Adapting M&A Strategies for a Changing Market

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1 Adapting M&A Strategies for a Changing Market Sticking to your playbook for growth C FO P U B L I S H I NG 1

2 M&A activity appears to have remained fairly strong in That's following what was, by most accounts, a banner year in 2015 with deals in the United States estimated at about $4-5 trillion. However, corporate finance executives are becoming wary of potential soft spots in the M&A marketplace. They perceive a risk of being caught up in an acquisition frenzy at a time when business conditions are trending downward. Sometimes, says Curt Espeland, CFO of Eastman Chemical Company, the market can convince you to pay more than you really should. In this environment, finance executives emphasize the importance of following the playbook understanding the role that M&A plays in your corporate growth strategy, and being selective in evaluating the opportunities that make the best fit. These were some of the themes coming out of interviews with 10 senior finance professionals who have extensive experience in corporate M&A. The interviews were conducted in spring 2016 by CFO Research, and were sponsored by KPMG LLP. The finance executives were asked for their advice on how to make the most out of acquisitions and, in some cases, divestitures and conversely, how to avoid the pitfalls that can destroy value in a transaction. We have summarized their insights in a series of five articles. To start the series, we asked finance executives about their expectations for the year ahead. Steven Eigen, who is the Chief Financial and Administrative Officer for the global pulp, paper, and forest products distributor, Central National Gottesman, summed up the case for a continuing positive outlook in the coming year: The market can convince you to pay more than you really should. In general, I expect transaction activities to remain strong. I think the biggest factors affecting transaction appetites are the pressures associated with increasing shareholder value for public companies. Interest rates remain low. Companies are at high cash levels. So it s a good time to pursue acquisitions if you re a public company. It allows you to spread your fixed costs over a larger base, improve ratios and hit your targets, and Wall Street rewards companies that do that. However, the finance executives interviewed also expressed some caution about the outlook. Around the world, economic growth has been disappointing, if not alarming. Companies are keeping a wary eye on business prospects, and this, in combination with lingering high multiples still being commanded in the M&A market, often means that finance leaders are taking second or third looks at transactions instead of leaping at every opportunity that comes across their desks. CFO PUBLISHING 1

3 So, for example, Gary Crowe CFO for Ricoh in the Americas, a subsidiary of the global technology company Ricoh Company, Ltd. starts out by declaring, To me, any acquisition is about growth. But he then follows up by noting, [With] the multiples we re seeing, especially in the U.S., we re more focused on growing organically now. Two years ago there was more optimism out there, so M&A activity was booming and a lot more people were willing to pay a higher price. Crowe also sees capex spending tightening [at some companies], so that obviously would impact M&A activity as well. At Ricoh, all prospective deals come through Crowe, and he says he is still contacted on a regular basis by bankers presenting interesting acquisition opportunities. However, the flow has slowed a bit, he notes, and today he is more likely to take a pass. If there s something very strategic, that aligns with our goals, Crowe concludes, then we ll act on it. But with the combination of economic sluggishness around the world and multiples remaining high, it simply takes a lot more these days for a deal to make sense. Gould Paper Corporation, which was founded 130 years ago as a family-owned business but recently was itself acquired by Japan Pulp and Paper as part of both companies complementary expansion strategies. Gould says of the prospects for further growth in his maturing industry, We feel it s eat or be eaten and we prefer to be the eaters. For that reason, he notes, at the moment, we re full speed ahead in terms of keeping an eye out for favorable transactions as part of the larger, global corporation. Chuck Boynton, CFO of the Silicon Valley solar energy firm SunPower Corporation, also expects his company to be dealing from a position of strength. In a fragmented industry, he says, weaker players tend to be looking for homes, providing opportunities for the acquisitionminded firm. Other finance chiefs take a similarly opportunistic approach. For example, at Eastman Chemical Company, Curt Espeland views the company s acquisitions as accretive, rather than transformational bolt-on, he calls them. And that s something you always do, in good times and bad, he says. M&A AS A WAY OF LIFE At several of the companies included in our research, M&A is not a goal in and of itself, but is more a way of life an important and regular component of corporate strategy. At these companies, finance leaders see little reason to abandon their well-established processes in the face of current contingencies. However, they also stress the importance of being attuned to the global business environment and understanding where their companies are positioned in the M&A cycle. For some, an aggressive acquisition strategy is a competitive necessity. Ed Silver is CFO of the But according to Espeland, the flip side of that approach is that, in a sluggish business environment, the company is also likely to divest non-core or under-performing businesses. That way, says Espeland, Eastman can take advantage of the current high multiples, while managing risk by taking large-scale acquisitions off the table. THE M&A PLAYBOOK In a volatile and clouded business environment, interviewees emphasize that it s more important than ever for companies to stick with the strategies that have made them successful up to now. For Espeland, this means that every CFO PUBLISHING 2

4 business should have an M&A playbook as part of their overall growth strategy. The playbook lays out guidelines for when to consider acquisitions, when to go after them aggressively, and when to back away. Tony Tripeny, CFO at Corning Inc., is an avid proponent of the focused, selective approach to M&A. Corning looks for ways it can utilize the company s strong operating cash flow, and so, says Tripeny, We view M&A as an important part of our corporate strategy and capital allocation framework, as a way to grow the business. But it s critical, he notes, to remain very focused on those areas where an acquisition can deliver the most value to shareholders. THE OUTCOME IS ALWAYS BETTER For virtually all the executives interviewed, acquisition strategy starts with the big picture the playbook. As Ed Silver says, First of all, have a game plan going in. Keep in mind, how does the acquisition fit into your business? What is the purpose of the acquisition? Curt Espeland agrees, when he notes, You always go through a methodical process [when evaluating an acquisition opportunity], just to remind yourself where you re at with your strategy. George Montague, CFO at Smiths Medical, says, Acquisitions and divestitures have been, and will continue to be, a key part of our playbook as we optimize our portfolio and migrate to more focused, higher-growth market segments. And a key use of the playbook is to keep the strategic rationale in front of you at all times, Montague insists understanding why we re choosing to buy versus make or develop on our own. execution. Any transaction involves a large number of moving parts, and so the finance executives stress the importance of bringing everybody on board early in the process. When cross-functional teams are included in the process from the beginning, says Corning s Tripeny, the outcome is always better. It is at this point that tax implications, in particular, can be the difference between creating and destroying value in a transaction, according to Hemanshu Parwani, who has turned his experience as a finance officer working on transactions at two different companies, including a Fortune 500 global engineering firm, into a successful M&A consulting practice. Parwani says, The pricing of the transaction certainly affects a go/no-go decision, and tax considerations are important for affecting pricing and the structure of the deal. Acquisitions and divestitures have been, and will continue to be, a key part of our playbook as we optimize our portfolio and migrate to more focused, higher-growth market segments. A successful transaction depends primarily on the attention to detail in its structuring and CFO PUBLISHING 3

5 KPMG s Perspective Recent tax law developments have been significantly affecting the M&A market s deal structuring, tax due diligence, and, in some cases, deal viability. The three major changes having the biggest effects are: 1) statutory changes to auditing partnerships, 2) final regulations under section 385 for treating debt and equity in intercompany transactions, and 3) legislative and regulatory changes to taxing certain real estate investment trust (REIT) transactions. By enabling the IRS to assess a partnership for payment of the taxes allocated to its partners, the Bipartisan Budget Act of 2015 may significantly change the partnership tax landscape. Beginning in 2017, a partnership, rather than its partners, will be liable for unpaid taxes. If a partnership either (i) underreports and therefore underallocates income to its partners, or (ii) does not allocate income to its partners consistently with the substantial economic effect rules, on audit, the partnership may be held substantively liable to pay any unpaid tax, subject to exceptions and various elections. In the M&A market, once these new rules are fully in effect, a buyer or a partnership will have to worry about the partnership s historical income tax positions, or risk having its newly acquired entity assessed for unpaid taxes. Another momentous change came in the form of final regulations under section 385, published on October 21, 2016, which address the treatment of related-party debt for U.S. federal tax purposes. The proposed version of the regulations, issued on April 4, 2016, was incredibly broad in its scope, covering related-party debt issued by U.S. and foreign entities. As proposed, the regulations would have had a significant effect on the M&A market by inhibiting global, intercompany movements of cash to service debt and pay dividends and by creating a due diligence nightmare. The final regulations are considerably narrower in scope, as they currently apply only to debt issued by U.S. corporations, but multinational groups must still be careful to ensure that intercompany debt is respected as such and not recast as equity. Finally, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) prevents certain spinoff transactions involving REITs. The IRS and Treasury followed up with temporary regulations intended to prevent avoidance of the PATH Act s prohibitions. The result of these new rules have substantially affected a corporation s ability to spin-off real estate assets into a REIT, either directly or through a C corporation that later acquires a REIT a strategy which had become increasingly common in recent years. The PATH Act severely curtails this sort of planning. KPMG CONTRIBUTORS Joe Pari National Principal in Charge, Washington National Tax, KPMG LLP jpari@kpmg.com Phil Cioffi U.S. National Leader, M&A Tax, KPMG LLP pcioffi@kpmg.com This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. For more information, please visit 4