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And How Will You Be Paying for That?

To the alternatives of cash, common shares, or a cash-common blend, you may add preferred stock.
Andrew Osterland, CFO Magazine
February 1, 2002

For most of the past decade, the bull market made common stock the favorite currency for corporate acquisitions. It kept buyers from overleveraging themselves, and allowed them to avoid huge charges by accounting for a deal as a pooling of interests, in which the balance sheets were merged and no goodwill was booked.

But two changes in the world suggest that common's heyday may be over, and that an old friend--preferred stock--may be about to make a reappearance.

The most dramatic change is in the market, of course. In most cases, a company's common stock just doesn't buy what it used to, and fewer buyers or sellers are keen on it as payment. The proportion of cash in the average deal thus increased sharply in 2001.

Almost as important, though, is the disappearance of the pooling-of-interests merger-accounting method, which required the use of common stock. The Financial Accounting Standards Board's final deadline for pooling transactions was on June 30 of last year. Now, companies must employ purchase accounting, regardless of payment terms. And stock offers no advantage in purchase accounting.

"With pooling of interests no longer a factor, I expect to see more eclectic forms of consideration used in business combinations," says Robert Willens, a tax and accounting expert with Lehman Brothers. And preferred stock is one tool he thinks companies may now employ more frequently in financing their acquisitions. Like corporate bonds, preferred shares offer investors a predictable income stream, in the form of dividends that must be paid before any distributions to common shareholders. While those preferred dividends can't be deducted for tax purposes, as interest payments on debt are, preferred shares offer the same equity relief for stressed corporate balance sheets that common stock does.

The U.S. market in general has reflected a renewed interest in preferred stock. Through December, issuance was up 168 percent, to $41 billion, while common stock underwritings fell 32 percent, to $128 billion, according to Thomson Financial Securities Data. RenaissanceRe Holdings Ltd., a Bermuda-based reinsurance company, sold $150 million of 8.1 percent preferred shares to investors on November 14. "With interest rates down, the appetite for the [preferred] paper was strong," says CFO John Lummis.

While no major acquisitions were completed using preferred shares last year, it's only a matter of time, say some experts. "Whether companies sell preferred shares to the market or use them as actual currency for acquisitions, I expect to see more of them going forward," says Fitch analyst Glen Grabelsky.

A big advantage of equity is its ability to preserve a transaction's tax-free status for selling shareholders. For an acquisition to qualify as a tax-free reorganization, sellers must maintain a "continuity of interest" in the new business. That's usually accomplished by a common share swap, but preferred shares can also do the trick.

Last July, media company USA Networks offered a combination of common, preferred, and equity warrants worth roughly $1.5 billion for online travel company Expedia, founded by Microsoft Corp. Microsoft owns 66 percent of Expedia's shares, and stands to make a profit of $650 million on the sale. The deal has since been delayed because of Vivendi Universal's proposed acquisition of USA Network's entertainment assets. But if the USA-Expedia deal is done, Microsoft's gain would be tax free, at least for the time being.

For his part, Willens cautions companies to heed legislation passed by Congress in 1997 defining "nonqualified" preferred--shares that are taxable because they fail continuity-of-interest standards. (For example, if shares are redeemable by holders after a short period, or convertible but very unlikely to be converted, they may fail to meet these standards.) Still, says Willens, "if companies issue 20-year nonputtable, nonredeemable preferred stock, recipients can usually get it on a tax-free basis."




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