Fairness Opinions: Evaluating a Buyer’s Shares from the Seller’s Perspective

Strong performance of U.S. equity markets in 2024 combined with narrowing credit spreads in the high yield bond, leverage loan and private credit markets are powerful stimulants for M&A activity. According to the Boston Consulting Group, U.S. M&A activity based upon deal values rose 21% though September 30 compared to the same period in 2023 after Fed rate hikes during 2022 and 1H23 weighed on deal activity.

Deal activity measured by the number of announced deals is less compelling as deal activity has been dominated by a number of large transactions in the energy, technology and consumer sectors.

While large company M&A may continue, the broadening rally in the equity markets (Russell 2000 +13% YTD through October 16; S&P 400 Midcap Index +14%) suggests that deal activity by “strategic” buyers may increase. If so, deals where publicly-traded acquirers issue shares to the target will increase, too, because M&A activity and multiples have a propensity to increase as the buyers’ shares trend higher.

It is important for sellers to keep in mind that negotiations with acquirers where the consideration will consist of the buyer’s common shares are about the exchange ratio rather than price, which is the product of the exchange ratio and buyer’s share price.

When sellers are solely focused on price, it is easier all else equal for strategic acquirers to ink a deal when their shares trade at a high multiple. However, high multiple stocks represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.

Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”

A fairness opinion is more than a three- or four-page letter that opines as to fairness of the consideration from a financial point of a contemplated transaction. The opinion should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.

Key questions to ask about the buyer’s shares include the following:

• Liquidity of the Shares.What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be heavily scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.
• Profitability and Revenue Trends. The analysis should consider the buyer’s historical growth and projected growth in revenues, EBITDA and net income as well as trends and comparisons with peers of profitability ratios.
• Reported vs Core Earnings. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated (preferably over the last five years and last five quarters) with particular sensitivity to a preponderance of adjustments that increase core earnings.
• Pro Forma Impact. The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital structure in addition to dilution or accretion in EBITDA per share, earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.
• Shareholder Dividends. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?
• Share Repurchases. Does the acquirer allocate some portion of cash flow for repurchases? If not, why not assuming adequate cash flow to do so?
• Capex Requirements. An analysis of capex requirements should focus on whether the business plan will necessitate a step-up in spending vs history and if so implications for shareholder distributions.
• Capital Stack.Sellers should have a full understanding of the buyer’s capital structure and the amount of cash flow that must be dedicated to debt service before considering capex and shareholder distributions.
• Revenue Concentrations. Does the buyer have any revenue or supplier concentrations? If so, what would be the impact if lost and how is the concentration reflected in the buyer’s current valuation.
• Ability to Raise Cash to Close.What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?
• Consensus Analyst Estimates.If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.
• Valuation. Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.
• Share Performance.Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.
• Strategic Position. Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?
• Contingent Liabilities. Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.

The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.

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