Shared auditors may signal opportunities for bargain purchases, and deals also more likely to close
The more things change, the more they stay the same. Many industries are becoming more concentrated and that means the Big 4 auditors can control more of the matchmaking pie.
Nearly ten years ago, in 2014, a team of researchers found that shared auditors are observed in nearly a quarter of all public acquisitions and that targets are more likely to receive a bid from a firm that has the same auditor. They also concluded that the targets typically get screwed on the deal because there are a lot of incentives for the auditors to help the acquirer.
Some recent deals — Cisco and Splunk (PwC), Broadcom and VMWare (PwC), AbbVie and Immunogen (EY), and a rumored tie-up between Cigna and Humana (PwC), suggest that you’ll be more successful getting a bargain deal if you listen to your auditor.
Shared Auditors in Mergers and Acquisitions, published in the Journal of Accounting and Economics in early 2015, warned that these shared auditor deals also come with potential conflicts of interest and the temptation to violate client confidentiality for commercial purposes. Analysis of data collected at the time — bids from Securities Data Corporation's Mergers and Acquisitions Database (SDC) from the beginning of 1985 to the end of 2010 — suggested that audit firms favor client acquirers at the expense of the client targets, which tend to be smaller audit clients, by prioritizing their own self-interest when deciding which client to help.
The impact of this potential conflict is strongest when both audits are serviced from the same office. The Shared Auditor Office indicator variable is set to one when the target and acquirer receive audit services from the same practice office of an audit firm in the year immediately preceding a bid.
The researchers — Dan S. Dhaliwal was at the University of Arizona before he passed away in 2016, Lubomir P. Litov of the University of Oklahoma, Phil Lamoreaux of Arizona State University and Jordan B. Neyland now at George Mason University — limited their sample to economically meaningful bids on public targets from public bidders because they needed auditor, accounting, and stock price data for both bidders and targets. Bidders had to own less than 50% of the target before the offer and had to seek to own more than 50% of the target at deal completion. Deal size was required to be at least ten million dollars, and targets had to have book assets of at least five million dollars.
I wrote about this research more than once at MarketWatch. It remains one of my favorite academic papers ever because of the willingness of the researchers to clearly state their conclusions, even though they cast a negative light on the practices of the largest global accounting firms.
We find that shared auditor deals appear to favor acquirers, specifically when the target and acquirer receive audit services from the same auditor practice office and when the target is small. These results are consistent with auditors favoring acquirers by facilitating information about the target firm, perhaps unintentionally through informal “water cooler” discussions within an auditor’s practice office. Importantly, the results of this study do not suggest a widespread systemic violation of conflict of interest rules across auditor’s multiple practice offices.
At a minimum, client firms may need to consider potential information leakage within an auditor’s office and internal audit firm policies about client confidentiality within an office. We suggest that future research may address other potential forms of violation of conflict of interest rules within practice offices.
Lastly, while conflict of interest rules appear to have been violated, this study does not examine violations of conflict of interest rules in M&A and an auditor’s independence as it relates to subsequent truthful reporting on client financial statements. The important relationship between shared auditor’s conflict of interests in M&A activity and subsequent audit quality could potentially be an interesting venue for future research.
I first wrote about the study after barely a week on the job at MarketWatch, May 19, 2015. Verizon Communications, and its target, AOL not only shared the same audit firm, but their respective audit opinions were also signed by the same office — the New York office of Ernst & Young, or EY.
Bazinga!
On May 12, 2015 Verizon Communications offered to pay $50 per share for AOL. That was a 28% premium over the average price for the last 20 trading days — but it fell far short of the premium of 46% that is typical, according to the study.
Why the poor premium? The researchers plainly stated that auditors “facilitate the flow of information between bidders and targets.”
Let me be clear about what they're saying:
When bidders share an auditor with a target bidders gain an information advantage relative to competing bidders as a result of formal or informal assistance of auditors. Those bidders can leverage this advantage into a better bargaining position with the target. Other potential bidders have less information and less incentive to bid and this reduced bid competition provides the bidder more negotiating power, therefore reducing the premium paid.
AOL Chairman and CEO Tim Armstrong said at the time there was no auction for the company, as transcribed in a regulatory filing.
(EY was same firm that signed AOL’s opinions during its earlier disastrous hook-up with Time Warner. EY settled with private investors by paying $100 million for its role in missing advertising-revenue recognition at the combined company in 2005.)
In October of 2015 I wrote again about the research, this time focusing on Dell and EMC, "Why Dell may have got a bargain with EMC," because, you guessed it, they shared auditor PwC. Under the terms of the deal, Dell and private-equity firm Silver Lake agreed to buy EMC Corp. for $67 billion in cash and stock, or $33.15 a share.
That is a 19% premium over Friday’s closing price for EMC. According to an academic study, Shared Auditors in Mergers and Acquisitions, published in the Journal of Accounting and Economics earlier this year, that’s much lower than the typical premium of 42% when a target and its acquirer share an auditor—PwC, in this case. The typical premium when an auditor isn’t shared is 47%.
Some of the relatively small premium may be driven by the fact EMC is such a big company, says Jordan Neyland, senior lecturer at the University of Melbourne’s business and economics school and one of the researchers, “but the return, in particular, looks low.”
At the time I thought that the secret sauce the shared auditor, PwC may have served up to Dell may have been related to knowledge about some legal or regulatory action against its client that might have a material impact on the financial statements. That's because independent investment research site, ProbesReporter.com said that the SEC had confirmed to it there was at least one open investigation of EMC that had not been disclosed to investors.
There was also an open probe of VMWare, a unit of EMC at the time, after being purchased by EMC in December of 2003.
In 2013 Michael Dell took Dell private and, after acquiring EMC, took it public again in 2018. According to the FT:
Along the way, [Michael Dell] fought heated battles with dissident shareholders over claims that he bought Dell on the cheap and used complex financial engineering in the EMC deal to short-change investors.
In November of 2021 Dell spun off its 81 percent stake in publicly traded VMware, creating an independent software company with a stock market value of nearly $64bn. Why was VMWare publicly traded and why did Dell own only 81 percent? Again, from the FT:
The attempt to retain control of VMware forced Dell into some convoluted financial engineering. To overcome a funding gap in its purchase of EMC, Dell issued a second new class of VMware stock that theoretically tracked part of its holding in the software business, though there was no formal connection between the two. The tracking stock traded at a hefty discount before finally being bought back two years later, after a bruising fight with investors who claimed that Dell was underpaying.