Considering Contingent Consideration

Contingent consideration is a common feature of M&A when both parties are private, or the acquirer is public, and the target is private. There are many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.

What Do Earnouts Entail?

The most common contingent payment is an “earn-out” that bridges the buyer’s bid and the seller’s ask by ensuring the business produces an agreed upon level of revenues and/or earnings (typically EBITDA) within an agreed timeframe before the payment is made.

Earn-outs could be considered the ultimate form of confirmatory due diligence. From a buyer’s perspective, earn-outs reduce risk by reducing up-front cash and the likelihood of materially overpaying absent an adverse turn in the economy or industry conditions. From a seller’s perspective, contingent consideration allows sellers to obtain an acceptable price and sometimes a premium or stretch valuation if the Company attains the agreed-upon targets. Further, earnouts create an alignment of interests to the extent roll-over management and ownership is incented to optimize the company’s performance.

In our experience, most buyers are willing to pay in a range of value that produces an acceptable return based upon conservative assumptions about the business’ future earning power (EBITDA or EBITDA less capex) and growth rate. Unless the business is viewed as having above average risk, most buyers’ required rate of return on an unlevered basis will be conservative but not ridiculously high. This reflects buyers’ natural aversion to risks that may not be readily apparent to most sellers. An earn-out is a means by which to close or narrow this gap.

When earnouts are involved, buyers and sellers must understand the waterfall of post-closing events, and their respective timing and terms to gain a full understanding of transaction consideration. Earnouts are a form of purchase consideration where acquirers tender value to the target seller if certain future events occur. Earnouts provide sellers with potential value fulfillment or upside while simultaneously allowing buyers to defer payment of consideration with the possibility of recovering a designated portion of the purchase price if post-closing hurdles are not achieved.

By its nature, contingent consideration adds complexity for both buyers and sellers, particularly when the features of the earnout reflect significant speculation on post-closing outcomes. These might include high growth, reversals of trend, or specific events such as new business developments or failed business retention.

Despite the complexities, earnouts and other forms of contingent consideration can be critical to achieving a successful closing when market conditions are ebbing more than flowing or when winning the day requires the buyer to make a stretch offer.

Mid-Market Deals Increasingly Reflect Up-Market Deal Structures

According to GF Data®, a firm that provides data on private equity-sponsored M&A transactions with an enterprise value of $10 to $250 million, 38% of 432 transactions in 2021 entailed either seller financing or earnouts compared to 44% of 329 deals in 2020. The reduction last year reflected a seller’s market that was characterized by too much capital chasing a limited pool of sellers. Given tighter financial conditions this year that may lead to a recession later this year or next, it would not surprise us to see the percentage of deals with an earnout increase because the risk to a target’s earnings and maybe long-term growth prospects will rise.

A financial advisor can be an important intermediary for both buyer and seller to craft a well structured earnout to facilitate successful deal negotiations rather than letting a poorly crafted and/or poorly socialized earnout create a negotiation wedge that can delay or overwhelm momentum required to finalize a purchase agreement.

Buyer Awareness and Financial Reporting

While it should not impact the economics of a transaction, buyers face the added burden of accounting for contingent consideration per FASB’s ASC 805, which addresses business combinations. It requires that the fair value of contingent consideration be recorded as a liability at the acquisition date, resulting in an increased amount of goodwill or other intangible asset depending upon how value is allocated to the acquired assets. Fair value also must be re-measured for each subsequent reporting period until the contingency is settled. Mercer Capital’s years of M&A purchase price allocation work for both strategic and financial acquirers gives us unique insight into the sometimes nettlesome issues of purchase price allocations in M&A transactions.

Concluding Thoughts

While this article is an installment in our larger buy-side series of content, it is important to draw advice for buyers from our near universal advice to sellers.

We often advise sellers to be content with the consideration they receive at closing and to assess contingent consideration with a healthy degree of skeptical risk, particularly when achieving the earnout represents a stretch in future outcomes.

A logical extension of that advice for buyers is to be prepared to pay even if the benchmarks are deemed a stretch. The occasional extraordinary outcome can create significant buyer liability. Whether the net effect on the buyer is a beneficial deferral of payment or a deal premium (or otherwise) must be assessed in the context of the overall offering stack.

Buyers should determine the reason for using an earnout and then determine an appropriate design for the earnout. Clear, unambiguous terms and measurements are recommended to minimize negotiating friction and incent smooth post-closing integration and alignment of interests both operationally and financially.

If your development needs involve growth through acquisition, and you find the market for quality targets requires the thoughtful use of earnout consideration, Mercer Capital can provide useful insight while helping quantify the real-time financial equivalency of any earnout consideration offered.

Tesla Walks the Entirely Fair Line with SolarCity

Evaluating Fairness of the Tesla Motors, Inc. and SolarCity Corporation Merger

In March 2016, Jonathan Goldsmith retired from a long advertising stint for Dos Equis beer as the Most Interesting Man in the World with a final commercial in which he was sent on a one-way trip to Mars. The same month Elon Musk, arguably the most interesting man in global business then and now, was laying the ground work for the merger of Telsa, Inc. (NASDAQ: TSLA) and SolarCity Corporation of which he owned about 22% of both companies.

Fairness as an adjective means what is just, equitable, legitimate and consistent with rules and standards. As it relates to transactions, fairness is like valuation in that it is a range concept: transactions may not be fair, a close call, fair or very fair.

This presentation looks at the issues raised by plaintiffs who alleged Musk orchestrated the deal to bail-out SolarCity, and how the Delaware Court of Chancery ruled on the issues on April 27. 2022 under the entire fairness standard rather than deferential business judgment rule.

Meet the Team – David W. R. Harkins, CFA, ABV


In each “Meet the Team” segment, we highlight a different professional on our Family Law team. The experience and expertise of our professionals allow us to bring a full suite of valuation and forensics services to our clients. We hope you enjoy getting to know us a bit better.

David Harkins, CFA, ABV began his valuation career at Mercer Capital as an intern in the summer of 2016. After finishing his degree at Sewanee, David joined Mercer Capital in 2017 as a financial analyst.

He works in our Nashville office and is a member of the firm’s Litigation Services Support team. In this role, David has worked on family law engagements with scores of companies in a wide range of industries. However, as a member of the firm’s Auto Dealership industry team, he has industry-specific experience working with auto dealership clients throughout the U.S.

What is the most rewarding part about your job?

David Harkins: I like that the numbers matter.

In litigation support engagements, we are valuing businesses and giving a number that will be used for selling, buying, or dividing a business. I think these types of engagements are interesting because of the immediate, tangible importance of the final answer.

The report will be thoroughly read and there needs to be an in-depth analysis to make sure that the concluding number is as reasonable as possible. It makes the work rewarding that our analysis is valuable to the clients.

What should family law clients understand about valuation and the services a firm like ours can provide?

David Harkins: I think the most important thing is for clients to involve us early on in the process. We can help narrow or expand the scope of an engagement to guide our clients and make the process as efficient as possible. We offer valuable services that are often underutilized.

Outside of solely giving a number for the value of a business, we can provide guidance throughout the process. We help clients understand the value of their business, explain another expert’s testimony, assist with questions, and provide expert advice on what steps should be taken in litigation matters, especially to ensure financial efficiency.

Another piece of advice I have for divorcing clients is to consider joint retainment. This is when both parties hire one financial expert. This could alleviate some of the stress that comes with divorce conflicts and help to avoid financial disputes that come up in court. We give the most accurate and reasonable valuation possible, and joint retainment can ultimately be beneficial to both sides.

What type of family law matters do you work on?

David Harkins: I am involved in numerous aspects of litigation-related engagements, but the majority of my work in this area comes back to a business owned by divorcing parties. We can help the business spouse translate their day-to-day operations and cash flows into the valuation and help the non-business spouse understand the key levers that drive the value of the business.

We also provide ancillary services such as setting up the marital balance sheet or assisting in determining a reasonable range for alimony expenses, should it be relevant to the case. While some of this may sound intuitive, we often find having someone well-versed in this area can help put the picture together much more efficiently.

What top three skills or traits do you think someone needs to pursue a role in family law litigation support in a business valuation firm?

David Harkins: Number One is taking notes and juggling many projects at a time because litigation projects can be stop/start. Continuations, attempts to reconcile, and failed mediations can lead to large gaps throughout the normal course of a project or accelerate the timeline of our work. The ability to efficiently transition between projects is valuable, but this is also an underrated benefit of hiring a firm with the appropriate bench of analysts to make sure client needs are met in a timely manner.

Number Two is attention to detail. And Number Three is experts providing litigation support must be reasonable in their conclusions and unbiased in the presentation of their conclusions. Misconstruing opinions as facts can make an expert less reliable to a trier of fact.

What influenced your concentration in the auto dealer industry?

David Harkins: I started following the industry based on the experience of my colleague Scott Womack.

I particularly enjoy the analytical opportunities provided by the dealer financial statements which dealers must report to the manufacturers on a monthly basis. Combining these statements with available benchmarking data from the vast dealership network in the U.S. gives us a good picture of the dealership’s operations before we even get a chance to discuss operations with the dealer principal.

What is the best advice that you received throughout your career?

David Harkins: I find myself holding onto little nuggets from colleagues that have helped my professional development.

“Be an analyst” reminds me to not solely focus on setting up the analytical framework for a project but to make sure our assumptions are reasonable and lead to a conclusion that makes sense.

“Say what you mean” is particularly important in a litigation context to make sure that our opinions are stated plainly. While we want our reports to be well written, it is more important that our conclusions are understood by all parties involved.

Negotiating Working Capital Targets in a Transaction

This is the sixth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read previous articles click here.


In middle market transactions, some of the most crucial points of negotiation are the net working capital targets agreed upon by the buyer and seller. Net working capital targets set a defined minimum amount of working capital that the buyer requires the seller to leave in the business at the close of a transaction.

Given that net working capital targets can have a direct effect on the final purchase price of a transaction, understanding the how and why of these types of negotiations is crucial for buyers looking to negotiate deals that not only look good at closing but also pass the test as the buyer takes over the operation of the newly acquired business.

Defining Net Working Capital

Before negotiating working capital targets and benchmarks, it is important that the buyers, sellers, and their advisors in a deal setting have a clear understanding of what will and won’t be included in net working capital for the purposes of closing the deal.

By the book, net working capital is defined as current assets less current liabilities. While this definition is acceptable for financial statement analysis and other accounting-adjacent applications, in the M&A universe, the most commonly used measure of net working capital is cash-free, debt-free net working capital. This is the standard definition of net working capital in a deal setting because it assumes that a seller will retain the cash in the business after paying off any short-term debts that the business owes. These debts could potentially include related party notes and lines of credit with banks.

In an M&A transaction, net working capital and net working capital targets are often defined terms in both the letter of intent and the purchase agreement. For buyers, it is crucial to understand these definitions because the basis of the net working capital calculation could directly affect the final purchase price.

Why Are Net Working Capital Negotiations Necessary in a Deal?

Net working capital targets are necessary in deal settings because the amount of net working capital in a business often fluctuates from month-to-month and even week-to-week. Therefore, it is important that a benchmark or base level of net working capital to be left in the business at closing is agreed upon by both the buyer and the seller.

For example, a seller could aggressively collect accounts receivable in the months leading to closing in an effort to convert these receivables into cash. Conversely, a seller could let accounts payable inflate in the months leading to closing and theoretically retain a higher amount of cash. Even absent any sort of concentrated effort to impact the working capital, most companies have some level of fluctuation in their various balance sheet accounts. Setting a net working capital target negates the impact of these fluctuations and prevents the seller from “gaming” cash and working capital levels in anticipation of a transaction.

If net working capital levels at closing are not in line with the targets established in the negotiation process, an adjustment to the purchase price can be triggered.

The purchase price adjustment related to net working capital is typically applied after the close of the transaction – based on a final accounting as of the closing date. Usually, a defined amount of the purchase price is set aside in a short-term escrow specifically for any negative adjustment related to the final net working capital balance. If the final determination of net working capital comes in below the established threshold, then the buyer retains funds from the escrow to make up for this shortfall. If the final net working capital figure is above the threshold, the buyer makes an additional payment to the seller for the excess amount.

From the buyer’s perspective, it is important to negotiate an escrow amount that is large enough to cover any potential swings in net working capital that could result at closing.

Negotiating Net Working Capital Targets

The most practical and commonly used method of setting net working capital targets and benchmarks is to calculate a historical average amount of net working capital needed to fund a company’s operations. This is most often done by calculating the average net working capital on a monthly basis over the twelve months preceding the valuation date used in the transaction.

Calculating an average over a historical period removes any seasonality effects and reveals a “normalized” level of net working capital needed to support the company’s ongoing operations with no capital disruption. Since valuations are typically predicated on trailing twelve months EBITDA (or some other measure of earnings), it is typical that the lookback period for the net working capital target calculation coincides with the twelve-month period in which EBITDA is calculated. In other words, the calculation of a net working capital target should be on the same historical basis as that of the measure of earnings used to support the transaction value.

In situations where EBITDA from the most recent period is deemed to be unsustainable or if there is significant short-term growth underlying the transaction value, it might be necessary to calculate the net working capital benchmark by applying a percentage (based on historical averages) to an ongoing revenue figure in order to consider that net working capital needs will change as revenue either declines or increases post-closing.

While conducting due diligence, buyers may find potential adjustments to certain balance sheet items that comprise net working capital, which can affect the calculation of the net working capital target. Buyers will want to confirm that the seller has properly accrued (both historically and at closing) for certain items such as accrued vacation, payroll, bonuses, warranty obligations, etc. These potential adjustments can add another layer of complexity to the negotiation of net working capital targets, as buyers may find that there is an excess or deficiency of net working capital at certain points in the historical lookback period.

Sellers will often make the argument that they have historically operated with excess working capital based on comparisons to industry averages. Buyers should always approach any “excess” adjustment of this type with caution. It can be difficult to understand why the selling company would have operated with this “excess” when the capital could have been paid out to shareholders or invested in another way. With further analysis, there is often an explanation as to why the “excess” working capital has historically been carried on the company’s balance sheet.

As an example, the “excess” could have historically resulted from a quick turnover of payables such that the company has lower current liabilities than the industry average. The quick payments may have earned the company discounts from its vendors, which likely equated to higher profit margins. If the cash flow figures underlying the transaction value include the benefit of these discounts, then it could be double counting to adjust the net working capital to a “normalized” level.

One question that will arise in the negotiations is whether a specific dollar amount or a range should be utilized as the net working capital target. The logic of applying a range is straightforward – it prevents minor variances from creating a post-closing adjustment and reduces the likelihood of disagreements between the buyer and seller regarding the calculation of net working capital to the specific dollar. A word of caution on ranges: if the range is left too wide, it invites the same type of balance sheet “gaming” from the seller that the setting of a target was meant to prevent in the first place.

Our experience has been that, if a range is preferred, it should be tight enough that any amount that would be potentially gained from the closing working capital figure falling at the bottom or top of the range should be immaterial to both the buyer and the seller.

Concluding Thoughts

Having a team of seasoned advisors to assist with the acquisition and due diligence process can ensure buyers that the net working capital targets, and thus the purchase price, are set at levels that are appropriate and fair to the buyer. Mercer Capital has acted in this capacity in hundreds of transactions over our 30+ years of existence. If you are looking for an experienced team of professionals to assist in the due diligence and negotiation process, please reach out to one of our Transaction Advisory Group professionals to assist.

Specialty Finance Acquisitions

In 2021, there were 21 deals announced with a U.S. bank or thrift buyer and a specialty lender target.  This represents a significant uptick from the prior two years and the highest level since 2017.  Deals in 2021 were largely driven by a desire to deploy excess liquidity and grow loans.  Other drivers of deal activity include efforts to find a niche in the face of competition or diversify revenue and earnings.  Through May 19, six deals had been announced in 2022.

Bank & Thrift Acquisitions of Specialty Lenders

Specialty lenders encompass a variety of business models including mortgage companies, equipment finance, and auto lenders, among others.  Over the past ten years, equipment lenders have been the most popular targets for bank acquirers.  Other popular categories include niche commercial lenders and diversified mortgage companies.

Acquisitions by Target Focus

Rationale

The premise for a bank/specialty lender deal is intuitive: higher yielding loans funded with cheap/excess deposits.  Such a deal also allows the acquirer to diversify the exposure in their loan portfolio.  One reason equipment lender deals in particular have been more common is the generally steady demand for equipment.  Companies are buying equipment as they expand in good times, but critical purchases cannot be scrapped in a downturn either.

According to the FDIC’s Quarterly Banking Profile, banks with assets of $100 million to $1 billion reported a median earning asset yield of 3.57% as of the fourth quarter of 2021.  The cost of funding earning assets for these institutions was approximately 30 basis points.  Yields on specialty finance assets can range from 6% to 7% on equipment leases to more than 20% on unsecured consumer loans in some cases.  However, these assets are not funded with cheap deposits.

For example, Ohio-based Peoples Bancorp Inc. (PEBO) announced the acquisition of equipment lender Vantage Financial in February.  Peoples’ CEO commented on the first quarter earnings call that the Vantage portfolio was expected to yield about 7% in 2022 with an additional 5% from the income based on residual values at the ending of the leases.  This compares to Peoples’ reported earning asset yield of 3.61% for the first quarter.  In addition, Peoples acquired small ticket equipment leases from North Star Leasing in 2021, and these assets were yielding approximately 15% as of 1Q22.

On the liability side, Vantage’s funding situation was not disclosed beyond the $21 million recourse loan paid off by Peoples at closing.  It is safe to assume that Vantage’s debt was more expensive than Peoples’ total deposit cost of 14 basis points.  These funding synergies were expected to lead to 3% earnings accretion in 2022 and 6% accretion in 2023.

Another benefit to acquirers is the opportunity to cross-sell by providing traditional banking products that a specialty lender could not provide.  While additional revenue from these opportunities is usually not factored into the deal math, it is an important strategic consideration. Regions acquired home improvement lender EnerBank in 2021, and management framed the deal in terms of Regions’ plan to deepen relationships with EnerBank customers by providing a comprehensive suite of banking services

Risks

Banks considering a specialty lender acquisition need to be aware of the potential risks as well.  A trade off exists between risk and reward with higher yields compensating the originator for greater credit risk.  Specialty finance assets exist on a risk spectrum, ranging from assets such as home improvement loans to borrowers with generally clean credit history to consumer loans to those with poor or no credit history.

EnerBank, the home improvement business acquired by Regions, reported an average customer FICO score of 763 at the time of announcement, and average annual net losses of approximately 1.5%.  CURO Group Holdings (CURO), a consumer finance business, estimates net charge-offs in its U.S. Direct Lending business of 11% to 13% of average loans.

For comparison, net charge-offs represented 0.08% of loans for banks with assets of $100 million to $1 billion and 0.14% of loans for banks with assets of $1 billion to $10 billion as of 4Q21.  The credit concern may be especially pertinent in the current setting as the benign environment over the past few years is due to normalize at some point.

In addition to credit quality, bank acquirers should be aware of the potential regulatory implications of acquiring a specialty lender.  Regulatory agencies have stepped up scrutiny of banks as of late, prompting many banks to reexamine their practices related to consumers (note the large number of banks doing away with overdraft and NSF fees).  Acquirers should be comfortable with the credit and regulatory risk profile of the target, making sure the overall risk level will be acceptable in context of the bank’s total portfolio.   

Recent Bank/Specialty Finance Deals

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Valuation

While pricing data for specialty finance acquisitions is limited, these businesses tend to transact at lower multiples largely due to the risk factor.  The price to earnings multiple for the S&P U.S. Specialty Finance Index was 6.7x as of May 17, and the price to book multiple was 1.7x.  For publicly traded specialty lenders (based on S&P Capital IQ Pro classifications), the median P/E was 8.2x, and the median P/B was

0.93x.  This compares to P/E and P/B multiples on the KBW NASDAQ Regional Bank Index of 11.0x and 1.2x, respectively.

Comparisons should be made with caution, as the homogeneity in the banking sector does not apply to the same degree in specialty finance.

Price / Earnings (x)

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Conclusion

In summary, a specialty finance acquisition may not be right for every institution, but for the right buyer it can provide a new growth channel and help diversify revenue and earnings.  Mercer Capital has significant experience in valuing and evaluating a range of financial service companies for banks.

Buy-Side Considerations

Many observers predict that the market is rife for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity.

Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth.

For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition.

In this series of articles, we cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market.

Click the links below to read the articles in this series


1. Identifying Acquisition Targets and Assessing Strategic Fit

Our first topic in this buy-side series starts at the beginning. Whether your motivations to buy are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.

2. How to Approach a Target and Perform Initial Due Diligence

This is the second article in a series on buy-side considerations from the perspective of middle-market companies looking to enter the acquisition market. Our focus in this article is to summarize some practical considerations for approaching and vetting an identified target.

3. Strategic Premiums: Can 2+2 Equal 5?

Many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium. In this article, we discuss the theory behind strategic premiums, and how they can be advantageous or detrimental to acquirers.

4. Considerations in Merger Transactions

When considering a buy-side transaction to expand, many middle-market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well. In this article, we discuss the key questions that must be addressed when considering a merger transaction, including, corporate governance, social issues and economic questions.

5. The Importance of a Quality of Earnings Study

This is the fifth article in a series on buy-side considerations. Our focus in this article is on how the quality of earnings (QoE) analysis can help acquirers better analyze possible acquisition targets.

6. Negotiating Working Capital Targets in a Transaction

This is the sixth article in a series on buy-side considerations. Our focus in this article is on understanding how and why net working capital targets are crucial for buyers looking to negotiate deals that look good at closing and pass the test as the buyer takes over the operation of the newly acquired business.

7. Considering Contingent Consideration

This is the seventh article in a series on buy-side considerations. In this article we discuss the many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.

The Importance of a Quality of Earnings Study

This is the fifth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read previous articles click here.


Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.

A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).

What is a Quality of Earnings Study?

A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.

Ongoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.

Analysis performed in a QoE study can include the following:

  1. Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.
  2. Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.
  3. Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring.

The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:

  • Workforce / employee analysis
  • A/R and A/P analysis
  • Customer Analysis
  • Intangible asset analysis
  • A/R aging and inventory analysis
  • Location analysis
  • Billing and collection policies
  • Segment analysis
  • Proof of cash and revenue analysis
  • Margin and expense analysis
  • Capital structure analysis
  • Working capital analysis

For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:

  • The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.
  • A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers’ perception of the company and its products.

The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.

Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.

Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

Strategic Premiums: Can 2+2 Equal 5?

This is the third article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read previous articles click here.


When given the choice between paying more or less for a good or service, it only makes sense that people prefer to pay less. Following this, a rational person would be expected to pay no more than the minimum available price for an item. Many modern business acquisitions appear to defy this logic – at least at first glance. According to Bloomberg, acquirers paid an average premium of 25.86% when making transactions in 2021. In other words, the average acquirer was willing to pay almost 26% above the intrinsic market value of a target business to successfully bid on an acquisition.

Theory holds that the value of any corporation, especially a controlling interest in such corporation, should have a value equal to the present value of the cash flows expected to benefit shareholders. This is called a financial control value and represents the intrinsic value of the company on a stand-alone basis. As evidenced by the premium data noted above, many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium.

What Is a Strategic Premium?

A strategic premium exists when a buyer expects that two plus two equals five, or possibly even some figure above five. In less abstract terms, acquirers pay a strategic premium when they expect that the combination of their business with another will generate more cash flow than both businesses on a standalone basis. A strategic premium reflects the portion of this added benefit that the buyer is willing pay to the seller to secure a deal.

To give an example, let’s say that Company A and Company B both generate $2 in EBITDA each year. Both companies may have an intrinsic stand-alone value of $12 (6x EBITDA). When Company A acquires B, they might pay 7.5x EBITDA ($15) because they expect that by combining into Company AB, the Company will generate a total of $5 of EBITDA per year (2+2=5) – providing for a combined intrinsic value of $30 (6x EBITDA). The difference between Company B’s stand-alone value of $12 and the $15 that Company A is willing to pay for it is $3, a 25% strategic premium. Company A spends $15 to increase their value from $12 to $30 – a deal that is accretive to shareholder value.

What Justifies a Strategic Premium?

The framework we provided for the strategic premium begs a larger question: what justifies a strategic premium? Ultimately, there are several possible explanations. Acquirers pay a strategic premium when they expect to gain some sort of efficiency through a business combination. As outlined in our previous example, they expect that these efficiencies will generate more cash flows than both companies can produce on a standalone basis. There are many efficiencies that companies could expect from a transaction, but three are most common.

Cost Savings

Cost savings are the most common justification for strategic premiums, often because they are comparatively easy to forecast.

Let’s go back to our two companies from earlier. Let’s say that Companies A and B both need to purchase the same raw material to create widgets. Once the companies combine, they still need the same amount of raw materials, but they will likely place a smaller number of larger orders. Since each order that comes in will now be larger, their suppliers may give them a bulk discount, which lowers the overall cost. By combining, Companies A and B are spending less money to bring in the same amount of revenue-generating raw materials, leading to larger amounts of profit and free cash flow.

Cost savings can come from supply costs, staff eliminations, or any number of other areas. These savings are usually both the most obvious and quickly achieved strategic enhancements following an acquisition.

Revenue Enhancements

Revenue enhancements are another common justification for strategic premiums but are harder to model.

There are many ways in which revenue enhancements can occur, but we focus on a simple example for the sake of this article. If Company A has a large distribution network, they can use that network to sell Company B’s products to a larger group of people than Company B had been able to previously. Bringing in this additional should increase profits and create more free cash flow.

Process Improvements

Process improvements come about when the companies involved in a transaction absorb each other’s core competencies or assets. Mixing these competencies or assets can create revenue enhancements and/or operational efficiencies.

Continuing our examination of Companies A and B, Company A might pay a premium for Company B if they see that Company B has some sort of proprietary efficient process for creating widgets that Company A could learn and take advantage of. In today’s world, such considerations often focus on technology – be it software of some other form of technology. If the target company’s technology can be utilized by an acquirer to enhance the acquirer’s own cash flow, a strategic premium may be in the offing.

Should You Pay a Strategic Premium?

Now that we have reviewed the theory behind strategic premiums, we discuss how they can be advantageous or detrimental to acquirers.

Perhaps the most obvious benefit of paying a strategic premium is that it can prevent other firms from purchasing the acquiree first. Sellers in a transaction are incentivized to maximize price. By paying a higher premium, strategic acquirers can entice sellers away from financial buyers or other seemingly “less strategic” buyers. On the other hand, paying a strategic premium is a potential risk. A higher acquisition price increases the amount of cash flows necessary to recoup the acquirer’s investment. If the premium is too high, even an acquisition with compelling strategic benefits can become unprofitable.

Ultimately the reasonable price to pay for a target depends on the buyer. Different suitors will expect different efficiencies from the acquisition. To avoid paying too large of a premium, acquirers must have a realistic notion of what they can pay for a target before entering negotiations. Even then, buyers need to exercise discipline and know when to walk away from a bidding war that has gotten too heated.

Acquirers are most likely to be successful when they have an organized process for ensuring that the rationale behind the acquisition justifies the transaction price. Such a process usually includes the analysis (and scrutiny) of the specific enhancements anticipated from a transaction. Strategic enhancements often seem reasonable when considered generally but may fall apart (or at least shrink in magnitude) when under the light of detailed financial inspection. Premiums paid on the basis of only a general consideration of strategic enhancements could be doomed for failure. The success of such deals is often based more on luck than anything else.

Concluding Thoughts

To mitigate the risk of overpaying for an acquisition (and to reduce the impact of pure luck), we recommend a detailed financial inspection of both the target company and the potential strategic value of any transaction. As part of this analysis, it will likely benefit an acquirer to retain a transaction advisory team that possesses financial and valuation expertise.

Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

Considerations in Merger Transactions

This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read previous articles click here.


When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well.

A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company.

Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.

Why a Merger?

A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.

Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.

Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:

  1. Neither ownership group wants to truly exit; and/or
  2. Neither company has enough capital to fund a buy-out acquisition.

In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position.

Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.

Relative Value

In a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.

In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.

While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.

While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.

True-Ups

As with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.

If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.

In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.

Who Is in Charge?

As with any acquisition, an organized post-transaction integration is critical to the success of a merger.

No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.

A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.

A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.

Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.

However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.

Concluding Thoughts

We think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.

Active vs. Passive Appreciation of Closely Held Companies

Determining the value of financial assets in a divorce case can often be the most complicated aspect of the case.

The value of certain assets, such as a retirement account or a bank account, can be determined by a brokerage or bank statement/balance as close to the date of trial or settlement as possible.

An asset such as a closely held business may be the most valuable asset in the marital estate and can require a business appraiser to determine its fair market value since no market indication of value is generally available (unlike a publicly traded company).

The valuation date is also important. In addition to the value of the business or business interest (%) at the current date, other indications of value, such as the value at the date of marriage, may also be required. This varies depending on the facts and circumstances of ownership as well as state statutes.

Net asset division in divorce proceedings are further complicated because they are governed by laws that differ by state. The majority of states are referred to as Equitable Division (“ED”) states as opposed to Community Property states. In ED states, courts determine the equitable or fair distribution of the marital assets based on the characteristics of each case. Further, a majority of ED states are referred to as Dual Property ED states, meaning that assets are categorized as either marital or separate.

While definitions vary by state, some states define marital assets as those acquired or earned during the marriage. Those states then define separate assets as those consisting of property owned by a spouse prior to marriage or property received by gift or inheritance that has not been commingled or transmuted during the marriage. Generally, marital assets are subject to division in a divorce proceeding whereas separate assets, as the name implies, are held separately and not factored into the equitable division of marital assets.

Can a separate asset ever become a marital asset? Yes. In many states, the increase in value of a separate asset during the course of the marriage can potentially be considered a marital asset. Using the example of a closely held business, the increase in value, or appreciation, is often measured by the fair market value of that asset at the date of marriage and some other date as defined by the individual state law or statutes. Other measurement dates are the date of trial, date of separation, or date of filing, among others. In an article published in Family Lawyer magazine, we discussed the importance of the valuation date and its impact on the value of a closely held business.

Active vs. Passive Appreciation

Consider a simple example of a closely held business that one spouse owned at the time of marriage. Let’s assume that the fair market value of the business at the date of marriage is $1 million and the fair market value of the business at the date of trial is $10 million. The simple calculation of the appreciation, or increase in value, is $9 million. Is the entire difference of $9 million considered marital property in this example? The answer may be “it depends,” because it may not be that simple depending on the state or jurisdiction of the case.

In many states, the entire portion of appreciation is not treated as marital property, though, valuation experts must confirm state statute and precedent with the attorneys.

Many states make the distinction between “active” and “passive” appreciation. Active appreciation refers to the increase in value, due to the active, direct and indirect, efforts of one or both spouses. Passive appreciation refers to the increase in value, due to external factors such as market forces, or efforts of other individuals other than the spouses in the divorce.

Depending on the state, courts may then classify active appreciation as marital property, while passive appreciation generally remains separate property.

Active and passive appreciation can also be illustrated by looking at certain assets, such as retirement accounts or real estate. Assuming no contributions during the marriage, the growth in value of a retirement account as a result of the increase in the market values of the underlying investments since the date of marriage would be an example of passive appreciation. The rise in value of a piece of real estate or property due to general market conditions and absent any additional investment, improvement, or management of that real estate during the marriage would also constitute passive appreciation.

Appreciation in retirement accounts and real estate can be simply illustrated and defined through reasonable methodologies. Determining active and passive appreciation in the value of a closely held business can be much more complex. The assumptions used in the overall valuation of the business requires the business appraiser to use qualitative and quantitative analyses. Active appreciation can be supported through direct efforts of one or both spouses such as financial investment in the business, ownership and labor hours contributed to the business, management, marketing strategy, etc. Passive appreciation can consist of economic or market conditions and/or the efforts of non-divorcing individuals.

Examples of Passive Appreciation Factors and Techniques to Quantify

Market forces refer to the economic or market conditions that affect the price, demand, or value of an asset. Market forces happen naturally and are outside of the control or direct efforts of the owners of the company or spouses involved in a divorce. For a closely held business, market forces that can affect value include changes in interest rates, discount/capitalization rates, tax rates, pricing of products or billing rates, legislation that causes an increase in demand for a company’s products or services, etc. Value appreciation attributable to market forces would generally be classified as passive appreciation and as a result, would not be included in the marital estate in those states that recognize active/passive appreciation as marital/separate.

Consider a simple example of a company before and after the tax rate changes brought on by the 2017 Tax Cuts and Jobs Act (“TCJA”). Let’s assume the Company has $1 million in earnings, and the capitalization factor to determine value is 5x. Let’s also assume the tax rate changed from 35% to 21% after TCJA with no state income tax. In this example, all else being equal and not changed, the change in tax rate caused a 21.5% increase in value of the company.

Efforts from individuals other than the spouses could be another area where passive appreciation is present. Business appraisers can perform analyses of these third-party efforts through several techniques. When considering ownership, the following questions are addressed. What is the overall ownership of the company? Is the divorcing spouse the only owner or is he/she one of several owners? The presence of other owners could indicate efforts of other individuals. Management of the Company is also a consideration. Who are the key members of management and how are decisions made? Is the company controlled by a board of directors, and if so, how many individuals serve on the board? In terms of the the role of the spouse, appraisers can analyze these roles and the roles of other key individuals and determine what impact those duties have on the company’s strategy and performance overall. Finally, business appraisers can perform an analysis of the revenue contribution of each owner or key member of management to the overall revenue of the company. Does the company have multiple locations? If so, is the divorcing spouse active and participating at all locations?

Balance sheet factors can also impact the overall value of a company. The presence of excess cash or non-operating assets can add to the value determined under an income or capitalization method (used in the tax rate example above). The Company may have experienced an increase in these items from the date of marriage to the current date of measurement. From our experience, it is not uncommon to see companies in certain industries with more cash on the balance sheet in the last two years as a result of remaining funds obtained from PPP loans or elevated profits. Non-operating assets can consist of real estate not used in the core operations of the business or an investment account. We discussed both of these assets earlier and illustrated how their values can increase due to passive appreciation factors.

Consider a company with the following changes to its balance sheet: excess cash increased by $250,000 and non-operating assets increased by $500,000. In this example, the change in potential value to the company could be $750,000 and may be characterized as passive appreciation depending on the specific factors. While these are assets and liabilities of the business, they may be categorized as “non-core” assets that have different considerations for separate or marital appreciation from those of the core business operations.

Allocating Active/Passive Appreciation

Once the appraiser identifies and quantifies the areas of passive appreciation, the remaining appreciation, or increase in value, is concluded to be active appreciation. The conclusion of passive appreciation could be in dollars of value or percentage of overall value.

Let’s revisit our original example involving a company worth $1 million at date of marriage and $10 million at the date of trial. If the appraiser had determined passive appreciation to be $4 million, then the resulting active appreciation would be $5 million as seen below:

Conclusion

Determining the value and classification of financial assets can be challenging during a divorce proceeding. As we have discussed, the classification of an asset can also change from the date of marriage to the current date of measurement (trial, separation, filing, etc.) and depending on state statute and precedent. Many states make the distinction between active and passive appreciation, only considering the active appreciation to be a marital asset.

The value of a couple’s closely held business could be the most valuable asset in the marital estate. If the business was owned prior to marriage, the identification and quantification of any appreciation as active or passive could be critical to the overall marital value placed on that asset.

A detailed valuation analysis of the appreciation will be needed in addition to the valuation of the business at each measurement date. A qualified business appraiser can perform both tasks, including examining the specific factors that contribute to the overall value of the business. It’s important for the appraiser to understand the applicable state laws of the jurisdiction in question and to discuss those with the attorney.

Statutory Fair Value vs Fair Market Value (and Fair Value): Not So Subtle Differences

Over the past year we have seen an uptick in transactions (and contemplated transactions) in which boards seek to reduce the number of shareholders via reverse stock splits and cash out mergers. The central question for a board aside from fairness and process is: what price?

While the terms “fair market value” and “fair value” appear to be similar, they are very different concepts.  When seeking a business valuation, it is critical to ensure that the appraisal is performed according to the relevant and proper standards.

Transactional Value

Fair market value (“FMV”) and fair value as defined in Accounting Standards Codification (“ASC”) 820 define value in the context of a market clearing price. Statutory fair value (“FV”) is defined in state statutes and is interpreted through precedents established in case law over the year, most notably in Delaware.

The accounting profession defines fair value in ASC 820 as:

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date.

The accounting profession defines fair value from the seller’s perspective with the indicated value used for a variety of purposes including disclosure in financial statements for Level 1, 2, and 3 assets and liabilities.

In the business valuation community, FMV is the most widely recognized valuation standard. FMV is the primary standard used in valuations for estate tax, gifting, and tax compliance.

The IRS defines fair market value in Revenue Ruling 59-60 as:

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

What brings hypothetical, willing buyers and sellers to the intersection point of fair market value is their respective assessments and negotiations regarding the expected cash flows, risk, and growth associated with the subject interest. Depending on the corporate governance of the specific interest, fair market value also may incorporate discounts to reflect a business interest’s lack of control or lack of marketability. 1, 2   

Expropriated Value

Statutory fair value is governed by state law and interpreted by state courts in which dissenting shareholders to certain corporate transactions (e.g., a merger approved by a shareholder vote) petition the court for the fair value of their shares.

Most state statutes provide appraisal rights that allow shareholders to obtain payment of the FV of their shares in the event of various corporate actions, including amendments to the articles of incorporation that reduce the number shares owned to a fraction of a share if the corporation has the right or obligation to repurchase the fractional share.

In 1950, the Delaware Supreme Court offered this interpretation of fair value:

“The basic concept of (fair) value under the appraisal statutes is that the (dissenting) stockholder is entitled to be paid for that which had been taken from him viz. his proportionate interest in a going concern. By value of the stockholder’s proportionate interest in the corporate enterprise is meant the true intrinsic value of his stock which has been taken by merger.”

In effect, the noncontrolling shareholder who is dissenting to a transaction is entitled to his or her pro rata share of value of the company as interpreted in most jurisdictions. As a result, the controlling shareholder cannot expropriate value from the minority shareholder who is being forced out. Therefore, some state statutes explicitly declare and most case law affirms the view that neither a discount for lack of control and/or an illiquidity discount should be considered in determining fair value. 3

While there is no official valuation hierarchy in the Delaware Court of Chancery, based upon a review of recent cases a few observations can be made:

  • Unaffected stock price immediately before the transaction announcement in an efficient market (with regards to both volume and information) is the best indication of value
  • Deal price is a reliable indicator if the analysis excludes the benefit of synergies
  • No recognized valuation methods have been ruled out
  • The discounted cash flow method is generally one of the preferred valuation methods if unable to observe efficient transaction prices that occurred before the transaction

The observations from Delaware case law about the meaning of statutory FV are reflected in some states’ business corporation act. For instance, FV according to the Guam Business Corporation Act §281301(d) shall be determined:

  • Immediately before the effectuation of the corporate action to which the shareholder objects excluding any appreciation or depreciation in anticipation of the corporate action objected to;
  • Using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; and
  • Without discounting for lack of marketability or minority status except, if appropriate, for amendments to the articles pursuant to §281302 (a)(5).

Shown below is a graphic detailing the different levels of value and how we at Mercer Capital think about them in relation to fair value and fair market value.

Controlling interest basis refers to the value of the enterprise as a whole and may be analyzed from two perspectives:

  • Strategic Control Value is best described as Investment Value, based on individual investment requirements and expectations. The strategic control level of value is not generally consistent with FMV, in that it considers the motivations of a specific buyer as opposed to a hypothetical buyer. In other words, the “strategic control premium” is often deemed to be outside both the fair market value and statutory fair value standards. Most bank M&A deals take place at this level of value given cost save assumptions that are common in the industry. In a statutory fair value appraisal, deal value generally may not include the benefit of synergies.
  • Financial Control Value is most often consistent with the fair market value and statutory fair value standards because (i) the underlying premise is a going concern; (ii) it typically does not include any premiums that might be paid by a buyer with specific motivations and the ability to implement synergistic structural and financial changes; and (iii) no minority interest or marketability discounts are applied.

Marketable minority interest basis refers to the value of a minority interest, lacking control, but enjoying the benefit of liquidity as if it were freely tradable in an active market. The marketable minority level of value also is an enterprise level of value that may align with the financial control value.

Nonmarketable minority interest basis refers to the value of a minority interest, lacking both control and market liquidity. The standard of value for a nonmarketable minority interest valuation is usually fair market value and is seldom statutory fair value.

Conclusion

Mercer Capital has decades of experience working with boards of directors regarding statutory fair value in the context of transactions that create appraisal rights and dissenters’ rights. While we sometimes are called to assist in such matters once a transaction has occurred, it is better to address the issue of fair value (and fairness) beforehand. Please call if we can assist your institution.


1 Valuation of Noncontrolling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes, page 8, Accessed Online March 31, 2022 | https://www.irs.gov/pub/irs-utl/S%20Corporation%20Valuation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf

2 Statutory Fair Value, Accessed Online March 25, 2022, https://mercercapital.com/content/uploads/MerceCapital-Statutory-Fair-Value.pdf.

3 Tri-Continental v. Battye, 74 A 2d 71, 72 (Delaware 1950)

First Quarter 2022 Review: Volatility Resurfaces

The first quarter of 2022 marked the most volatile period since the first quarter of 2020.  The quarter began with significant deterioration in the market’s outlook for growth stocks, particularly those lacking demonstrable earning power.  Then, a geopolitical crisis, building for some time, intensified with the invasion of a European country, roiling markets ranging from commodities to equities.  Last, the Federal Reserve announced, as expected, a 25 basis point change in its benchmark rate and telegraphed six more rate increases in 2022, taking the Federal Funds rate to nearly 2.00% by year-end 2022.  In a speech on March 21, 2022, though, Chairman Powell suggested a greater likelihood that future Fed moves may occur in 50 basis point, rather than 25 basis point, increments to combat inflation, which mirrors the position taken by Governor Bullard in dissenting to the Fed’s 25 basis point rate change at the mid-March meeting.

The following tables summarize key metrics we track regarding equities, fixed income, and commodity markets leading up to the invasion of Ukraine on February 23, 2022 and thereafter.

Equity Indices

Index data per S&P Capital IQ Pro

Treasury Rates

Treasury yields per FRED, Federal Reserve Bank of St. Louis

Debt Spreads

Corporate Credit Spreads per FRED, Federal Reserve Bank of St. Louis
CMBS spreads per ICE Index Platform

Commodities

Oil price represents West Texas Intermediate; WTI prices per FRED, Federal Reserve Bank of St. Louis
Corn & wheat prices per Bloomberg

Residential Mortgages

How to Approach a Target and Perform Initial Due Diligence

This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the first article, Identifying Acquisition Targets and Assessing Strategic Fit, please click here.


Business is good for many middle market operators and investment capital is generally plentiful. Are you an investor whose capital is industry agnostic, or does your capital need to be targeted at add-on investments that build on a pre existing business platform?

All business investors are “financial” investors – the real question is how “strategic” is their ability to leverage the assets of the target. Providing practical guidance on approaching a business target and conducting initial due diligence depends on the investor’s criterion, competencies, and execution bandwidth.

In this article we assume you have identified a target or group of targets and you are attempting to learn enough about the target to determine whether to proceed with developing a meaningful indication of interest. Of course, an active seller is likely prepared for the sale process and represented by an advisor who is postured to provide the financial and operating information necessary for investors to quickly determine the suitability of a deal (i.e., a pitchbook and defined protocols for communication and information access).

However, many desirable targets may not be seeking a sale because business conditions are favorable, and their businesses have been managed to provide options to the owners regarding continued independence and turn-key ownership and management succession. If the former, you, as a prospective buyer may have already pinged on the radar of the seller, and if the later, you have mined for target opportunities and are ready for the next step to accomplish an acquisition.

Our focus here is to summarize some practical considerations for approaching and vetting an identified target.

First Contact

M&A is not easy. For every transaction that is announced a very long list of items for both the buyer and seller were satisfactorily addressed before two parties entered into a merger or purchase agreement. For the acquirers, first impressions matter a lot. There are no second chances to make a good first impression.

How a target is contacted can be pivotal to achieving receptivity and obtaining a critical mass of information. In cases where market familiarity or professional collegiality already exist, it can make sense for an investor’s senior leadership to make direct contact with the target’s senior management and/or owners.

In cases where the target is not familiar to the investor, then following a respectful and empathic set of protocols is key. Investors using professional advisors and/or who involve their senior decision makers are likely to be taken seriously by the target. Peer-to-peer contacts too far down the chain of command are more likely to be dismissed.

Owners and senior managers are keen to prevent the rumor mill from derailing business momentum and disturbing internal calm. A mindful and considerate process of first contact and initial discussions that is highly sensitive to the discrete nature of exploratory discussions will increase the probability that initial discussions and diligence can proceed to the next phase as a relationship based on trust develops.

In our experience, contacting a target through a financial advisor has an important signal function that the potential acquirer is serious and has initiated a process to prioritize and vet targets. Diligence procedures will be thorough and well organized; deal consideration and terms will be professionally scrutinized. Alternatively, some business owners and investors who initiate a process may be perceived as canvassing to see what sticks to the proverbial wall. This can inadvertently serve to inflate seller requirements and expectations assuming the initial inquiry is successful.

Initial Due Diligence

Once the initial contact is established, it is important to follow-up immediately with an actionable agenda. Actions and processes include:

  • Non-disclosure agreement;
  • Information request list;
  • Clear set of communication protocols involving specified individuals;
  • A centrally controlled and managed information gateway;
  • Establishment time frames and target dates for investigative due diligence, IOI, LOI, pre-closing due diligence, deal documentation, and ultimately closing.

Organization begets pace and that pace culminates in a go or no-go decision.

Preliminary Valuation

Procedurally, our buy-side clients typically request that we perform a valuation of the target using a variety of considerations including the standalone value of the target and potentially the value of the target inclusive of expected synergies and efficiencies.

A properly administered valuation process facilitates an understanding of the target’s business model, its tangible attributes, its intangible value, its operating capacity, its competitive and industry correlations, and many other considerations that investors use not only for the assessment of target feasibility but as an inward-looking exercise to assess the pre-existing business platform.

For first-time buy-side clients, our services may also include building leverageable templates and processes for future M&A projects. Additionally, our processes may also be critical to the buyer’s Board consents, the buyer’s financing arrangements, and other managerial and operating arrangements required to promote target integration.

Concluding Thoughts

Conducting target searches, establishing contact, and performing initial due diligence are critical aspects of successful buy-side outcomes. In general, there are as many (if not more) consequential considerations for buyers as there are for sellers.

Some buyers covet the conquest and go it alone without buy-side advisory representation. Conversely, even seasoned investors can benefit from third-party buy-side processes. Unseasoned acquirers may find their first forays into the M&A buy-side world untenable without proper guidance and bench strength.

As providers of litigation support services, we have seen deals that have gone terribly wrong as if predestined by inadequate buy-side investigation. As providers of valuation services, we have valued thousands of enterprises for compliance purposes and strategic needs. As transaction advisors, we have rendered fairness opinions, conducted buy- and sell-side engagements and advised buyers concerning a wide variety of deal structures and financings. If you plan to take a walk on the buy-side, let Mercer Capital’s 40 years of advisory excellence guide and inform you.

Understand the Asset Approach in a Business Valuation

What Is the Asset Approach and How Is it Utilized?

In previous posts, we wrote about the income and market approaches used in business valuations. This article presents a broad overview of the third approach, the asset approach. While each approach should be considered, the approach(es) ultimately relied upon will depend on the unique facts and circumstances of each situation.

The asset approach refers to methodologies used under the economic principle that the value of a business can be viewed as an assemblage of net assets. In practice, appraisers begin with the company’s balance sheet, which lists the assets, liabilities, and equity of the company. The values shown on a company’s balance sheet are the “book” values of the assets and liabilities, which are based on accounting standards. As such, these book values may or may not align with current market values. The appraiser will analyze each asset and liability and adjust values (as needed) to reflect market value. The market value of the company’s liabilities are then netted against the market value of the company’s assets to arrive at a Net Asset Value of the business.

The asset approach is appropriate for valuing real estate holding companies, investment holding companies, and capital-intensive operating companies. In the case of operating companies, the asset approach’s indicated value can be interpreted as the value of an assemblage of revenue-producing assets. However, sometimes the operating company is worth more than its assets, for a myriad of reasons. Understanding how well the balance sheet represents the business’s ability to generate earnings is a logical way to evaluate if the value per the asset approach is appropriate.

Asset Classes and Typical Balance Sheet Adjustments

The asset approach is applied based on the identification and discrete appraisal of the company’s assets and liabilities. The assets, if necessary, are adjusted to reflect their market values. Generally, the identifiable assets fall into five categories:

  1. Financial Assets
  2. Inventory
  3. Tangible Real Property
  4. Real Estate
  5. Intangible Assets

Financial Assets

Financial assets include cash and highly liquid investments like marketable securities, accounts receivable and prepaid expenses. This class of asset is typically the most straightforward to adjust, as the book values of cash and receivables usually require no adjustments to reflect market value.

Inventory

In some cases, inventory can be marked up or down based on the economic reality underlying those inventory balances. If there is identified obsolete inventory, a downward adjustment might be necessary. If the company carries its inventory at historical cost and the value of that inventory has increased or decreased, an upward or downward adjustment might be necessary. An example of this could be a company that holds commodities as inventory.

Tangible Real Property

Tangible real property includes furniture, fixtures, and equipment. The value of these assets may decrease over time through use or obsolescence. Accountants capture this effect by depreciating the book value of these assets over a period of time. If the assumptions used in the accounting depreciation of these assets are in line with the economic depreciation of these assets, the book value may be a reasonable indication of the assets’ market values. Otherwise, appraisals of the individual furniture, fixtures, and equipment may be necessary.

Sometimes, businesses may choose to take accelerated depreciation for tax benefits, while the financial statements may reflect either that same tax depreciation, or straight-line depreciation; it is important to be careful in understanding the historical depreciation methods within the financial documents.

Real Estate

The book value of real estate may reflect current market values of the underlying properties or may be dated and require a current appraisal. This can be attributed to appreciation or depreciation in value over time.
Intangible Assets

A company might have intangible assets on its balance sheet. Intangible assets are typically added to the balance sheet during the accounting process of an acquisition, and can be comprised of customer relationships, customer files, existing favorable contracts, existing workforce, tradenames, intellectual property, proprietary technology and general goodwill. In practice, Net Asset Value typically does not include value attributable to intangible assets because it is presented on a tangible, operating basis.

Conclusion

The asset approach is an intuitive approach to valuation, as it is based on the market value of a company’s equity, i.e. assets less liabilities. The asset approach can be a more insightful business valuation approach for entities which hold and manage assets, or perhaps entities which have high balances of machinery and equipment. A competent valuation expert is needed to thoroughly review a company’s balance sheet and assess the adjustments necessary to reflect market value of the underlying assets and liabilities, as well as determine if the approach best represents the value of the business at hand.

Identifying Acquisition Targets and Assessing Strategic Fit

Identifying Acquisition Targets and Assessing Strategic Fit

With aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations.

With labor tightness, supply chain disruptions for capital goods, and financing costs fluctuating in real time, buyers and sellers are increasingly strategic in their mindset. Inflation and interest rates represent potential headwinds, but pent-up demand and plentiful war chests are likely to fuel elevated M&A activity in the foreseeable future. More than a few baby boomers have held on to their business assets making ownership succession and liquidity significant concerns.

Additionally, many middle market business assets are churned by financial investors with defined holding periods. Large corporate players and private equity buy-out groups generally have their own corporate development teams. However, small and mid-market companies, occupied with day-to-day operations, often find themselves with limited bandwidth and a lack of financial advisory resource to identify, vet, and develop a well-crafted strategic M&A rationale and then execute it.

This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.

Motivation and Objectives

A rejuvenated appreciation for optimal capital structures and fine-tuned operations has largely debunked the oversimplified notion that bigger is always better. However, right-sizing is about achieving a proper, often larger scale at the proper time for a supportable price. A classic question in strategizing to achieve the right size is that of “buy” versus “build.”

Many acquisitions are as much about securing scarce or unavailable hard assets and labor resources as they are about expanding one’s market space.

Whether your investment mandate is to alleviate scarcities or to achieve vertical or horizontal diversification and expansion, tuning your investment criterion and financial tolerance to motivations and objectives is key.

These collective questions, among others, help address the who and the what of recognizing potential targets and assessing the pricing and structural feasibility of a business combination in whatever form that may take (outright purchase or merger in some form).

Given our experiences from years of advising clients, we have learned that the most obvious or simple solution is generally best. Many buyers already know the preferable target candidates but lack the ability to assess and the capacity to engage those targets. Additionally, many well-capitalized buyers lack the financial discipline to score, rank, and sequence their target opportunities with the expertise employed by large, active corporate developers and private equity investors.

Understanding the magnitude and timing of the returns resulting from your investment options is critical. Constructing financial models to study the options of now-versus-later and the interactive nature of deal pricing, terms, and financing is vital to the process. These technical and practical needs must be addressed competently to grant buyers the freedom of mind and energy to critically assess deal intangibles that often influence the overall decision to move forward with a target or not. Cultural fit, command and control for successful integration, brand and product synergies, and many other factors ultimately manifest in an investment’s total return on investment.

Scoring opportunities by way of traditional corporate finance disciplines using NPV and IRR modeling as well as using various frameworks such as SWOT Analysis or Porter’s Five Forces is highly recommended. However, blind ambition and soulless math may not result in the best choice of targets.

One common sense and often overlooked assessment is how a seller’s motivations may have a bearing on the risk assessment of the buyer. A seller today may be alerting today’s buyer about future realities the buyer may experience. In some cases, sellers are motivated by a deficit of ownership and management succession. In other cases, a seller’s motive may be the result of industry dynamics and disruption that may one day be the concern of today’s consolidators. Get informed, get objective and be rational when assessing a target. If you cannot do that with in-house resources, get help. If you have in-house resources, have your mandates reviewed and your target analysis checked by an experienced advisor with the right balance of valuation and transaction awareness.

Take a Walk in the Seller’s Shoes

We know that sellers often fear opening-up their financials and operations to certain logical strategic buyers. This may stem from generations of fierce competition or from a concern that not selling means the seller has revealed sensitive information that will compromise their competitive position or devalue the business in a future deal. Many sellers are extremely sensitive to retaining their staff and keeping faith with suppliers and customers. Buyers should understand that sellers require comfort and assurance regarding confidentiality.

Being proactive with non-disclosure agreements and even better using a third party such as Mercer Capital to establish contact may facilitate a process of mutual assessment that is initially a no-go for many tentative sellers. Buyers that demonstrate empathy for the seller’s position and who employ a well-conceived process to initiate exchange are more likely to gain access to essential information.

It is common for the seller’s initial market outreach to set the hurdle price for the winning buyer. That may occur as a result of the seller having reasonably skilled advisors who help establish deal expectations or through first-round indications of interest. As such, it should be no surprise for truly strategic buyers to be able to hurdle the offers of first round financial buyers or less optimal fringe buyers.

Buyers should also be aware that third party deals must win against the seller’s potential ability to execute a leveraged buy-out with family members or senior managers, which may facilitate favorable tax outcomes versus the asset-based structures in open-market M&A processes. Of course, strategic buyers should be equally aware that many private equity or family-office buyers may also be strategic in their motivations and pricing capabilities based on pre existing portfolio holdings.

Awareness of competing concerns for the target must be considered if you intend to win the deal. Buyers, with the help of skilled advisors, can actually help sellers address the balance of considerations that underpin a decision to sell. Having plans for human resource, communicating employee benefits and compensation structures, and laying the groundwork for a smooth integration process are part of walking the talk of a successful acquisition.

Concluding Thoughts

Whether your motivations are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.

Regardless of your past experiences and deal acumen, we recommend retaining a transaction advisory team familiar with your industry and possessing the valuation expertise to maximize transaction opportunities and communicate the merits your firm has to offer the target and all its stakeholders.

Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

Acquire or Be Acquired (AOBA) 2022: Review & Recap

After going virtual in 2021, the Omicron waved peaked just in time for the Acquire or Be Acquired (AOBA) conference to resume its normal physical presence in Phoenix, Arizona during late January.  The virtual sessions in 2021 lacked their normal impact, given the inability, through face-to-face communications, to delve deeper into emerging strategies and industry trends with peers and subject matter experts.  The most common sentiment expressed this year was simply the gratitude that we could gather once again, connecting with existing industry contacts and establishing new relationships.

AOBA’s emphasis has evolved.  When we first attended the conference, the sessions emphasized acquisitions of failed banks to such a degree that presenters struggled to avoid overlapping content.  Then, the conference shifted to emerging from the Great Financial Crisis and the transition to unassisted M&A transactions.  We still remember the years that distressed debt buyers roamed the halls looking for unsuspecting bankers with loans to sell.

More recently, the traditional financial services industry structure—with separate, and somewhat inviolable, silos for banking, insurance, wealth management—has been fractured by new challengers from the FinTech sector.  Armed with venture capital funding, a willingness to tolerate near-term losses, and a mindset not shackled by traditional operating strategies, the FinTech challengers have sought product lines prone to automation and homogeneity, like consumer checking accounts and small business lending.  However, while seeking to disrupt the banking industry, FinTech companies also need the banking industry for compliance expertise, funding, access to payment rails, and the ability to conduct business across state lines.

AOBA 2022 sought to unify several discordant themes.  The first theme is fracturing and convergence.  While FinTech companies seek to challenge the traditional banking industry, they rely on the industry and, indeed, have entered into M&A transactions to acquire banks.  The second theme is threat and opportunity.  Banks face challenges from FinTech companies for certain customer segments, but FinTech products and partnerships offer access to new products, new markets, and more efficient operations.  For fans of price/tangible book value multiples, though, AOBA 2022 still offered plenty of perspective on recent bank M&A trends.  We’ll cover four themes from AOBA 2022.

1. FinTech Competitors/Partners & the Nature of Competition

FinTech’s presence continued to increase at AOBA, both in terms of conference sponsors and mentions throughout the conference.  The most popular breakout session we attended was entitled “Crypto/Digital Assets – A Threat or Opportunity for Your Bank,” although it is difficult to ascertain whether the attendance reflects mere curiosity or a leading indicator that more banks will enter the Crypto space.

One common thread of FinTech-related presentations is that bankers should take a more expansive view of their competitors.  Three FinTech-related companies would rank among the twenty largest U.S. banks, as measured by market capitalization, including Paypal Holdings (#4), Square (#9), and Chime (#12, based on the value implied by its last funding round).  One speaker encouraged banks to adopt an “ecosystem” strategy instead of an “industry” strategy, noting that families often have 30 to 40 relationships with financial services providers, defined broadly.1  Thus, banks’ strategies should not be defined by traditional boundaries but rather embrace the entire financial “ecosystem” in which a range of competitors seek to displace banks from their traditional roles.  In this view, banks compete for customers from the “inside out,” while FinTech companies challenge from the “outside in.”

It remains difficult to quantify the direct impact on community banks from the current crop of non-bank competitors.  Nevertheless, banks’ strategic plans should evolve to reflect the growing population of well-financed non-traditional competitors, for which the pandemic has in some cases accelerated customer adoption.

The last FinTech theme related to “partnerships.”  This term has evolved towards a somewhat expansive definition this millennium, with seemingly any relationship (even as a customer/vendor) deemed a “partnership.”  Certainly, many banks are evaluating FinTech products, with an eye on both expanding revenues and increasing efficiencies.  Others are becoming more intertwined with FinTech companies, either as investors or as the banking platform used by the FinTech company itself.  There is some evidence that banks more closely allied with FinTech companies are being warmly received by the market, given their potential revenue upside.

When evaluating “partnerships,” we suggest deploying a risk/reward framework like banks use in evaluating other traditional banking products.  The lower risk/lower reward end of the spectrum would entail limiting the “partnership” to a particular FinTech product or service, such as for opening consumer checking accounts or automating a lending process.  The higher risk/higher reward part of spectrum would include equity investments or facilitating the FinTech’s business strategy using the bank’s balance sheet, compliance expertise, and access to payment rails.  Like with any bank product, different banks will fall in different places along this spectrum, given their histories, management and board expertise, shareholder risk tolerance, regulatory relationships, and the like.

2. Traditional Bank M&A:  Tailwinds & Headwinds

Mercer Capital provided its outlook for bank M&A in the December 2021 Bank Watch .  Naturally, the investment bankers at AOBA are bullish on bank M&A in 2022.  This optimism derives from several sources, including the pressure on revenue from a low interest rate environment and the technological investments needed to keep up with the Joneses.

Several headwinds to activity exist though:

  • Some transactions initiated prior to the COVID-19 pandemic in March 2020 were placed on hold throughout 2020, but negotiations resumed in 2021.  These transactions likely enhanced the reported level of deal activity in 2021, but this deal backlog now has likely cleared.
  • With the banking industry consolidating, fewer potential buyers exist.  Smaller banks or banks in more rural areas may face a dwindling number of potential acquirers.  Meanwhile, the remaining acquirers may seek to focus on larger transactions in strategic markets.  This could lead to a supply/demand imbalance, although non-traditional buyers—read credit unions—could fill the void.
  • After the drama over the FDIC’s leadership, many observers are expecting a more rigorous regulatory review of merger applications, such as around competition issues or fair lending compliance.  In the near term, navigating the regulatory thicket would appear most fraught for larger buyers.

Another trend to watch is M&A activity involving non-traditional buyers.  Mercer Capital’s Jay Wilson presented a session on credit union acquisitions of banks, focusing on the perspective credit unions take when evaluating potential acquisition targets.  In a reversal of roles, FinTech companies now have entered the scene as acquirers.  In February 2022, SoFi completed its acquisition of Golden Pacific Bancorp, and several other precedent transactions exist.

3. Subordinated Debt:  Act Now?

The subordinated debt market has been quite active, with bank holding companies issuing debt typically with a ten-year term, a fixed rate for the first five years and a variable rate tied to SOFR for the second five years, and a call option in favor of the issuer after five years.  Pricing tightened throughout 2021.  Through early 2022, pricing of newly-issued subordinated debt has remained stable in the 3.50% range, despite rising Treasury rates.  This implies that the spread between the fixed rate on the subordinated debt and five-year swap rates has tightened, falling to levels even below those observed in 2021.

Subordinated debt counts as Tier 2 capital at the bank holding company level but can be injected into the bank subsidiary as Tier 1 capital.  If bankers expect rising loan volume as the economy continues to recover from the pandemic, then it may behoove institutions to issue subordinated debt now and lock in a low cost source of capital.

4. The Regulatory Wild Card

Some attendees expect greater regulatory enforcement and rule making activity in certain areas, with the most likely suspect being fair lending.  However, leadership at some regulatory agencies remains in flux, such as at the OCC where President Biden’s nominee was withdrawn in the face of Senate opposition.  This would not be a constraint, though, at the CFPB, which has a Senate confirmed director who appears ready to take a more active stance on fair lending matters.  Interestingly, many larger banks have moved to limit overdraft and insufficient funds charges, even absent any actual (as opposed to hinted at) regulatory changes.  Tightening practices around overdrafts appears to be another risk to community banks, which may lack the revenue diversification that permits larger banks to absorb a loss of consumer banking fee revenue.

Conclusion

We sense that AOBA is moving into a new era, as it did when the Great Financial Crisis passed.  Attendees and sponsors are, to an ever greater extent, coming from outside the traditional banking industry.  This mirrors the banking industry itself, with its widening set of non-traditional competitors targeting different customer niches.  Future conferences will reveal the extent to which traditional and non-traditional competitors converge.  Regardless of what happens with the intersection of banks and FinTech companies, we can only hope that we’ve attended our last virtual conference.

  1 See Ronald Adner, Winning the Right Game, How to Disrupt, Defend, and Deliver in a Changing World, The MIT Press, 2021.

A Primer on a Growing Breed of Bank Acquirers

Credit Unions & FinTech Companies

While still making up a small proportion of overall deal activity (<10% of total deal volume in 2021), acquisitions of banks by both Credit Unions and FinTechs have been increasing in recent years.

The first credit union to acquire a bank occurred in 2011/12.

Since then, approximately ~55 whole bank transactions have been announced with the peaks occurring in 2019 (14 transactions) and 2021 (13 transactions announced).

The first announced FinTech acquisition of a bank was Green Dot’s purchase of a small bank back in 2010 for $15 million.  There were also several online brokers that acquired banks from the late 90s to mid-2000s.  In 2021, there was a marked increase with six announced transactions whereby FinTechs announced acquisitions of banks.

This emerging breed of bank acquirers (CUs and FinTechs) provides bank sellers with an additional pool of potential buyers to consider when evaluating strategic options and liquidity events.


Mercer Capital’s Jay D. Wilson and Honigman’s Michael M. Bell presented this session at the 2022 Acquire or Be Acquired Conference sponsored by Bank Director.

Meet the Team – Z. Christopher Mercer, FASA, CFA, ABAR


In each “Meet the Team” segment, we highlight a different professional on our Family Law team. The experience and expertise of our professionals allow us to bring a full suite of valuation and forensics services to our clients. We hope you enjoy getting to know us a bit better.

Christopher Mercer, FASA, CFA, ABAR is the Chairman of Mercer Capital. He has been working in the valuation industry for over forty years and founded Mercer Capital in 1982.

As someone who frequently speaks and writes about the valuation profession, how did you get involved in this process and what do you enjoy about it?

Chris Mercer: Writing and speaking has been an integral part of my personal strategy and Mercer Capital’s strategy towards growth and development. When I started Mercer Capital, I had enough exposure to successful people in a variety of fields to know that one of the ways I could differentiate myself was through writing and speaking. I enjoy the process of writing and have written consistently ever since my first article was published. Writing to me, outside of being something I enjoy, was essential to create the reputation of Mercer Capital. With the firm headquartered in Memphis, we were at a disadvantage from firms located in major markets. Mercer Capital needed to differentiate itself from these firms. All of the writing and speaking I did put me in front of a national audience beginning in the late 1980s and the early 1990s, which eventually gave Mercer Capital national exposure, and our firm has continued to grow from there.

How has the valuation profession evolved since you started, and what are your hopes for this profession?

Chris Mercer: When I got into the valuation profession, it was sort of like the Wild West. Valuators did not have a set of universal processes. When I performed my first valuation in early 1979, there were no books on business valuation. So, I went around and talked to everyone I could talk of and asked them what valuation looked like. Then, in 1981 Shannon Pratt’s first edition of Valuing a Business was published which was really the only reference book back then. I call those times the Wild West because people did not know what a marketability discount was or what a control premium was. Marketability discounts were guessed at by looking at restricted stock studies.

I tried to change that in 1997 when I wrote Quantifying Marketability Discounts and developed the Quantifying Marketability Discount Model (QMDM), and people have been having to deal with the reality of cash flow, risk, and growth since then. We at Mercer Capital have been attempting to bring an organized financial focus to the business of valuation since the late 1980s. I have seen this profession evolve in terms of information, size, and credentialing. My hope over the next five to ten years is for the profession to embrace an integrated theory. We cannot continue as a profession to do things in a non-uniform way. I think that is what will change over time, that we will become a more cohesive profession.

What attracted you to a career in business valuation and litigation support?

Chris Mercer: When I started Mercer Capital, I already knew that I liked business valuation. As for litigation, I only had one testimony experience prior to starting the firm. However, litigation was one of the main avenues to get into the valuation business. I began to testify in the local area divorce courts, as working in this market was a way for appraisers to gain experience. I also did a number of statutory fair value cases. Overall, litigation is challenging, mentally stimulating, and I find it satisfying to deal with some of the best and brightest in the country.

What advice would you give to someone who is looking to begin a career in business valuation?

Chris Mercer: My advice to anyone who wants a career in valuation is to take charge of building your own reputation and then the reputation of your firm. You create a brand within the brand. We have created a structure at Mercer Capital that allows people to create their personal brand within the firm brand by focusing on industry specializations, as well as service line specialization. Some of those industry specializations are banking, insurance, asset management, oil & gas, auto dealers, and so many more.

It is also important to gain credentials and credibility. At Mercer Capital, we support the CFA designation. We currently have 19 CFAs. We are proud of that. In addition, we support the ASA designation from the American Society of Appraisers (14 ASA credential holders and one Fellow (FASA)) and the CPA, ABV, and CFF designations from the AICPA (nine ABV credential holders), in addition to others. Continuous learning is part of the Mercer Capital way of life.

What would you say you are most proud of in your career at Mercer Capital?

Chris Mercer: Hands down, I am most proud of the fact that we sit here today as a firm with almost 50 employees, that we are employee-owned, and that we have a succession plan in place and working that assures the continuation of the firm for decades to come. We have created a firm that is providing great careers for a lot of people. I am pleased that the firm is here, and that we have created the opportunity for our employees to save, invest, and build their futures.

Net Interest Margin Trends and Expectations

Much has transpired since Bank Watch’s last review of net interest margin (“NIM”) trends in May 2019.  The emergence of COVID-19 in early 2020 resulted in economic shutdowns that led to emergency rate cuts from the Federal Reserve and unprecedented monetary and fiscal stimulus.  While the economic recession that followed COVID-19 proved to be short-lived, low rates and excess liquidity lingering in the system have weighed on margins.

As 2022 gets underway, the industry is hopeful that rate increases and loan growth, stemming from the continued economic recovery, will deliver a boost to margins.  This potential inflection point provides a good opportunity to review recent margin trends and examine how banks may be impacted by rising rates this year.

Figure 1 :: Net Interest Margin Trend

As shown in Figure 1, NIMs contracted sharply in 2020 and have remained depressed relative to long-term averages.  With deposits accumulating on the balance sheet and a lack of attractive lending opportunities, many banks’ asset composition shifted in favor of short-term, lower-yielding assets.  According to FDIC data, the loan to deposit ratio for community banks reached record lows in 2020 and 2021, reported at 73% as of the third quarter of 2021.  This compares to an average 83% from 2012 to 2019.

Aside from the earning asset mix and deposit base, NIMs reflect a lending margin over a base rate determined based upon competition.  The base rate has been severely depressed, and excess liquidity in the system has squashed any additional lending margin to be had.

NIMs for small community banks (assets $100 million to $1 billion) fell 39 basis points from the fourth quarter of 2019 to the second quarter of 2021, while banks with $1 billion to $10 billion in assets experienced margin compression of 36 basis points over the same period.  We would note that margins have been somewhat distorted by PPP loans and the associated fee income.

The third quarter of 2021 showed some positive trends for NIMs, with both small and large community banks reporting modest expansion of 2 to 11 basis points.  Margins could expand further in the fourth quarter if loan growth materializes and payoffs subside.  Lower premium amortization expense should provide another tailwind for banks with MBS exposure as prepayments speeds decline.

2022 Expectations

Banks are optimistic for 2022 with the Fed winding down its asset purchases and potentially raising rates as early as March. The 30 day and 90 day forward curves for LIBOR imply the Fed will raise rates three to four times by the end of 2022. The 10-year Treasury yield spiked to start the year, settling at 1.78% as of January 25, up from 1.52% at year-end

Figure 2 :: 30/90 Day LIBOR Forward Curve @ 1/26/22

The absolute level of rates is an important factor on the deposit side of the equation, specifically rates out to about 3 years. Higher rates increase the value of non-interest bearing and very low-cost deposits as they provide more lift to the NIM. Banks with a higher proportion of non-interest bearing deposits stand to benefit more from a rising rate

Deposits accumulated during the pandemic have proven to be stickier than many initially thought, and 2022 should provide a good test of that stickiness. As a percentage of total assets, deposits have increased each quarter since Q2-20 for both small and large community banks.

Some banks are concerned about the possibility of deposit run-off with rising rates, but the prospect of deposit run-off significant enough to hinder lending opportunities seems unlikely. Deposit rate adjustments by banks in periods of rising rates tend to lag Fed rate movements. There is reason to expect, given banks’ liquidity, that deposit rate adjustments will have a longer than normal lag in this rate cycle.

Banks that were hesitant to deploy excess cash at low yields should have some opportunities to invest at higher yields in the bond market this year. Anecdotally, some banks reporting Q4-21 earnings have mentioned shifting a greater proportion of funds to the securities portfolio. For example, Independent Bank Corp. (INDB) expanded its securities portfolio by $445 million in Q4-21 and plans to be “aggressive” with securities investments in 2022.

Rising rates notwithstanding, margins may still not return to historical levels due to excess liquidity. For one, loan growth may not be enough to absorb the sheer amount of cash that banks accumulated in 2020 and 2021. In addition, loan pricing reflects a base rate plus a lending margin, as mentioned previously. The base rate will come up, but the additional margin could remain challenged if would-be lenders remain flush with liquidity and the intensity of competition for loans does not wane.

These challenges will likely be a driver of M&A activity this year. Sellers face profitability challenges with continued margin pressure, the loss of PPP fees, and normalization of mortgage income. Buyers may find it more attractive to acquire targets with legacy loan books at better rates versus trying to grow loans organically in the current environment or investing in securities at low yields.

Public Market Perspective

Bank stocks have outperformed since mid-September when investors concluded the Fed was likely to raise rates in 2022 rather than 2023. As of January 26, the KBW Nasdaq Bank Index is up 6.1% from September 15th compared to the S&P 500’s 2.9% decrease.

Analysts are anticipating margins to bottom out in the first quarter of 2022. Smaller rate increases may have a limited near-term impact on loan yields. For example, Bank OZK (OZK) announced in Q4-21 that 63% of its variable rate loans would still be subject to rate floors after a 50bps change in the base rate.

Margins are forecast to begin increasing in subsequent quarters and pick up steam in early 2023. However, margins will likely remain below pre-pandemic levels for the foreseeable future. The chart below shows historical and forecast margin performance for a group of public regional banks.

Figure 3 :: Historical and Forecast Margin Performance for Public Regional Banks

Click here to expand the chart above

Banks with assets between $5 billion and $10 billion traded at 12.6x projected 2022 earnings and 1.60x tangible book value as of January 26. Banks with assets from $1 billion to $5 billion traded at 11.1x projected 2022 earnings and 1.29x tangible book value. Valuations presumably capture the impact of three rate hikes in 2022. As noted earlier, this has been the case since September when investors shifted their expectations for Fed rate actions.

Conclusion

Ultimately, rate increases on the horizon and economic recovery should provide a tailwind to margin expansion in 2022.  However, excess liquidity still presents a challenge, and uncertainty remains as to further impacts from COVID-19.

Navigating Tax Returns: Tips and Key Focus Areas for Family Law Attorneys and Divorcing Individuals/Business Owners – Part III

Part III of III- Schedule K-1 and Relevant Business-Related Schedules

This is the third of the three-part series where we focus on key areas to assist family lawyers and divorcing parties. Part III concentrates on Schedule K-1 (Form 1065 or Form 11-20-S) and additional business-related schedules which can be useful in divorce proceedings. Part I discusses Form 1040 and can be found here, and Part II discusses Schedule A (Itemized Deductions) and can be found here.

Entities taxed as general partnerships, limited partnerships, limited liability partnerships, limited liability corporations, and S corporations prepare a Schedule K-1 (“K-1”) for each of its owners. The Schedule K-1 identifies the owners of the business and specifies the percentage of equity, profits, and losses that will be attributed to each for tax purposes, among other information. K-1s must be distributed to each owner and filed with the entity’s tax return. Owners then utilize the K-1 when preparing their personal tax returns to substantiate the profits and/or losses they are claiming.

Why Would Schedule K-1 Be Important in Divorce Proceedings?

Schedule K-1 provides information regarding the business, the individual partner (or member or shareholder), as well as the portion of taxable income or loss that is attributable to each owner. A business owner may not receive a salary and therefore, might not get a Form W-2 Wage and Tax Statement.  Schedule K-1 provides the details on profit and loss allocated to the individual from the business. Sometimes other agreements are in place for bonus sharing, etc. and the K-1 reflects each business owner’s proportionate share of taxable income or loss.

The K-1 provides evidence of ownership in a business, details the percentage of ownership, and shows business gains and losses for the year allocated to the specific owner, among other information. The business ownership (whether 100% or an interest in the business) may be divisible within the marital estate. If multiple business interests exist, each entity would generate a separate K-1 per owner. The Schedule K-1 can also be used in conjunction with other documents for income determination purposes.

Key Areas of Focus for Family Law Attorneys and Divorcing Parties

Part II of Schedule K-1, Information about the Partner –provides details on each individual partner such as the type of entity, partner’s share (beginning and ending) of profit, loss, capital and liabilities, and the beginning and ending capital account of the individual. Box G will indicate if the taxpayer is a general, limited, or other type of partner. Another item to pay close attention to is Box J which is the line that states: “Check if decrease is due to sale or exchange of partnership interest.” If checked, more information may need to be requested to understand the transaction, amended agreement, or other type of sale or exchange.

While the K-1 offers helpful information on business ownership percentages and annual profit or loss, additional documentation of the business entity should be requested when performing a business evaluation and/or in conjunction with other forensic services such as income determination.

Box L – titled Partner’s Capital Account Analysis presents the ending capital account for the individual partner by showing the following: the beginning capital account, plus capital contributed and current year net income (loss) for the year, less withdrawals and distributions, if any.

One should pay attention to the information presented on the Partner’s Capital Account Analysis because it may be a starting point for evidencing distributions (which may or may not be included in W-2 salary), and investments into a business such as a capital call.

Part III of Schedule K-1 – is Partner’s share of current year income, deductions, credits, and other income. A few of the individual boxes are explained below.

Box 1 – represents the taxpayer’s share of Ordinary Business Income, or Loss, from the corporation. The individual’s income amount is further categorized within Form 1040 depending on whether the income is deemed active or passive. Passive income includes money earned from interest, dividends, and rental property. Active income includes pass-through income or loss, wages and salaries (these may also be included on an individual W-2) or supplemental income. Refer to Schedule E – Supplemental Income and Loss for information on the income; specifically Line 28, which includes column (H) for passive income and column (K) for active or nonpassive income.

Box 12 – Section 179 Deduction – is an immediate expense deduction that business owners have the option to utilize for purchases of depreciable business equipment rather than capitalizing and depreciating the asset over a period of time (referred to as straight-line depreciation). This allows businesses to lower their current-year tax liability rather than capitalizing an asset and depreciating it over time in future tax years, i.e., the tax reduction is taken in full versus in smaller amounts over a period of time. The Section 179 deduction is offered as an incentive for small business owners to grow their business with the purchase of new equipment. To qualify, the property is limited to items such as cars, office equipment, business machinery, and computers; this property also must be used for business purposes more than 50% of the time to qualify. This deduction election will also be reported for the individual taxpayer on Form 4562 – Depreciation and Amortization.

Information on the K-1 can guide questions to ask and subsequent documents to request in order to understand and evaluate business interest(s).

Additional Relevant Business-Related Schedules and Why Each Could Be Important in Divorce Proceedings

Form 4562 – Depreciation and Amortization is used to claim deductions for the depreciation or amortization for tax purposes. Other uses include making an election under Section 179 to expense certain property, and to provide information on the business/investment use of automobiles and other assets. Individuals and businesses can claim deductions for tangible assets, such as a building, and intangible assets, such as a patent. Section 179 property does not include property held for investment, property used outside of the United States, or property used by a tax-exempt organization.

The Depreciation & Amortization Schedule can assist the divorce process by providing a listing of depreciable assets. While the form refers to all as “property,” the term stems from an accounting identification of “property, plant & equipment.” These types of assets typically qualify for depreciation, while intangible assets are typically those that qualify for amortization. Amortization is similar to the straight-line method of depreciation in that an annual deduction to taxable income may be allowed over a fixed time period. The taxpayer can amortize such items as costs of starting a business, goodwill, and certain other intangible assets. Part VI – Amortization is the last section of Form 4562, where the business amortization costs are described and listed to calculate amortization for the year for the individual taxpayer.

Depreciation and amortization can be found on both the balance sheet and the income statement. Annual and accumulated depreciation/amortization are contra-assets to the respective underlying asset on the balance sheet. On the income statement (also referred to as the profit and loss statement), depreciation and amortization are expense items.

One other focus area for divorcing parties is Part V – Listed Property – specifically, Section A – Depreciation and Other Information – Lines 26 and 27. These lines are used to determine depreciation for property used more or less than 50% in a qualified business use, respectively. Generally, a qualified business use is any use in trade or business; however, it does not include investment use, leasing to a 5% or less owner, or the use of property as a compensation for services performed. Column (C) – Business/investment use percentage is where this will be displayed.

Schedule L Balance Sheet per Books, Schedule M-1 Reconciliation of Net Income/(Loss), and Schedule M-2 Analysis of Partner’s Capital Account are also worthy schedules to review in conjunction with individuals who own business(es) or interest(s) in business(es). These schedules within Form 1065 or Form 1120-S for S corporations present the financial statements of the business and the activity on a capital account. If business financial statements, such as an income statement and balance sheet, are obtained, these schedules can be used in conjunction with the review of the financial records. Schedule C Profit or Loss from Business can also be helpful if the business owner is a Sole Proprietor, as this schedule is specific to sole proprietorships. As the name implies, this Schedule C provides income, expenses, cost of goods sold, and other expenses during the respective tax year.

Schedule L provides the beginning and ending balances on the items on the balance sheet. Schedule M-1, as its name implies, provides the reconciliation of income or loss. The reconciliation occurs because some items are allowed, disallowed, or capped for tax purposes, which may be present on the income statement of the business – travel and entertainment and depreciation are two examples included within Schedule M-1. As we previously discussed, the business may take all of its depreciation in one year for tax purposes, while using straight-line depreciation in accordance with GAAP (generally accepted accounting principles). Depending on the current tax laws, a maximum dollar threshold may be allowed for expensing travel and entertainment for tax purposes, while the business may choose to expense more for internal financial purposes.

A review of Schedule M-1 can provide information about potential differences between profits or losses prepared for tax purposes versus internal financial reporting purposes.

Some small businesses may not maintain financial statements beyond the information presented in the tax return schedules; hence, it is important to understand which schedules and sections to review if your client owns an interest(s) in a business. However, for businesses that have financial statements, one should request multiple years of financial statements in addition to multiple years of tax returns and understand how to review the documents in conjunction with one another.

Reviewing the items listed in these schedules can provide useful information and lead to further document requests in order to review and evaluate business assets, business ownership(s), and active and passive income, among other information.

Conclusion

Understanding how to navigate key areas of Schedule K-1 and supporting schedules is often necessary in divorce proceedings. While we provided background on Form 4562, Schedule C, Schedule E, Schedule L, Schedule M-1, and Schedule M-2, there may be further supporting schedules with helpful information or indicators to request further information. Remember that each case presents different facts and circumstances, and tax returns may vary (specifically which schedules are included).

Information within the tax return and supporting schedules can provide support for marital assets and liabilities (specifically those associated with business ownership and/or other types of assets), sources of income, and potential further analyses. Reviewing multiple years of Schedule K-1s and accompanying supplemental schedules may provide helpful information on trends and/or changes and could indicate the need for potential forensic investigations.

While we do not provide tax advice, Mercer Capital is a national business valuation and financial advisory firm and we provide expertise in the areas of financial, valuation, and forensic services.

Bank M&A 2022 | Gaining Altitude

At this time last year, bank M&A could be described as “on the runway” as economic activity accelerated following the short, but deep recession in the spring. Next year, activity should gain altitude. Most community banks face intense earnings pressure as PPP fees end, operating expenses rise with inflation, and core NIMs remain under pressure unless the Fed can hike short-term policy rates more than a couple of times. Good credit quality is supportive of activity, too.

Should and will are two different verbs, however.

One wildcard that will impact activity and pricing is the public market multiples of would be acquirers. Consideration for all but the smallest sellers often includes the issuance of common shares by the buyer. When bank stocks trade at high multiples, sellers obtain “high” prices though less value than when public market multiples are low and sellers receive low(er) prices though more value.

If bank stock prices perform reasonably well in 2022, after a fabulous 2021 in which the NASDAQ Bank Index increased 40% through December 28, then activity probably will trend higher as more community banks look to sell. MOEs may be easier to negotiate, too. If bank stocks are weak for whatever reason, then activity probably will slow.

A Recap of 2021

As of December 17, 2021, there have been 206 announced bank and thrift deals compared to 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.

As a percent of charters, acquisition activity in 2021 accounted for about 4% of the number of banks and thrifts as of January 1.  Since 1990, the range is about 2% to 4%, although during 2014 to 2019 the number of banks absorbed each year exceeded 4% and topped 5% in 2019. As of September 30, there were 4,914 bank and thrift charters compared to 9,904 as of year-end 2000 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.

Pricing—as measured by the average price/tangible book value (P/TBV) multiple—improved in 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.

The national average P/TBV multiple increased to 155% from 135% in 2020, although deal activity was light in 2020. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 158% in 2019 as the Fed was forced to cut short-term policy rates three times during 3Q19 in an acknowledgment that the December and probably September 2018 hikes were ill-advised.

Earnings—rather than tangible book value — drive pricing as do public market valuations of acquirers who issue shares as part of the seller consideration. Nonetheless, drawing conclusions based upon unadjusted reported earnings sometimes can be misleading.

As an example, the national median P/E for banks that agreed to be acquired in 2018 approximated 25x, in part, because many banks that are taxed as C corporations wrote down deferred tax assets at year-end 2017 following the enactment of corporate tax reform. Plus, forward earnings reflected a reduction in the maximum federal tax rate to 21% from 35%.

Also, the median P/E in 2021 fell to about 15x from 17x in 2019 and 2020 in part because the earnings of many sellers included substantial PPP-related income that will largely evaporate after this year.

Buyers focus on the pro forma earnings multiple with all expense savings in addition to EPS accretion and the amount of time it takes to recoup dilution to tangible BVPS. Our take is that most deals entail a P/E based upon pro forma earnings with fully phased-in expense saves of 7x to 10x unless there are unusual circumstances.

Public Market Multiples vs Acquisition Multiples

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Figure 2 compares the annual average P/TBV and P/E for banks that were acquired for $50 million to $250 million since 1997 with the SNL Small Cap Bank Index average daily multiple for each year. Among the takeaways are the following:

  • Acquisition pricing as measured by the P/TBV multiple peaked in 1998 (when pooling-of-interest was the predominant accounting method) then bottomed in 2009 (as the GFC ended) and trended higher until 2018.
  • Since pooling ended in 2001, the “pay-to-trade” multiple as measured by the average acquisition P/TBV multiple relative to the average index P/TBV multiple, has remained in a relatively narrow range of roughly 0.9 to 1.15 other than during 2009 and 2010.
  • The reduction in both the public and acquisition P/TBV multiples since the GFC corresponds to the adoption of a zero interest rate policy (ZIRP) by the Fed during 2008 that has been in place ever since other than 2017-2019.
  • P/E multiples based upon LTM earnings have shown little trend with a central tendency around 20x other than 1998 (1990s peak), 2018 (tax reform implementation) and 2020-2021 (COVID distortions).
  • Acquisition P/Es have tended to reflect a pay-to-trade multiple of 1.25 since the GFC but as noted what really matters is the P/E based upon pro forma earnings with expense saves. To the extent the pro forma earnings multiple is 7-10x, the pay-to-trade earnings multiples typically are below 1.0 to the extent buyers are trading above 10x forward earnings.

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Premium Trends Subdued

Public market investors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to the pre-announcement prices. Investors tend to talk about acquisition premiums as an alpha generator, but long-term performance (or lack thereof) of the target is what drives shareholder returns. Sometimes the market is suprised by acquisitions with an outsized premium, but in recent years premiums often have been modest.

As shown in Figure 4, the average one-day premium for transactions announced in 2021 that exceeded $100 million in which the buyer and seller were publicly traded was about 9%, a level that was comparable to the prior few years excluding 2020. For buyers, the average day one reduction in price was less than 1%, though there are exceptions when investors question the pricing (actually, the exchange ratio). For instance, First Interstate (NASDAQ: FIBK) saw its shares drop 7.4% after it announced it would acquire Great Western for about $2 billion on September 16, 2021.

About Mercer Capital

M&A entails a lot of moving parts of which “price” is only one. It is especially important for would be sellers to have a level-headed assessment of the investment attributes of the acquirer’s shares to the extent merger consideration will include the buyer’s common shares. Mercer Capital has roughly 40 years of experience in assessing mergers, the investment merits of the buyer’s shares, and the like. Please call if we can help your board in 2022 assess a potential strategic transaction.

Highlights From Recent Conferences | 2021 AICPA & CIMA Forensic and Valuation Services Conference and 2021 AAML Annual Meeting and AAML Foundation Luncheon

2021 AICPA & CIMA Forensic and Valuation Services Conference

Last month I had the honor of co-chairing the AICPA & CIMA Forensic and Valuation Services Conference in Las Vegas, Nevada. I have served on the Conference Planning Committee since 2018 and served as the Valuation Chair for the 2020 and 2021 Conferences.

Over 920 were in attendance – including speakers from the U.S., Canada, virtual attendees, in-person attendees, exhibitors and AICPA staff team members. It was wonderful to be back in-person this year, while joined by our virtual audience during all concurrent sessions!

The AICPA & CIMA Forensic and Valuation Services Conference is a premier annual conference which provides timely updates on industry trends, cutting-edge information on new technology, and networking opportunities. In general, this conference is geared towards forensic accounting professionals, business valuation services professionals, litigation services consultants and experts, emerging FVS professionals, CFOs, Controllers, and senior financial professionals.

Four Mercer Capital professionals, Chris Mercer, Travis Harms, David Harkins and myself were on the agenda, speaking at five sessions.

Click the links below for session descriptions and objectives:

To promote the conference and selected sessions, I was interviewed by the Journal of Accountancy about the session Lessons in Career and Business Development During Times of Disruption given by me and Hubert Klein, Partner at Eisner Advisory Group. Below are a few excerpts from the interview.

Interpersonal skills, flexibility, understanding of new technologies, and adaptability are more important than ever, according to Calhoun, and your development plan should incorporate the skills that will be necessary for thriving in continuous disruption.

“This is an opportunity for us as a profession to come together and exchange general best practices, think about what the next roadblocks will be, and how we can hopefully overcome those together,” Calhoun said.

Hubert and I had a great time putting this session together. It’s full of hard earned lessons that you might find of interest. The article does a great job of encapsulating the session.

In addition to the above sessions led by Mercer Capital professionals, the full agenda including speaker biographies can be found here. Below is a list of other sessions you might be interested in.

Sessions of Interest:

  • The Valuation Conclusion Synthesis of Multiple Methods: The Why & How of Using Multiple Methods
  • Intro to Damages: The Intersection of Law and Financial Analyses
  • Key Valuation Issues in Matrimonial Litigation
  • Active vs. Passive Appreciation: Overview and Examples
  • Valuing Digital Assets/Cryptocurrencies
  • Pandemic-Fueled Prosecutions: The Rise of White-Collar Criminal and Regulatory Enforcement on Main Street USA
  • Being Right Isn’t Always Enough: Strategies for Presenting Persuasive Expert Trial Testimony in Complex Damages Cases
  • Shareholder Oppression: Advising Clients on Shareholder Disputes
  • COVID-19 and the Path to Recovery — Lessons Learned About Cost of Capital
  • Attorney’s Perspectives: Good vs. Great Expert Witness Testimony
  • Issues in Valuing Small Businesses
  • Valuation & ESG
  • Complex Support and Property Division Dissolution Issues: Considerations of Alternative Asset Management, Equity and Deferred Compensation
  • Social Media Forensics – Game Stop Case Study

The AICPA Conference Committee is already hard at work debriefing and planning for next year. Our committee works diligently to identify in-demand and current topics followed by inviting national and international thought leaders to lead our sessions. If you are interested in attending or submitting a topic for consideration at next year’s event, email  me.

2021 AAML Annual Meeting and AAML Foundation Luncheon

Last month I also had the pleasure of attending the 2021 AAML Annual Meeting and AAML Foundation Luncheon in Chicago, IL. There was a mixture of continued education sessions, networking, sponsor and exhibitor events, committee meetings, dining and social events. This year’s annual meeting marked the Diamond Anniversary of the AAML. It was wonderful to see and meet so many individuals in person in Chicago and discuss various current and complex topics!

Highlighted sessions:

  • Business Valuations: Untangling the Web of Complex and Startup Businesses
  • Designing Families: New Technologies and Their Critical Legal Implications
  • How Does PPP Money Impact Business Valuations
  • Trial Practice and Cutting Edge Technology: Bitcoin Virtual Currency in a Real Word Divorce

We look forward to attending 2022 AAML and AAML Foundation events!

Insurance Valuation Services for Financial Sponsors

In recent years, financial sponsors such as private equity, venture capital firms, investment companies, and family offices have taken a more prominent role in funding and growing firms in the insurance industry. From insurance brokerage/distribution to underwriting to InsurTech start-ups, there are many opportunities for investment in the insurance sector and transaction activity in the space has steadily been increasing.

Mercer Capital has worked with financial sponsors in the insurance industry for years and we understand both the dynamics of the industry as well as the accounting and valuation issues that are likely to be encountered.

Key areas where Mercer Capital can help include:

  • Valuations of Shares/Units for 409A / ASC 718 Compliance If you anticipate granting equity to founders or key management at acquired companies, using rollover equity as part of a growth strategy, or issuing options or RSUs as part of your employee compensation plans, supportable and defensible valuations are critically important.
  • Valuations for Financial Reporting Acquisitive growth strategies will likely necessitate ASC 805 purchase price allocations, earn-out liability measurements, and goodwill impairment testing.
  • Financial Due Diligence We provide financial due diligence and quality of earnings reports on target companies, including analysis/trending of the pro forma P&L, potential earnings adjustments, working capital assessments, unit economics analysis, and other areas of financial analysis.
  • Financial Opinions (Fairness and Solvency Opinions) Certain types of transactions, related-party issues, or fiduciary concerns can lead a board to seek an independent opinion of fairness or solvency as it pertains to a transaction involving the subject company. These situations might include going-private transactions, special dividends, and leveraged recapitalizations.
  • Portfolio Valuation for ASC 820 Compliance We provide a range of services to assist fund managers with the preparation and/or review of periodic fair value marks. These services are cost-effective and include a series of established procedures designed to provide both internal and investor confidence in the fair value determinations.

To discuss any of these services in confidence, please contact a Mercer Capital professional today.

ATRI’s Report on Critical Issues in 2021

In October 2021, the American Transportation Research Institute released its 2021 survey of Critical Issues in the Trucking Industry.  The ATRI survey was open from September 8, 2021 through October 15, 2021 and includes responses from over 2,500 stakeholders in the trucking industry in North America.  Respondents include motor carrier personnel (52.4% of respondents), commercial drivers (24.1%), and other industry stakeholders (23.5%, including suppliers, trainers, and law enforcement).

Driver-related concerns – including driver shortages, driver retention, and driver compensation – continued to dominate the list of top concerns.  The driver shortage claimed the top position for the fifth year in a row.  The driver shortage is being exacerbated by increasing demand for freight services, COVID-related training, and licensing backlogs, and drivers exiting the industry due to COVID risks.  Driver compensation has been a top-ten concern for three years running and is strongly linked to the driver shortage problem.

Lawsuit abuse reform took the fourth slot in the overall ranking.  ATRI estimates that the average verdict size increased 967% between 2010 and 2018, due largely to nuclear verdicts that have skewed the dangers of litigation to trucking industry participants (see our previous analysis of nuclear verdicts originally published in the second quarter of 2020).  Lawsuit abuse, insurance costs and availability are linked – the rising expenses of trucking industry litigation has caused some insurers to drastically raise premiums or to exit the trucking industry altogether.

It is interesting to see the differences in opinions held by drivers versus motor carrier stakeholders.  As one might expect, the commercial drivers tend to focus on the day-to-day issues of trucking, including parking, fuel prices, and legal compliance.  Motor carriers are more concerned about driver retention, litigation, insurance, and technician shortages, as shown in the table below.

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ATRI also provided a breakdown of the top three concerns of company drivers compared to owner-operators or independent contractors.  While both groups included compensation and parking in their top three concerns, company drivers rated driver training standards as a critical issue, while owner-operators and contractors were more concerned with fuel prices.

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