It will come as no surprise that merger and acquisition activity in the construction industry has decreased in the past 18 months. The same is true across all sectors of the economy. Acquisitions that were completed were strategically focused. However, for those companies with the financial resources, the past 18 months have presented opportunities for growth and expansion at a reasonable price.
Strategic vs. Financial The current trend in mergers and acquisitions (M&A) is toward strategic rather than purely financial deals. Buyers and sellers often are looking for a strategic match that complements their business, expands their geographic presence or eliminates a competitor. Struggling companies, including those emerging from Chapter 11 bankruptcy protection, are vulnerable to take-over. Additionally, the ready financing of two or three years ago seemingly has dried up, so that even though there are opportunities to pick up great companies at bargain prices, cash has not been readily available to finance the deals. Therefore, when a financially stable suitor appears and promises to save the day for pennies on the dollar, too often it’s an offer that many are finding hard to refuse.
Finally, private equity firms, which were buying up everything in sight showing a profit, have been less prevalent in the market.
One explanation is that there are fewer profitable companies to choose from. However, this absence may be short-lived. It should be noted that private equity firms are sitting on approximately $400 billion in funds waiting to invest. The reasonable assumption is that they will soon return to the market looking for opportunities.
Cash vs. Financing Many companies that have made strategic acquisitions in the past year have done so using their own war chest of cash reserves. This has given them tremendous leverage in the marketplace, as they have acquired companies at one-third to one-half of what they would have paid a year earlier. For the strongest companies, including those with large inventories of equipment to use as collateral and those with a healthy backlog of business, bank financing was still available but the process was arduous. Prospectively, as the financial industry continues to be more risk-adverse, it may take several sources of financing on a participating basis to complete a deal where traditionally one bank was involved.
Deal Structure Acquisitions are generally structured in one of two ways: the purchase of the stock or ownership units of the target company, or a purchase of the target company’s assets. Generally, a stock purchase brings with it all the assets and liabilities of the target. An asset purchase allows the acquirer to pick and choose the assets it wants to purchase and the liabilities it is willing to assume. In the current economy, with greater risks of potential unknown liabilities, unpaid vendors and potential unpaid taxes, an acquirer must give serious consideration to the structure of a proposed acquisition. An acquirer also must give careful analysis to the integrity of the backlog, work-in–process, assignability of the contracts, and the look-back liability. Comprehensive due diligence by qualified professionals is paramount.
An additional trend in M&A deals is the greater utilization of earn-outs and contingent consideration. The percentage of the purchase price that is contingent upon the future performance of the company has grown substantially. Buyers now expect sellers to be able to prove their expected growth or performance projections before they are willing to write the check.
New Accounting Rules To top off everything else occurring in the economy, in 2007 and 2008, the Financial Accounting Standards Board and the International Accounting Standards Board established new rules for the accounting for business combinations. They determined that a new method, the acquisition method, would become the new standard.
The two areas in which M&A deals are most impacted by these new rules are as follows:
Contingent Consideration – Contingent consideration can be classified from an accounting standpoint as either equity or a liability (or an asset if contingency is returnable). When accounted for as equity, contingent consideration should not be re-measured; its subsequent settlement is accounted for within equity. But when accounted for as a liability or asset, contingent consideration should be fair-valued and re-measured at each period until the contingency is resolved. The changes in fair value are recognized in and have an impact on reported earnings.
Acquisition-Related Costs – These are costs the acquirer incurs to effect the business combination. Direct costs include legal, accounting, valuation and consulting, and finders’ fees. Indirect costs are associated with maintaining an M&A department. Acquisition costs should be expensed in the period they are incurred, while financing costs, which include costs to issue debt or equity instruments, generally are not considered acquisition costs and usually are capitalized. For tax purposes, said costs generally are required to be capitalized subsequent to the date of the letter of intent.
While the face of business growth in the construction sector has changed to become more strategic, with proper planning, structuring, due diligence and creative financing, opportunities remain to grow through M&A.
Edward Kidner has more than 29 years of experience and specializes in mergers, acquisitions, reorganizations, divestitures, due diligence and tax planning and structuring for large public and privately-held entities. Kidner also is an accomplished public speaker, conducting presentations for Clifton Gunderson and for industry and trade organizations.