How to drive M&A success by buying the right intangible assets
Research has found that intangible assets such as data, brands and customer relationships can add value for companies on the M&A hunt
In today’s knowledge economy, companies increasingly rely on intangible assets to create value. Some common sources of intangible value include intellectual property (such as patents and copyrights), brand equity, customer relationships, supplier lists, and proprietary technology. Conversely, less common and emerging sources of intangible value are often related to the digital economy, and can include data analytics capabilities, software algorithms, online community engagement, digital content, and expertise in emerging technologies like artificial intelligence and blockchain, according to the authors of new research that examines sources of value in merger and acquisition (M&A) transactions.
Intangible assets can be difficult to value, but the research found they can be a major source of value creation in M&As. Co-authored by Ronald Masulis, a Scientia Professor in the School of Banking and Finance at UNSW Business School, together with Syed Walid Reza, Assistant Professor at Canada’s University of Waterloo, and Rong Guo, Assistant Professor at Texas A&M University, the research paper found that intangible assets are increasingly significant in a world where digital transformation and data-driven decision-making are pivotal to business success.
A prime example of this was Facebook’s acquisition of WhatsApp. In February 2014, Facebook announced it would acquire WhatsApp for a hefty US$19.6 billion. The acquisition was a case study in synergistic growth. Launched in 2009, WhatsApp had an average of more than 1 million new users per day by 2014. The app had more than 2 billion users as of 2020 (compared to Facebook’s 2.8 billion monthly active users) and it is expected WhatsApp will reach 3.14 billion users by 2025.
In its 2014 Form 10-K to the US Securities and Exchange Commission(SEC), Facebook stated that 85 per cent of the Whatsapp purchase price was allocated to “goodwill”, which was attributable to “expected synergies from future growth, from potential monetisation opportunities, from strategic advantages provided in the mobile ecosystem, and from expansion of our mobile messaging offerings.” As for the rest of the purchase price, Facebook told the SEC that 11 per cent was for acquired users, 3 per cent was for tradenames, 2 per cent for technology and 0 per cent for tangible assets.
Quantifying the value of intangible assets in M&As
The research found that companies doing the acquiring can create value by carefully considering the target’s intangible assets and ensuring that they are a good strategic fit.
The catalyst for the research paper, The sources of value creation in acquisitions of intangible assets, was an interest in the growing importance of intangible assets in the US economy, coupled with a lack of a comprehensive understanding of the role of intangible assets in corporate acquisitions. While existing research shows that intangible assets are a significant part of a firm’s value, the authors observed that these assets are understudied in mergers and acquisitions research. “Therefore, we started to investigate the profitability, motives, and synergies created in acquisitions involving a broad array of intangible assets, which include patents, trademarks, trade secrets, and customer/supplier lists,” said Assistant Professor Raza.
To evaluate the value implications of intangible asset acquisitions, the authors began by analysing 5420 acquisition announcements by US companies from 2002 to 2021. They found that only 192 public targets in the sample reported patents in the year before their acquisition announcements, whereas 921 out of 1113 public target firms in the sample had at least some amount of intangible assets during 2002–2021.
With 27.4 per cent of deal value represented by intangible assets, patented and unpatented innovations (technology-based intangible assets) accounted for only 3.36 per cent of deal value, while customer-related, marketing-related, and contract-based intangible assets account for a total of 77 per cent of target intangible assets.
Furthermore – and importantly – the authors observed that the average value of target intangible assets to deal value has grown substantially over the sample period: averaging 20.5 per cent before 2010 and rising to 31.4 per cent more recently. “This suggests a serious need to study acquisitions involving broader measures of intangible assets,” the authors noted in their research paper.
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Performance of acquirers and targets
The research found that stock prices rise more for acquiring companies with the acquisition of other entities that have greater proportions of intangible assets. This shareholder wealth creation is associated with profitable acquirers purchasing complementary intangible assets and promising growth options for less profitable targets.
Specifically, out of the companies that made the 5420 acquisition announcements, the research paper found that acquirers of exclusively tangible assets in 632 deals experienced no significant gains in shareholder wealth after their acquisition announcements. However, 4788 acquirers of targets with non-negligible intangible asset holdings, on average, experienced significantly positive deal announcement cumulative abnormal returns (CARs).
The research also found that bidders that acquire a larger proportion of intangible assets, along with their targets, also exhibit improved operational performance (such as reduced operating expenses and increased non-debt tax shields), according to the authors.
Because identified intangible assets are depreciable after 2001, the research paper said this is likely to be a significant motive for intangible acquisitions. According to their modelling, the authors found that acquirer non-debt tax shields rise substantially after acquisitions of intangible assets. “So, while lower R&D expenses and high depreciation tax savings are often suggested benefits of intangible asset acquisitions, this is the first study to empirically validate this finding,” the authors observe.
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This is one reason why acquirers of intangibles experience higher returns on assets after acquisitions. “In summary, our analysis of the post-acquisition accounting performance of acquirers and the importance of acquisitions with complementary assets, growth options, weak target financial condition, and classes of intangible assets enable us to identify specific channels through which acquirers benefit from buying targets with substantial intangible assets.”
Three significant intangible value channels for M&A value creation
The research found that profitable acquirers with fewer investment opportunities tend to acquire targets that are not profitable but have high-quality projects – so acquirers purchase these targets for future growth.
“We find that acquirers of targets with more intangible assets exhibit greater profitability due to their lower production costs, but they appear to lack promising internal investment opportunities given their relatively low investment rates,” the research paper said. On the other hand, it found targets with more intangible assets tend to have many promising investment projects based on their relatively high investment rates, but they also face higher production and distribution costs.
The research paper details a few examples of how acquirers report the purchase of intangible assets along with goodwill and other tangible assets in their SEC filings. Procter & Gamble, for example, announced on 28 January 2005 the purchase of Gillette for US$53.426 billion, with US$29.736 billion paid for Gillette's intangible assets. In its SEC merger proposal, these intangible assets were defined predominantly as brand intangibles in addition to technology and customer relationships.
A second channel of intangible asset value is that acquirers usually pay a lower price to purchase targets with more intangible assets, as these targets are financially constrained. “We find that targets with relatively more intangible assets have lower cash flow levels, cash holdings, net working capital, and higher leverage ratios prior to acquisition announcements, indicating that they face serious financial constraints,” the authors said in their paper. “These findings provide fresh evidence that targets with larger fractions of intangible assets tend to have more difficulty financing all their investment opportunities, which can also make them more attractive takeover targets.”
Third, acquirers purchase targets that overlap with acquirers’ products and technologies in order to reduce information asymmetry and the risk of overbidding. “Potential scale and scope economies are realised through the consolidation of acquirer and target production, distribution, and research facilities as well as from important strategic benefits,” the research paper said.
“Targets tend to undervalue their intangible assets due to their inability to profitably exploit them relative to acquirers who can realise greater profits from them due to various scale and scope economies in development, production, marketing, and distribution. Thus, this type of M&A deal shifts the property rights over the productive opportunities associated with target intangible assets to firms better able to exploit them.”
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Implications of intangible asset value in M&As for shareholders
For shareholders in companies that are acquiring or merging with another company, Professor Masulis said that, by and large, such decisions come down to boards of directors. “Shareholders only get to voice their opinion if they get to vote on the acquisition, which is infrequent,” he said.
“However, shareholders can get a strong signal about the expected profitability of such a deal based on how the acquirer’s stock price reacts (measured by the daily stock return) to the initial announcement of the deal, adjusting for the overall stock return for that day. If the announcement occurs after the close of the market, then it is the next day’s stock price change that captures the market’s assessment of the deal.”