“We’re seeing some companies that were previously owned by a private equity firm four or five years ago being re-acquired by that same PE firm. So it’s really a strong market, strong valuation, in many ways a seller’s market.”
Strategies from an industry pro to avoid common intangible asset valuation issues
On this episode, Kison talks with PJ Patel, Co-CEO and Senior Managing Director at Valuation Research Corporation (VRC). VRC is a full-service, independent, global valuation firm that focuses exclusively on valuations that offer judgment beyond modeling. Kison and PJ discuss how to navigate intangible asset valuation in today’s market, how the current M&A climate is affecting valuation, and how to avoid the most common mistakes when conducting a valuation.
PJ is a valuation professional with a focus on the valuation of assets, liabilities, and businesses for financial reporting, tax, and other corporate purposes. He leads VRC’s financial reporting practice and is a frequent presenter on valuation issues. He recently spoke at the Financial Accounting Standards Board (FASB) roundtable to discuss how goodwill is valued and is often quoted in the press regarding valuation issues.
“In today’s environment where companies are more intangible asset-based rather than tangible asset-based, there’s probably an evolution that needs to happen in terms of how you value inventory.”
Text version of interview
Let’s kick off with a brief introduction on yourself.
I am Co-CEO at Valuation Research Corp. I spend a lot of time speaking with companies, clients, presenting on valuation issues around financial reporting and tax. I also work on a lot of deals and get to see a lot of different structures and that’s a big part of what we do.
How do you see the current M&A climate affecting valuation?
It’s really a strong market and strong valuation, and, in many ways, a seller’s market. Multiples are increasing and there is a lot of competition for good companies.
Can you talk about some of the trends you are seeing in structures?
From a structure standpoint, there is often a gap between the buyer and the seller. We see the already seen structures, but more of them. They are announced and usually doing partial sales as opposed to the entire sales.
What do you think is going to happen long term? What do you think are some of the repercussions of these deals if they don’t get their anticipated value?
There is lot of dry powder out there and share prices for public companies are really high, given where the S&P 500 is at these days. The models that we get to see are probably getting a little more optimistic, a lot of synergies are being built in and companies are focusing on synergies at the time of the acquisition, as opposed to probability adjusting those synergies over time. Overall, I believe deals will continue at the rate that we have seen in the past few years.
What are some of the most common valuation issues you are seeing in M&A transactions?
Number one is how competitive the environment is. It’s pretty rare to see a proprietary deal, and when you have that sort of environment, everybody knows they have to put their best foot forward in terms of doing the deal and the price that they are willing to pay. From a technical standpoint, from time to time we see errors in the deal. With high prices, we also see impairment issues as you move forward and today when companies are doing deals there isn’t a whole lot of margin for error.
Beyond just looking at transactional M&A valuation, what other types of valuation issues could come up?
Some of the issues we are seeing are on the tax side with tax reform here in the U.S., but also the implications of that globally. We are seeing tax jurisdictions around the world becoming more and more aggressive in how they tax companies, how they look at IP, and how stock compensation is valued.
Regarding goodwill impairments - How do they reveal the quality of management?
What we see is a typical pattern. Companies do the deal and about six months in, they realize the company is not at the exact spot they thought it was. The first five years they spend getting to the point where you feel like they got an asset that they paid for. At this point, most companies don’t have an impairment, and beyond five years there is impairment from time to time but it typically doesn’t relate back to the acquisition model and the purchase price. So, in zero to five years it’s all about the deal that was done and beyond five years, its about management’s ability to adjust and adapt over time.
Could you give a brief explanation of what goodwill impairment is for those that aren’t familiar with it?
In the simplest form, it’s basically the comparison of the carrying value of the company with the fair value. So, if you do and acquisition for one hundred billion, that becomes its carrying value. On day one, you are comparing the fair value of the company with it’s carrying value. By definition, on day one, the two are equal to each other.
What is the impact when there is a significant difference between the two?
You need to look at things such as are there assets that are impaired, do you have long-lived assets or fixed assets, and are intangibles that are being advertised impaired. If there is a difference you need to look at other impairments that exist. In many situations its probably single digits on a percentage basis.
What is the biggest obstacle you face when it comes to intangible asset valuation?
Today there are really good methods that can be used to value intangible assets and some of the things that are hard to value, such as a consumer product brand, technology, or customer relationships that aren’t contractual, but more transactional. An earlier stage company is harder to value than a later stage company, but overall the tools are in place.
What kind of tools would be out there to help you?
With intangible assets, the relief from royalty method is something that’s been out there for a long time. It’s good and objective, but on the other hand, the negative is that you probably don’t have the identical asset being licensed. There is also another method called Multi-Period Excess Earnings Method and it relies on the forecast for the company. It takes contributory asset charges for use of trademarks technology and working capital, fixed assets, and other things.
You come up with a residual cash flow amount and you infer that cash flows relating to the asset that you are trying to value. It is commonly used, especially for customer relationships. There is also a distributor method and here we use the distributor data as a proxy for the inputs that we would use as a customer relationship model.
Why is there such a variance between sectors?
There’s going to be differences because of different patterns. There are situations where one particular methodology is more relevant or prevalent to one industry versus another.
And what about strategic views when it comes to valuating a business?
There are differences between a strategic buyer and a financial buyer, but that difference is declining. Today, synergies are a big part of the acquisition rationale in both cases. We frequently see synergies as a significant component of cash flow that’s being generated. A lot of times it is operational synergies that are easier to get your arms around, but from time to time you also see revenue synergies, which makes things a little more difficult.
Synergies are very unique to the deal. In terms of your role, is that part of the valuation or is that something that just needs to be done by the company?
We are typically not brought in to look at these synergies. However, being an analyst, we see these deal models, we are informally looking at these things and we get to analyze if they are aggressive or not, do they overpay or not. Part of that is also that we are broadening at the time of the deal to do a purchase price allocation and after the deal, we are doing goodwill impairments and similar and we get to see when companies overpay, which is what we see first.
A lot of folks, especially the corporate setting are primarily incentivized to close deals. Does that correlate with them being so optimistic in their predictions?
I think it does. The CEO and CEOs’ office has a strategy in terms of what they want to do and where they want to go and corporate development teams do a lot of the heavy lifting to achieve those goals. I think there is a balance. On one hand, there is the corporate development team that is incentivized to do the deal, and there is the controllers group that has to account for these things. There is a push and pull between these two groups and in a good company, this internal friction leads to a positive outcome.
You have a criteria you usually want to measure success on, but don’t things get a little foggy after the deal in terms on whether the objectives are met or not?
That definitely happens over time. Typically what we see, if the deal is big enough, in the first few years you are not completely integrated and you still have balance sheets and income statements that you can leverage for this testing. Beyond three years, this gets harder and harder to do. Within the first year, 95 percent of the time you still have good financial statements and after year three it’s 50 percent of the time.
Do you see companies pushing or specific firms that really pushed to get it done in a year?
Yes, and typically it is a smaller transaction. Even if you want to integrate immediately, my experience is that you get to that moment maybe three or six months in. Even the most optimistic company that wants to integrate significantly as close to transaction as possible ends up holding businesses out as separate entities, separate reporting units until they can really get their arms around what they have.
I was reading that the inventory valuation practice rules and methodologies are from 1977 and haven’t been updated since. Why is it taking long for rules and regulations to get updated?
In today’s environment where companies are more intangible based rather than tangible asset-based there is probably an evolution that needs to happen in terms of how you value inventory. Companies have been complaining about this because it dilutes earnings in year one and dilutes the profit margins that the company will generate. When you think about inventory needing to be valued as part of the business combination, what you are trying to do is compensate the seller for activities that happened prior to the closing of the transaction. This means that they have taken some raw materials and converted them and the thing is we know today how to calculate and value those things directly.
What do you see making a bigger impact on intangible asset valuation, conceptual problems, or practical problems?
I don’t think today either one is an issue. When you look at VRC I can say we have a lot of practice in doing deals and identifying assets. In terms of practical issues, the IT systems of the companies we work with are so well developed that we have a pretty good understanding of how to get to the inputs that we need to value assets.
Are pain points of goodwill valuation generally agreed upon universally, or do you see opposing viewpoints from different sides of the industry?
Pain points are the same. Valuation itself is pretty easy and typically there is a pretty good market data available as well. As you move from there there are some things you need to look at in terms of taxable and nontaxable transaction structures, which becomes a little more difficult. What becomes difficult for the companies is, once the valuation is done, there is a lot of audit scrutiny around it, there’s PCAOB’s and things like that.
Do you think the trend of tax restrictions becoming more aggressive worldwide will continue?
I think so. Everybody wants their piece of the pie. Everybody wants to ensure that they are getting the right amount of tax inflow as a result of activities that are happening in their country. This is not just legal or contractual, but also economic risk-based.
Why do people give valuations in the first place?
What we are involved with is more regulatory based. At the time companies do a deal, be it for the board, tax, or financial reporting, you need a third party like us to give you an opinion of value. Your board may want to know if the deal is fair or if the company is solvent after doing a deal. For tax purposes, you may need to allocate value to the different legal entities around the world. For financial reporting purposes, you may need to identify what assets you’re acquiring, the intangible assets, goodwill, tangible assets, etc.
What are the biggest concerns when getting a valuation done?
We are just looking at the deal and making sure that there is consistency between why the company did the deal, what they pay and what they’re projecting. It is important to understand why the company is doing the deal and how their model reflects that. Sometimes there can be problems in terms of how to communicate the deal internally and externally, how do you hold up to external scrutiny and similar.
Do you ever get people that try to influence valuation?
Luckily, it happens only from time to time. There is always going to be scrutiny and it probably comes from areas you did not expect at the time of the valuation. We find that doing a valuation that benchmarks, where the market is objective and neutral, is the best thing we can do for ourselves and our clients.
Do you interact with people-side of these deals when doing valuation work?
Not really. We do due diligence as part of the valuations that we do, so we get to interact with management. If we are doing an independent valuation that’s maybe outside of the transaction, it may add to the risk profile that we look at for the company. There is always a subjective risk element that we have the ability to add in if appropriate, but it’s not something that we see every day.
What’s the craziest thing you’ve seen in M&A?
There was this company that we were evaluating for a while and they had some trouble with their value. A strategic came in and they paid two billion dollars for it, which was 100 percent more than what we valued the company at. I was really surprised, given the things that we’ve seen.
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