The late Richard Russell, editor of Dow Theory Letters for 57 years, famously remarked that “markets make opinions.” One does not have to know much about markets to acknowledge that there is much truth in that statement. Trends tend to be extrapolated.
Taken at face value, investors should be biased and bullish today. The S&P 500, as of June 23, 2023, has risen 13% year-to-date after declining 19% in 2022. The NASDAQ is up 29% after falling 33% in 2022. However, ten or so mega-cap companies have driven the turnaround in these two market-cap-weighted indices. Shares of Nvidia, Alphabet and Tesla have more than doubled, while a 44% increase in Apple’s shares has pushed its market cap to $2.9 trillion.
On the other hand, the equal weighted S&P 500 (RSP), S&P 400 Mid Cap and Russell 2000 indices have each risen less than 5% after declining 15% to 20% in 2022. Most stocks are well below the highs that were posted in 2021.
Given the depressed market for many and sharply higher borrowing costs, it is not surprising that M&A activity has been subdued since the third quarter of 2022. Markets and M&A activity may not turnaround later this year, but some level of M&A activity will continue.
The role of the financial advisor becomes tougher when markets are depressed. Questions of value and fair dealing may be subjected to more scrutiny. Declining or depressed markets in the context of negotiating and opining on a transaction will raise the reasonable question: How do current market conditions impact fairness?
There is no short answer; however, the advisor’s role of reviewing the process, valuation, facts, and circumstances of the transaction in a declining or depressed market should provide the board with confidence about its decision and the merits of the opinion.
Some of the issues that may weigh on the decision process and the rendering of a fairness opinion in a depressed market include the following:
Process vs. Timing. Process can be a tricky consideration in any transaction (see our review of the Tesla-Solar City shareholder litigation here). A review of fair dealing procedures, when markets have fallen sharply, will raise additional process and valuation considerations. The analysis should be sensitive to actions that may favor one party and disadvantages shareholders (e.g., a buyback of a significant shareholder’s interest when prices were higher). Even an auction of a company may be subject to second guessing if the auction occurred in a weak environment.
Corporate Forecasts. A management forecast covering three-to-five years is a staple of any valuation analysis and board deliberations regarding a significant corporate transaction. Consideration should be given to the context of when the forecast was prepared and how different economic environments affect the subject company. A reasonable question to consider is whether depressed equity markets and widening high-yield spreads merit a below trend baseline forecast or vice versa. There is no correct answer, only perspective and alternatives to the baseline forecast to consider.
Valuation. Valuation should be viewed through multiple lenses, including absolute, relative to comps, and relative to the subject’s historical and prospective performance. Depressed markets add further nuance. Are markets temporarily depressed or resetting to a new normal that will require valuations to reset to a lower level? Does consideration consist of a fixed amount of cash, or does it entail the issuance of a fixed number of buyer shares that may (or may not) be temporarily depressed?
Exchange Ratios. Since the GFC, most acquisitions structured as stock swaps entail a fixed exchange ratio because buyers need certainty about the number of shares issued. Theoretically, declining markets do not change the calculus for buyers and sellers subject to a fixed exchange ratio to the extent the buyer’s shares have declined in line with the market; however, declining markets cause sellers to focus more intently on “price” rather than pro rata ownership and pro forma financial metrics. The more challenging analysis is when the buyer’s shares have materially underperformed a declining industry index that is not remedied through a provision in the merger agreement that provides for an upward adjustment to the exchange ratio.
Buyer’s Shares. Regardless of market conditions, fairness analyses should consider the investment attributes and merits of the buyer’s shares based on financial performance, share performance, and valuation relative to peers. Declining or depressed markets make this calculus harder, especially when the buyer’s shares have underperformed peers and/or are materially valued above peers because the shares have not fallen as much. If so, the outcome raises the issue of more downside potential even though fairness opinions and supporting analyses do not forecast future share performance.
Financing. If the consummation of a transaction depends upon the buyer raising cash via selling shares or issuing debt, a sharp drop in the market may limit financing availability. If so, the board and the financial advisor will want to ensure the buyer has backup financing from a bank. No matter how remote, the absence of backstop funding is an out-of-no-where potential that a board and an advisor should consider. Down markets make the highly unlikely possible if capital market conditions deteriorate unabated. While markets periodically become unhinged, a board entering into an agreement without a backstop plan may open itself to ill-informed deal-making if events go awry.
Summing it Up. Tomorrow is always uncertain. Fairness opinions do not offer opinions about where a security will trade in the future. Instead the opinion addresses fairness from a financial point of view to all or a subset of shareholders as of a specific date. The evaluation process is trickier when markets fall sharply, but it is not unmanageable. We at Mercer Capital have extensive experience valuing and evaluating the shares (and debt) of companies engaged in transactions during bull, bear, and sideways markets garnered from over three decades of business.
