Three ways takeovers rip off shareholders

Directors love takeovers. But shareholders should loathe them. As Thisismoney.co.uk reports, "disastrous decisions by the bosses of Britain's biggest companies have resulted in the loss of billions of pounds after value destroying takeovers". The damage amounts to more than £80bn. Takeover accounting rules offer directors a triple bonus: they make predators look good, allow them to cushion poor performance for years after an acquisition, and only reveal it was a bad idea years later.

The biggest culprits

Many firms do takeovers badly. Vodafone wrote off £45.2bn following its £112bn acquisition of German telecoms company Mannesmann in 2000. ITV has written off £2.6bn, more than its £2.5bn stockmarket valuation. Royal Bank of Scotland wrote off £14bn in goodwill following its mis-timed acquisition of Dutch bank ABN Amro in 2007. Many studies show that takeovers add little value to shareholders. So why can't directors see that?

Why feeding frenzies are so common

For an ambitious FTSE 100 director, takeovers are all good news. He or she is only interested in boosting the firm's share price quickly, being poached by a bigger firm and moving up the FTSE 100, and taking an ever-increasing paycheck.

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Why grow a firm the hard way ('organically') when you can buy another? Deals are a self-congratulatory love-in for bankers and directors with a five star post-deal dinner thrown in better than the boring challenges of running an existing business. They are also self-perpetuating once deal frenzy takes hold, in every business cycle the mind-set is "eat, or be eaten".

Plus they generate huge fees (usually a percentage of the deal) for the investment banks who push directors to take bigger and bigger risks. All this is well known. But the games directors can play with the numbers add a few nasty twists. Here are the three big ones.

The goodwill pump and dump

When one company buys another, it creates a headache for the bean counters what to do with the gap between what a firm pays and what it gets in return. Say you buy a firm (either by buying its assets or a majority of its voting shares) for £12bn. Its 'net assets' might only be worth, on paper, £6bn. Why the gap?

You are not just buying the 'net assets' such as machinery; you are also buying reputation, market share and expertise (people). These are hard to value, so accountants call them 'goodwill' (£6bn here). It then sits on the predator's balance sheet as an 'asset', written off over some arbitrary 'useful life' of 20 years. Occasionally it is tested for 'impairment' a permanent drop in value.

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What is goodwill?

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Directors at Vodafone, ITV and RBS admitted, years later, that they over-paid. So goodwill is written down fast now.

If it sounds like a huge accounting fudge, it is. Helpfully (for directors) most analysts ignore goodwill. A number they like earnings before interest, tax, depreciation and amortisation (EBITDA) strips it out. So directors gamble that the rest of us won't be interested in goodwill, let alone interpret it, and they'll get away with awful purchases. But this is not the only benefit of the takeover rules.

Every pig comes with free lipstick

Goodwill is the difference between what you pay and what you get. The purchase price is hard to fudge, but what about the 'net assets acquired'? When you buy a firm, your accountants do 'due diligence' scour the numbers and the business to check the two stack up.

But determining a 'fair value' of a firm's assets requires judgement. Some, like the debt book, might need writing down straight away. Perhaps extra provision should be made for costs you will incur as the buyer.

Say the target declares net assets of £6bn and you decide these need to be written down by £1bn. Goodwill rises to £7bn (£12bn less £5bn). In accounting terms, you now have a £1bn cushion on your books. You can later claim you were too cautious and write this buffer into your profit and loss account as a gain. Yet you always knew you'd do this to mask your poor business integration skills and ensure the results look good post-acquisition.

The timing trick

Timing is everything in takeovers. Say you buy 100% of a firm midway through this financial year that's made £100m of operating profits for a while and is forecast to continue to. From the midpoint of this year you own it, so under the accounting rules you report its profits as your own and present a combined result. You will report none of the target's £100m of profits made last year, half of this year's £100m, or £50m, and all of next year's profit of £100m. You show your shareholders a profit profile for the target that reads £0, £50m, £100m for three consecutive years. Suddenly a firm that isn't growing is doing so magic!

Takeovers are often a con

Takeover rules allow directors to cushion results after a deal and unwind the fact that they overpaid years later. They reckon you won't understand this or they will have moved on before you find out. So be wary of fast-moving, acquisitive firms.