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T Magazine 04 Magazine Tax insight for business leaders

Deals back on

Emerging markets deals take center stage the agenda? How tax can make or break Corporates revisit their an acquisition M&A strategies Signs of distress bring new assets to market Imprint Publisher: Ernst & Young EMEIA Tax Bleicherweg 21, 8002 Zurich, Switzerland

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A part of this issue will be distributed as an insert in the Financial Times across Europe, Middle East, India and Africa in May 2011. By Stephan Kuhn Editorial The involvement of tax often makes the difference between winning or losing

Dear Reader

After three years of retrenchment, many companies have emerged from the financial crisis with strong balance sheets and increased organizational efficiency. And although the economic recovery remains patchy and uneven, an increase in M&A activity seems likely as companies take advantage of their stronger financial position, attractive valuations and improving credit conditions.

At the beginning of the upswing, companies are again thinking about growth. As part of their growth strategies, many are looking for acquisitions; either acquisitions in new markets (to reach new customers) or new products (to use more effectively existing distribution channels). Stephan Kuhn At the same time, the global map of M&A is changing. An important driver of the current increase in deal volumes is the growing ambition of emerging market multinationals. Having weathered the downturn well, these fast-growing, cash-rich companies are cementing their reputation as a new breed of global dealmakers. They are sizing up targets in other emerging markets, often to control infrastructure and to gain access to natural resources, and also looking further afield to acquire assets, brands and know-how in developed countries.

Despite a gradual recovery in M&A activity, a quick return to the pre-crisis days of mega-mergers and highly leveraged deals seems unlikely. Companies may be more optimistic about the future than at any time in the past three years, but most remain cautious. They are scrutinizing potential deals more carefully, conducting thorough due diligence and being more realistic about potential synergies. Part of this stronger discipline is driven by management, but investors and lenders are also becoming more questioning. Today, most stakeholders will require a clear and convincing rationale for potential deals and valuations before giving their blessing.

The need to extract the maximum possible value from a deal is encouraging companies to consider tax much more carefully in their transaction planning than in the pre-crisis years. They now recognize that tax plays a vital role both in structuring a deal and the realization of any post-merger synergies. By getting the tax function involved at an early stage in the deal planning process, acquiring companies stand a much better chance of identifying tax savings and compiling more accurate valuations. Often, the involvement of tax may make the difference between winning or losing the deal.

In this issue of T Magazine, we assess the outlook for M&A across the EMEIA region against a backdrop of continuing economic uncertainty. We explore the deal structures and types that companies are likely to pursue and examine the important role that tax plays in maximizing the chances of a successful transaction.

We hope you find the publication valuable and stimulating.

Stephan Kuhn

Stephan Kuhn is Area Tax Leader for the Europe, Middle East, India and Africa (EMEIA) region at Ernst & Young.

Ernst & Young Issue 04 T Magazine 3 Contents Credits: Ed Thompson / LUZphoto; Getty / Justin Guariglia; Laurence Voumard; Cover: Keystone / EPA / Olivier Hoslet

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News 26 __ A shift in the balance of power 5 __ Global tax news Emerging markets are playing an increasingly Round-up of recent tax developments. important role in global M&A activity. Discover more content, news and features on 6 __ M&A and competition policy 32 __ Driving value from transactions the T Magazine website at Large M&A deals present strong potential growth Until recently, tax directors were rarely involved in www.ey.com/tmagazine opportunities for corporates. But for regulators, every stage of a transaction but the quest for these ambitious deals raise competition issues. value from deals has seen them play a bigger role.

Features management 8 __ A return to dealmaking 36 __ Grappling with deal valuations The financial crisis is giving way to a gradual return Valuation of assets is always challenging but is of confidence in M&A markets. particularly tricky in a volatile environment.

14 __ A changing global landscape for transactions 38 __ Government sales ahead A visual representation charting the break-down of Strained public finances and ongoing programs M&A by region and sector. of liberalization are encouraging governments to embark on a new wave of privatizations. 16 __ Risk and return of acquisitions in emerging markets 42 __ Assets in need of care and attention More and more companies are acquiring Distressed assets may look like bargains but they assets in rapidly growing emerging economies. carry greater risks than normal transactions. But the challenges are considerable. 46 __ Getting to grips with a shifting policy 18 __ View from the hotseat landscape James Nolan of Royal Philips Electronics discusses Tax policy can play a vital role in determining the trends in M&A. success or failure of a cross-border transaction.

Focus Outlook 20 __ Unloading ahead 48 __ Today’s transactions are creating value Companies keen to focus on core competencies or The myth that transactions destroy value needs raise cash are turning to carve-outs. to be dispelled, says Scott Moeller, Director of the M&A Research Centre at Cass Business School. 24 __ A healthy pipeline for M&A deals? Giuseppe Monarchi of Credit Suisse offers his outlook for M&A activity.

Magazine 04 Tax insight for business leaders Cover

Deals back on

Emerging markets deals take center stage the agenda? Corporates revisit their Joaquín Almunia, Vice-President of the European Commission and How tax can make or break an acquisition M&A strategies Signs of distress bring new assets to market Commissioner responsible for competition

“The basic idea behind centralized merger control at an EU level is that all mergers with a significant cross-border impact must be cleared according to a uniform set of rules before they take effect. I believe this is good for companies and for fellow European citizens alike.” Taken from a speech about merger control held in October 2010.

4 T Magazine Issue 04 Ernst & Young News

Global tax news A roundup of recent developments from major governments and tax administrations

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European Union to 5%, and from 2.5% to 2% sheets of 0.075% for 2011, expense, and tax return March 2011 for foreign companies. This rather than the 0.05% that disclosure requirements. The European Union has would reduce the effective tax was originally imposed. It is adopted formal proposals rates for both domestic and estimated that this will 6 Belgium regarding a Common foreign companies. generate an additional £800m. March 2011 Consolidated Corporate Tax The Belgian government has Base (CCCTB). The goal of the 2 Singapore 4 Kenya proposed changes to the directive is to produce a February 2011 March 2011 participation exemption regime uniform standard for In its 2011 budget, the At a conference in Nairobi with respect to portfolio calculating the tax base of Singapore Government hosted by the International investments. The proposals, multinational groups announced the introduction of Monetary Fund and the if enacted, would impact the operating in the EU. The significant enhancements to government of Kenya, senior Belgian tax regime on Directive is based on the the Productivity and Innovation tax officials from more than portfolio investments for both assumption that companies Credit incentive, which was 40 African countries convened EU and non-EU dividends. will treat the EU as a single originally announced last to discuss ways of improving market for corporate tax year. Companies will now be tax revenue mobilization 7 Spain and Germany purposes, instead of dealing able to deduct up to 400% of across sub-Saharan Africa. February 2011 with 27 different tax systems. their expenditure on training, The Spanish and German investment and other 5 Taiwan governments signed a new tax 1 India categories of activity covered January 2011 treaty to avoid double taxation February 2011 by the scheme. The government of Taiwan that will replace the treaty Presenting his government’s introduced new thin currently in force that was budget for 2011-2012, 3 United Kingdom capitalization rules, including signed in 1966. The structure India’s finance minister Pranab February 2011 a 3-to-1 debt-to-equity and content of the new treaty, Mukherjee announced that The British Chancellor George ratio, computation of non a draft version of which has the surcharge on income tax Osborne announced that the deductible interest expense, been very recently released, is rates for domestic companies government was planning to definitions of related-party mostly based on the OECD’s would be reduced from 7.5% impose a levy on bank balance debts, equity and interest current model tax convention.

Ernst & Young Issue 04 T Magazine 5 News Credit: European Union 2011

M&A and competition policy

__ Although volumes dropped precipitously M&A Maturity scores M&A Maturity scores during the financial crisis, the past decade has seen a significant increase in the size of M&A Western Europe 0% 20% 40% 60% 80% 100% deals. For companies, these ambitious deals 75% 75% Western Europe North America can, if executed well, unlock strong growth 89% potential. But for regulators, the increase in 72% 88% deal size raises competition issues. 92% In the European Union, merger regulation Asia has had to move with the times. The sustained 75% Asia globalization of many industries has changed 76% 53% many of its core assumptions about what 49% constitutes an appropriate market — from 68% national ones, to multinational, to truly global. 86% The key, for most regulators, is to strike a CEE/CIS 54% CEE/CIS careful balance. On the one hand, mergers can 51% and very often do have a positive impact 39% on the economy, job creation, innovation and 43% 83% EU Commissioner Joaquín Almunia indeed competition itself. But on the other 74% hand, there needs to be a framework to Middle East Middle East prevent abuse and the build-up of monopoly 65% M&A per country (2010) 51% power. Ranking by number of the top 10 countries 58% Joaquín Almunia, the EU Competition 55% Commissioner, recently argued: “Companies 57% Deal Value Number 47% Country (US$m) of deals that say they must merge to compete globally, Africa Africa 1 United States 117,446 1,089 regardless of the competitive consequences 53% for the home market, are not looking at the 48% 2 United Kingdom 90,292 647 complete picture. Without merger control, we 34% 3 Brazil 38,187 195 43% would see many more companies buying up 53% 4 Australia 33,859 431 their competitors, weakening the competitive 32% 5 Canada 31,505 409 structure of markets, and reducing incentives 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% 6 Germany 26,107 396 to innovate. The very existence of our system Economic factors 7 France 20,932 322 acts as a deterrent. Because we have Economic factors Financial factors Financial factors 8 Spain 19,571 237 merger control, we see very few attempts to Political factors Political factors 9 Netherlands 15,982 183 merge to monopoly.” Regulatory factors Regulatory factors Socio-cultural factors Socio-cultural factors 10 Hong Kong 14,861 163 Technological factors Technological factors http://ec.europa.eu/commission_2010-2014/ Source: Thomson Reuters almunia/index_en.htm Source: MARC M&A Maturity Index Source: MARC M&A Maturity Index 2008 2009 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep

Top deals (announced date)

Burlington American Life Northern XTO Energy Insurance Cadbury Santa Fe acquired by Alcon acquired by acquired by acquired by Exxon Mobil acquired by MetLife for T-Mobile Kraft Foods Berkshire for US$40.3b Novartis for US$16b acquired by for US$18.8b Hathaway for US$27.7b Orange for US$36.7b US$8.5b

6 T Magazine Issue 04 Ernst & Young Credit: Reuters / Toby Melville; Reuters / Stringer Italy

“Competition stimulates and rejuvenates economies. A relapse into policies of 50% nationalism and protectionism – whether in A proposed production joint relation to goods or services or investment – venture between leading would be a massive, and costly, mistake.” international mining companies BHP Billiton and Vince Cable, Britain’s Secretary of State Rio Tinto, which would involve for Business, Innovation and Skills, speaking at the the two companies taking a European Parliament, in September 2010. 50% stake in their combined iron ore assets, was finally signed in 2009. The deal attracted intense scrutiny London __ United Kingdom Regulatory challenges from competition watchdogs Following the acquisition of Cadbury by Kraft, the UK __ In March 2011, the UK in the EU and Australia. Takeover Panel issued a consultation paper that Culture Secretary Jeremy proposed changing the takeover rules to give Hunt announced that he would acquisition targets greater protection against hostile accept News Corporation’s takeovers, and to reduce the tactical advantages proposed bid for BSkyB, currently enjoyed by bidders under UK law. provided the media giant would spin off Sky News as a 2.4b Rome __ Italy separate company. If these In 2009, China’s Ministry of The Italian cabinet headed by Premier Silvio Berlusconi conditions were met, Rupert Commerce rejected Coca- (right, with Finance Minister Giulio Tremonti) discussed Murdoch’s News Corp would Cola’s planned US$2.4b plans to adopt a series of measures that will prevent avoid a referral to the takeover of Huiyuan Juice, unwanted takeovers of Italian companies by overseas UK Competition Commission. arguing that the US firm could firms. The moves may include the establishment of abuse its dominant position committees to monitor strategically important __ The EU Commissioner in the country’s beverage industries, and the potential freezing of voting rights of Joaquin Almunia recently market. In recent years, both shareholders in hinted that the proposed bid China and India have enacted companies considered by Deutsche Börse to acquire tough anti-trust laws, and to be strategically NYSE Euronext is likely to face made it clear that they will important. The regulatory challenges. The take a firm line against initiative follows a Commissioner said he was deals that they perceive could similar move concerned about the “vertical create monopoly concerns. implemented by France silo” business model and earlier this year. its impact on competition. 2010 2011 Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar

Brasilcel acquired by Carso Global Lihir Gold Telefónica for Telecom acquired by US$9.7b acquired by Newcrest Genzyme US property América Móvil Smith Zain Africa Mining for acquired by assets of for US$17.8b International acquired by US$9b Sanofi-Aventis Centro acquired by Bharti Airtel for US$20.1b acquired by Schlumberger for US$10.7b Blackstone for US$11b Group for US$9.4b

Ernst & Young Issue 04 T Magazine 7 Feature Outlook on M&A Credit: Ed Thompson / LUZphoto US$209b Total global value of corporate deal-making in January 2011, the highest in more than a decade, according to the Financial Times.

A return to dealmaking After a subdued period of mergers and acquisitions, deal-making is making its way back onto corporate agendas, particularly in emerging markets. But a starkly different approach to such transactions is now being taken.

• By Rob Mitchell of earnings rather than invest in acquisitions. The tentative economic recovery continues to ver the past three years, large mergers encourage a cautious approach to dealmaking. and acquisitions (M&A) have been far Although emerging markets are growing at O from the minds of many executives. rapid rates, developed economies continue to Although there has been a slow, steady flow of face barriers to a strong recovery, including transactions throughout the downturn, deal- fragile business and consumer confidence, high making activity has been for the most part unemployment, rising inflation and large subdued. Rather than putting in place ambitious government deficits. plans to expand market or Faced with these clouds on the horizon, many customer reach, most companies are adopting a “wait and see” approach Summary executives have focused on before embarking on M&A strategies. According As business confidence cost management, to Ernst & Young’s April 2011 Capital Confidence returns, so is a renewed divestments and restoring Barometer, most corporates remain focused on appetite for M&A. But balance sheets to health. organic growth, rather than M&A. Although the companies are taking a Even if companies did number of companies looking to acquire over the much more cautious want to acquire, the external next six months has increased slightly compared approach to how they environment has often not the previous survey in October 2010, the survey finance and structure such been conducive to predicts a fall in appetite for M&A over a longer deals, value assets and transactions. The banking timeframe. Other metrics, such as forward price/ quantify outcomes. The sector’s own focus on earning ratios, which can provide an indication of role of tax is also being deleveraging has the market’s willingness to do deals, have also more closely considered. dramatically curtailed its dropped in recent months, suggesting the tide of lending capacity. Although investor confidence has yet to turn in earnest. data from the European Central Bank shows that net lending to companies Signs of recovery has increased slightly over the past year, many But despite these continuing challenges, there banks are reluctant to loosen lending standards. are signs of a nascent recovery in deal- And most corporates are choosing to keep hold making activity. According to Thomson Reuters,

8 T Magazine Issue 04 Ernst & Young Abby Ghobadian Professor

__ Abby Ghobadian is Professor of Organizational Performance at Henley Business School at the University of Reading. His specialist research subject relates to the various factors that influence organizational productivity and competitiveness and what can be done to improve it. He also edits the International Journal of Process Management and Benchmarking. Feature Outlook on M&A

announced M&A grew by almost 20% in 2010 developed markets. With forward-looking earnings Which of the following Which of the following compared with the previous year, to US$2.25t forecasts in these countries looking exceptionally are you likely to undertake are you likely to undertake globally. The first few months of2011 have also strong, this optimism is likely to translate into or seriously consider in or seriously consider in seen fairly strong activity, although some a high number of deals over the coming months. the next 6 and 12 months? the next 6 and 12 months? of this has been driven by divestments rather Over the past year, deal volumes in emerging Acquisition in developed markets than true AcquisitionM&A. In February, in developed there markets was a flurry of markets have increased much more rapidly than 35 deals between35 stock exchange companies, with those in the developed world. According to 30 London Stock30 Exchange’s announcement data from Dealogic, a data provider, emerging 25% of a merger with26% its Canadian25% peer TMX swiftly market transactions grew by 65% in 2010 and 25 25 22% 22% 22% followed by news that Deutsche21% Börse and NYSE accounted for more than one-third of global deal 20 18% 20 21% 20% Euronext were15% discussing a merger.20% In the same value and volume. This reflects a growing desire 15 15 Apr 10 Oct 10 Apr 11 month, the SpanishNov 09 bankApr Santander10 Oct 10 announced a among multinationals to gain market share bid for Poland’s Bank Zachodni WBK, and the in some of the world’s most dynamic regions. Acquisition in emerging markets pharmaceuticalsAcquisition firm in emerging Sanofi-Aventis markets agreed Deal flows from East to West are also 35 terms for 35its US$20b acquisition of35% the becoming more pronounced. Emerging market 35% 35% 31% biotechnology company Genzyme 31%Corporation. multinationals and sovereign wealth funds are in 30 31% 31% 32% 30 26% 27% In the longer term, deal-making activity is a cash-rich position, often have state backing 25 27% 25 21% expected to recover. A global survey of senior and are hungry for natural resources, brands and 20 20 executives conducted for Planning for growth, a know-how. This makes Western companies 15 15 Apr 10 Oct 10 Apr 11 recent ErnstNov & Young 09 report,Apr 10 foundOct that10 three- appealing targets, particularly at a time when quarters of respondents expected consolidation valuations and exchange rates are still attractive. 0–6 months in their industry0–6 months over the next three years. In March 2010, for example, the Chinese 6–12 months 6–12 months “Although we observe that in some markets company Geely announced that it would acquire Source: Ernst & Young Capital Confidence companiesSource: are Ernstusing & Youngcash Capital reserves Confidence to fund the Volvo brand and its assets from Ford Motors Barometer organic growth,Barometer in the long run M&A will for US$1.8b. The bid by Korea National Oil for continue to be a strategic option as it is the most the UK oil explorer Dana Petroleum offers effective way of quickly expanding market another example of this East to West trend. reach,” says Joachim Spill of Ernst & Young’s Emerging market multinationals are also The rising importance The rising importance of tax issues in deals Transaction Advisory Services in Germany. acquiring in other emerging markets. This of tax issues in deals SignificantlyWith the more financial crisis having increased activity is often driven by a desire to gain access theSomewhat gap between more the best and worst-performing to natural resources. In February, the Chinese Significantly more companies,Somewhat lessdeals offer an opportunity for oil and gas company Sinopec announced that financiallySignificantly secureless companies to strengthen their it would take a 40% stake in Repsol Brazil, Somewhat more position further. “The financial crisis has a subsidiary of the Spanish energy group Repsol About the same widened the gap between the successful and YPF. Chinese companies have also invested Somewhat less not-so-successful companies in the economy, heavily in Africa. In 2009, China became South givingSource: Ernstthose & Young that Global have tax done trends well the opportunity Africa’s largest trading partner. Significantly less to consolidate their stronger position,” says The maturity of emerging markets from an Abby Ghobadian, Professor of Organizational M&A perspective varies widely. The MARC M&A About the same Performance at Henley School of Management Maturity Index provides a high-level summary of in the United Kingdom. risks and opportunities for M&A transactions in Source: Ernst & Young Global tax trends 175 countries around the world. It has been M&A confidence on the rise developed by the M&A Research Centre at Cass For most companies, particularly in developed Business School, City University London, of markets, the past three years have been which Ernst & Young is a senior sponsor. The Why is tax more important Why is tax more important in an M&A Why is tax more important in an M&A Why is tax more important in an M&A characterized by the need to focus on index shows that, among the BRIC economies, in an M&A context? context? context? context? cost efficiencies and cash preservation. But with China tops Brazil, India and Russia in the M&A 91% confidence91% tentatively returning and balance maturity91% rankings.Technological maturity has Increasing focus on tax efficiency to reduce Increasing focus on tax efficiency sheetsIncreasing now lookingfocus on taxmuch efficiency healthier, to reduce a growing the cost of deals, contributedIncreasing strongly focus on tax to efficiencythe success to reduce of China, the cost of deals, the cost of deals, or improve 91% to reduce the cost of deals, or improve the return from deals or improve the return from deals number of companies will inevitably be turning while regulatory and political issues have the return from deals or improve the return from deals their attention to growth again. “Many companies impinged74% on its progress. Brazil also shows Increasing complexity of tax 74% have74% done all they can from a cost-efficiency strengthIncreasing in technology complexity of but tax legislationis again heldaffecting back deals by legislation affecting deals 74% Increasing complexity of tax Increasing complexity of tax legislation affecting deals perspective within their own organization,” says the same52% factors. Russia offers a similar profile, legislation affecting deals Increasing scrutiny of deals Prof Ghobadian. “This leads them to consider with Increasinga strong scrutinyperformance of deals byin taxthe authorities sociocultural by tax authorities 52% 52% M&A52% both as a means of achieving growth and as arena, but an even weaker political score. And in Increasing scrutiny of deals a sourceIncreasing of furtherscrutiny ofpotential deals by tax cost authorities synergies from India, good performance in financial and by tax authorities Source: Ernst & Young Global tax trends Source: Ernst & Young Global tax trends making the acquired company more efficient.” technological indicators is offset by regulatory, TheSource: twin-track Ernst & Young nature Global taxof trendsthe global economic political and sociocultural concerns. Source: Ernst & Young Global tax trends recovery means that the world’s fastest-growing regions will become an important center for A new supply of assets deal-making activity. The Planning for growth On the supply side, a growing trend for report from Ernst & Young found far higher demergers and carve-outs will be another driver levels of business confidence among respondents of M&A activity. “One clear trend we are seeing is from Brazil, India and China than those in companies re-evaluating the returns they achieve

10 T Magazine Issue 04 Ernst & Young Credit: AFP / Bjorn Larsson Rosvall / SCANPIX

Welcome to China: Geely chairman Li Shufu shakes hands with Ford CFO Lewis Booth to seal his firm’s acquisition of Volvo from Ford. from their capital – and one of the results of this Volvo Geely in pricing and other issues, and few new lenders is that they are selling assets that they no longer Chinese carmaker Geely are likely to materialize. At the same time, see as core,” says Aidan Stokes, Global Director continued the shift of deal- exit by IPO remains unlikely for most assets. of the Transaction Tax Practice at Ernst & Young. making gravity from West to So, as global government stimulus recedes and “This means that we are likely to see a wide East with its US$1.8b refinancing pressures increase, it seems likely range of businesses coming up for sale over the acquisition of European marque that the number of distressed assets coming to next few years over and above those which Volvo from its US parent Ford. market will grow in number. would normally have been expected.” The deal marked the largest “Over the next few years, private equity funds According to the Financial Times, large purchase of a foreign car will need to refinance a vast amount of debt at carve-outs are dominating deal-making activity. manufacturer by a Chinese higher cost and on more stringent terms, which January 2011 saw the strongest start to the company. means that many will either have to tap investors year for more than a decade, with US$209b of for more equity or sell the investment,” says global corporate deal-making activity. Carve-outs Stokes. “Although some will be able to refinance formed a large proportion of this. The illustrations this debt, the expectation is that there will be a cited in the article include Cargill’s US$24b lot of companies coming to market.” spin-off of a majority stake in Mosaic, ArcelorMittal’s demerger of its stainless steel A new approach to dealmaking division and Hutchison Whampoa’s decision to While this combination of trends suggests that a raise US$6b by spinning off its ports business return of deal-making activity is imminent, and listing it on the Singapore Stock Exchange. the way in which companies approach these Private equity funds will be another source of deals will be fundamentally different in future. In deal targets in the coming years. A looming stark contrast with the pre-crisis years, most debt maturity cliff means that many will need to companies will be much more cautious about the refinance acquisition debt attributable to way they structure deal financing, value assets portfolio companies. Much of this was agreed at and quantify expected synergies. the height of the boom years, when finance Academic research has consistently shown was cheap and leverage multiples generous. Many that the majority of M&A transactions do not lenders will be unwilling to renew such deliver all their expected benefits, with arrangements without substantial improvement estimates for the proportion that do not live up

Ernst & Young Issue 04 T Magazine 11 Feature Outlook on M&A

The role of tax in the post-crisis environment

__ The downturn in the emphasis of tax due diligence valuations, which can make 4. The trend toward increasing transactions market has to focus more on sources of the difference between winning scrutiny of transactions by created an environment in future value. and losing a deal. This is tax authorities and the shift which companies are being particularly true in emerging of M&A activity toward forced to squeeze greater value 2. The range of tax issues that markets, where tax regimes emerging markets are making from their deals if they are to companies are now considering can be more uncertain and companies more cautious achieve their commercial in their transactions has companies need to give about assuming tax risks. But and economic objectives. In expanded rapidly beyond themselves as much time as the commercial imperative to practice, this has a number of matters such as tax relief for possible to evaluate tax risk. seize the opportunities that important implications for how the costs of transaction debt. Early involvement of a are presented by a returning tax is managed in corporate It now includes many areas company’s tax function in the corporate M&A market transactions. that were not previously process of transaction ahead of their competitors considered in transaction planning can help to improve is a powerful counterbalance 1. Anticipated tax efficiencies structuring. companies’ ability to realize for many companies. are now being evaluated more tax efficiency. Companies As a result, striking the right rigorously in validating the 3. Identifying tax savings and getting the most out of such balance between managing expected after-tax effects of potential tax pitfalls early in deals will maintain a close tax risk and the most deals. In turn, this is raising the process of a transaction dialog between their tax tax-effective transaction the profile of tax in the M&A has become more critical – it function and those initiating structures has never been context and changing the can lead to more accurate transactions. more important.

to expectations generally ranging between 50% focus on identifying potential tax synergies at and 80%. Issues that can derail transactions the outset of a deal to give enough time to 20.6% range from overpaying for assets, poor timing evaluate them thoroughly and make an informed The energy and power sector or failures in due diligence or integration. decision about whether they should be reflected was the most active during “To be successful in M&A you have got to be in valuations,” says Matthew Peppitt of Ernst & full-year 2010, commanding extraordinarily careful with due diligence and Young’s Transaction Tax Practice. 20.6% of announced M&A. you have got to walk away if the deal becomes In Global tax trends, a recent report from According to Thomson too expensive,” says Professor Ghobadian. Ernst & Young, more than half of the tax Reuters, private equity-backed Investors are also likely to scrutinize deals more directors surveyed said that their organization M&A activity totaled carefully and in an increasingly public manner. places more emphasis on tax issues when US$225.4b during 2010, the They expect assurances that the deal will meet conducting transactions than it did three years biggest year for global buyout executives’ expectations. A recent survey by ago. In a growing number of companies, tax activity since 2008. Schulte, Roth & Zabel and mergermarket found directors are playing a broader role across the that two-thirds of activist investors are expecting whole life cycle of a transaction, from structuring more shareholder interventions in 2011. “In the the deal through to post-merger integration. current environment, the stakeholders in any This growing importance of tax in M&A deal are looking much more closely at the value is driven above all by the pursuit of enhanced that is attributable to synergies and whether that transaction value. In particular, companies can be realistically achieved,” says Stokes. globally are seeking to take account of future costs and savings, including taxes, when The role of tax in transactions evaluating transactions. More than nine out of Careful attention must to be paid to the role of ten tax directors cited the increasing focus tax in structuring deals and managing synergies. on tax efficiency to reduce the after-tax cost of A transaction has the potential to affect every deals as the principal driver of the growing area of a company’s operations; but until now importance of tax in the M&A context. the impact of tax on the structure and overall “Companies are now starting to look at the economics of a deal has not always been role of tax in a transaction much more broadly,” considered. Instead, companies have tended to says Peppitt. “They are considering the tax confine their consideration of tax in the context of impact of the transaction on every area of a a transaction to those areas requiring immediate company’s operations that may be affected by it, attention to get a deal done. This is now not just those matters that require immediate changing. Rather than being seen as an attention to get the deal done. Where appropriate, enhancement that can be made after the they are also recognizing the benefits in deal decision to do a deal has already been taken, tax valuations.” This broadening of the role of tax is increasingly seen as a fundamental component highlights the importance of bringing tax of the decision itself. “There is now much more professionals into the deal-making process at an

12 T Magazine Issue 04 Ernst & Young Credit: Reuters / Chris Wattie

Deal challenger: Canadian industry minister Tony Clement saw off a hostile acquisition bid from Australian miner BHP Billiton.

Tony Clement early stage. Although companies may want to tax revenues, the risk of controversy associated Canada’s industry minister keep planning teams small at the outset of a deal with cross-border deals is becoming increasingly blocked BHP Billiton’s proposed to ensure an efficient use of resources, earlier severe. The Indian tax authorities, for example, US$39b acquisition of involvement from the tax department can be have challenged a number of major corporate Canada’s PotashCorp in hugely beneficial. It offers companies the best transactions in recent years. Companies planning November 2010, arguing that opportunity to address the tax costs and realize transactions in India are watching these cases the deal failed to deliver a the tax savings that the transaction presents and carefully because their outcome could have “net benefit” to the country. to reflect both in the deal valuation. significant implications on further cross-border The deal would have been by The need to involve tax specialists early in the deals in the region. India is by no means alone. far the largest deal of 2010, process becomes even more important in Australian miner BHP Billiton’s blocked US$39b had it been approved. the context of cross-border transactions, and bid for PotashCorp of Canada in November 2010 particularly when the target is headquartered in is another example of governments placing deals an emerging market. “In some cross-border under the microscope. deals, you are dealing with countries that have less developed tax systems or where there is Adopting a rigorous approach a lack of binding tax regimes,” says Alistair Craig Given the risks that acquirers face when of Ernst & Young’s Transaction Tax Practice. embarking on M&A deals, it is perhaps not “You really need to understand the effect of those surprising that realizing the full value expected factors because they can have a fundamental from a transaction is so difficult. At a time impact on the transaction.” of continuing economic uncertainty, it is Equally, companies or sovereign wealth funds undoubtedly challenging to make the right from emerging markets face challenges when strategic decisions, value assets accurately and they buy assets in developed countries. Acquirers realize any expected synergies. But by adopting from the Gulf states, for example, where tax a rigorous approach to due diligence and rates are either very low or zero, may not be as ensuring that tax is factored into the valuation familiar with the concept of tax as a value-adder process from the outset, acquirers will give or value-destroyer within cross-border deals. themselves a much better chance of being in the With tax administrations around the world minority of companies for whom M&A deals are stepping up enforcement in order to increase truly successful.

Ernst & Young Issue 04 T Magazine 13 Feature M&A in figures Credit: Golden Section Graphics GmbH

A changing global landscape =mjgh]2k]]hj]nagmkhY_] ;YfY\Y =mjgh]2k]]hj]nagmkhY_] ;YfY\Y Ea\ Fgjl` Kgml` O]kl =Ykl Cgj]Y for transactions MK MK Kgml` Ea\ Fgjl` ;`afY O]klO]kl =Ykl Cgj]Y MK MK Kgml`MK BYhYf The world of M&A is changing. With the impact of the financial crisis still being felt, O]kl MK ;`afY MK Kgml` @gf_Cgf_ BYhYf MK 9^ja[YYf\ Af\aY Gl`]j deal volumes and values are showing only tentative recovery. Ea\\d]=Ykl @gf_Cgf_EYdYqkaY 9^ja[YYf\ Af\aY Gl`]j Ea\\d]=Ykl ;]fljYdYf\ Kaf_Yhgj]EYdYqkaY Kgml`9e]ja[Y Af\gf]kaY __ Around the world, companies are once again ;]fljYdYf\ Kaf_Yhgj] Kgml`9e]ja[Y Af\gf]kaY turning their attention to growth. For some, Fgj\a[ this will mean a return of M&A activity as a way of securing market share or access to new Fgj\a[ 9mkljYdaY MCYf\ markets. The precise mix of sectors and regions Aj]dYf\ 9mkljYdaY MCYf\ :]f]% ;]fljYdYf\ that will dominate M&A remains to be seen, *$()1 Aj]dYf\ dmp =Ykl]jf=mjgh] but as the charts on this page show, history :]f]% ?]jeYfq ;]fljYdYf\ NYdm]g^ *$()1 suggests that energy and natural resources, and dmp =Ykl]jf=mjgh] Yffgmf[]\\]Ydk$ 1** >jYf[]?]jeYfq NYdm]g^*(((Æ*((1 )$(() financial services will be active, while theUK, Yffgmf[]\\]Ydk$ 1** >jYf[] Kgml`=Ykl]jf afZaddagfMK )$)-. 00) -0+ )$(() US and China will be key players in their regions. AZ]jaY AlYdq =mjgh] *(((Æ*((1 )$).1 Kgml`=Ykl]jf afZaddagfMK )$)-. 00) -0+ --( AlYdq (1 (( AZ]jaY =mjgh] -*0 )$).1 -+. (0 () )$01) --( +-* (1 (( )-1/ ,0( (/ (* -*0 -)(-+. (0 () )$01) +-* *++ .(- )-1/ ,0( (. (+ -(. -)( =mjgh]2Eapg^Yffgmf[]\\]YdkZq_]g_jYh`a[j]_agf*()(ÇnYdm]Yf\ngdme] (/ (* )$/-+ ,) *. -01 )0, Gl`]j2(&) (- (, .(- -( *- *++ )$+*, -(. (. (+ 1(+ ,) *. *), =mjgh]2Eapg^Yffgmf[]\\]YdkZq_]g_jYh`a[j]_agf*()(ÇnYdm]Yf\ngdme] q]Yj )$/-+ /(1 00 )) -01,.) )0, *)&, *(&1 /&0 0&. .&0 1&0 .&+ )+&-Gl`]j2(&) ,$. g^MK.*1&0Z (- (, )$*/( )$+*, -( *- *,0 1(+ 10( ., ** *), ;]fljYdYf\ Kgml` /(1 00 )0+* )) ,.) +1/ MCAj]dYf\*)&, ?]jeYfq*(&1 >jYf[]/&0 AlYdq 0&. AZ]jaY .&0 :]f]dmp 1&0 .&+ Fgj\a[ )+&- ,$. g^MK.*1&0Z q]Yj )$*/( =Ykl]jf =Ykl]jf 10( ., ** *,0 ;]fljYdYf\ Kgml` 9e]ja[Yk =mjgh] 9^ja[Y$Ea\\d]=Ykl)0+* 9kaY%HY[aÔ[+1/ MCAj]dYf\*)&, ?]jeYfq)-&. ))&/>jYf[] AlYdq-&1 /&+AZ]jaY :]f]dmp 0&/ Fgj\a[),&) =Ykl]jf)*=Ykl]jf +&) g^,$--/\]Ydk 9e]ja[Yk =mjgh] 9^ja[Y$Ea\\d]=Ykl 9kaY%HY[aÔ[ *)&, )-&. ))&/ -&1 /&+ 0&/ ),&) )*Gl`]j2(&) +&) g^,$--/\]Ydk LghÔn]k][lgjk*()($[gehYj]\lg*((1 Gl`]j2(&) 9e]ja[Yk2Eapg^Yffgmf[]\\]YdkZq_]g_jYh`a[j]_agf*()(ÇnYdm]Yf\ngdme] LghÔn]k][lgjk*()($[gehYj]\lg*((1 NYdm]afMKZ )).$* )-1$, *0 0*$) )*)$. /+$- **$+ .+$+ ,1$+ .( 9e]ja[Yk2Eapg^Yffgmf[]\\]YdkZq_]g_jYh`a[j]_agf*()(ÇnY*)&* )*&- */&* dm]Yf\ngdme])+&0 0&* )/&) g^MK/),&,Z *((1 *()( )).$* )-1$, *0 0*$) )*)$. /+$- **$+ .+$+ ,1$+ .( NYdm]afMKZ ;]fljYdYf\ MK *)&*Fgjl`=Ykl! MK Ea\O]kl!)*&- MK*/&* Kgml`! MK)+&0 O]kl!0&* ;YfY\Y )/&) g^MK/),&,Z +)( +., /*- 1)/ +,1 ,*, **, +(- -0- /(( <]Yd[gmfl*((1 *()( Kgml`9e]ja[Y ;]fljYdYf\ =f]j_q$Eafaf_Mladala]k Af\mkljaYdk;`]ea[Ydk >afYf[aYdK]jna[]k H`YjeY$E]\a[Yd:agl][` ;gfkme]j MK Fgjl`=Ykl! MK Ea\O]kl! MK Kgml`! MK O]kl! ;YfY\Y +)( +., /*- 1)/ +,1 ,*, **, +(- -0- /(( <]Yd[gmfl ).&- )-&* *-&1 *(&1 )(&1Kgml`9e]ja[Y )(&. g^+$,*0\]Ydk =f]j_q$Eafaf_Mladala]k Af\mkljaYdk;`]ea[Ydk >afYf[aYdK]jna[]k H`YjeY$E]\a[Yd:agl][` ;gfkme]j ).&- )-&* *-&1 *(&1 )(&1 )(&. g^+$,*0\]Ydk LghÔn]k][lgjk*()($[gehYj]\lg*((1 Ogjd\oa\]E9lghÔn]k][lgjk ,(($((( LghÔn]k][lgjk*()($[gehYj]\lg*((1 MKeaddagf! )01$/ 1.$0 Ogjd\oa\]E9lghÔn]k][lgjk 1* )/1$+ 1)$1 )(,$. /1$) .0$* ,*$, .)$/ NYdm]afMKZ ,(($((( *((1 *()( MKeaddagf! *(($((( )01$/ 1.$0 NYdm]afMKZ EYl]jaYdk*((12 1* )/1$+ 1)$1 )(,$. /1$) .0$* ,*$, .)$/ *((1 *()( *(($((( MK)10$++/e **1 +*+ +/( ,(0 *./ +.0 ,-+ -*/ +,( ,1, <]Yd[gmfl ( EYl]jaYdk*((12 >afYf[aYdK]jna[]k 0(($((( (( () (* (+ (, (- (. (/ (0 (1 =f]j_q$Eafaf_Mladala]k H`YjeY$E]\a[Yd:agl][` Af\mkljaYdk;`]ea[Ydk :mkaf]kkK]jna[]k MK)10$++/e **1 +*+ +/( ,(0 *./ +.0 ,-+ -*/ +,( ,1, <]Yd[gmfl 0(($((( ( =f]j_q$Eafaf_Mladala]k >afYf[aYdK]jna[]k H`YjeY$E]\a[Yd:agl][` Af\mkljaYdk;`]ea[Ydk :mkaf]kkK]jna[]k .(($((( .(($((( (( () (* (+ (, (- (. (/ (0 (1

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14 T Magazine Issue 04 Ernst & Young =mjgh]2k]]hj]nagmkhY_] ;YfY\Y =mjgh]2k]]hj]nagmkhY_] ;YfY\Y Ea\ Fgjl` Kgml` O]kl =Ykl Kgml`Cgj]Y Ea\ Fgjl` Kgml` Ea\MK =YklMK Cgj]Y O]kl =Ykl ;`afY Cgj]Y O]kl MK MK MK MKKgml` MK ;`afY BYhYf O]kl ;`afY MK MK MK Kgml` BYhYf MK @gf_Cgf_ MK 9^ja[YYf\ Gl`]j Af\aY @gf_Cgf_ 9^ja[YYf\Ea\\d]=Ykl @gf_Cgf_ Gl`]j 9^ja[YYf\ Af\aY EYdYqkaY Gl`]j Ea\\d]=Ykl EYdYqkaY ;]fljYdYf\ EYdYqkaY Kgml`9e]ja[Y Kaf_Yhgj] ;]fljYdYf\ Af\gf]kaY Kgml`9e]ja[Y Kaf_Yhgj] Kgml`9e]ja[Y Af\gf]kaY

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Ernst & Young Issue 04 T Magazine 15 Feature Emerging markets Risk and return with emerging market acquisitions

Rapid growth in emerging markets is encouraging more and more companies to acquire assets in these economies. But while the growth can be spectacular, the challenges are considerable.

• By Ben Voyles three questions – and the degree of certainty one can have about the answers.” 89% he emerging markets have been rising so Mergers and acquisitions relentlessly, it’s easy to take the recurring What are you buying? in India and China’s mining T miracle for granted. But as solid as the Companies need to be very clear about what and metals sectors grew fundamentals may seem, there are no sure bets. they are buying – and whether there are by 89% in 2010, according Even if the emerging markets do prove potential liabilities as a result of historical to Ernst & Young’s report unsinkable, business practices can be very practices. In many – though certainly not all – Ungeared for growth. different from what executives are used to in emerging markets, the frequency with which due developed markets. Companies contemplating diligence turns up “skeletons in the closet” from an acquisition should evaluate the target in a a tax perspective is far higher than in more disciplined way, and probably even more carefully mature markets. than they would with a mature market asset. Such issues turn up in many forms as a result Any acquisition process essentially comprises of a number of techniques, but the effect is the three questions: What are you buying? What same, in that the purchaser could be taking on is it worth? And what are your options for buying significant undisclosed liabilities - and the it? As Aidan Stokes, Global Director of penalties and interest may be worse than in most Ernst & Young’s Transaction Tax Practice, who developed markets. In China, for example, the has spent over 10 years working in emerging penalties alone could run to 500% of the tax. markets during his career, explains: “The only And the exposure need not be recent. The things that are different in an emerging statute of limitations does not apply to “serious” market are how one goes about answering those tax violations in China, with “serious” defined

16 T Magazine Issue 04 Ernst & Young as errors in excess of 100,000 Renminbi – or around US$15,000. The tax systems in many emerging markets 175 are relatively new and the meaning of The MARC M&A Maturity Index, which tracks the maturity of legislation is not always clear. Further, new 175 countries in terms of their M&A maturity, found that statutes mean a limited body of case law and a Asia is emerging as the most favorable region for global M&A activity significant proportion of individual tax officials outside the traditional Western markets. are themselves on a learning curve.

What is it worth? Valuation is the second important piece. Here sophisticated, the likelihood of significant (and too, the story may differ from an acquisition in a Conclusion regular) tax reform increases. Significant tax more mature market – with tax issues significantly With their high-speed reforms took place in China in 2008, for example, changing the valuation model. trains, high-rise office and are expected in 2012 in India – with new Stokes recalls one deal from his time in China, towers and fast-paced provisions adopted from 2011 in Russia. when a listed European multinational looked urban life, today’s Lack of certainty as to application: in more at acquiring a Chinese target group that had an emerging markets are mature markets, there is generally detailed effective tax rate of around 4%. As soon as very different from guidance from the tax authorities as to how they the due diligence started, it became clear that the markets in which will interpret contentious issues in the event the main operating business had been Western multinationals of uncertainty, with a body of case law from the transferred to a newly incorporated company first began to invest legal system providing further comfort. In every two years, to take advantage of a two-year 20 years ago. This is not emerging markets, this simply isn’t the case – tax holiday that existed at the time for companies just a veneer. Economic and this means cautious investors often take a in that industry. As the European multinational growth, the development conservative and proven approach. had no intention of adopting such behavior, of more robust Slow or uncertain dispute resolution: if one the earnings would be subject to Chinese tax of institutions and has a dispute in a mature market, the issue may 20%-25%. This was more than was reflected in advanced technology be appealed relatively quickly through the courts. the valuation model and this alone was sufficient have transformed the The outcome of tax litigation in emerging markets for the buyer to walk away. lives of billions. tends to be more unpredictable – and can take In valuing an emerging market asset, one However, this modernity far longer. For example, resolving a tax dispute in crucial tool is the pro forma profit and loss is unevenly distributed. India by going through all levels of appeal account. This seeks to model the profit and loss In many markets, tax currently may take anywhere between 15 to 20 statement as if the new owner had run the and regulatory years. In some emerging markets, too, a negative business under a variety of (very important) authorities are facing reaction of tax authorities to court proceedings assumptions. a challenge to catch up. is not always in the interests of the taxpayer. In some cases, the profit and loss statement Until they do, foreign Sophistication of the legal system: many based on local accounting rules and the target’s buyers should proceed things that would be assumed in a mature market historical approach – particularly around taxes with caution. in terms of achieving desired results may simply – can be significantly different from the pro not be possible. For example, if the legal system forma profit and loss account. In addition to the does not provide for preference shares or a ongoing implications for earnings, account must convertible instrument, the tax treatment that also be taken of any historic tax risks. Companies would apply is simply not relevant. should also take into account withholding taxes Exchange controls: finally, many emerging applied to income flows coming out of the target markets have stringent exchange controls, – together with taxes arising in the hands of the generally designed to prevent capital flight by purchaser. While all of this is equally true for an residents. Whatever the intent, one practical acquisition in a mature market, the frequency corollary for foreign direct investors is that there and scale of the issues buyers face are often are significant burdens on investors to determine much greater. the circumstances under which capital may be withdrawn. What are your options for buying it? If the relevant approvals are not obtained at The options for financing in an emerging market the time of the investment, it may never be tend to be far more limited than in a mature possible to extract the funds again. Further, market – and not necessarily wholly as a result of additional income flows to a new foreign owner the tax provisions themselves. Stokes says this is may not always be possible, given the need to caused by a number of factors, including: convert local currency to make settlement, Lack of detail: in many emerging markets, tax creating yet another planning challenge for legislation is extremely limited. Even when would-be investors. supplemented by guidance from the tax Over and above these systemic issues, many authorities, there are generally huge areas of emerging markets are focused on ensuring uncertainty as to how issues will be handled. that assets (and gains) are not transferred abroad. Potential for change: even where one treatment Often, withholding taxes tend to be high applies, the potential for sudden change and commercial issues are not reflected in tax is high. Further, as tax authorities become more legislation.

Ernst & Young Issue 04 T Magazine 17 Feature Deal-making decisions Credit: Rob Huibers / LUZphoto View from the hotseat Royal Philips Electronics has been on the acquisition trail for years. James Nolan, its head of M&A, explains some of the megatrends that drive its deal-making decisions. Interview by Gerri Chanel

T Magazine: How has M&A at Philips changed portfolio of solutions for health problems such since you first arrived at the company? as sleep apnea, which, along with obesity, is James Nolan: I’ve been working in the M&A becoming a real issue. department here for 11 years and have been head of M&A for six years. During that time, we What are some of the challenges of M&A in have refocused the company by divesting many emerging markets? businesses – for example, semiconductors – and Although it might sound banal, one of the 40 reinvested those funds in growing our remaining biggest challenges is finding true value. We have Philips, headquartered in businesses: lighting, hospital and home seen an explosion of optimism in emerging the Netherlands and employing healthcare, and consumer lifestyle. markets but it is not always easy to invest there. 119,000 people in more than When I joined the M&A function, it was very In China, for example, owners of companies that 60 countries worldwide, has centralized and quite Euro-centric. Now, are doing well do not want to sell – and they completed 40 acquisitions in we’ve really globalized. We are more globally certainly don’t want to sell to Western the past four years. decentralized and represented by multiple companies. They want to do IPOs where they nationalities. And our acquisitions are more will continue to run the companies they have global as well, resulting in a significant number built. And they command fantastic premiums of acquisitions in emerging markets. over and above what we could possibly pay and still make money from. There is so much Why are emerging markets a focus for Philips? first-generation optimism in a market that only Because emerging markets are the growth sees growth year on year. That’s reflected in markets and tend to have favorable demographics. the valuations. If you look at the demographics in Western Europe, they are quite challenging, with strict What else plays a role in M&A besides value? immigration policies and very low birth rates. One factor, among many, is that M&A is a There can also be reasons to invest in long-term game. We don’t just identify a company emerging markets where the fertility rate is low. and then turn up at the door. Often, we will get to In China, for example, expenditure on children is know companies over years and build a long- increasing despite the one-child policy. Every term relationship with them. People want to deal child has two parents, both working, and then with a company that is known for its integrity and two sets of grandparents, so this is the only with senior officers who exemplify that. grandchild as well as the only child. In the Another key issue is investor relations. When affluent Chinese market segment, people will paying a premium, it is important to explain spend much more on these children, so this has to shareholders why we’re paying that, how we’re been a good business for our AVENT brand of going to earn it back, and then how we’re going baby feeding bottles. to make money from the acquisition. You always have to maintain the trust of your shareholders. You mention demographics as one megatrend driving M&A. What are some of the others? How should acquirers justify paying a premium? We see a second wave of globalization underway. To some extent you always need to pay more Countries like Mexico, Turkey, Thailand and than the stand-alone value of a company. This is Indonesia are major centers of population that what the premium is. If you just offer a company people aren’t yet focusing on. Urbanization is what it’s worth without any premium, the owners another megatrend. For example, we just bought will simply say, “Why should I sell it to you?” a company in India, called Preethi, which unless they need liquidity. The key challenge with makes compact domestic appliances to serve M&A is how you recoup the premium. It’s like an urban population. We look at M&A that entering a 400-meter race and you’re standing serves an aging population, such as our 2007 120 meters behind the rest of the field. You have acquisition of Lifeline, the world’s largest to make up that 120 meters to catch up, then provider of personal emergency response overtake the rest of the field. And if you don’t do services. We’ve also done deals to expand our both, the deal is not successful.

18 T Magazine Issue 04 Ernst & Young James Nolan

As Executive Vice President and Head of M&A at Philips, Nolan leads a multinational M&A team consisting of 21 people, comprising nine nationalities across five countries. “We’ve really globalized,” he explains. “We are more globally decentralized and represented by multiple nationalities.”

“The key challenge with M&A is how you recoup the premium,” says James Nolan. Focus Carve-outs Credit: Getty / Justin Guariglia

Unloading ahead In the next few years corporate carve-outs and spin-offs will become more commonplace – but also more complex.

Hong Kong’s port is one of the world’s busiest, handling over 200,000 vessels each year.

20 T Magazine Issue 04 Ernst & Young Hutchison Whampoa One of the world’s biggest port operators, the Hong Kong conglomerate has carved out its ports business through an IPO on the Singapore Stock Exchange.

• By Paul Kielstra

ergers and acquisitions may have been in short supply over the past few years, but M carve-out activity has remained brisk. Although carve-outs fell out of favor in the run-up to the financial crisis, they have become increasingly popular in the past 18 months. Examples of firms that have hived off assets via carve-outs include the 2010 sale by Royal Bank of Scotland of its payment processing division WorldPay, and the sale by Marsh & McLennan in the same year of its corporate investigations unit Kroll. This activity has continued into 2011. Already, corporate deal-making has been dominated by carve-outs, including Cargill’s US$24b spin-off of a majority stake in Mosaic and ArcelorMittal’s demerger of its stainless steel division, Aperam. In the next few years, it is likely that carve-outs will become more commonplace. A challenging economic environment is encouraging many companies to focus on their

Cargill’s US$24b spin-off of a majority stake in Mosaic is one of the headline deals of 2011

core competencies, which means that peripheral or non-performing assets will no longer be seen as part of the strategic vision. Regulation can also be a factor. In the financial services industry, some banks have come under pressure to sell off assets to pay down government debt. And at a time when access to credit remains constrained, carve-outs offer the opportunity to free up capital that can be more effectively applied elsewhere. “Ongoing mega-trends will further accelerate carve-out activity,” says Max Habeck,

Ernst & Young Issue 04 T Magazine 21 Focus Carve-outs

EMEIA Operational Transaction Services Leader do not attract tax. In fact, one consideration at Ernst & Young. “Major industrial groups impacting the decision to list in Singapore, rather are currently “cleaning up” their asset base, than HWL’s home market in Hong Kong, could be demonstrating that they have understood that the latter does not have provision for listing investors’ revised expectations. This will provide business trusts – a situation which regulators are ample opportunity for buyers with a clear now examining. In most jurisdictions, if the strategic roadmap.” parent company sells its shares of the carved-out Carve-outs, sometimes called spin-offs, entity directly, then it is liable to pay capital gains involve a parent company selling some or all of tax. The carve-out, however, can raise new an existing business. One route to achieving a money by issuing its own shares in an IPO, which carve-out has historically been via an initial has the effect of bringing cash into the carve-out Summary public offering (IPO). By showing that the but dilutes the ownership of the parent company. Companies are subsidiary can stand on its own two feet, while In some jurisdictions, a parent company can increasingly exploring still retaining control of it, the parent company receive dividends from the subsidiary tax-free if carve-outs, or spin-offs, can demonstrate the value of the entity to it owns a significant proportion of shares in that as a means of potential buyers ahead of an eventual sale. The subsidiary (often 80%). At a later date, the demonstrating the IPO can also raise capital that can be reapplied to parent company can either spin off the shares to value of an entity fund other strategic objectives. its own shareholders (usually tax free), sell them in their business. But One of the most striking recent examples on the open market (which is liable to capital such deals, which of a carve-out is the sale by Hong Kong gains tax but still likely to be an after tax profit), are often complex, raise conglomerate Hutchison Whampoa (HWL) of or continue to have a majority stake in and numerous challenges its ports business. In addition to being one tax-free dividends from the company. for those involved in of the world’s largest port businesses, HWL holds The complexity of tax issues associated with planning them. substantial investments in property, retail, a carve-out means that the tax function telecommunications, energy and infrastructure. should be part of the discussion from the outset. Together, these assets yielded revenues of Yet according to a survey conducted for nearly US$40b in 2009. Ernst & Young’s Global tax trends report, only The company has raised approximately US$6b 53% of tax directors questioned say that by carving out its ports business and listing it their company involves the tax function at an on the Singapore Stock Exchange. The resultant early stage of exit planning. “It’s critical to 53% holding company is a business trust named involve the tax director from the beginning to The proportion of companies Hutchison Port Holdings Trust (HPHT). By selling ensure that tax considerations are reflected that involve their tax functions about 75% of the units of HPHT, HWL will yield in the transaction structure,” says Roger Coates, at an early stage of exit substantial funds that will help to pay down its Tax Director at Thomas Cook. “Bringing tax planning, according to debt. The IPO, which took place at the beginning people in at the end of the process is a recipe for Ernst & Young’s Global tax of 2011, was one of the biggest in Singapore’s disaster – by that late stage you can already have trends report. history. unwittingly picked up sizeable and unnecessary The exercise illustrates well how carve-outs liabilities.” Earlier planning gives companies are used to generate capital without severing more options. “Those companies which are most assets completely from the parent company. successful consider tax well in advance of an Hutchison currently controls 308 berths at exit – if left until a transaction is imminent or 51 ports in 25 countries. For the carve-out, it already under way, tax issues cannot always be needed to begin by severing off its south China addressed as effectively,” says Matthew Peppitt holdings, which are the oldest assets of the of Ernst & Young’s Transaction Tax Practice. group and currently the most profitable ports. Early involvement by the tax function is As part of the arrangement, there will be a important, but it can also be dangerous if its role tails off once the initial planning has taken place. A challenging economic “You do see tax brought in at the beginning to advise on structuring the transaction and then environment is encouraging firms having no further involvement,” says Coates. to focus on their core competencies “That is risky because things can change and discussions can lead down other paths. It’s non-compete clause with the rest of HWL’s global critical that tax specialists are kept involved port companies. In addition to holding about a throughout the process. Sometimes there is no quarter of HPHT units, the group will maintain simple solution.” influence by placing another subsidiary, Adding to the complexity is the need to Hutchison Port Holdings Management – in which engage in tax planning that focuses not just on it indirectly holds 80% of shares – as the new the requirements of the parent company in entity’s trustee and manager of its assets. isolation, but also seeks to achieve value out of Tax considerations shape carve-outs in many a carve-out transaction by accommodating different ways. In the HWL carve-out, one major the buyer. This may require simultaneous decision clearly influenced by tax considerations consideration of the tax situation of the seller, of is listing as a business trust. Among the benefits the carved-out business when it is a separate of such a structure, dividends to unit holders entity, and of the – perhaps still unknown – buyer.

22 T Magazine Issue 04 Ernst & Young HowWhat likely will is be your your company main How likely is your company to execute divestments/acquisitions How likely is your company to execute divestments/acquisitions tosource execute of divestments deal financing in in the following time periods? in the following time periods? thein followingthe next 12time months? periods?

70 Divestments Acquisitions Divestments Acquisitions 50 67% 60 59% 80 80 80 57% 54% 80 28% 47% 40 21%48% 21%49% 70 70 66% 70 41% 41% 70 50 18% 15% 28% 60 60 60 33% 60 30 18% 42% 42% 57% 54% 44% 24% 40 40% 50 41% 50 38% 50 50 38%36% 36% 47% 41% 21% 28% 20 38% 27% 21% 30 40 21% 20% 40 18% 40 40 21% 29% 18% 15% 10 30 16% 19% 30 32% 42% 30 30 20Nov 09 Apr 10 Oct 10 18% 40% 20 20 38% 20 20 100–6 months 10 10 10 10 Apr 10 Oct 10 Apr 11 Apr 10 Oct 10 Apr 11 Apr 10 Oct 10 Apr 11 Nov 09 Apr 10 Oct 10 Nov 09 Apr 10 Oct 10 Nov 09 Apr 10 Oct 10 6–12 months 1–2 years Cash Bank loans 0–6 months 6–12 months 1–2 years 0–6 months 6–12 months 1–2 years

Source:Source: Ernst Ernst & Young & Young Capital Capital Confidence Confidence BarometerBarometer Source: Ernst & Young Capital Confidence Barometer Source: Ernst & Young Capital Confidence Barometer

“These interests may compete,” explains Peppitt. statement to understand what is on offer. These When does tax get “A successful carve-out is all about finding what statements, however, are equal parts art and involved in the deal? is going to be mutually agreeable.” science, because they must reflect performance This does not always have to be the most that would have occurred had the carve-out 45% tax-efficient route for the seller. If, for example, a been independent rather than what happened Soon after the deal is identified, certain approach adds to the value of the asset while it was part of the parent company. as part of preliminary reviews by corporate development teams for the buyer, and the parent company could Preparation of these requires more than accordingly charge a price premium in excess of assigning a percentage of the parent company 37% tax in a given year to the carve-out. Instead, Once a decision has been made the statement needs to show what taxes the new to perform initial due dilligence “Those companies that are most on a deal entity’s activities would have attracted given its successful consider tax well in foreseen structure and tax jurisdictions, as well 18% advance of an exit.” as any relevant reliefs. Only after initial due dilligence has been undertaken by other – Consider the appropriate distribution of functions its higher tax liability, it might be worth taking deferred assets and liabilities, as well as tax steps that would permit such an arrangement. attributes. Among the most difficult problems in Source: Ernst & Young Global tax trends Such complexity does not allow a one-size- creating a carve-out is the distribution of fits-all approach, or even a comprehensive deferred assets and liabilities between the parent tax-planning checklist for carve-outs. Each case company and the new entity. The split of assets will have its own unique features. Nevertheless, and liabilities will be shaped by the business certain themes common to these transactions requirements of each entity, but the tax impact make consideration of this multi-dimensional will also need to be considered. Similarly with tax puzzle a bit easier. Typically, the seller will want attributes, losses carried forward might not to minimize tax liabilities, in addition to securing be transferrable to a new entity in some the best possible price. Besides looking to keep jurisdictions or usable by the parent company in the price down, the buyer will wish to obtain tax others. Moreover, a buyer may even have built reliefs for the purchase either immediately or up losses that will eliminate any tax liability from over time. The buyer will also want to avoid tax deferred income. risks related to earlier activity, such as deferred – Reduce the tax uncertainty for the buyer. gains, from being triggered. Anything that decreases or eliminates risks With these themes in mind, those preparing associated with the carved-out enterprise will for a carve-out would do well to consider the increase its value to a buyer, and therefore following points as early as possible: improve the price. Prior to any potential sale, – Plan ownership from the start. A company sellers should make sure that they address any carving out a new entity would normally have outstanding disputes with the tax authorities. several options about how to structure its This is especially important in international controlling interest. It could, for example, take on transactions, but it is also useful to get pre- direct ownership of shares in the carve-out or transaction clearances from tax authorities for maintain effective ownership through a holding domestic ones where possible. company. Whatever the solution chosen, tax is It seems clear that carve-outs are set to an important factor in the decision. become a significant feature of theM&A – Financial statements for the carve-out need landscape. Carve-outs almost invariably involve to do more than simply assign a percentage of complex decisions, where tax is one of many the parent company’s tax liabilities to the carve- issues. Early planning, however, is essential for out for any given year. Prospective buyers of a companies to realize the full value of the asset carve-out will want some type of financial they are selling.

Ernst & Young Issue 04 T Magazine 23 Focus M&A activities A healthy pipeline for M&A deals? After several years of depressed M&A activity, deal confidence is returning, says Giuseppe Monarchi of Credit Suisse. Interview by James Watson

T Magazine: After several years of reduced deal there is a geographic angle linked to those deals, volumes, how do you see the outlook for M&A which points towards emerging markets. Those in Europe over the next 12 months? are the two main themes we see. There are Giuseppe Monarchi: There are signs that the other themes of course, such as what will happen market is continuing to strengthen. I don’t think with financial institutions. We think there’s a we’ve seen massive shifts, but certainly during compelling rationale for consolidation in banks, the last year confidence has started to build. with a number of transactions waiting to happen. It seems to me that we’re off to a much stronger Will that happen this year? Well, it’s due to come 22.9% start this year, but I think it’s too early to call a back, but it may take a little longer. Increase in value of total global big revival in M&A yet. Certainly volumes are up M&A activity in 2010 over on last year, but I don’t think we’ll end up In terms of cross-border M&A, which regions 2009, according to Thomson anywhere close to the previous peaks. are likely to be the biggest recipients of M&A Reuters. investment and why? Which factors are likely to increase the level of Emerging markets for sure. These economies M&A activity? have been growing steadily for a number of There are a number of factors, but a lot of this years. It’s no longer just about developed market has to do with the strengthening of the equity companies investing in emerging markets, which markets. Historically, there is a high degree used to be the case. Increasingly, we see a of correlation between M&A and equity markets. lot of players from emerging markets investing in There are also a number of economies pulling both developed and other emerging markets. out of recession although, of course, situations The most attractive destinations are the biggest may be quite different from country to country. and most obvious, such as Brazil in Latin America, and India and China in Asia. I think that What are the downside risks that could hamper will probably continue to be the case. The M&A activity? development of African markets is clearly well In equity markets, the correlation I mentioned behind, but this will be another place companies can work either way. To the extent that equity will look for growth in the longer term. markets are weak, or volatile, that hampers M&A. And clearly geopolitical factors, such as what’s What trends are you seeing in deal financing? happening in North Africa or Japan, can affect High-grade corporates have had access to the mood. The extent to which these downside finance for quite a while. In the course of last risks can prevent deals from taking place varies year, financing market conditions went from depending on the deal. In the case of strategic strength to strength. What’s shifted over the past M&A, where there is a compelling strategic six to nine months is the strength of the rationale, you can take a longer-term view. leveraged finance market. Leverage was Significant market disruptions may hold such available before, but it is now much more deals back, but generally they will continue. For available in both absolute and relative terms. In opportunistic M&A, you need a shorter-term contrast, I don’t think you see as many stock payback period, and if the short-term outlook is deals, because these are more complicated and cloudy, then you become more cautious. people often feel their stock is undervalued.

Which sectors and geographies do you think What change has there been in the extent to are likely to be most active in terms of future which shareholders are scrutinizing potential M&A activity and why? deals? In terms of sectors, natural resources have been This is something we’ve seen for some time. In very active, and will continue to be so. And often general, shareholders have become more vocal

24 T Magazine Issue 04 Ernst & Young Credit: Credit Suisse

Giuseppe Monarchi Head of EMEA M&A Group

Giuseppe Monarchi is Managing Director at Credit Suisse’s Investment Banking division, and Head of the company’s Mergers & Acquisitions Group for Europe, Middle East and Africa. He has conducted a wide range of deals for the bank, including Lottomatica’s acquisition of GTECH, the sale of Golden Telecom to Vimpelcom, the Greek Government’s sale of OTE to Deutsche Telekom and Telefonica’s acquisition of Vivo from Portugal Telecom.

– on both sides of a deal. Investors in the acquirer changes in tax law. In general, these markets are are keen to ensure that the deal will create much more dynamic. This is not always a good value and that it is being conducted within very thing, as it can bring unforeseen change, such as specific guidelines. And on the other side of political unrest. the transaction, investors in the target company want to make sure that the deal achieves What is the outlook for private equity over the an appropriate value. They’re not necessarily next 12 months? following what the board may recommend. The outlook has improved. There are a number of reasons for this. One is the improvement What issues should companies examine when in equity markets, which is enabling investors to they are considering the acquisition of realize a return from some of these investments. emerging market assets? The second reason is that the type of financing One key issue concerns access to information that private equity needs is now much and the quality of that information. Accounting more available. Some transactions were simply standards may be different. Traditional approaches not possible before, because banks did not to valuation can be tricky. For example, just have enough underwriting capacity. This calculating the cost of capital can be very difficult is expanding on a nearly daily basis. Transaction in some markets. There is also the local regulatory limits are expanding, and risk appetites are environment to consider, which may include improving.

Ernst & Young Issue 04 T Magazine 25 Focus M&A deals by regions Credit: Getty / ChinaFotoPress

Outbound value 2010: US$68,322.4m

Inbound value 2010: US$55,304.4m

Beating the gong: the chairman of PetroChina started an IPO ceremony at the Shanghai Stock Exchange in 2007. Source: Thomson Reuters

China 2000 2003 2007 2010 Inbound value (US$m) 44,403.6 21,844.2 36,799.3 55,304.4 Outbound value (US$m) 5,509.0 18,286.4 42,098.1 68,322.4 Inbound number 288 875 1,375 1,033 Outbound number 142 642 1,022 880

26 T Magazine Issue 04 Ernst & Young A shift in the balance of power Over the past decade, emerging market companies have become increasingly important players in the M&A landscape.

• By James Watson But resource security is just one piece of the puzzle. Emerging market acquirers are __ The year 2010 marked a watershed of the increasingly keen to gain access to technology development in global M&A activity. For the first and to gain a foothold in rapidly expanding time, deal volumes were more or less equally infrastructure networks. In 2010, for example, divided between North America, Western Europe the Indian telecoms company Bharti Airtel and the emerging markets. Up until then, acquired the African assets of Zain, a Kuwaiti developed markets had always dominated M&A group, in an all-cash deal worth US$10.7b. The league tables, so the shift is hugely significant. deal gives Bharti access to a fast-growing market Over the past decade, emerging markets have and increases its user base to 179m. The grabbed an increasing share of M&A activity. As company’s experience of running low-cost 3,000 shown on the next few pages, the volumes of operations in countries where customers are on According to Thomson inbound and outbound M&A deals involving low incomes offers a foundation to support Reuters, the most targeted emerging markets have grown rapidly – often growth over the coming years. emerging market nation in outpacing the growth in developed markets. Sometimes, outbound M&A from emerging 2010 was China, with 3,000 Cross-border M&A activity involving emerging markets has the goal of gaining access to deals worth a combined markets is flowing in many directions. valuable technology and intellectual property. US$131.1b. Multinationals from the developed world are When the Chinese car company Geely announced looking east, keen to capture the benefits from its US$1.8b acquisition of Volvo from US car rising consumption and economic prosperity giant Ford in 2010, it explained that one of the against a backdrop of sluggish growth in objectives of the deal was to integrate Volvo’s their own markets. Meanwhile, emerging market design and technology expertise into three multinationals are snapping up assets in new manufacturing facilities in China. These the developed world, while also buying in other would then be used to serve the fast-growing emerging markets. local market. A common driver of this deal activity – Emerging market acquirers are also keen to although by no means the only one – is a desire gain a foothold in developed markets. Even to gain access to natural resources. China and though their own markets are growing much India, in particular, have been pushing to secure more quickly, developed markets still hold many deals that will help to provide long-term energy of the world’s most prized assets. In December and resource security. Ever-increasing 2010 for example, the Indian company Sahara commodity prices, a strong cash position Pariwar acquired London’s Grosvenor House and concerns about the scarcity of energy and Hotel for £470m. natural resources are fueling deals even further. Although relatively small, the Sahara A number of Chinese companies have acquisition highlights an important trend. acquired assets in resource-rich countries. Competition for the deal did not consist of In 2009, for example, Yanzhou Coal acquired Western hotel companies, but sovereign wealth Australia’s Felix Resources for US$2.8b funds from Qatar, Singapore and China. while,in the same year, Sinopec acquired the The balance in the M&A landscape is shifting, Swiss-registered oil and gas company Addax and it is emerging market acquirers who are for US$7.2b. becoming key players.

Ernst & Young Issue 04 T Magazine 27 Focus M&A deals by regions Credit: Getty / Bloomberg / F. Carter Smith

Outbound value 2010: US$688,746.3m

Inbound value 2010: US$659,950.2m

Largest global brewer: Anheuser-Busch InBev NV, grown from mergers of legacy brewing companies.

United States 2000 2003 2007 2010 Inbound value (US$m) 1,711,665.2 458,414.6 1,644,915.6 659,950.2 Outbound value (US$m) 1,548,797.8 483,373.6 1,612,842.6 688,746.3 Inbound number 9,997 6,999 10,437 6,753 Outbound number 10,558 7,295 10,916 7,103

28 T Magazine Issue 04 Ernst & Young Credit: Getty / Bloomberg

Outbound value 2010: US$32,103.4m

Inbound value 2010: US$20,541.4m

Connecting markets: Indian telecom company Bharti Airtel acquired African operations from Kuwait-based Zain Group.

India 2000 2003 2007 2010 Inbound value (US$m) 4,866.6 3,291.3 33,038.1 20,541.4 Outbound value (US$m) 3,309.0 4,148.3 19,087.7 32,103.4 Inbound number 521 386 838 688 Outbound number 395 320 731 615

Ernst & Young Issue 04 T Magazine 29 Focus M&A deals by regions Credit: Keystone / Vladimir Smirnov

Outbound value 2010: US$29,892.9m

Inbound value 2010: US$22,817.4m

Treasures of the soil: The M&A market in the oil and gas sector sets the pace for other industries in Russia.

Russia 2000 2003 2007 2010 Inbound value (US$m) 2,583.7 30,219.9 86,966.4 22,817.4 Outbound value (US$m) 1,763.3 30,675.7 82,349.3 29,892.9 Inbound number 310 341 594 3,105 Outbound number 248 330 500 2,775

30 T Magazine Issue 04 Ernst & Young Credit: Getty / Bloomberg

Outbound value 2010: US$425,793.2m

Inbound value 2010: US$475,162.3m

Sweet taste: Kraft Foods acquired British confectioner Cadbury in 2010.

European Union 2000 2003 2007 2010 Inbound value (US$m) 1,277,852.6 480,681.6 1,415,975.1 475,162.3 Outbound value (US$m) 1,526,893.4 466,071.9 1,468,107.7 425,793.2 Inbound number 14,021 8,817 14,272 12,774 Outbound number 14,163 8,433 14,104 12,455

Ernst & Young Issue 04 T Magazine 31 Focus Tax directors Credit: Ed Thompson / LUZphoto

Summary M&A deals involve a great deal of complexity from a tax perspective, including pre-deal structuring to an assessment of liabilities. The involvement of the tax director is crucial for identifying efficiencies.

Driving value from transactions Company tax directors can play a major role in driving value from M&A transactions, but only if they are included in the transaction early enough.

• By Gerri Chanel these considerations to the table. One of the Tax function involvement primary roles of the tax director is to identify in exit planning hile taxes, by their very nature, play a opportunities to structure transactions that major role in the economics of an optimize the tax outcome – whether identifying 9% W M&A transaction, the impact of tax tax synergies with the existing business (or considerations on the overall value of a deal has issues that might undermine this), preserving tax not always been fully recognized. Today, though, assets such as losses in the acquired company, many companies are more focused than ever or minimizing transfer taxes. 38% 53% on driving the maximum value possible from Pre-deal planning also involves tax due potential deals. This means that they are taking diligence. In part, this involves identifying and a much broader view of the role of tax in mitigating risk arising from historic tax issues. transactions, and recognizing the significant But equally, says Janine Juggins, Global Head of role that the tax director can play in helping to Tax at Rio Tinto plc, it means focusing on sources From an early stage drive value from deals. of future value. “Tax due diligence needs to When divestment plans are in progress and due diligence Both tax directors and a company’s corporate consider how the business will look in the parameters are being set development team should be acutely aware of future,” she says. “Depending on the plans for When divestment terms are the impact of a transaction on their group’s the business post-acquisition, does it have close to agreement and when formal due diligence is effective tax rate. But there is a plethora of tax a tax-efficient capital structure, are there any requested by the buyer issues, planning opportunities and risk supply-chain planning opportunities, and considerations that can significantly enhance or what is the business going to look like in your Source: Ernst & Young Global tax trends limit transaction value – and tax directors bring corporate structure?”

32 T Magazine Issue 04 Ernst & Young Janine Juggins Global Head of Tax, Rio Tinto

__ By assessing the tax details and implications of Rio Tinto’s many M&A deals, Juggins is one of the key individuals behind the scenes of the mining giant’s acquisition trail, making sure that such transactions are a success. “For a company like Rio Tinto that is generally making acquisitions with a long- term investment horizon, any tax planning that we do needs to be sustainable.”

See interview on page 35. Focus Tax directors Credit: Keystone / EPA / Wei Leung

Rio Tinto is a leading international business involved in each stage of metal and mineral production. The Group combines Rio Tinto plc, which is listed on the London Stock Exchange, and Rio Tinto Limited, which is listed on the Australian Securities Exchange. Rio Tinto produces aluminum, copper, diamonds, coal, iron ore, uranium, gold and industrial minerals. With production mainly in Australia and North America, Rio Tinto operates in more than 40 countries and employs about 75,000 people.

Rio Tinto’s diversified mining and resource operations have been built up through numerous M&A deals.

Assessing the The need for early involvement by tax in M&A it may be essential to set some conditions implications transactions is fundamental but often not precedent with the seller that could impact the The tax director can add recognized. “Early involvement of a tax director deal timetable. These may arise where tax value to a deal by identifying in any transaction is critical to assess whether rulings or clearances must be obtained as part of and planning for: there are likely to be issues that could kill the the transaction structuring – and before the deal – Availability of tax relief transaction stone dead as well as preventing an can be closed. “You may be required to ask the for financing costs in unacceptable outcome further down the track,” providers of debt to make certain certifications in structuring a deal says Vinay Tanna, Joint Global Head of Tax at structuring a transaction to meet certain tax – Tax-efficient or structured Diageo plc, which owns famous brands like criteria,” says Juggins. “This may require financing Johnnie Walker and Guinness. considerable explanation to the commercial – Pre- and post-transaction Alistair Craig, a Director in Ernst & Young’s team.” business combinations Transaction Tax Practice in London, points out – Indirect tax planning that corporate development teams will Cross-border complexities – Tax-efficient supply-chain sometimes bring tax on board at the last minute, Cross-border deals require particular attention. planning when the deal is already structured. “This is The tax director has a vital role to play in – Intangible asset planning too late,” he says. “It is essential to involve the assessing whether tax risks exceed the board’s – Employment tax and tax director early in the process so that the tax risk tolerance – and in some cases, whether the pension tax planning opportunities and costs are factored into the deal happens at all. “It is vital to have a proper – Ensuring post-deal structure pricing and terms. Not getting this appreciation of each fiscal regime and how it execution and right can sometimes make the difference could impact your business before planning maintenance of pre-deal between the transaction happening or not.” transactions in that territory,” says Tanna. tax planning strategies Early involvement can also influence the – Identifying tax risks in transaction cost, timing and management’s price Areas considered for deal Areas considered for deal planning the target and strategies expectations. For example, modeling is a planning for mitigating those risks process that can result in many iterations before 19% 67% 14% – Addressing tax getting to a refined19% view of 67%the tax rate.14% If the Availability of tax relief for financing costs in structuring a deal accounting issues to avoid tax input is notAvailability included of in tax the relief first for financingfew passes, 21% 57% 21% costs in structuring a deal post-deal profit impact for it can cause delays and unnecessary costs in the Post-transaction business combinations pre-deal tax liabilities acquirer’s post-deal income statements. In 21% 57% 21% 30% 56% 14% – Opportunities and risks in addition, if suchPost-transaction costs are not business factored in to early Tax-efficient or structured financing a wide range of other iterations of thecombinations model, management can 36% 43% 20% areas, depending on the have unrealistic30% price expectations,56% which14% are Indirect tax planning, e.g., VAT, sales taxes or customs duties company and the deal hard to adjust Tax-efficientlater in the or process. structured financing 36% 43% 20% Is a primary component of transaction value Is an important part of the overall mix of fiscal factors It’s not just aboutIndirect price tax planning, e.g., VAT, Is not a significant factor In some situations,sales taxes the ortax customs director duties can play a Source: Ernst & Young Global tax trends role in the timingIs ofa primary a deal. component In certain situations, of transaction value Is an important part of the overall 34 T Magazine Issue 04 Ernst & Young mix of fiscal factors Is not a significant factor

Source: Ernst & Young Global tax trends The tax director often takes the lead in driving the tax accounting process. If items such as Interview with Rio Tinto Global Head of Tax, Janine Juggins: goodwill (or negative goodwill), pre-existing tax liabilities or other deferred tax issues are not “Any tax planning we do needs accounted for properly at the time of the deal, there can be a post-deal hit to earnings and to be sustainable.” other unanticipated consequences. Properly identifying pre-existing tax liabilities in the opening balance sheet of an acquisition is Rio Tinto, a leading global mining of a transaction, the tax director is critical. If this does not happen, says Tanna, they group that works in some of the told what’s going on in outline and will be treated as liabilities that have arisen world’s most difficult terrains and what the key underlying drivers are. afterwards and will impact earnings, particularly climates, began life in 1873 as a If you’re not involved right at the if indemnification or warranties from the seller venture to extract copper at an start, there’s a risk that things can are not adequate. ancient mine in southern Spain. Here, get agreed before anyone on the deal Rio Tinto Global Head of Tax Janine team appreciates that there are tax Synergy in post-merger integration Juggins talks to T Magazine about the consequences. Companies must ensure that they structure deals role of the tax director in mergers and that make sense from both a tax and overall acquisitions. Does Rio Tinto do anything to business perspective. Tax directors can play a enhance how the tax and business role here by unlocking synergies and by T Magazine: How would you describe development teams work together? identifying where value generators and drivers the ways a tax director adds value in The business development teams at lie together with the people who are key the M&A arena? Rio Tinto now go through an induction to their realization. Another area of synergy Janine Juggins: The tax director process and tax is one of the functions comes from unlocking trapped tax attributes identifies tax efficiencies in the that plays a part in that program. So of the acquired business, such as losses or transaction structure and manages we will have the opportunity to meet benefits. “The value chain and future synergies tax risk. He or she also contributes to new business development people are fundamentally at the heart of any acquisition the successful integration of the asset and explain to them what we do. because if you don’t understand how the and manages some of the legacy Another practice is that the business synergies are going to arise you’re not going to issues that result from the transaction. development team organizes regular understand the business case associated with Tax directors play a unique role. They update meetings to which the tax the transaction,” says Tanna. need to both interpret tax law and partners are invited. Tax directors should also play a role in understand financial impact, but the educating constituents that tax considerations most valuable thing they bring is the What are some other elements of alone should not make a deal pass the investment need to apply their problem-solving your approach to tax in M&A deals? hurdle. “An anticipated tax holiday may skills in a very commercial way. For a company like Rio Tinto that is disappear if there’s a change in government The best tax planning strategies are generally making acquisitions with a or policy,” says Juggins. The optimal tax always in tune with the underlying long-term investment horizon, any outcome of a deal depends on an early and solid commercial drivers of the transaction. tax planning that we do needs to be partnership between the tax director and the And, above all, tax professionals need sustainable. This means ensuring that corporate development team. “This requires to exercise significant professional it is in step with the way that we an established relationship and a dialog that judgement in a way that’s consistent manage our business as a long-term fosters an understanding by the corporate with the tax risk parameters set by investment. development team of how tax can add value to the board. At the start of our investment deals,” says Stephen Hales of the EMEIA process, we review how we expect the Transaction Tax Practice at Ernst & Young. How important is it for tax directors incremental cash that’s generated “These attributes need to be in place before a to get involved early on in the by our project to be distributed among specific deal arises.” planning of a transaction? a broad range of stakeholders. There must be a free flow of information To add significant value, every tax Understanding how those potential between tax directors and the corporate director will tell you the earlier the cash flows are shared is a really development team to ensure success. “I don’t better. The earlier you identify either helpful tool to help you analyze think anything actually replaces the value of opportunities or pitfalls, the better whether you’ve got something that’s working at relationships and making sure the tax prepared you are during the got a good chance of delivering a director has good lines of communication with negotiation process. This can also sustainable outcome. This is perhaps the corporate development team,” says Juggins. help the company be more efficient. most appropriate for industries with “While a company can put formal processes in For example, if you find something very long-term investment horizons, place to require the involvement of tax, it’s very that’s so material that it can’t be such as extractive industries, the important for the tax team to know the corporate resolved, cutting off the transaction energy sector and infrastructure. development people. You need the kind of as early as possible in the process Transaction memos, where you relationship where the development team will saves a lot of money and time. set out the transaction steps and seek out the tax people at the outset.” The degree of involvement the treatment of each step in the When this is achieved, tax is an area that can obviously changes as the transaction transaction, are invaluable to ensure add major value: “The opportunities for tax progresses. What works really well that you really have thought through directors are as broad as their imagination allows is to make sure that, at the very start every angle. them to be,” says Tanna.

Ernst & Young Issue 04 T Magazine 35 Management Valuation Credit: Keystone / Photoshot / Richard B. Levine Grappling with deal valuation Calculating the likely future value of an asset is often challenging, especially in an uncertain and volatile marketplace. But getting this right is crucial to the success of a proposed merger or acquisition.

Wireless lead: AT&T has moved to reshape the US telecoms industry with an agreement to buy T-Mobile USA from Deutsche Telekom.

• By Rob Mitchell asset by calculating the value of cash flows over the life of the company, taking into successful M&A deal depends on a variety account depreciation, capital expenditure and of factors, but an accurate, realistic amortization. A discount rate is then applied to A valuation model is undoubtedly one of the reflect the costs of capital. most important. As a forward-looking measure of Estimating future cash flows is rarely simple, financial performance over a period of several but economic volatility compounds the years, valuation is an inherently uncertain challenge. “When there is uncertainty and process. There is a huge range of unexpected volatility in the market, it can be very difficult to factors that can affect future cash flows, from project future cash flows of a potential target,” changes in the macroeconomic environment to says Kenneth Lehn, Samuel A. McCullough new competitors. But while there can never be Professor of Finance at the University of certainty about what the future holds, a rigorous Pittsburgh in the United States. “Although approach to valuation can improve the chances acquirers want the range of values on a target to of long-term success in a variety of scenarios. be as narrow as possible, the sensitivities that The most common way of determining the you would run in a volatile environment are likely value of an asset is the discounted cash flow to encompass a wider range of outcomes.” (DCF) method (see sidebar on next page). Using Financial modeling techniques, such as this approach, an acquirer will seek to value the sensitivity analysis, can help companies to test

36 T Magazine Issue 04 Ernst & Young their assumptions against both benign and Valuation methods 2011 Pan-European Tax Executive Workshop adverse scenarios. By assessing the impact of There are essentially in Rome, Aidan Stokes, Global Director of the changes in different input variables, such as three valuation methods for Transaction Tax Practice at Ernst & Young, costs, economic growth or revenues, acquirers M&A transactions: described this trend further. “Companies now can have a much better picture of the viability of Discounted cash flow: the place much more emphasis on tax issues than their valuation under various scenarios. DCF approach is probably they did three years ago, and many attribute As more and more companies consider the most widely used this to the competitive pressure to improve the acquisitions in emerging markets, they will face valuation method. It returns from their deals in an uncertain new valuation challenges. Compared with involves valuing an asset economic environment,” he explained. deals conducted in developed economies, based on the present value Despite the benefits to be gained from taking emerging markets often suffer from a lack of of its projected free cash tax synergies into account when planning price history and empirical market evidence on flows over a period of time transactions, collaboration between valuation which to base valuations. In addition, accounting and applying a discount teams and tax departments remains the practices may vary, making it difficult to to take account of the cost exception, rather than the rule. “In an ideal benchmark a deal against comparable of capital. The DCF valuation world, appraisers and tax directors would work transactions in other jurisdictions. “There is an also includes a terminal hand in hand but all too often they operate increased need for due diligence when acquiring value, which refers to the in very different worlds,” says Karklins. in emerging markets to take account of value of the investment “Valuation and tax are seen as different differences in tax systems and treatments,” says after the projected period is disciplines and this ultimately means that Alexis Karklins, the Valuation and Business complete. acquirers are not capturing the value from deals Modeling Services Leader for Ernst & Young’s Comparable companies that they should be.” Europe, Middle East, India and Africa region. analysis: the comparable The valuation of intangible assets may be Any valuation model needs to take into account companies approach another spur for tax departments and corporate expected synergies from the deal. Typically, the involves identifying development officers to collaborate more closely. corporate development team will seek input from companies that have similar Traditionally, the valuation of intangible assets managers across a range of business functions, characteristics to the target has been a key challenge. “Intangible assets, including sales, human resources, finance and and basing the valuation such as trademarks or copyrights, that generate marketing, to determine where synergies can be on a comparison of certain independent cash flows, are generally reasonably expected. Common synergies may include a financial ratios, such straightforward to value,” says Professor Lehn. reduction in headcount, process improvements, as a price/earnings multiple, “Where it becomes much more difficult is in the a reduction in sourcing costs and the across this peer group. area of assets that don’t stand alone as rationalization of IT systems or manufacturing. Precedent transactions independent assets, such as brand or corporate But while the potential for operational analysis: the precedent culture, but affect the overall cash flow of the synergies is generally well understood in valuation transactions approach firm. You can’t segregate those cash flows from models, the impact of tax is less widely involves basing the valuation the rest of the firm so you have to figure out considered. “All too often, acquirers only think on the prices paid by a way to pass the contribution of these intangible about synergies from an operational perspective,” purchasers of similar assets on to the company’s overall cash flow.” says Karklins. “They don’t think about companies under similar One approach that companies can take is the structuring the deal in a tax-efficient way or circumstances. “relief from royalty” method. This involves M&A building post-merger tax synergies into appraisers valuing intangible assets according to the valuation model. These should both the amount that an independent purchaser would be crucial aspects of any potential synergy be willing to pay for them. This bears many calculation.” similarities to the “arm’s length principle” that In some cases, the consideration of potential underpins transfer pricing methodology. “The tax synergies can make the difference between question that is now emerging is whether there winning or losing a deal. Acquirers that have is any consistency between the parameters built tax savings into their model can offer that we’re using for the valuation methodology a higher valuation than a competitor that has not and those underpinning the transfer pricing taken these efficiencies into account, and may policy,” notes Karklins. therefore be a more attractive bidder. Tax synergies and tax-efficient deal structuring can play a major role in enhancing There is an increased need the value of any deal, but companies must also avoid controversy. With many governments for due diligence when acquiring in around the world seeking to maximize their emerging markets tax revenues, there is an increased risk of abrupt legislative change or step changes in “Integration often involves restructuring the enforcement. “Around the world, tax business, regrouping or moving functions administrations are becoming more reluctant from one jurisdiction to another and rationalizing to see aggressive positions and deal structuring,” business units and the supply chain,” says says Karklins. “It is therefore essential that Karklins. “By building tax synergies into the acquirers take good advice not only to ensure valuation model, acquirers can identify and that they realize tax synergies but also that recognize a wide variety of tax savings across a they do so in a way that will not pose risks from number of areas.” Speaking at Ernst & Young’s a tax controversy perspective.”

Ernst & Young Issue 04 T Magazine 37 Management Privatization

Government sales ahead An urgent need for additional funds is forcing governments around the world to re-examine their assets to see what could be put up for sale. But past experience has shown the need to tread carefully.

• By Rodrigo Amaral the private sector, governments can reduce the costs of delivering essential services to the ash-strapped governments in some public, giving an extra boost to deficit-cutting countries will need to use every tool at efforts. In some jurisdictions, privatized C their disposal to restore public finances to companies can also generate additional tax health. And while tax increases and spending revenues – an important goal at a time when cuts will be the main methods used to reduce many governments are struggling with record deficits, a significant number will turn to fiscal deficits. privatizations as an additional way of raising For corporates turning their attention to much-needed funds. growth strategies, this new wave of The disposal of state-owned assets could privatizations could well be a source of potential certainly play an important role in raising acquisition targets. “It is likely that many government revenues. Over the next five years, cash-rich companies and pension funds would it has been estimated that in total, European jump at the opportunity to buy some of the governments could raise assets that are coming to the market,” notes more than €650b James Close, of the Government Services Summary through privatizations. In Practice at Ernst & Young in the United Major privatizations the United Kingdom Kingdom. are looming as alone, the sale of Governments seeking to maximize the sale governments scramble remaining commercial price of their assets will need to consider the to raise funds. But enterprises held within timing of their sales carefully. Conditions in those seeking to the public sector could financial markets will be an important factor. maximize these deals yield up to £90bn over More buoyant equity markets will lead to higher need to consider both the next few years, valuations, although ongoing volatility means the timing and according to the Adam that it will be difficult to plan ahead. approach used to Smith Institute, a think- In recent months, a number of European ensure deal success. tank. This figure includes governments have announced that they will the potential sale of engage in privatization efforts, which means that the Government’s stakes many assets could be coming to market at in the Royal Bank of Scotland, Lloyds Banking around the same time. This creates the potential Group and Northern Rock, as well as Network for market saturation and a depression in prices. Rail, Scottish Water and Channel 4, the For example, Greece aims to raise up to €7b broadcaster. by selling stakes in airports, energy firms, the In addition to providing a much-needed postal service and a manufacturer of defense injection of capital, privatizations can also help equipment. Portugal has outlined plans to sell its governments to cut costs over the longer term. remaining stakes in the energy companies Galp By handing over responsibility for a service to and EDP and an electricity distributor REN, along

38 T Magazine Issue 04 Ernst & Young Credit: Keystone / Camera Press / Guillermo Navarro / ALFAQUI; BilderBox

€7b The Greek government has outlined plans to raise €7b from the privatization of assets ranging from its postal service to its airports and utility firms.

Madrid Airport Spain plans to raise €8b by selling 49% of its airports authority, while allowing Madrid Airport to be run by private concessions. Hellenic Post The Greek postal service is one of a number of state assets that is being considered for privatization, as part of the government’s plan to raise up to €7b.

Ernst & Young Issue 04 T Magazine 39 Management Privatization Credit: Keystone / EPA / Yuri Kochetkov; Reuters / Eddie Keogh

Rosneft The Russian government has outlined plans to sell a 15% stake in Rosneft, the state oil company, as part of wider plans to raise US$32b from the sale of state assets.

Royal Bank of Scotland RBS is one of the assets that the UK government is looking to re-privatize, in order to realize a return on its 84% stake in the bank that it took on during the financial crisis.

40 T Magazine Issue 04 Ernst & Young with TAP, the airline. It is also looking at a sale of Privatization deals by country, 1995–2010 its share of Inapa, one of Europe’s largest paper distributors, although the execution of the 180 200,000 privatization program will be delayed until after 160 180,000 the elections convened for early June. 140 160,000 140,000 Spain is launching the partial privatization of 120 120,000 its national lottery operator and its airport 100 100,000 authority, AENA, while also offering both its 80 80,000 million US$ 60 Madrid and Barcelona airports as private 60,000 Number of deals of Number concessions under a 40-year license system. It is 40 40,000 also planning to sell stakes in the country’s cajas, 20 20,000 or savings banks. And all are considering going 0 0 UK

to market in the near term. Italy Spain France

It is not only cash-strapped, Western Sweden Portugal Germany governments that are following the privatization Netherlands route. Some emerging European countries are US$1b or greater US$50m to US$249m using it as a means to enhance their economic US$500m to US$999m Total volume prospects. Poland has an ambitious divestment US$250m to US$499m program in place, while Turkey, Serbia and Croatia are also considering disposals. Russia Source: Thomson Reuters SDC Platinum has embarked on an ambitious privatization process, which includes the sale of a 15% stake in Rosneft, the oil giant, a 7% stake in Sberbank, benefits to society that are not always financial. and the recently completed secondary public “The goal of privatization may be to raise money offering of VTB, a formerly state-controlled bank. for the government, but this is not the only 70% The Russian government hopes to raise a total factor to be considered,” says David Murray of In the Ernst & Young survey of US$32b from these sales over the next Ernst & Young’s Transaction Advisory Services in Maximizing value from three years. the UK. “Governments also need to think about privatizations, 70% of While budget pressures may encourage the post-privatization landscape and the impact respondents admitted that governments to act quickly, research shows that of the sale on both the economy and society.” they did not maximize value officials would do well to proceed cautiously with Privatization can sometimes be a during the privatization privatizations. In a survey by Ernst & Young of controversial issue, particularly if voters consider process. officials in several countries that had been the asset to be part of their national heritage involved in privatizations, 70% said that they did or culture. When the UK Government announced not maximize value during the process. And an that it was planning the sale of woodland overwhelming majority of 90% said that they held by the state-owned Forestry Commission, would like to have had more time to prepare if public opposition to the plan was extremely they were to go through the process again. vocal. In February 2011, the Government Careful planning of a privatization, including announced that it would put part of the sale on the consideration of more innovative structures hold and re-examine the criteria for the disposal. for the transaction, can help to maximize the This highlights the importance of choosing value of the sale. At the most basic level, it may assets to be privatized carefully. In general, well prove more profitable to sell off an asset in governments prioritize assets that are likely to component parts over a period of years rather generate the most investor interest and that than all at once. are straightforward from a political and economic perspective. “The focus right now is on selling European governments could stakes in companies that are very easy to divest,” says James Close. raise more than €650b through Equally, financial markets may complain that privatizations privatization efforts are not going far enough. The Irish Government has been criticized for not Governments may also want to look at less including the sale of its attractive utilities conventional deal structures – for example, at companies among the budgetary measures present there is extensive press speculation as to introduced to cut the country’s deficit. In Austria, how the UK government will go about selling off the Vienna Exchange has publicly challenged its 84% stake in RBS and 41% stake in Lloyds politicians to invite private investment in the Banking Group, which were taken on following many energy and transport firms that are owned emergency bail-outs in the financial crisis. One by state entities. idea mooted is the prospect of each UK citizen “Privatization remains an emotional political taking a stake in the banks. term, and there are divergent views about But governments also need to look at a it in Europe,” says James Close. “But the scale broader range of factors than just maximizing of deficits makes the economic reality more the price. They also have a responsibility to significant than political ideology. The bottom ensure that the privatization process brings line is that governments need the money.”

Ernst & Young Issue 04 T Magazine 41 Management Distressed assets Credit: Laurence Voumard

Assets in need of care and attention Adverse conditions have led to a rise in distressed assets, such as companies on the brink of failure. But those stepping in to snap up a deal will need to move fast and deal with numerous challenges.

• By Bill Millar requires considerable know-how along with sophisticated due diligence,” she says. uy low; sell high. The idea that an acquirer Companies that have been under financial can generate handsome returns by buying stress for some time may well have a range of B assets cheaply is alluring. So much so that issues. A common problem is the failure to keep an array of “financial” investors (private equity up with funding of pension liabilities. Acquirers 53% firms, hedge funds and banks) and “strategic” may find themselves liable to fill funding gaps or According to Ernst & Young’s acquirers (traditional corporations) are in hot deal with other liabilities, such as employment Global tax trends survey, pursuit of distressed assets. Throughout 2010, a contracts. In some cases, however, these 53% of companies say that they number of hedge funds and other financial liabilities can be negated by insolvency. would consider a distressed buyers, including CQS and Oaktree Capital, Product liability and regulatory issues can also asset deal should the right launched funds specializing in this market. Many be problematic with distressed acquisition opportunity present itself. are focusing on acquiring distressed debt targets. In the run-up to distress, companies from troubled companies. According to often begin to compromise a recent survey from Prequin, a data on quality, which can lead provider, nearly one-third of institutional Summary to the risk of extensive investors saw distressed debt as among Acquiring distressed warranty claims at a later the most attractive opportunities. assets can lead to a date. Or perhaps poor bargain. But a quality led to distress in the An array of challenges successful outcome first place. A purchaser But there are limits to the opportunities. depends on a wide array should explore possible First and foremost are the intricacies of considerations, from buyer or client warranty and risks associated with such deals. As potential product issues faced by the target. Bridget Walsh from Ernst & Young’s liabilities to regulatory Similarly, depending on the Transaction Tax Practice explains, such issues. Such deals also target’s industry, due assets are usually distressed for a bring tax complexities diligence should include a reason. “They can have any number of and risks. close look at facilities, fundamental flaws, so taking them on supply chains and

42 T Magazine Issue 04 Ernst & Young Arnd Schwierholz Vice President and Head of Mergers & Acquisitions

__ Arnd Schwierholz has been Vice President and Head of Mergers & Acquisitions at Deutsche Lufthansa AG since 2004. He has been with Lufthansa since March 2002, when he joined the company as Vice President of Lufthansa Commercial Holding, the Group’s investment vehicle, helping to streamline the Group’s non-core portfolio.

See interview on page 45 Management Distressed assets

products, with special attention to regulated Alternatively, prior to any formal insolvency, an substances, hazardous materials, recalls of acquirer might elect to begin buying the shares related products or even violations of trade or of a target on the open market, a strategy often operational regulations. In the run-up to a sale, it referred to as “buying the option.” Or a buyer is possible that the seller may not be paying might also purchase a target’s debt, the so-called sufficient attention to these issues, which could “loan to own” approach. cause significant problems for the buyer. A distressed target may also expose the buyer The most taxing issues to breach of contract claims. Often, such In addition to the challenges already described, companies may be guilty of having violated the distressed assets carry heightened tax terms of contracts with suppliers or customers. complexity and risk. “These companies often Due diligence here should include analyzing how exhibit a considerable number of tax problems,” faithfully the firm has been at meeting its says Walsh. “They may be behind in tax filings contractual obligations — and finding out or transfer pricing documentation and that whether there are any potential penalties or means they may have judgments against them, damages involved. pending or otherwise. Similarly, the sale or Not to be overlooked are challenges in the any pre-sale reorganization could trigger tax integration of distressed assets. Physical assets liabilities, which transfer to the purchaser.” may be in disrepair or well behind in routine The prevalence of these problems means that maintenance schedules. It is also possible that tax considerations figure prominently in the top talent at a failing firm will have already left, structuring of most distressed asset deals. For The recent Ernst & Young leaving behind a less experienced and possibly example, in an insolvency situation, acquirers publication Distressed demotivated workforce. may seek to gain control of the assets Asset Investing: Finding themselves, rather than ownership of a company Opportunities and How to acquire or its shares. “This enables the buyer to take Addressing the Risk includes For those undaunted by these challenges, the over the assets without assuming any lingering a checklist of questions first step is to identify and pursue appropriate tax issues or, for that matter, many of the that companies should ask assets. Be warned: distressed asset transactions potential product liability, regulatory or related themselves before moving are highly competitive. Moreover, they tend to risks,” says Walsh. to acquire a distressed proceed at a rapid pace, with deals often moving Tax rules can also come into play in cases asset. from opportunity awareness to deal closing in where a would-be seller of distressed assets less than 30 days. To participate, a buyer must cannot find a suitable buyer. Often, a The checklist is available for enter the arena well prepared and ready to move management team will perceive that the download on www.ey.com/ fast. It will be important, for example, to have a mediocre or even negative performance of tmagazine/04/assets clear idea of the types of assets desired as well distressed assets is proving to be a drag on the as the capital available for their acquisition. business as a whole. In such cases, companies Decision-making processes will need to be may choose to divest such assets from the streamlined, while valuation and due diligence corporate parent via a carve-out. This means resources must be ready at a moment’s notice. that the unwanted assets are separated from the Moving fast will also mean early identification parent company’s balance sheet to create an of opportunities. The first line of information entirely new company. In most cases, however, gathering is a company’s own staff. Those who such a transaction is in principle a taxable event, know where and how to look will see the early generating immediate cash-flow consequences. warning signs of distress well before any actual event. Ask sales and supply chain managers to One last challenge discreetly query their contacts, customers and For those with the courage, often born of clients regarding any problems with deliveries or experience, distressed asset investing can be order fulfillment. Meanwhile, ask finance staff to rewarding. But despite ongoing turmoil in the stay on top of credit alerts, downgrades or macroeconomic environment, there may be similar events, which can be precursors to severe fewer opportunities than imagined. Those on the distress. Expanding awareness throughout the hunt for distressed assets in sectors, such organization can lead to better intelligence and as real estate, are finding their efforts create a competitive head start. Lufthansa’s disadvantaged by a rebound in risk appetite that 2009 acquisition of Austrian Airlines, for has raised prices on many would-be bargains. example, was aided by the two companies’ Meanwhile, banks and other lenders are existing alliance, which helped ensure close increasingly getting involved and doing more awareness of the target’s operating situation. of the needed work-outs themselves. “They’re Would-be acquirers that suspect an asset may finding that this is better than taking the hit to be in distress could even approach the target in capital,” explains Walsh. advance of any legal proceedings to see if it is No doubt distressed assets are out there. But possible to negotiate “pre-event” terms. An early in addition to the many challenges associated approach may reduce the likelihood of a rock- with profiting from their purchase, the biggest bottom price, but it does mean that there will be difficulty of all may be finding appropriate less competition from other bidders. targets in the first place.

44 T Magazine Issue 04 Ernst & Young Credit: Keystone / Martin Ruetschi

airline will always try to provide them with a Take-off for dealmaking global and seamless offer but one single airline will not be able to do that on its own. That’s why Consolidation in the airline industry used to be rare, but a tough we need partners. A lot of things we do within an decade has served as a deal catalyst. Arnd Schwierholz, alliance, such as aligning our frequent flyer programs and harmonizing our products, we do Vice President and Head of M&A at Lufthansa explains why. in an acquisition as well. In an acquisition, you get far more aligned in terms of synergies compared with an alliance, • Interview by James Watson but you take on much higher operational and balance sheet risks when consolidating those What are the recent M&A trends that you have companies. If you look at airline M&As, these are seen in the airline industry and how have you probably 50-50 in terms of revenue and cost responded? synergies. Our hypothesis is that you can Arnd Schwierholz: Ten years ago, the airline capture a lot of the revenue synergies in an sector was highly fragmented, with little M&A alliance, but not as much on the cost side. activity. That has changed dramatically, especially in the past five years. Today, we see a What options do you consider to drive growth considerable amount of consolidation, typically for Lufthansa? within the same geographic region. There have Growth is driven across three pillars in the been a number of mergers in the United States, sector. One is organic growth. European and as well as some activity in Latin America and Middle Eastern carriers are all adding capacity. Asia. You also see a lot of consolidation in Consider the huge order books for planes such Lufthansa has been an Europe, with Lufthansa playing an active role. as the A380 which, due to their low unit costs, active acquirer of ailing There have been two objectives for our are fundamentally changing the industry. The airlines across Europe. transactions. The first is to consolidate our second pillar is about alliances. The third is M&A, position in key markets and grow our revenues. which is used on a more opportunistic basis. We Companies such as SWISS International Air look at specific markets to see how we can serve Lines, acquired in 2005, Brussels Airlines and that market best and whether there is room for Austrian Airlines, acquired in 2009, are all organic growth, or if we can find the right market leaders in their home markets and have alliance partner, or if there is room for M&A. additional exposure in emerging markets. Obviously, this requires a selling partner, as well Secondly, those companies have been as the necessary cost and revenue synergies. struggling to survive on their own. SWISS had been just coming out of bankruptcy when it was Many airline deals involve distressed assets. acquired by Lufthansa and Austrian Airlines only How do you deal with the issues that such survived because of a €200m rescue loan from transactions raise for you? the Austrian Government. By putting our Unfortunately in our industry, a lot of deal revenue and cost synergies on top of the solid opportunities are in a distressed situation. market positions, those companies have a good Airlines tend to have highly leveraged balance chance to find their way back into profitability. sheets and high operational leverage. Softness Indeed, SWISS has already done so. in demand or a rise in oil prices puts them in a difficult situation. What is the outlook for M&A in the airline Government owners, in particular, have been industry? trying to wait as long as possible to follow With the recent merger of British Airways and a stand-alone strategy, and only if things get Iberia, I think the level of consolidation activity really tough do they turn to M&A. If you take within Europe has peaked. Will there be other the example of Austrian Airlines, we tried to €1.1b acquisitions? There are obviously some more minimize taking on risks by applying The Lufthansa Group ended candidates, but not at the same level as before. an acquisition framework that included a the 2010 business year with Most players will be looking at high-growth mechanism for an earn-out for the Government a strong balance sheet. emerging markets to see what kind of M&A can as selling shareholders instead of the public The Group earned a full-year be done there. Of course, the regulatory share price that has been paid to the free float. operating profit of €876m, framework is not easy in those countries. And There was also a balance sheet restructuring and net profit rose to €1.1b. taking a majority position outside Europe is with the help of the Austrian Government to difficult. There needs to be more political will to put Austrian Airlines’ balance sheet on more form the basis for further consolidation. competitive terms. Of course, we did our due diligence to cover all aspects of their financial Do you consider alliances in the industry, such and legal situation. We also came up with a plan as your own Star Alliance, as an alternative to revise their operational performance and model when M&A deals are not feasible? look at what we could do together in terms of At Star Alliance, it’s all about customers. An revenues and costs.

Ernst & Young Issue 04 T Magazine 45 Management Policy environment Credit: AAP Image / Alan Porritt

Michael D’Ascenzo, Commissioner of Taxation at the Australian Taxation Office, has taken a firm line on the taxation of foreign investments.

Getting to grips with a shifting policy landscape With tax policy changing rapidly around the world, potential acquirers would do well to understand how forthcoming legislation might affect their investment

• By Fergal Byrne tax authority has at the forefront of its mind when developing tax policy – can help companies hanges in tax policy can have a significant to make a much better appraisal of the risks impact on the profitability and even the around any particular investment,” says C viability of cross-border mergers and Chris Sanger, Global Head of Tax Policy at acquisitions. More than ever, companies Ernst & Young. interested in pursuing cross-border mergers and Although tax policy varies widely from one acquisitions need to develop a perspective on jurisdiction to another, there are some common where tax policy is heading across different themes that can be identified - and often, there jurisdictions. In order to be armed with the right is a clear line between developed and emerging information, companies need a thorough markets. For many developed markets, the awareness of a country’s political, economic, priority is to restore public finances to health in a regulatory and fiscal outlook, which are all key way that maintains their overall competitiveness. determinants of its tax policy. “Many countries faced with a shortfall in their “Having what we call good tax authority funding are looking to raise tax revenues,” says intelligence – understanding the issues that the Sanger. “But they are fully aware that their

46 T Magazine Issue 04 Ernst & Young policies will directly impact inbound investment. profits rather than capital gains. This means that Accordingly, they are attempting to develop they are subject to ordinary rates of income 5.8% policies that do not hinder investment in their tax if they have an Australian source, instead of Australia is seen as an country.” being tax-free capital gains. Any attempt attractive destination for Even in developed countries with record to interpose a holding company in a tax treaty foreign direct investment (FDI). deficits and debt-to-GDP ratios, the focus country to access a tax exemption without a Over the last five years, continues to be on making the tax environment sound commercial purpose will be regarded as inward FDI stock has increased conducive to foreign investment. Countries such treaty shopping by the ATO and may be attacked by an average of 5.8% per as Ireland, for example, rely on foreign under Australia’s anti-avoidance rules. annum, according to the investment for the growth that will be required to Australian Trade Commission. reduce their deficit to a level that is seen as China taxing indirect sales of investments As of 30 July 2010, the stock acceptable by the European Union and In December 2009, the Chinese tax authorities of inward FDI in Australia was International Monetary Fund. Despite putting in issued Circular 698 which, among other things, about US$447b. place a package of fiscal austerity measures, had the effect of taxing indirect sales of Chinese Ireland has been very careful to ensure that its investments made by foreigners. It applies where low corporate tax rate remains unchanged. there is an intermediary country company Large emerging markets, on the other hand, between the foreign investor and the Chinese do not face the same pressures. “Countries like investment and where the intermediary is sold India and China tend to be more focused on rather than the investment itself. internal considerations, rather than international Where the use of the intermediary cannot be competitiveness,” says Sanger. “This means that justified for business or commercial reasons, the they are likely to take a more aggressive existence of the intermediary can be ignored, approach to raising tax revenue.” thus potentially exposing the sale to Chinese Although tax policy varies widely, there is an taxation. In addition to asserting China’s right to increasing trend for policy to be exported from tax such gains, the circular imposes a self- one country to another. This means that the risks reporting obligation on a foreign seller to report that crystallize in one country can rapidly be such sales and to provide relevant information. transmitted, as policy options, to governments in other countries. The treatment of indirect capital India implementing a new tax code gains, for example, has been in the limelight in In the past, foreign investors in India have often India and Australia, while China has brought invested through companies in Mauritius, relying forward Circulars 601 and 698, which also relate on the treaty provisions to protect against to this area. taxation in India of capital gains. India is now In part, this policy transmission is due to the focusing far more on the substantive nature of fact that many governments are now talking the Mauritian intermediary before it is willing to to each other about tax policy. Tax information provide treaty benefits. Under a broader move, is being shared across borders to an there is a suggestion that India’s new tax code unprecedented extent, and this naturally (known as the Direct Tax Code) will have the encourages greater convergence of tax policy. effect of treating all capital gains as ordinary Supra-national institutions, such as the G20 income. or OECD, also play a role. They are increasingly developing frameworks on particular areas Indonesia combating treaty abuse of tax policy, providing the basis for governments In November 2009, the Indonesian Government to develop their own implementations. released two regulations designed to combat But despite this trend for greater convergence treaty abuse. DGT Regulations 61 and 62 set out of tax policy, companies must be extremely a series of new procedures that must be followed careful to examine carefully the idiosyncrasies of in order for reduced rates of withholding tax individual markets. Tax policy remains uncertain to apply to payments made to foreign residents and, by failing to take the situation in a particular under various treaties. market into account, companies may find that In July 2010, the Indonesian Government their investments are not as viable as they released a new regulation where any merger or first thought. Below, we outline some of the key acquisition – exceeding a certain size – must be policy trends that are being seen in specific reported to the Commission for the Supervision jurisdictions. of Business Competition within 30 business days of the transaction closing. Australia limiting tax concessions Under these regulations, the non-resident New developments in Australia could have a must demonstrate to the authorities that the profound impact on the taxation of cross-border intermediary treaty party is in fact the beneficial investments that are made into the country. In owner of the income. This entails being able 2009, the Australian Taxation Office (ATO) to show that the treaty partner is not merely issued two draft rulings, both finalized in2010 , present there to enjoy tax treaty benefits. Instead, which clearly state the ATO’s belief that gains on it must be demonstrated that it has economic Australian investments made by foreign investors substance and that a certain degree of genuine (including private equity firms) can be revenue business activity is taking place.

Ernst & Young Issue 04 T Magazine 47 Outlook M&A as a value creator Today’s transactions are creating value

Biography here is a common perception, often repeated about the degree to which companies are using Scott Moeller is a in articles and research reports, that the due diligence to validate their decisions. professor in the Practice T majority of mergers and acquisitions end up Thanks to these and related changes, companies of Finance and Director destroying, rather than creating, value. But while are becoming more skilled at identifying and of the M&A Research this once may have been true, recent research executing transactions. But this is not to say that Centre at the Cass shows that this is no longer the case. It is time for transactions are becoming a core competence for Business School, City companies and investors to update their thinking corporations. On the contrary, those companies University London. and realize that transactions lead to value creation. that are most successful are the ones turning to He has extensive It is easy to see why this misconception has outside experts, for whom dealmaking really is a experience in global lingered. In previous merger and acquisition waves, core competence. Even those who do the most M&A and is a much such as those in the 1980s, 1990s and the one deals rely on the expertise of outside accounting sought-after speaker ending in 2002, it is true that most deals failed to firms, consultants, investment banks and law firms. and commentator. create significant value — and often destroyed it. I believe this is making a tremendous difference in But empirical data, some produced by the M&A helping to maximize the chances of a positive Research Center at the Cass School of Business, outcome for a potential deal. shows that the tide has turned. Looking at deal activity since 2004, those companies that execute ompanies today are also finding that they transactions regularly tend significantly to have to pay far more attention to tax issues. outperform those that do not. C Relative to earlier merger and acquisition So what has changed? Perhaps most notably, waves, today’s deal landscape features many more companies are becoming much more capable at cross-border transactions. That means more conceiving and executing transactions. They are jurisdictions, more tax positions that need to be spending more time understanding the strategy evaluated and more sets of rules to be followed. behind their deals and are much more focused on This is another reason why firms are relying more what they are trying to achieve. Instead of just on outside expertise. doing a deal to do a deal, they are seeking to do Our research is also showing that, whenever the right deals. companies have a change in leadership, that significantly increases the likelihood of a major nother change is a greater focus on post- transaction. On average, companies will announce merger integration. In the past, too many a major deal, either an acquisition or divestiture or A companies failed to plan for this. Only when both, within the first seven to nine months of a new they had won the deal did they think about how to CEO’s arrival. The likelihood is greater if the integrate the acquired company. Today, companies executive has been brought in from the outside — are making plans for their new assets even before and greater still if the outgoing CEO did not play a the deal closes. There is a conscious alignment major role in the selection of the new CEO. This between a deal’s strategy and the operations that makes sense when you consider that, by bringing are necessary to achieve it. Companies are someone in from the outside, a company is assigning responsibility to specific actors in the signaling that it aims to move in a new direction. integration process to make sure all the levers that So the overall message is that it is time to will create value are being pulled. This, to me, is a update the thinking. Yes, there was a time when very large departure from prior deal-making cycles. dealmaking led to value erosion. In many cases, It is also clear that companies are realizing the transactions were at best neutral and, in too many importance of an expanded definition of due cases, counterproductive. But the empirical diligence. In the past, this was very much a legal evidence today links dealmaking with significantly and compliance-driven exercise. But today, stronger overall performance. For companies companies are employing due diligence resources seeking to pursue acquisition strategies, and for to evaluate and validate a much wider range of deal those that provide services to the dealmakers, this components and are much more focused on the is good news. issues that can add or detract from the value of the deal. Consider the fact that, out of four of the By Scott Moeller, largest deals announced in the past year, only one Director of the M&A Research Centre, actually made it to closing. This says a great deal Cass Business School

48 T Magazine Issue 04 Ernst & Young Credit: Ed Thompson / LUZphoto

Scott Moeller

Ernst & Young Issue 04 T Magazine 49 Publications

2010 Global Transfer Finance Forte Indirect Tax 2011 Tax Policy and

Pricing Survey No one expects the top finance WIth the ongoing shift to Controversy Briefing Since 1995, Ernst & Young has job to be easy. As organizations indirect taxes of all types, it is As governments try to balance surveyed multinational look ahead to an uncertain more challenging than ever to increasing competitiveness enterprises (MNEs) on future, the responsibilities of understand the changing with boosting revenues, and tax international tax matters with the CFO role will only increase. indirect tax landscape. This authorities adapt their special emphasis on what Finance forte provides insight publication provides a high-level enforcement strategies and continues to be a leading on the future of the CFO role overview of significant policies, staying up-to-date with international tax issue — the and what current CFOs, aspiring developments in indirect the tax landscape is a challenge. increased regulatory activity CFOs and boards need to do to taxation that may have an This quarterly publication around transfer pricing. keep up. impact on global businesses. covers the key issues.

Preview In issue 5 of T Magazine, which will also be published as an insert Connect with in the Financial Times, T Magazine we will focus on sustainability. Topics Website covered will include: Stay ahead with international tax news, the latest tax insights and web features on • The emerging tax www.ey.com/tmagazine policy agenda eNewsletter • Increased calls for The latest news and insights corporate from the T Magazine website transparency delivered to your inbox. Submit your subscription on Magazine 04 • Sustainable www.ey.com/tmagazine/ Tax insight for business leaders sourcing of raw enewsletter materials Deals back on Emerging markets deals take center stage the agenda? Twitter How tax can make or break Corporates revisit their an acquisition M&A strategies Signs of distress bring • Developing a Follow T Magazine on new assets to market carbon strategy twitter.com/eytmagazine

• The challenges of putting a price on carbon

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Ernst & Young Issue 04 T Magazine 51 S10443_EY_T MagazineMaze297x210_V1.indd 1 lie within. The best answers Through extensive research with To learn more about Competing See More | 1,400 senior executives around Do the world’s leading businesses Ernst & Young office or visit are returning to profitable growth. or develop it from within? developed key insights into how ey.com/competing the world Ernst & Young has for Growth, contact your local the world’s leading businesses purchase innovation from outside

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