Inspection audits can maximise Asian M&A potential: study

With the M&A market set to explode across the region, doubling down on reputable audits may critically affect a transaction’s success

by Gaoguang Zhou
Inspection audits can maximise Asian M&A potential: study
The central business district in Beijing that is expected to drive M&A activity in the Asia Pacific this year. Photo: Wikipedia

(ATF) Despite the delicate nature of the new normal, the mergers and acquisition (M&A) in Asia is set to continue its hot streak in 2021 as it emerges as an important tool for companies to reshape their businesses for future.

M&As in the region surged against a broad global trend - that declined 5.5%- with China and Japan leading Asia’s M&A growth in 2020. China, the world’s second largest economy, particularly staged a strong recovery by reporting 28% increase in deals from 2019.

The year 2020 also saw a 12% YoY increase in M&A deals in Asia Pacific at $1.2 trillion. The market continues to heat up with seven of last year’s 10 largest transactions – accounting for a total of 40% of the year’s deals by value – struck in the third quarter alone. Telecom, retail and consumer products and service firms were the biggest beneficiaries from this spike.

Nevertheless, the region’s M&As face head winds as well. For one, the pandemic has strained relations and is escalating economic nationalism amongst rivals. This causes uncertainty for international M&As, especially for deals involving firms from countries on lukewarm (if not outright hostile) terms.

The rising geopolitical tensions coupled with ideological conflicts and growing inequality (both domestically and cross-border) have also become risk factors for impacting M&As adversely.

In the current environment hence, Chinese companies looking to make outbound M&A transactions must prepare and account for tougher government scrutiny in economies like the US, United Kingdom, Australia and Canada.

A good example of this is President Donald Trump’s legislation in 2020 targeting Chinese firms on American exchanges that threatened to trigger delisting of Chinese companies in the US and hurt investors. The legislation also mandated stricter auditing of Chinese companies.

Although the incoming Biden administration is likely to stabilise Sino-US relations, this is an instance of a volatile geopolitical factor that could impact M&As as countries grapple with new norms.

Benefits of inspection audits

Cognizant of the need to offset scrutiny, Chinese companies have proactively undertaken measures in pursuit of M&A deals that satisfy all overseeing parties. Some firms have deliberately engaged with overseas investors or enlisted international institutions to finance their outbound investment projects. This furthers a sense of adhering to international compliance - but are there any other steps companies should take in pursuing M&As?

My team and I conducted a study that shows firms planning and/or managing an M&A benefit greatly from inspections by reputational organizations such as the Public Company Accounting Oversight Board (PCAOB).

Beyond the fact that such inspections may become mandated at most of major economies – and thus it may be prescient to bite the bullet before push comes to shove – this level of audit inspection demonstrably helps enhance the chances for a successful M&A, both in the short run when a deal is announced, and in the long-term post-acquisition.

While the prospect of audit inspections on surface may appear stressful to firms, there are undeniable benefits – our research findings strongly support the relationship between overall audit quality as shown by PCAOB inspection reports and capital allocation efficiency.

First, firms whose auditors were inspected by PCAOB are more likely to receive an acquisition bid following the public disclosure of PCAOB-inspection report. Not only are they more likely to receive the takeover bid, deals involving such firms are also more likely to be completed. Accounting numbers, especially those signed off by reputational auditors, have tremendous value in facilitating cross-border M&As.

Second, when inspection reports are made public, firms involving inspected auditors observe that their subsequent deals get a boost in announcement returns. This boost is anything but short-lived, as M&A deals involving firms whose auditors have publicly available PCAOB inspection reports exhibit superior post-acquisition performance.

Finally, in countries with weaker legal institutions or deals with greater information asymmetries, the effect of PCAOB-type audit oversight on M&A outcomes is even more pronounced - audits can be of critical importance to M&A deals in these environments.

Understandably, the multifaceted risks of this time are likely to induce certain acquirers to postpone their M&As. However, by leveraging the available expertise of high-quality auditor inspection team such as PCAOB, acquirers can still strive to make more informed M&As to capitalise on the market while many targets are under-valued. There are encouraging signs on the horizon.

While the coronavirus is driving the technology sector and pushing M&A activities across Asia Pacific, for Chinese overseas M&As, a stronger renminbi and a new Sino-EU investment pact will further reignite interest. In this exploding space, firms are well-served to look for every advantage they can ascertain to differentiate themselves from competition during this window of opportunity.

Dr Gaoguang Zhou from Hong Kong Baptist University School of Business

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