Acquisition Appraisal – The M&A IRR Test
16 May, by
Article 16:
Written by : Michael Matthew Lee
Acquisition Appraisal – The M&A IRR Test
(preventing post-acquisition impairment upfront!)
- Introduction
During the 40-odd years when I was Group CFO of listed companies executing many M&A deals, I realised that there is no way to appraise the estimated return of an acquisition upfront. We tend to pay hefty “goodwill” for the target, largely based on a percentage of its value. And the reasonableness of the premium is based on industry norm. But industry norm does not consider the company’s (bidder’s) financial and operational characteristics, nature, and situation of its businesses. With a premium paid on the acquisition there will be inevitable erosion of the shareholder value! And if the company cannot fully realise its acquired synergies, and implement its strategic plans, serious impairment of the acquisition (target) would ensue.
Currently the appraisal of the target is based on many factors which are not known immediately. We need a metric to enable us to decide very quickly whether the target is worth pursuing.
We must then know upfront the “return on investment” or IRR (Internal rate of return) on the acquisition (its purchase price) and how much it is below the bidder’s hurdle rate (WACC – Weighted Average Cost of Capital). So, to compute the acquisition‘s IRR, we must turn the acquisition exercise into an investment appraisal exercise. There are reasons why currently this important aspect of M&A deals cannot be done. It is simply because M&A deals do not and cannot easily provide the data necessary to compute IRR.
- Acquisition appraisal- Importance of IRR
Why is IRR so important is assessing an acquisition purchase price?
In a normal acquisition, we establish the company value of the target. We then work on due diligence to determine the synergies to be extracted from the target (among other considerations and factors) and arrive at a defensible purchase price. We then raise funds (either debt or equity or a combination) for the acquisition. Let us pause for a moment to assess what could go wrong so far.
a) The cost of funding is WACC, say at 9%, and it sets the hurdle rate to determine if the acquisition provides a return (its IRR) higher than the hurdle rate. Unfortunately, there is no way you can determine the IRR of an acquisition! Why? Because an acquisition deal is not an investment appraisal exercise!
b) If somehow we can establish the acquisition‘s IRR, then we will need to know the IRR at 2 points viz. at target value, and at target purchase price.
c) We need to know if target value IRR is higher or lower than hurdle rate and to what extent.
d) We also need to know to what extent the target purchase price is lower than hurdle rate, knowing full well that there is a “goodwill” element in target purchase price.
e) With a good understanding of the 2 IRRs vis-a-vis the hurdle rate, we can assess how well we can
I) determine at which point in the negotiation we have to walk away because the IRR (of the purchase price) is well below the acceptable IRR established by the bidder’s financial policy.
ii) comfortably close the gap between hurdle rate and IRR of purchase price within one year based on the expected realisation of the identified synergies and other strategic growth factors in the acquired company.
The crux of this issue is the establishment of the acquisition IRR. And this could be done by turning the acquisition exercise into an investment appraisal exercise. We will then be able to make a cogent decision on whether to accept or reject the acquisition and not allow the acquisition to be accepted “blindly” resulting in post-acquisition impairment!
- The characteristics of an M&A.
Before we get into the computation of the acquisition IRR, we need to understand the characteristics of M&A.
These are,
a) we do not know the investment amount upfront until a business valuation is done on the target and negotiated price finalised.
b) business valuation is based on after-tax cashflows in perpetuity of the target and application of WACC to discount the cashflows to present value. There is no fixed duration.
c) discount rate may be adjusted for riskiness of the cashflows.
d) a “goodwill” element is added to the valuation for purchase price of the target. And this purchase price may seriously erode shareholder value, unless we know what the return on investment in the target (its IRR.) is
Given the characteristics of the M&A there is currently no way to determine how badly the purchase price could “eat away” shareholder value and this causes the impairment of the target post-acquisition! All we can acknowledge at point of S&P (Sale & Purchase agreement) is that goodwill is say, about 20% of target valuation and should be acceptable based on industry practice. But industry practice is generalised. Much depends on the nature, characteristics, and financial situation of the bidder! And the 20% “goodwill” may well result in say 2% IRR (in total purchase price) against bidder’s hurdle rate of 9%! That 7% gap may not be acceptable under the company’s financial policy! It would be extremely hard to close that gap within a year after target acquisition.
- Investment appraisal
We also need to understand the characteristics of investment appraisal, since we are going to turn the acquisition exercise into an investment appraisal exercise.
To perform an investment appraisal, we need
a) the investment cost upfront
b) constant stream of after-tax cashflows, and
c) a finite lifetime (duration of project).
All these data are not available at the outset in an M&A exercise!
We therefore have to make certain adjustments and assumptions to turn the acquisition deal into an investment appraisal proposal.
- The 7 pitfalls in M&A deals
Before I explain the M&A IRR Test, I would go through briefly the 7 M&A pitfalls. This allows us to appreciate the importance of appraising the acquisition upfront instead of proceeding with it “blindly” in the false hope of redemption and subsequent “salvation“!
5.1. Acquisition strategy
Most companies perform M&A opportunistically, without any formal corporate planning framework. This would result in sub-optimal results at best, especially when there is no acquisition appraisal upfront.
5.2. Extent of acquisition deals to fulfill strategic objectives
To achieve strategic objectives for corporate growth, there must be adequate knowledge of size (in turnover terms) and number of acquisitions. Currently there are no tools to enable this requirement. I have developed a financial model to satisfy this.
5.3. Target valuation/overpayment
Valuation of the target is normally performed based on business valuation models. This can be miscalculated if assumptions given are inadequate or non-defensible. The purchase price is then negotiated based on a premium (“goodwill”) over target value. There are always concerns in over-pricing simply because currently, acquisition appraisal (IRR of the acquisition) cannot be assessed.
5.4. Inadequate/misdirected DD
Due diligence is the most important part of the M&A exercise. If done hurriedly or inadequately, it impinges on the negotiation and finally the purchase price.
5.5. Quantification of extracted synergies
As the M&A exercise is primarily to extract synergies from the target to enhance and grow shareholder value of the bidder, wrong or lack of identification and quantification of synergies will impact due diligence, resulting in a purchase price which is inadequately defended.
5.6. Acquisition funding
Funding either by debt and/or equity can impact the WACC rate and/or the combined EPS. So a careful use of funding is critical.
5.7. Post-acquisition integration
This is the most intriguing part of the exercise as many factors cannot be foreseen at acquisition. Besides proper integration of all the key functions of business, and the realization of synergies, the implementation of strategic plan is the most difficult. It depends on how well the target CEO (on a 3-year continuing contract) is forceful enough to bring the business to new heights.
All these pitfalls are fully discussed in my book “Corporate Growth & Cashflow Sustainability” Online orders at:
Books Kinokuniya: Corporate Growth & Cashflow Sustainability / Lee, Michael Matthew (9789811886102)
If the acquisition is a non-starter at the outset based on an acquisition appraisal, we can avoid having to suffer the pitfalls and the subsequent impairment. We therefore need to perform an acquisition appraisal to determine whether to accept or reject the acquisition. If accepted, then the purchase price is defensible and subsequent impairment could be avoided.
- Acquisition appraisal – the M&A IRR Test
The M&A IRR Test is akin to the IRR in investment appraisal where we accept or reject the investment if the IRR is above or below the hurdle rate.
After much thought and analysis, I have concluded that the way to compute the M&A IRR is as follows:
Step 1. First determine the company valuation (enterprise value) of the target using WACC (or with risk premium) as discount rate. This is akin to the investment cost under an investment appraisal exercise.
Step 2. Assess duration of Cashflows up to the point (the distant year) when discounted cashflows gravitates into insignificance. This is akin to the fixed duration of the project under investment appraisal.
Step 3. Given the valuation of the target, the fixed duration in Step 2, and the WACC, we can find the amount of constant stream of yearly cashflows.
Step 4. Compare this yearly cashflow (in Step 3) to the steady state cashflow in year 6 (or start of RV (Residual Value))
Step 5. Adjust constant yearly cashflow stream accordingly.
Now you have
- Constant after-tax cashflows
- Fixed Duration
- Investment cost (target purchase price – target value plus premium)
and it becomes an investment appraisal exercise or an acquisition appraisal exercise.
Step 6. Use Excel formula to find the IRR of the “acquisition/investment” project.
Step 7. Compare IRR in Step 6 to bidder’s hurdle rate. Assess the gap and
a) consider reasonableness, and
b) bidder’s ability to manage it in the short-term to close the gap.
c) accept or reject the acquisition based of the bidder’s financial policy.
This gap establishes the potential shareholder erosion of the acquisition and if not well managed will result in post-acquisition impairment.
To be able to apply the M&A IRR Test, accountants/CFOs will need to fully understand:
a) the characteristics of an M&A process and target valuation
b) business valuation parameters ie explicit forecast period, residual value, Gordon model, WACC/discount rate, enterprise value and equity value.
c) investment appraisal mechanics and metrics ie IRR and NPV.
Further discussions on the M&A IRR computation will be covered in my “The Finance Managers’ Masterclass” Run 35, commencing on Thur 6 Jun 2024. Weblink as follows:
- Moving forward
This concept of an acquisition appraisal using M&A IRR Test was “germinated” when I was writing my 2nd corporate finance book “Corporate Growth & Cashflow Sustainability”. I realised that it is not addressed at all in financial circles, and it is good for academic institutions and corporate finance bodies to develop this concept further, to take the “sting” out of M&A exercises upfront!
It helps significantly in determining the IRR rate during the negotiation process instead of just depending on extraction of synergies and gut feel. It establishes firstly, the extent of IRR above the hurdle rate when a premium of discounting of Cashflows is applied in valuing the target, and secondly, the IRR below the hurdle rate (based on purchase price) which cannot be rationally acceptable. Current practice does not have such decision tools/metrics.
- Conclusion
I hope that there will be continuing discussions in this area of corporate finance (M&A) and that the M&A IRR Test becomes a necessary part of M&A deals in mainstream practice.
——————————————-MMLee 16May24—————————————–
