Acquisition Due Diligence – Pro Forma Information
Author: Doug Van Meter
Bank acquisitions have increased in the last three years and are approaching pre-financial crisis levels. Approximate average deal value to tangible common equity is 140 percent for 2014, based on 226 completed and pending deals, compared to 235 percent in 2007 for 247 deals. Average deal values to earnings are slightly lower after the financial crisis—23.8 percent in 2014 compared to 25.5 percent in 2007.
Source: SNL Financial
Various factors have contributed to the rise in bank acquisitions—increased regulatory compliance, succession planning issues, increasing capital requirements, the need to leverage excess capital and uncertainty in operating risk associated with government regulations. Many bank management teams are assessing their strategic plans to buy or sell.
While this article is geared toward banking organization buyers and their due diligence in preparing pro forma financial information, sellers may find this information useful as well.
One of the first considerations in the acquisition process is obtaining regulatory approval. The application process should include thorough due diligence of the target, a well-documented post-acquisition business plan and pro forma financial statements and disclosures with post-closing capital ratios. Pre- and post-close capital ratios will be an important area of emphasis for regulators to evaluate the viability and ultimate approval of the transaction. Therefore, the buyer should carefully evaluate the transaction and recording of pro forma financial information.
The first step in preparing accurate pro forma financial information and disclosures is summarizing the deal contract, including the purchase price, contingencies, obligations and transactions occurring due to a change in control provisions and transfer of assets acquired and liabilities assumed. Once a clear understanding of the transactions is obtained, the acquirer will need to apply Accounting Standards Codification (ASC) 805 – Business Combinations to the transaction, which requires a thorough analysis and recording of assets acquired and liabilities assumed at fair value. Here are some high-level reminders for recording a target acquisition:
- With limited exceptions, assets acquired, liabilities assumed and noncontrolling interest are recorded at fair value.
- Merger-related costs, such as legal, accounting and consulting fees, aren’t capitalized into the acquisition price.
- None of the target’s allowance for loan losses transfers to the acquirer.
- Goodwill can’t be adjusted one year after the acquisition.
- Any excess of net assets acquired over the purchase price (formerly negative goodwill) is recognized in earnings as a bargain purchase gain.
- The acquisition date is the date assets are acquired and/or liabilities are assumed.
- Fair value adjustments may be made post acquisition within a year of the acquisition date.
Estimating fair value can be challenging before the acquisition and may require outside assistance, particularly with loan portfolios and intangible assets. Bankers generally practice good due diligence processes when evaluating loan credit quality; however, other fair value adjustments often are overlooked, such as those related to current interest rates and terms as compared to a contractual agreement in place, liquidity premiums or prepayment estimations—all of which can have a material impact on fair value measurements individually or in the aggregate. This is similar to other financial instruments, including deposit portfolios and long-term debt arrangements, such as Federal Home Loan Bank borrowings. In addition, all intangible assets, such as core deposit intangibles, must be identified and recorded at fair value as of the acquisition date. Property, plant and equipment acquired also must be recorded at fair value as of the acquisition date. Third-party valuation specialists may need to measure the fair value of these assets.
The effects on the financial statement may be long-lasting due to post-acquisition accretion or amortization of discounts or premiums applied to assets and liabilities to arrive at fair value. These subsequent adjustments and impairment considerations are important to the pro forma financial disclosures because they may have a significant impact on the entity’s operations and cash flows.
It’s also important to understand Statement of Financial Accounting Concepts No. 6 (Con 6) – Elements of Financial Statements regarding elements of financial statements and criteria for recording an asset or liability. In some cases, assets or liabilities recorded on a target’s balance sheet may not qualify as an asset or liability on the acquirer’s books during the acquisition process and vice versa. Items to carefully examine can include prepaid assets, unrecorded payables, employee relocation costs, terminations, payroll liabilities arising from stock-based compensation plans, equity method investments, favorable or unfavorable leases and assets and liabilities arising from contingencies.
In other cases, costs an acquirer expects but isn’t obligated to incur in the future aren’t liabilities at the acquisition date; rather, they’re costs to be incurred by the acquirer subsequent to the acquisition date. A common example is the decision to terminate the target’s software contracts after the acquisition. In that case, the buyer may have incorporated the termination cost into the acquisition price and cost to the selling shareholders, with a perception that the cost will be recorded as a liability at the acquisition date. However, a liability or related expense isn’t incurred until the software is terminated, often post-acquisition, resulting in a buyer expense.
Another area that warrants close attention during the due diligence process is employee compensation arrangements. According to ASC 805, employee compensation arrangements should be analyzed to determine whether they represent compensation for pre-acquisition services, post-acquisition services or a combination of both. Amounts attributable to pre-acquisition services are accounted for as part of the transferred consideration. Amounts attributable to post-acquisition services are accounted for separately from the business combination and usually recognized as compensation cost in the post-acquisition period. Amounts attributable to both services are allocated between the transferred consideration and post-acquisition services.
Many purchase and assumption agreements include purchase-price allocations based on a target’s capital, as stated in accordance with generally accepted accounting principles. Applying a thorough due diligence process with an understanding of the concepts described above will help clarify buyer and seller expectations related to deal values and pro forma information results. This will lead to more accurate pro forma information that can help expedite regulatory approval and depiction of the transactions after closing.
For more information about how these issues could affect your institution, contact your BKD advisor.