Write-Offs May Bruise Egos More Than Finances: With the Demise of Pooling, Buyers Can No Longer Camouflage Overpayments and Botched Deals

It’s time for companies to let it all hang out about their muffed acquisitions – and the revelations won’t be pretty, accounting authorities say. The heaviest penalty may not be in the financial area where the results of squaring bad-deal accounts may look more painful than they really are. But the effects could be excruciatingly embarrassing for managements that have to admit that they paid too much, botched integrations, or just didn’t generate value from their big-buck commitments of the past. Yet, tarnished images and damaged credibility could impose a powerful discipline on buyers and their advisers to tighten up on deal pricing and valuation while treading gingerly in bidding contests and paying more attention to operating their expensive additions after closing. The opening quarter of 2002 is the first time acquirers must come clean as a result of last year’s shake-up in the rules governing accounting for acquisitions. An edict issued by the Financial Accounting Standards Board (FASB), the accounting profession’s rule-making body, scrapped pooling-of-interest accounting treatment for mergers. Concurrently, the board replaced staggered annual write-downs of goodwill with annual tests for goodwill impairment and one-shot write-offs for goodwill that has lost most of its value. Initial tests must be conducted in the January-to-March quarter of 2002 and the first write-offs taken by no later than the third quarter, if required. In acquisition terms, goodwill is generally the difference between the fair market value of a target and the purchase price, so radical goodwill surgery represents a correction of deal misfires. The experts expect huge numbers of these write-offs in the months ahead. “Overpayment is exactly what that is saying,” says Robert Willens, a managing director at Lehman Brothers. “It’s also saying that the goodwill that arose from an acquisition is not going to produce the cash flows that were projected at the time of the acquisition. The cash flows are not going to be anything like what was expected at the time of acquisition.” A few companies with brisk acquisition programs already are ahead of the official curve and have come in with astonishing numbers. Optical-fiber equipment maker JDS Uniphase Corp. is booking write-offs that may go north of $55 billion while AOL Time Warner Inc. has unveiled a write-off in the $40 billion to $60 billion range in connection with the giant merger that created the media behemoth last year. Nortel Networks Inc., the big maker of information system networks, uncorked a write-off of about $12.8 billion in 2001. Future write-offs may not be that stratospheric, but the experts still look for a slew of large erasures, sooner rather than later. “I think you will be seeing a lot of $1 billion and $2 billion write-offs,” Willens projects. And the ranks could very well include acquisition juggernaut Tyco International Inc., which is now moving haltingly toward a big breakup (see page 18 ). Brian Heckler, a transactions partner at KPMG, thinks that aside from dealmaking, the recession will contribute to a significant volume of hefty write-offs. “We have a lot of events converging,” he says. “A pretty significant downturn in the economy has impacted certain industries in a big way. That obviously will have some affect on asset values, including goodwill.” Although managing goodwill remains basically arcane to non-accountants, the current round of tests and write-offs could deliver a wake-up call to buyers, sellers, and their advisory troops. Heckler sees increased dealmaking care, supported by tighter pricing, to avoid future goodwill pressures and repeated write-offs. “There will be a lot more linkage between up-front analysis and what you are going to pay, how you account for it, and how you subsequently test for impairment and have write-offs, along with better descriptions of the whole process,” he says. “They have the potential for increasing management’s effectiveness in the whole m&a arena. It puts a lot more pressure on how effective management is in pricing, identifying problems, integrating and fixing them, and getting results. The records show that seven out of 10 deals don’t deliver value or don’t add value. This process increases the ability of outsiders to see how effective management is.” Heckler’s comments point to the disconnect between the relatively mild financial effects of the write-off and its harsh blow to management credibility. “It’s more or less a bookkeeping entry,” says Willens. The write-off may look huge, even staggering, and may throw a company technically into the red or sharply depress the bottom line. But it has no impact on cash or liquidity and requires “no outlay of resources,” he notes, although some companies may suffer a shrinkage of net worth that violates loan covenants. “I think that the largest damage is not financial but in the perception of managements and managements’ competence in making acquisitions,” he says. Because the financial impact is not dramatic, there’s a potential for misuse of the one-shot write-offs as a recurring safety valve for acquisition mistakes. Just like pooling used to do, Willens says, “I can see where the fact that you no longer have to amortize goodwill can lull you into a false sense of security that can lead to overpayments.” But both Willens and Heckler predict management fears of lost credibility will trump the temptation to cop out via frequent write-offs. To pull off a write-off every year or so is bound to raise suspicions on incompetence, Willens says. The new standards, Heckler points out, were designed to produce greater transparency in acquisition accounting and to speed up inclusion of ill effects in the profit-and-loss statements, thus providing a clear yardstick for judging management capability. Another irony related to the coming round of write-offs is that the companies that may look and fare best were the very firms castigated for parsimony during the acquisition boom of the 1990s. These are the firms that skipped bidding contests and bargained hard in one-off negotiations to keep purchase prices down. Most still managed to complete a healthy number of acquisitions but are now sitting pretty because they are not shouldering huge goodwill overhangs that have to be eliminated amid a glare of publicity. So what firms won’t be so fortunate? There could be some modest concentrations of jumbo write-offs by technology players, service providers, and other businesses that don’t sport a lot of hard assets and almost by definition must ante up the large premiums that lead to heavy goodwill bookings. But both Willens and Heckler believe that deep cuts will run across the board but will fall especially on consolidating industries wracked by intense bidding for targets. “I see it happening where there’s competition for targets, where the industry has been consolidating at a rapid pace,” Willens says. “I don’t see it as being unique to any particular industry.” Heckler says that among the most impacted companies will be those that have made “lots of acquisitions with lots premiums over and above what they assign to assets.” Technology-based companies, for example, may go for targets with attributes that can’t go on the books, such as talent and access to markets. “If you didn’t have a lot of those deals in the past, you don’t have exposure to that now,” he comments. But Heckler says frequent acquirers in m&a battlegrounds will be harder hit, regardless of industry. “These new rules are going to put significant pressure on the ultimate bidder in any kind of bidding war,” he notes. “Bidding wars are usually translated into paying more than you would have if there had not been a competition. So places where there are hostile situations or bidding wars are likely to have greater difficulty supporting the amount you paid over the long run – or you are likely to have goodwill impairment.” If Heckler’s analysis pans out, the new environment also may put significant pressure on investment banks and m&a intermediaries to reconsider their roles in the deals process. Agents representing sellers, for example, shoot for auctions or some kind of competitive bidding contests to stimulate the highest possible prices for clients. They may be checkmated by intensified reluctance among buyers to overpay with the edge shifting to buy-side representatives that can help clients cap the prices. The question is whether the new rules will be more powerful than such traditional drivers of the m&a market as acquisition ardor, strategic needs for coveted targets, and the compulsion to win at any price. There’s still a mystery as to how investors and analysts will deal with the coming write-offs that technically crunch earnings but don’t bother liquidity. Heckler says he has talked to some analysts but notes, “I don’t think they’ve really begun to formulate any opinion on whether a write-off after an acquisition would be viewed as an indication of management’s effectiveness for estimating price or integrating operations, or whether they would view it as something that is more specific to current events.” He adds that while AOL Time Warner’s write-off was of “unfathomable size,” it hasn’t had much effect on the stock price. With the mandate to get the goodwill ball rolling this quarter, many companies needing write-offs may have lucked out on timing. Conventional wisdom is to book all the bad news when times are economically rough so performance looks better in the upturn because the excess baggage has been dumped. That’s why authorities see big write-offs coming early.