Colgate's DCF approach proved valuable in such deals as the company's January 1995 acquisition of the Brazilian firm Kolynos. The economic environment was uncertain — the Mexican peso had undergone its steep devaluation just a month earlier (Kolynos had operations in Mexico) — and Brazil was coping with its own high-inflation environment. The valuation methodology enabled Colgate to compare this investment with others it might make elsewhere.
Now a corporate director serving on the board at Allied Waste Industries Inc., Agate has seen yet another new factor improving the depth and breadth of an acquirer's information: board activism. Inspired in part by the post-Enron focus on governance and the threat of shareholder lawsuits, board members have been pushing corporate managers to make a stronger case for the deals they propose. "For me, acquisition justification must cover at least strategic consistency; the financial plan, including scenarios for growth; and synergies, discounted cash flow expectations, and general risk issues," says Agate.
More-thorough due-diligence efforts also give acquirers better insight into the costs and revenues of target companies — and, of increasing importance, also their accounting practices. "Buyers are really doing much deeper accounting diligence now," says Glenn Gurtcheff, managing director and co-head of middle-market M&A for Piper Jaffray & Co. in Minneapolis. "They're not just taking the company's audited and unaudited financial statements at face value; they are really diving into the numbers and trying to understand not just their accuracy, but what they mean in terms of trends."
The Overpayment Quandary
Better DCF forecasts have another benefit: the ability to increase the complexity of M&A financing.
The past decade saw a rise in mezzanine financing, contingent convertible bonds, and interest-only notes, among many other structures — products that in some cases provide acquirers with cheaper and more flexible sources of capital.
Willamette's Reilly argues that such financing has become possible largely because better valuations have helped lenders see that deal pricing is less risky. "If you have done a rigorous analysis, are certain about the discount rate, and really know what the expected cash flow is going to be over the next 10 or 20 years, then you can convince the lender and the equity holder to buy these securities at a reasonable price," he says. "On the other hand, in the 1980s you might have priced the deal simply on multiples. The lenders would have said, 'I'm not really confident about what the future will bring, so I'm not willing to purchase that kind of security.'"
He cites the recent example of a $3.7 billion acquisition of power-generation company Texas Genco Holdings by a consortium of private-equity companies. The highly leveraged purchase included several layers of debt financing, made possible because the consortium was able to persuade lenders that its cash-flow forecasts were accurate. As part of the deal, buyers had arranged to sell some of the company's future electricity to investors as a commodity hedge.
If valuation has improved so much, why do analyses show that companies so often overpay? One obvious reason: the inexactitude that can creep into pricing when synergies are calculated poorly (see "Fool's Gold," New Deals, February). And then there's the role of the imperial CEO.
Thomas Lys, an M&A professor at Northwestern University's Kellogg School of Management, says the improvement in valuation techniques can be negated when M&A deteriorates into a game of tweaking the numbers to justify a deal the CEO wants to do regardless of price. "Valuation is just an excuse," he says. "The moment it becomes clear that the CEO wants to do the deal no matter what, his investment banker and advisers are best advised to tell the emperor that his clothes are beautiful." In other words, value is one thing — price can be quite another.
Don Durfee is research editor at CFO.
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