M&A Vocabulary – Understanding Experts: Purchase Price Allocation

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give or refresh a basic understanding of a term and provide some useful tips from our consultancy practice.

The accounting treatment of business acquisitions, i.e. the topic of Purchase Price Allocation ("PPA"), sooner or later becomes relevant in the transaction process. The provisions of IFRS 3 Business Combinations can be applied at the latest at the time of the initial consolidation of the acquisition target in the consolidated financial statements (share deal); however, they can also be applied in asset deals or mergers (in which case the effects are captured in the separate and consolidated financial statements).

Since key performance indicators (KPIs) such as EBIT, consolidated profit or loss or the amount of goodwill are influenced by a PPA, it is advisable to deal with this issue early on in the transaction phase as part of the so-called pre-deal PPA.

PPA for the derivation of goodwill

In the context of a PPA, the total consideration transferred on account of the business combination (purchase price) is to be allocated to the identifiable assets, liabilities and contingent liabilities of the acquiree revalued to their fair values at the acquisition date. The positive amount remaining as a result of a PPA, being a difference between the total consideration transferred and the proportionate fair value of the net assets (revalued equity) determined taking into account deferred taxes, results in the goodwill to be recognised under intangible assets. The example below illustrates the derivation of goodwill under a PPA.

Practical challenges of the PPA

The practical challenges of a PPA usually concern the identification and initial measurement of internally generated intangible assets such as trademarks and customer relationships, for which there is an explicit prohibition on recognition in the IFRS consolidated financial statements and which have therefore often not been recognised in any form to date.

A fundamental understanding of the business model, corporate planning, existing value drivers and the legal environment of the acquiree is necessary for the identification of previously unrecognised intangible assets.

When determining fair values, it should be noted that only those cash flows should be taken into account that are solely attributable to intangible assets (stand-alone). Accordingly, the cash flows arising from the budgetary accounting should be adjusted for genuine synergy effects. The economic life should be determined according to objective criteria and thus from the perspective of hypothetical market participants.

The following valuation methods are used in practice:

Relief from Royalty method: Valuation of trademarks, patents or technologies by using the analogy of royalty rates.
Multi Period Excess Earnings method: Valuation of customer relationships using the residual value method.

Intangible assets usually involve a higher degree of risk than average business risk. Therefore, the WACC to be determined on the basis of a hypothetical market participant should be adjusted to the respective risk profile of the intangible asset using appropriate premiums for the discount rate.

The WACC-to-WARA method, which compares the weighted interest rate of all assets to the WACC and should correspond to it, can be used to check plausibility.

Conclusion

In view of progressive digitisation, intangible assets are becoming increasingly important and are often the main value-drivers in companies. A transaction often has a significant impact on the balance sheet and key KPIs, as the so-called step-up of valuable intangibles can lead to substantial additional amortisation in the future. It is therefore advisable to take these effects into account early on in the transaction process.