follow the same presentation to account for its acquisition of Aventis. Already, all analysts who cover Pfizer go on the adjusted figures, not the accounting data. We believe they are right to do so.

The moral of this story is that accounting regulators, through a stubborn allegiance to fair value, have unwittingly cast discredit on accounts and accounting. When the accounts are correct, what need do their users have to restate them?

For each justified restatement, how many others will there be that are less justified, now that the door has been flung open?

(1) For more on consolidation see chapter 6 of the Vernimmen or click here.

Statistics : Criteria relied on by rating agencies

Unfortunately there is no table that shows the exact correspondence between a given financial ratio and a rating, whatever sector the company operates in. It is of course possible to calculate averages and medians. From 2000 to 2002, US industrial companies, depending on their ratings(1), presented the following financial medians:

The different specific features of each sector (fixed cost / variable cost breakdown, sensitivity to economic situation, visibility, etc.) mean that €1 of cash flow will not last as long in say the food sector as in the steel sector, and therefore does not carry the same risk.

For example, current estimations are that a pharmaceutical group with the following financial ratios would be rated as follows by Standard and Poor’s

And a consumer group, seen as less risky, as follows:

(1) For more information on ratings, see chapter 26 of the Vernimmen.

Research : Private equity performance

1998-2000 saw a spectacular rise in investment in start-ups in most western economies. Between 1991 and 2000, there was a 12-fold increase in investments in private equity funds in the US.

Most of these investments were made by venture capital firms, which specialise in investing in newly created companies, which are distinguished from firms specialising in leveraged buyouts (LBOs) of more mature companies. The major difference between the European and US markets can be seen in this split between venture capital and LBOs – LBOs dominate the European market of which venture capital has a relatively small share.

This class of assets, for which relatively little financial data is available, would appear to offer a very high ROI. Most of the funds are private and thus exempt from public disclosure requirements, which is why we know so little about their figures. Steve Kaplan and Antoinette Schoar (1), of the University of Chicago and MIT, studied the performance of private equity funds in the USA between 1981-2001.

They looked at the absolute performance of all of venture capital and LBO funds and, given that there is no accurate mechanism for measuring this class of asset and compared them with the rate of return of the S&P 500 over the same period. The average annual rate of return of private equity funds is 18% with at first sight, little difference between venture capital and LBO funds (respectively 17% and 18%).

Average returns to private equity funds are higher than those of the S&P 500, by 5%. Factoring in management fees, around 20% of profits and 1.5% to 2.5% of the funds managed, gross financial performance is much better than the S&P 500, and accordingly than the reference market of listed companies. This said, an annual premium of 5% does not seem excessive compensation for a higher risk and lower liquidity than an investor would get if he put his money into listed stocks. These results do however mask a great deal of variation between management teams and also time series variations.

Venture capital funds’ returns were relatively low in the 1980s, with rates of return much lower than the S&P 500. The 1990s saw a reversal of this trend, with returns rising sharply and average performances much higher than the S&P 500.

On average, over the whole period, venture capital funds’ returns were higher than those of the S&P 500, by 21%. LBO funds behaved in exactly the opposite way – in the 1980s, they performed very well, much better than the S&P 500, but in the 1990s returns fell sharply, both in absolute terms and also relative to the S&P 500.

What factors explain the financial performance of private equity funds? The authors show that the size of a fund impacts positively on financial performance relative to the S&P 500, up to a certain point – beyond this point, i.e. for very large funds, performance declines.

It would thus appear that diseconomies of scale are at work in this business. In the same way, if a fund has already raised money from investors on several occasions, this has a positive correlation on subsequent financial performance – intuitively, experience would seem to be a key factor in the financial performance of a fund.

This becomes even more evident when observing performance persistence, both in terms of the funds themselves and the fund managers. Funds which recorded high returns in the past recorded higher than average returns in subsequent years. Fund managers play a key role here – there is a very strong correlation between the performance of all of the funds managed by the same team of private equity fund managers. Fund performance persistence is greater for venture capital funds than for LBO funds. This persistence, which seems to be self-perpetuating, runs counter to results for mutual funds and hedge funds – these types of funds have never been able to demonstrate performance persistence from one year to the next.

The authors show that a good past performance of a private equity fund impacts positively on the subsequent raising of new funds and that managers of the best performing funds make a conscious decision not to grow their funds excessively, in order to avoid moving into zones where returns on investments decline. Here again, it would appear that diseconomies of scale are at work in this industry – investors either find themselves constrained by the employment market (it is difficult and / or expensive to hire a new private equity fund manager) or they are limited by the quality of good investment projects. In our experience, it is the latter that is usually the case.

The authors observed that during periods when there is a lot of money available for investing in private equity, a large number of new funds are set up by new entrants. These new partnerships are created when returns on private equity are high across the whole market. It would appear that the performance of funds managed by these new entrants is mediocre – they are unlikely to be able to raise new funds subsequently. It would thus seem that during periods when the economy overheats and private equity attracts more investors, new funds are allocated to the worst performing players on the market who will invest the money less efficiently. The entry of these players does not have negative impact on the subsequent overall performance of the private equity industry. However, it would seem that the arrival of these new entrants has had a greater impact on the performance of LBO funds than on venture capital funds.

Investment cycles…

(1) Kaplan, S. et A. Schoar “Private equity performance: returns, persistence and capital flows”, to be published in a forthcoming issue of The Journal of Finance.
(2) This measure of the average return is calculated net of commissions, and is weighted by the size of the fund.

Q&A : Can managers have leverage on WACC?

First there is little point in using debt and its tax advantages to lower the cost of capital. While net debt costs less than equity, it tends to increase the risk to shareholders, who retaliate by raising the required rate of return and consequently the cost of equity. Debt works to the advantage of the company, because the interest on the net debt can be deducted from its tax base (which it cannot do for dividends). The opposite tends to apply to investors.

In short, in a perfect world in which investors had diversified portfolios, one man's gain would be another man's loss.

Moreover, if debt really did reduce the cost of capital, one would have to wonder why highly efficient companies, such as L'Oréal, Nestlé, BMW or Heineken, are not levered, given that they have no reason to fear bankruptcy?

Since the cost of capital depends on the risk to the company, the only way it can be lowered is through risk-reducing measures, such as:

  • Lowering the break-even point by shifting from fixed to variable costs, i.e. sub-contracting, outsourcing, etc. Unfortunately, the margins will probably decline accordingly.
  • Improving the business's visibility and smoothing its cyclical nature, i.e. wining medium-term supply contracts with important clients. Here too, however, margins may be affected since, in exchange, the clients will demand price concessions.
  • Diversifying the business does not help as it does not reduce market risk, but rather specific risk, which is the only one to be remunerated.
  • Shifting from a risky activity (e.g. a biotech start-up) in a high-risk country like Pakistan to a safer business in a more stable country, (cheese in Switzerland) also lower profitability. In addition, it would have no impact on value, since it is simply a lateral move in the capital market line (1).

Under certain conditions, financial engineering (by using off-balance sheet financing (2)) can actually lower the cost of capital, but only by narrowing the CEO's margin for manoeuvre. In the real world, there are no free lunches!

In conclusion, managers have virtually no means of lowering the cost of capital while simultaneously creating value. Their only viable strategy is to improve the return on capital employed by increasing flows and reducing the amount of capital employed.

Similarly, increasing the risk of the capital employed increases the cost of capital, but value will not be destroyed if profitability improves at the same time.

(1) For more on the capital market line see chapter 21 of the Vernimmen.
(2) For more on off-balance sheet financing see chapter 47 of the Vernimmen.