Last Call for Pooling
from Summer 1999
by John R. Engen
Few companies have ridden the banking industry’s recent consolidation wave more effectively than Community First Bankshares. Since 1991, the Fargo, North Dakota-based holding company has made some 30 acquisitions, building a $6 billion-asset franchise that stretches from Wisconsin to Arizona.
Yet, five years ago, Chairman and CEO Donald Mengedoth and his board experienced an epiphany of sorts. Despite the soundness of a strategy that marries local control with big-bank efficiencies, Community First’s stock was being severely undervalued by investors. The culprit, directors concluded, was that its acquisitions had been accounted for as purchase transactions. As bank valuations soared, the company was being forced to amortize huge amounts of goodwill—the difference between the price paid for an acquisition and the seller’s book value—which were eating into reported earnings. So Community First did what so many other acquisitive companies have done in recent years and turned to pooling-of-interest accounting. It appears to have been a shrewd move: Since the accounting change, investors have nearly tripled the value of Community First’s stock, even as the bank has paid more than four times book value for several acquisitions. “In a purchase transaction, the accounting rules really reduce the financial contribution of the acquisition, and investors penalize you for it,” Mengedoth explains. “If you pool, you don’t have to book any goodwill.”
Community First has been far from alone in seeking the cosmetic boost to earnings that pooling can produce. In 1998, a total of 530 announced mergers were accounted for as pooling transactions. While that amounted to just 5% of all deals, the dollar value was a staggering $854.7 billion, or 52.5% of the total volume for the year. That’s a steep hike from 1995, when 335 deals valued at just $97.6 billion were done using pooling. But now the pooling party is coming to an abrupt end. In April the seven-member Financial Accounting Standards Board, the body that establishes U.S. accounting principles, voted unanimously to eliminate the accounting method. In July, it will release a draft proposal on the subject. And if, as expected, the change is adopted following a three-month comment period, pooling will be history by 2001.
“It is hard for investors to make sound decisions about combining companies when two different accounting treatments exist,” said FASB Chairman Edmund L. Jenkins, in explaining the vote. He added that purchase accounting “gives investors a better idea” of the transaction’s costs and the investment’s performance over time.
The elimination of pooling will likely affect the volume and pricing of M&A transactions as well as how investors value companies. Some investment bankers fret that deal volumes will slide so precipitously that industries such as high-tech or pharmaceuticals, where business combinations are seen as crucial to growth and innovation, could be harmed.
Already, investment bankers are gearing up for what some expect to be a surge in deal volumes as acquirers scramble to beat the deadline and get one more pooling deal under their belts. “We’re expecting a flurry of activity,” says Mark F. McDade, a partner with PricewaterhouseCoopers in New York City. “If you’re a director, you need to think about maximizing shareholder value,” McDade adds. “If you have a strategic plan to grow by acquisition and you’re a poolable entity, then you should strongly consider stepping up your acquisition program to take advantage of the limited time period left.”
Boards of companies on the cusp of selling also may conclude that sooner is better than later. Buyers, faced with the prospect of big goodwill hits, will likely be unwilling to pay the same high premiums they have in recent years. Mengedoth notes that he’s seen the number of smaller banks looking for a deal with his company increase to as many as 12 a month, compared to three or four a couple of years ago.
Under current rules, to qualify as a pooling transaction, a deal’s participants must meet 12 broad criteria, including such things as not employing share repurchase programs and being independent for at least two years. And the deal must be done with stock, not cash. The buyer and seller then combine their financials, restating prior periods to reflect the new entity; no goodwill is recognized.
Most of last year’s biggest mergers, including the marriages of Exxon and Mobil, Travelers and Citicorp, and NationsBank and BankAmerica, used pooling accounting. Community First’s numbers illustrate the appeal. In 1998 alone, the company doled out nearly 6 million shares of stock for five whole-bank purchases, adding about $580 million in assets to the company. With purchase accounting, those deals would have left more than $100 million in goodwill to be amortized. That would amount to annual write-offs of about $7 million—a big hit for a company that last year reported total net income of about $43 million.
Despite the fact that business leaders such as Mengedoth view pooling as a crucial tool in the war to maintain earnings momentum, most are already resigned that it will no longer be available. Pricewaterhouse Coopers’ McDade is among those predicting that deals will dry up. “CEOs and CFOs are rewarded today on what their stock price does,” McDade explains. “So they’re going to be hesitant to enter into a transaction that’s going to be dilutive and depress their stock in the short term, even if it helps achieve the long-term strategic goals of the company.”
Pooling has been especially popular in industries such as financial services, high-tech, and pharmaceuticals, where a combination of high-valuation multiples and low capital bases cause fair market values to exceed book values by large amounts.
David M. Burwen, managing partner of Venture Development Group, a Mountain View, California angel investment outfit, frets that pooling’s demise will slow advances in fields such as software and biotechnology, where start-ups—often funded by venture capitalists—create many of the new ideas. “The first thing a venture capital investor looks at is, ‘What’s the exit strategy?’” he explains. Initial public offerings and sell-outs are the two key methods. “Without pooling, you may not be able to sell it to somebody. That will absolutely stifle innovation.”
Not everyone thinks the end of pooling will carry disastrous consequences, however. Experts note, for instance, that many companies already use cash flow to measure performance for executive pay and other purposes. “I personally think it’s a non-issue,” says Rodney Jacobs, vice chairman and CFO of Wells Fargo & Co. While admitting that he’s in the minority among bankers, Jacobs predicts little impact on M&A volumes: “I honestly don’t think it will slow down mergers that much, because the economics of the business are such that consolidation will continue.” In fact, Jacobs and others foresee benefits from the change. “Since there will only be one way to account for an acquisition, it will make the thinking a little easier and allow directors to focus more on cash flow, which is what’s really important anyway.”
With pooling gone, companies will no longer be forced to finance mergers with equity, the most expensive form of capital. And there will be other savings, too: The rules governing pooling transactions are prone to ever-changing interpretations that have proven expensive for companies to keep tabs on. Moreover, purchase accounting will make it easier to do global deals. Australia doesn’t allow pooling at all, while the rules in the United Kingdom and Canada are stricter than in the United States.
And if you still need consoling over pooling’s imminent end, consider this: There’s evidence that pooling transactions deliver poorer long-term results than purchase deals. Mitchell Madison Group, a New York City management consulting firm, studied a database of more than 200 deals of $1 billion or more completed earlier this decade in an effort to determine which method produced higher total shareholder returns three years later. The outcome: About 75% of companies that employed pooling failed to do as well for their shareholders as their relative industry index. In contrast, about 50% of companies that used purchase accounting did at least as well as their peers.
“I frankly was stunned at how badly pooling deals had performed, relative to purchase transactions,” says Kenneth Smith, a Mitchell Madison partner in charge of M&A research and practice development.
The reason, Smith hypothesizes, has more to do with human nature than anything else. He found, for instance, that poolers didn’t pay any more for acquisitions than those who used purchase accounting. But they did seem to fall short when it came to following through on their strategies. “What differentiates the winners from the losers in M&A is the discipline of the post-deal implementation,” Smith says. “With purchase accounting, your earnings immediately look bad, because of goodwill. To make them look good again, you have to make enough improvements to overcome that amortization, which motivates people to achieve the post-deal synergies. “If you qualify for pooling, however, there’s no pressure to pursue those synergies.”
Back in Fargo, Mengedoth is willing to accept whatever rules FASB finally hands down. What choice does he have? “It won’t decrease our interest in growing by acquisition,” he says of pooling’s demise. “But it will affect how much we’re willing to pay.”
Others will likely reach the same conclusion. Whether that ultimately will impede the ability of companies to innovate and compete or merely introduce more pricing rationality and accountability to the market, remains to be seen. But most agree the environment for M&A deals in the coming decade will be starkly different from the one we’ve become accustomed to in this one.
