We are sometimes asked to value common equity securities where the target (usually our client) has agreed to be acquired but the transaction has not yet closed. The valuation could be required for a number of reasons: annual year-end ESOP/KSOP valuation, tax compliance matters, and litigation.
The valuation of such shares falls into the genre of “merger arbitrage” which on Wall Street is an “event-driven” asset strategy. Merger arbitrage strategies seek to capture a risk-adjusted return for the risk assumed that the transaction will not close. As time passes, discounts tend to narrow as the closing date approaches absent detrimental developments.
The S&P Merger Arbitrage Index produced total returns on an unlevered basis between 2018 and 2022 that ranged between 6.1% in 2021 and -4.2% in 2022. The five-year compound annual return was 3.2% or 1.9% over the average 90-day T-bill yield.
Given the uncertainty that an announced transaction will close for a variety of reasons (e.g., regulatory, shareholder actions, financing, etc.), acquisition targets that are publicly traded will usually trade at a discount to the acquisition price. In instances when a competing offer is expected, the target’s shares may trade at a premium, though this is unusual given the vetting process most boards undertake.
The valuation of privately held shares in a merger arb situation can be reduced to a binomial outcome: the deal closes, or it does not. The two outcomes may be close in value or they may be far apart, especially if minority and illiquidity discounts are to be considered in the no-deal scenario. Factors that may impact the discount between the target’s market price and the deal price include:
Our observation of bank stocks over several decades leads us to the conclusion that bank merger arbitrage discounts are modest in the order of high single digits to 10% or so on an annualized basis. However, it is important to note that fact patterns for individual transactions can cause discounts to be wider. Stated more succinctly: most announced bank deals close.
The ability to close is a key consideration for any board entertaining an acquisition or merger proposal. In our February edition of Transaction News Update, we opined that Spirit Airlines Inc. (NYSE: SAVE) may not have sufficiently considered whether JetBlue Airways Corp. (NYSE: JBLU) could obtain regulatory approval to acquire Spirit when it agreed to the JetBlue offer over a deal with Frontier Group Holdings, Inc.
While small bank deals almost always close, large deals take longer and are subject to more scrutiny since the Biden Administration took office in early 2021. Among three large deals that were announced in 2021 and early 2022, only two of the three closed: $125 billion asset MUFG Union Bank by U.S. Bancorp (NYSE: USB) on December 1, 2022, and $92 billion asset Bank of the West by Bank of Montreal (TSE/NYSE: BMO) on January 17, 2023.
On May 4, 2023, The Toronto-Dominion Bank (TSE/NYSE: TD) and First Horizon Corporation (NYSE: FHN) announced the termination of a definitive agreement that was signed on February 28, 2022 after TD could not provide assurance to FHN when or even if it could obtain regulatory approval to acquire. Subsequent press reports indicated that TD had compliance issues related to anti-money laundering reporting that precluded regulatory approval.
Figures 1, 2 and 3 provide perspectives on merger arb discounts and how discounts can change as facts, circumstances and market conditions change based upon the TD-FHN deal.
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The merger agreement signed on February 28, 2022 provided for TD to acquire all of FHN’s common shares for $13.4 billion of cash, or $25.00 per share. Pricing at announcement equated to 2.27x year-end 2021 tangible BVPS and 16.6x the 2022 consensus EPS estimate.
If there was any concern about TD’s ability to get regulatory approval, market participants did not express it because FHN’s shares rose 29% on February 28, 2022, to $23.48 per share from $18.25 per share the day before as shown in Figure 1 (on page 4). The discount to the cash (out) price by the close on the 28th was 6.5%, a level that is consistent with the modest discount we have observed for most bank deals over the years.
Then a series of events would cause the discount to widen, narrow, then blow-out before the termination was announced.
During the summer of 2022, the discount widened as more voices began to question the ability of TD to obtain regulatory approval against the backdrop of USB and BMO facing uncertain approval for their large bank deals, too. However, FHN’s shares trended at the nearly $25 per share cash-out price by November as USB and BMO obtained regulatory approval to close.
On February 9, 2023 the parties extended the termination date to May 27, 2023, from February 28 when it was clear that regulatory approval would not be forthcoming by the one-year anniversary. As shown in Figure 1, FHN’s price dropped 11% on March 1 when it disclosed in its 10-K that TD did not know when it would obtain regulatory approval. The shares then dropped about 20% on March 13 as investors digested the implications of the failures of Silicon Valley Bank (SVB) and Signature Bank New York (SBNY).
When FHN released 1Q23 earnings on April 19 without any updated written commentary about the then pending TD deal (FHN discontinued quarterly conference calls once the deal was announced), the shares did not move much given the then 26% discount to the $25 per share cash price. However, the shares fell to about $10 per share with the announcement that the parties terminated the deal on May 4.
As shown in Figure 2, the year-to-date drop for FHN’s shares through May 24 was 55%, an amount that exceeded the 25-40% drop peers experienced.
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Facts and circumstances can change merger arb discounts.
The impact of bank failures on investor psychology and possibly industry fundamentals was one factor. Another is a deteriorating earnings outlook as Fed rate hikes and sharply higher funding costs will cause 2022 margin expansion to flip to 2023 margin contraction. Also, Fed tightening has produced steep inversion of the yield curve, and inverted yield curves usually precede recessions by upwards of a year.
As a result, bank stocks have been revalued from low-to-mid teen P/E stocks when the TD-FHN deal was announced to single digit P/E stocks today even though analysts have been cutting estimates for nine months. The binominal outcomes for FHN and the merger arb community were wide: $25 if the deal closes or ~$10 per share if it does not close based upon 6-7x current year earnings.
Mercer Capital is a national valuation and transaction advisory firm with a focus on non-publicly traded equities and debt securities. We render valuation, fairness and solvency opinions and provide M&A and other transaction advisory services to depository and other financial services companies. Please call if we can be of assistance.
This article discusses the concept of fair market value and its various effects. First, we explain what fair market value means. Then, we explore the hypothetical negotiations between potential buyers and sellers when determining fair market value and the implications of these discussions.
Finally, we examine the impact on the so-called “marketability discount for controlling interests” by analyzing this “discount” from three perspectives: the meaning of fair market value, the integrated theory of business valuation, and the recurring and incorrect rationales for this discount.
Fair market value occurs at the intersection of hypothetical negotiations between hypothetical willing, knowledgeable, and able buyers and sellers. Therefore, in every fair market value determination prepared by business appraisers, it is critical that both buyers and sellers are present for the negotiation.
A fair market value appraisal should reflect considerations of both buyers and sellers and land at the intersection of their negotiations over the expected cash flows, growth, and risks associated with receiving those cash flows, whether for a business or an interest in one.
Every appraisal involves the specification of the relevant standard, or type of value. Fair market value is the most frequently used standard of value employed by business appraisers. Many times, appraisers cite a definition of fair market value and list the eight elements listed in Revenue Ruling 59-60 (“RR 59-60”) in their reports. The definition of fair market value found in RR 59-60 is:
2.2 Section 20.2031-1(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax Regulations 105) and section 25.2512-1 of the Gift Tax Regulations (section 86.19 of Gift Tax Regulations 108) define fair market value, in effect, 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 the relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.
The eight elements listed in RR 59-60 are as follows.
(I call these the “Basic Eight Factors”)
Once the definition and eight factors have been listed, there is often little or no consideration of the implications of the definition in the remainder of many valuation reports, although lip service may be paid in report headers that appear to follow the outline of considerations. These are relevant factors for consideration, but RR 59-60 also states that the elements of common sense, informed judgment, and reasonableness must enter the process of weighing those facts and determining their aggregate significance.
The following figure provides a conceptual look at fair market value. The key elements from the definitions are highlighted around the figure. Hypothetical willing sellers have different interests than do hypothetical willing buyers.
In the world of fair market value:
These elements above are important implications of the definitions of fair market value which are overlooked or misunderstood by some business appraisers, attorneys and judges. They are necessary, however, for the next element for consideration, the hypothetical transaction itself.
Fair market value assumes that both hypothetical buyers and hypothetical sellers are knowledgeable, willing, and able to transact, and that neither acts under any compulsion. The hypothetical parties negotiate at arm’s length and in their respective self-interests. And they engage in a hypothetical transaction with the following characteristics:
The hypothetical transactions of fair market value could not occur on the valuation date unless all hypothetical negotiations, including the marketing of the subject interest, had not been concluded on or before that date. Similarly, the hypothetical transactions could not be concluded unless all customary documentation of the transactions had been completed. We focus more on the resulting implications as we proceed.
The purpose of an appraisal is to simulate the hypothetical negotiations of hypothetical willing buyers and sellers and to determine, in the form of an opinion of fair market value, the intersection of their negotiations. In some appraisals, the hypothetical seller is not present and conclusions are too low to reflect fair market value. In other appraisals, the hypothetical buyer is not present and conclusions are too high to reflect fair market value.
What brings hypothetical willing buyers and sellers to the intersection point of fair market value? It is their respective assessments and negotiations regarding the expected cash flows, risks, and growth associated with the subject interest. Both the interests of buyers and sellers should be reflected in fair market value determinations.
The question of whether a marketability discount should be applicable to controlling interests of businesses has been around for a long time. I addressed the question in an article in the Business Valuation Review of the American Society of Appraisers in 1994. The answer to the questions was, and still is, no. I have addressed this issue in several books and numerous articles and blog posts since then.
Let’s first address the question based on the definition of fair market value, which represents a hypothetical transaction in a subject interest on the valuation date for cash or its equivalent. If there is a hypothetical transaction for a controlling interest in a company, say Acme Manufacturing, on the valuation date for cash at fair market value, what possible reason could there be for discounting that value for “lack of marketability?” It has just been marketed and the interest became fully liquid.
Next, let’s address the question of marketability discounts for controlling interests from the viewpoint of the integrated theory of business valuation.
Any valuation discount represents differences in expected cash flow, growth, and risk between one conceptual level of value and another. For example, the marketability discount, or discount for lack of marketability, represents differences in expected cash flow, growth, and risk between the marketable minority/financial control level of value (V = CFe / (Re – Ge)). CFe represents the normalized expected cash flow of an enterprise (business), Ge represents the expected growth of that cash flow, and Re represents the risks associated with the business and achieving the expected cash flows. The familiar Gordon Model represents the value of a business at the marketable minority/financial control level of value.
The nonmarketable minority level of value can be represented conceptually by the equation (Vsh = CFsh / (Rhp – Gv)). Vsh is the nonmarketable minority level of value. CFsh is the expected cash flow to the shareholder of a subject illiquid minority interest. CFsh is almost always less than CFe because of reinvestments into a business or agency costs imposed by controlling shareholders. Gv is the expected growth in value of the illiquid minority interest over the expected holding period of the investment (including liquidity assumed at the marketable minority/financial control level of value. Rhp represents the risks associated with achieving CFsh, including growth, over the expected holding period of the investment.
Why does a marketability discount (or DLOM) exist?
The lower cash flows of the illiquid interest and the greater risks create the wedge of lower value called the marketability discount.
Now, let’s try to conduct a similar analysis relative to a marketability discount for a controlling interest. First, we know that the marketable minority/financial control level of value is defined by the Gordon Model, or V = CFe / (Re – Ge). This is a summary statement of the discounted cash flow model in which normalized expected cash flows of the business are projected into the future for a finite period of time and then, a terminal value is calculated to represent the then value of all remaining cash flows beyond the finite forecast period.
Are the cash flows attributable to a controlling interest any different at the valuation date than those already projected in an appraisal? Of course not. It is the same business and the same interest. It is not possible to define lower cash flows attributable to the subject interest, or greater risks, or slower growth beyond the valuation date. After all, that is the date on which the assumed hypothetical transaction of fair market value occurs.
Let’s take the analysis a bit further. Assume we have valued 100% of the equity of Acme Manufacturing, a manufacturer of parts for the automotive industry. The initial financial control/marketable minority value is $30 million. You as the other appraiser, and I agree that this is a reasonable value. The question now is whether a marketability discount should be applied. In the following figure some of the typical arguments for such a discount are addressed and we find that they are not correct or reasonable.
To those who would suggest that a controlling interest is “marketable and non-liquid” and therefore, a marketability discount for controlling interests should be applied, please articulate what that means in terms of expected cash flows, growth and the risks of achieving those cash flows. Differences in these factors are the only sources of valuation discounts (or premiums). It cannot be done, so those authors who try to create a fictional level of value are, in my opinion, simply wrong.
First Republic Bank’s first quarter 2023 earnings release said little, yet little needed to be said. The balance sheet “repositioning” induced by the deposit run is almost incomprehensible. Deposits at March 31, 2023, excluding the $30 billion placed by the biggest U.S. banks, fell to $74 billion, which is modestly below FRC’s year-end 2018 deposits. That is, four years of deposit growth was reversed in three weeks. Noninterest-bearing deposits dropped to $20 billion, thereby falling to a level last reported in 2016.
FRC illustrates the asymmetry of banking. Rising shareholder value results from the slow, grinding agglomeration of decisions made over years. The business model does not create overnight riches. However, that accumulation of value can unravel in an instant. The downside exposure results, in part, from the leverage inherent in banking’s business model. It is difficult to identify a more pure of this asymmetry between the gradual creation of value and its precipitous destruction than FRC.
FRC did not disclose its post-run cost of funds, nor has the rate paid on the $30 billion deposited by large banks been disclosed to our knowledge. Using FRC’s paltry disclosures and our best estimates, the table on the right provides a rough approximation of FRC’s current cost of funds. We caution that, among other uncertainties, further contraction of noninterest-bearing deposits would cause even more funding cost pressure.
FRC’s yield on earning assets expanded by 15 basis points to 3.66% in the first quarter of 2023, as a 20 basis point expansion in the yield on loans (to 3.73%) was offset, in part, by an unexplained 29 basis point decline in the securities
The current yield on earning assets presumably is higher than in the first quarter of 2023 due to the continued (slow) repricing of loans and higher balances held at the Federal Reserve, but any such yield expansion is likely inadequate to produce a current net interest margin significantly greater than zero.
Interestingly, FRC did not recognize a valuation allowance against its net deferred tax asset, implying that it continues to believe the tax assets will be recoverable. Also, it maintained the held-to-maturity classification of most securities, indicating that recent events have not affected its intent and ability to hold the investments to maturity.
At the larger banks that funded the $30 billion deposit, we imagine that corporate development staff have been furiously creating scenarios over the last few weeks to preserve as much value as possible at FRC. The circumstances surrounding FRC are a throwback to the S&L crisis in which abundant—and quite creative—financial engineering was deployed. Remember supervisory goodwill? We will see what’s pulled out of the toolbox this time, if it’s not emptied entirely, to develop a solution for FRC’s woes.
What was expected to be a prosaic first quarter was anything but that. It was punctuated by the failures of SVB Bank and Signature Bank, the wind down of Silvergate Bank and the near(ing) failure of First Republic Bank (NYSE: FRC). Ironically, failures that were precipitated by deposit runs were triggered by fears of unrealized losses in bond portfolios that occurred five months after Treasury yields peaked.
Year-to-date (through April 26) the Nasdaq Bank Index declined 28% compared to 13% for the S&P Bank Index as deposits flowed into the presumed safety of “too big to fail” institutions. JPMorgan Chase & Co. (NYSE: JPM) is an outlier among banks in that its shares are up slightly YTD. Also notable is the outperformance of Technology Select Sector (NYSE: XLK) this year in a reversal of 2022 when tech stocks underperformed in the market.
To the extent falling stocks are foreshadowing poor earnings or dilutive equity raises at low share prices, it was not evident in first quarter earnings among community banks ($1-$10 billion of assets) and regional banks ($10 billion to $50 billion of assets) reports as of April 25. Earnings were fine, albeit down from the fourth quarter as is often the case given the 90 days to accrue interest compared to 92 days in the fourth quarter.
The quarter was hardly a disaster, though the severe underperformance of bank stocks before SVB failed portends problems to come with likely some amount of overreaction by investors.
Ultimately, stocks follow earnings (or cash flow) over time, while valuations ebb and flow with changes in interest rates, an industry’s profit cycle, and expected earnings growth. Quarterly earnings do not matter much other than what the current quarter implies about earnings expectations over the coming year or two and how those updated expectations get expressed in sell-side analysts estimates.
As shown in Figure 2, Wall Street banks posted upside surprises as a group with JPMorgan producing blow out results as a result of deposit inflows and because trading was very strong as market volatility exploded. Otherwise, most banks missed what were already low expectations due to NIM pressure from rapidly rising cost of funds (“COF”).
Figure 2 also partially explains why bank stock prices have fallen as consensus EPS expectations have declined over the past six months as a once benign rising rate environment has transitioned to a headwind. As shown in Figure 3 (on the next page) the gap between banks’ cost of funds and the quarterly average 3-month T-bill yield is unusually wide for a rising rate environment. The gap is now narrowing as banks have been forced to aggressively raise deposit rates and excess funds shift to interest bearing accounts.
Once analysts fully update estimates over the coming weeks, we suspect 2023 EPS estimates will show a much sharper reduction than what is reflected in Figure 2. However, the poor performance of bank stocks since the failure of SVB and SBNY implies investors have more worries than the COF/NIM dynamic on forward earnings.
To paraphrase the late Donald Rumsfeld, the known unknown is credit unless there is an unknown unknown that is troubling stocks. Inverted yield curves typically precede recessions by about 18 months compared to ten months of inversion so far in this cycle as measured by the 10/2 spread. Further, the failure of SVB/SBNY has tightened the availability of credit as banks seek to increase liquidity.
So far, leading credit indicators are mostly benign. Past dues and non-accrual loans within the banking system are low, and the option adjusted spread (“OAS”) on the BofA High Yield Index over U.S. Treasuries was 463bps compared to the 10-year average of 443bps. CMBS is showing some strain, however, with 5.6% of commercial mortgages remanded to special servicing though among subsectors retail remains very elevated, office is climbing and lodging has declined sharply over the past year.
Valuations are very low with community and regional banks trading for 8.1x and 8.7x consensus 2023 estimates and comparable multiples based upon flattish 2024 estimates. Super regionals trade for about 7x earnings. The long-term average based upon one-year forward earnings ranges from 12x for super regionals to 14x for community banks.
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Whether the current environment proves to be a tremendous buying opportunity or a sell-off in anticipation of a sharp recession or prolonged period of stagflation is to be determined. Banks are characterized as “early cyclicals” on Wall Street — meaning they turn down well in advance of a recession and turn up when the recession is in full force. Nonetheless, we expect most community banks to perform well or well enough given low-cost deposit franchises — provided they have not over-invested in long-duration assets and/or operate with high-cost structures.
FHN is a tough call for the merger arbitrage community: $25 per share of cash if the current deal closes; regulators reject the deal, causing FHN’s shares to trade freely in a tough market for bank stocks; or the parties extend the merger agreement again, but does the price get renegotiated?
In the February edition of the Transaction News Update, we featured an article discussing how Spirit Airlines Inc. (NYSE: SAVE) may not have sufficiently considered whether JetBlue Airways Corp. (NYSE: JBLU) could obtain regulatory approval to acquire when it agreed to the JetBlue offer over a deal with Frontier Group Holdings, Inc. (NASDAQGS: ULCC) that was viewed as more obtainable from a regulatory perspective.
Ability to close is a key consideration for any board entertaining an acquisition or merger proposal. Memphis-based First Horizon National Corporation (NYSE: FHN) faces that question as it relates to its pending deal to be acquired by The Toronto-Dominion Bank (TSE/NYSE: TD) for $13.4 billion cash, or $25.00 per share, announced on February 28, 2022. Pricing at announcement equated to 2.27x year-end 2021 tangible BVPS and 16.6x the then consensus 2022 EPS estimate.
As shown below, the deal has been a tough one for the merger arbitrage community because the parties extended the termination date to May 27, 2023, from February 28 earlier this year when it was clear that regulatory approval would not be forthcoming by the one-year anniversary. On March 1, FHN disclosed in its 10-K that TD did not know when it would obtain regulatory approval. When FHN released 1Q23 earnings on April 19, management did not provide any updated commentary with the release (FHN discontinued quarterly conference calls once the deal was announced.)
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At the time of announcement, a few on Wall Street questioned whether TD could get regulatory approval given a tougher review process promulgated by the Biden Administration to approve deals among large banks (TD-FHN would be the third largest deal since the GFC). However, the concerns were not reflected in the market because FHN’s shares rose 29% on February 28, 2022, to $23.48 per share from $18.25 per share the day before as seen above. The discount to the cash (out) price by the close on 28th was 6.5%, a level that is consistent with Mercer Capital’s experience with merger arbitrage discounts when a transaction involves small regionals and publicly traded community banks. Historically, such discounts have been modest because regulators almost always approve such deals, and deal attorneys will offer some level of informal assurance regarding approval.
We do not have any unique insight into the pending TD-FHN deal, but the deal offers two distinct outcomes for FHN’s share price: regulators soon approve the deal, which would push FHN’s shares to near the $25 per share cash-out price; or regulators reject the deal or the parties terminate the deal given an inability to obtain approval and FHN’s shares trade as an independent company in a depressed market for bank stocks with presumably no immediate acquisition prospects. A third outcome involves a second extension of the merger agreement deadline while awaiting regulatory approval if it is perceived to be obtainable, though some TD shareholders are pushing for a lower price in an extension scenario.
When confronted about falling behind on child support payments and the pending foreclosure of his 109-room mansion, Evander Holyfield, a former world heavyweight boxing champion, explained that he faced a liquidity crisis, not an issue of solvency. It is an apt metaphor for the ructions that began on March 8, 2023 when Silvergate Bank announced its intent to return depositor funds and wind-down. The astonishing events of the last few weeks are illustrated by a few numbers:
A number of factors contributed to the recent bank failures, as well as the severe pressure on the stocks of certain banks that investors perceive as having similar issues. It’s a bit like a blues song where not one thing befalls the protagonist, but rather a cascading series of events leads to turmoil — like when the protagonist’s woman leaves him and also takes the dog. As Taj Mahal sings:
She caught the Katy
And left me a mule to ride…4
Figure 1 provides the market backdrop for March 2023, with various bank indices declining approximately 20% through March 24, 2023. We also include several banks in the market’s line of fire, including First Republic, PacWest, and Western Alliance.
While Evander, on a self-reported basis, was solvent, the issue is complicated for the banking industry. We start by defining insolvency as a bank’s assets being worth less than its liabilities. Media reports fixate on unrealized securities losses, but from a valuation perspective, a bond maturing in ten years with a 3% rate is not much different than a loan with a similar structure (putting aside credit risk). However, this analysis overlooks an important asset that is not recognized on the balance sheet—the value of the bank’s deposit portfolio.
Figure 2 presents the tangible common equity/asset ratios for selected banks. While SVB’s bond portfolio duration and reliance on large dollar demand deposits no doubt were issues in its collapse, its balance sheet composition—with securities comprising 56% of total assets—contributed to the frenzy regarding SVB’s financial condition. If other banks had assets with observable prices equal to 56% of total assets, they might be in the same pickle. Note that SVB’s unrealized loss on securities (14.8%) is not the highest among these five banks.
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In our opinion, it is a sideshow to focus on only one component of the balance sheet — the securities portfolio—to determine solvency or skill at avoiding the effects of rising interest rates. From our client work, we suspect that unrealized “losses” on loans are lower than for securities (as a percentage of cost basis), due to a shorter duration. However, in dollar terms the unrealized losses likely are significant vis-à-vis equity. Sharply higher deposit portfolio values and strong capital positions, which offset the downward loan and securities adjustments, suggest that most banks are not insolvent. However, even if most banks are not insolvent, headwinds remain. The risk of a ruinous deposit run that crystallizes losses is now a risk the market must discount. Larger unrealized losses on assets imply longer asset durations, which place net interest margins at risk if depositors become more rate sensitive. Last, M&A remains difficult to accomplish, as mark-to-market accounting effectively realizes a target’s unrealized losses.
Into the febrile environment following Silvergate Bank’s announced wind-down, SVB launched a capital raise. While media reports indicate that a lead investor had been arranged and Goldman Sachs had soft orders for the remaining securities, the announcement of the offering—followed soon after by news of its difficulties—caused depositors to lose confidence in SVB’s financial strength and start the run on the bank. The failed offering raises several questions. First, was it a mistake to attempt the transaction in the immediate aftermath of Silvergate’s announced wind-down? Second, if SVB’s capital raise had closed before the bond portfolio restructuring was announced, would the deposit run even had occurred?
Across the Atlantic, Credit Suisse’s forced marriage to UBS led to the write-off of its contingent convertible (“CoCo”) bonds, with the CoCo holders faring worse than Credit Suisse’s shareholders. This inversion of the normal capital structure hierarchy, with shareholders faring better than some debtholders, caused yields to spike on CoCo bonds as the market repriced the risk of CoCo bonds. This raises a capital issue for some global banks. If stock prices are depressed and CoCo bonds are exorbitantly expensive to issue, then the only other capital raising alternative is to limit balance sheet growth with its attendant macroeconomic costs.
After SVB and Signature failed, First Citizens Bank purchased $72 billion of SVB loans at a $16.5 billion discount (23%) and Flagstar Bank purchased $12.9 billion of loans at a $2.7 billion discount (21%).5 While the nature of these loans was not disclosed, we assume that most of the discount was attributable to interest rate adjustments rather than credit exposure given the failed banks’ relatively low level of nonaccrual and delinquent loans at year-end 2022. Even if the FDIC was a distressed seller, the discounts indicate the potential capital hole that may exist in troubled banks as all the assets are marked to market.
These circumstances surrounding distressed banks point to difficulties in resolving interest rate induced solvency issues through additional capital. This differs from the Great Financial Crisis when the balance sheet problems could be isolated to, for example, land loans that represented 10% of total loans. In the current environment, “risk-free” assets like government bonds contribute significantly to solvency concerns; thus, a much larger proportion of a bank’s assets is underwater—though many of the assets are at no risk of credit loss.
Even if capital can be raised without triggering a deposit run, an offering that increases total equity by, say, 10% could be inadequate to resolve the market’s concern about capital and diminished earning power. The only remaining alternative for banks that become troubled is to backstop the banking system with liquidity in the hope that (a) banks have sufficient asset yields to cover higher funding costs, thus allowing them to gradually replace low yielding assets and/or (b) rates decrease.
Another perplexing thread in the story is the inability of SVB and Signature to access timely back-up sources of liquidity. As withdrawals accelerated in the afternoon of Thursday, March 9th, SVB sought funding from the FHLB and then the Fed. SVB missed an afternoon cutoff to process a large FHLB advance. Then, SVB attempted to transfer excess collateral from the FHLB to the Fed, but SVB’s transfer could not be processed before the Fed’s deadline. This left SVB with a negative cash balance of $1 billion on March 9th, leading to its closure the next day.6 Signature also faced issues borrowing from the FHLB as its deposit run intensified on March 10th. A request over the weekend to borrow $20 billion from the Fed was rejected, leading to Signature’s failure.7
An enduring question is whether these two failures had to happen, at least when they did. Not to diminish the financial issues involved, but depositors and the Fed/FHLB were moving at different speeds. It also is difficult to square Signature’s rejection by the Fed with First Republic obtaining, at one point, $109 billion from the Fed. This situation has some parallels to the Fed saving Bear Stearns but allowing Lehman Brothers to fail.
The Fed and FHLB have been essential in stabilizing the banking system, but the Fed’s reverse repo facility, used since 2013 to conduct monetary policy, also contributes to the volatility. Now, money market funds can park client funds at the Fed. Not only do these funds generate higher yields than most bank deposit accounts, but there is virtually no risk of the Fed collapsing. Therefore, uninsured depositors have the best of both worlds—higher yields than traditional deposit accounts and lower risk. Indeed, money market funds experienced inflows of $121 billion during the week that SVB failed.
Bill Dudley, a former president of the New York Fed, warned that allowing money market funds to access the Fed’s balance sheet could cause the “disintermediation of the financial system.” While depositors have not done this en masse, it suggests potential unintended consequences of current monetary policy.8
Even if SVB and Signature had been rescued, the rates on replacement funding for the deposit outflows likely would have exceeded their asset yields as may be the case with First Republic. As indicated in Table 2, the fourth quarter 2022 yield on earning assets was only 3.38% for SVB and 4.13% for Signature. Instead of an immediate failure, a low or negative NIM would have eroded capital. Did the banks have sufficient capital to absorb this gradual capital erosion while waiting for rates to decline? Given their asset durations, SVB’s and Signature’s failures may have been inevitable. PacWest and Western Alliance appear better positioned to handle the cost of replacing deposit outflows at market rates, while First Republic’s position is tenuous.
Both Silvergate and SVB cited NIM pressure, rather than deposit withdrawals, as the reason for liquidating securities. Silvergate’s CEO addressed an analyst question as follows:
Not knowing whether the deposit withdrawals were going to be temporary, we borrowed against our securities portfolio. That’s what it was there for. It was all pledgeable, high quality, and so we borrowed against it. But then to your point, when you’re borrowing, you’re borrowing at current rates, right? So if the securities portfolio was yielding a lower level at the end of the third quarter because it had been put in place and some of it was longer duration put in place in the past, then you could just connect the dots, right? We were borrowing at a higher level all in because the Fed had been raising rates so rapidly during 2022.
… How do we make sure we’re protecting the future capital? Well, it’s by selling the longest duration right now so that we can preserve the earnings power….9
SVB’s investor presentation regarding its capital raise described the transaction’s rationale as follows:
Today, we took strategic actions to strengthen our financial position–repositioning SVB’s balance sheet to increase asset sensitivity to take advantage of the potential for higher short-term rates, partially lock in funding costs, better protect net interest income (NII) and net interest margin (NIM), and enhance profitability. 10
The situation with NIMs for SVB, Signature, and First Republic is reminiscent of the S&L crisis. Fortunately, most banks have higher asset yields than this trio. This suggests several lessons. First, the gap between the rates on core deposits (1.58% for First Republic’s interest-bearing deposits, for example) and wholesale borrowings means that large core deposit losses can quickly devolve into severe NIM erosion, despite the most robust asset/liability modeling. Second, uncertainty will continue to cloud the outlook for banks with low yielding, long-term assets for which NIM preservation is reliant on depositors remaining insensitive to higher rates available elsewhere.
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The current rate environment is not unprecedented, but memories have faded as the long bull market for bonds continued unimpeded. In 2006 and 2007, the Fed Funds target rate remained in the 5% range, similar to the current target rate. Mercer Capital obtained data for banks with year-end 2022 total assets between $100 million and $3 billion that reported historical financial data over the entire period from 2000 to 2022.
During the 2006 to 2007 period, this group of banks reported a median cost of interest-bearing deposits in the 3.50% range.
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By contrast, Figure 5 shows the progression of the Fed Funds target rate and cost of interest-bearing deposits for the peer group in 2022. Though still rising, the cost of interest-bearing deposits was 0.75% in the fourth quarter of 2022. Deposit funding costs are almost exactly reversed from their level in late 2007. In the fourth quarter of 2007, 99% of banks had a cost of interest-bearing deposits over 2.00%, whereas 97% of banks had a cost of deposits under 2.00% in the fourth quarter of 2022.
It is interesting to speculate on depositor behavior in the current interest rate environment. Perhaps depositors are desensitized to higher rates after the long zero rate environment, despite the ease with which funds can be transferred to other alternatives. There are many more investment alternatives now than in 2006 and 2007. Thus, rate sensitive funds may have already fled bank deposit accounts for higher yielding alternatives, leaving the remaining depositors stickier than in past higher rate environments. Customers could be more appreciative of the technology and services offered by banks than in the 2006 to 2007 period.
Like the Katy leaving the station, the banking industry is embarking into the unknown after the failures of SVB and Signature. Most banks will remain as sturdy as the mule left behind, though not without greater uncertainty until the gap narrows between the book value and fair value of bank assets and funding costs stabilize.
ASC 805 provides guidance on the accounting and reporting for business combinations. Generally, an acquirer, whether public or private, must allocate the consideration paid for the business across tangible and identifiable intangible assets, with any residual purchase price over the fair value of such assets attributed to goodwill. The Division of Corporation Finance (the “Division”) of the U.S. Securities and Exchange Commission (“SEC”) ensures that publicly-traded firms disclose material information, such as those relevant to certain business combinations, to investors through its review of certain public filings, including Form 10-K, Form 10-Q, proxy materials, and other filings.
Upon completion of its review of the aforementioned filings, the Division may issue “comment” letters to the public filers. Comment letters set forth staff positions and do not constitute an official expression of the SEC’s views. Comment letters may request that a company (i) provide additional supplemental information so the Division staff can better understand the company’s disclosure; (ii) revise disclosure in a document on file with the SEC; (iii) provide additional disclosure in a document on file with the SEC; or (iv) provide additional or different disclosure in a future filing with the SEC. Several rounds of comment letters and response letters between the Division and the filer or the filer’s legal counsel may occur until the issues are resolved.
Comment letters are frequently issued in relation to business combinations. Comment letters and response letters are public information and can provide unique insight into both qualitative and quantitative factors that should be considered in determining the fair value of intangible assets when performing a purchase price allocation. The following is a sample of specific issues the Division has commented upon in recent years concerning business combinations and individual intangible assets.
On September 1, 2021, TD SYNNEX Corporation (“TD SYNNEX”) purchased all of the outstanding shares of common stock of the parent entity of Tech Data Corporation (“Tech Data”) for approximately $7.2 billion. Identifiable intangible assets included customer relationships with an allocated fair value of $3.86 billion. The Division reviewed TD SYNNEX’s Form 10-K filed on January 28, 2022 for fiscal year 2021, noting the following about the Tech Data customer relationships: (Click here to see full comments and responses)
“We note you recorded $3.86 billion as the fair value of customer relationships with a weighted average useful life of 14 years. Please tell us how you evaluated the guidance in ASC 350-30-35-3 in determining the useful life, including explaining the characteristics of the customer list that support this assigned life, and all other pertinent factors considered in your analysis.”
TD SYNNEX responded as follows:
“The Company respectfully submits that in measuring the fair value of the customer relationships acquired as part of the acquisition of Tech Data, we engaged an independent internationally-recognized firm that valued the customer relationships using the multi-period excess earnings method, a variation of the income approach. Under the multi-period excess earnings method, the remaining useful life is an output rather than an input. Therefore, the Company considered guidance under ASC 350-30-35-3 which states that if an income approach is used to measure the fair value of an intangible asset, in determining the useful life of the intangible asset for amortization purposes, an entity shall consider the period of expected cash flows used to measure the fair value of the intangible asset adjusted as appropriate for the entity-specific factors in this paragraph.”
In most cases, customer relationships acquired in a business combination are valued using the multi-period excess earnings method, or MPEEM. The various assumptions and mechanics of the MPEEM are beyond the scope of this article. The lesson here, though, is that choosing the correct methodology for valuing an intangible asset is just the first step. The Company’s response continued:
“The Company advises the Staff that Tech Data as a global IT distributor, purchased and resold technology products to an active customer base of more than 100,000 resellers, system integrators, and retailers. Tech Data predominantly sold products to its customers on an individual purchase order and transactional basis, rather than pursuant to long-term contracts. Although long-term contracts are not in place, customer relationships are strong within the IT distribution industry with relatively low customer attrition rates. In measuring the fair value of customer relationships, the Company established that approximately 90% of the present value of expected cash flows used to measure the customer relationships intangible asset were generated over a period of 12 to 15 years. The period over which 90% of the present value of expected cash flows were generated varied slightly within this range between the three geographic regions in which Tech Data operated (Americas, Europe and Asia Pacific). The customer attrition rates applied in valuing the customer relationships were based on the historical experience of Tech Data and the expected attrition in the customer base within each of the geographic regions. Based on the foregoing factors, we believe a weighted average useful life of 14 years is appropriate.”
TD SYNNEX’s response emphasizes a quantitative approach as it relates to the characteristics of cash flows from customer relationships that support the 14-year weighted average useful life as requested by the Division.
On December 30, 2017, Live Ventures Incorporated (“Live Ventures”) acquired 100% of ApplianceSmart Inc. and ApplianceSmart Contracting, Inc. (“ApplianceSmart”) for $6.5 million. The intangible assets included a trade name, which was assigned a fair value of $2.0 million. The Division reviewed Live Ventures’ Form 10-K filed on December 27, 2018 for the fiscal year ended September 30, 2018, noting the following about the ApplianceSmart trade name: (Click here to see full comments and responses)
“Given the financial deterioration of ApplianceSmart prior to purchase, please tell us in more detail how you determined the trade names acquired were worth over $2 million.”
Companies that are contemplating an acquisition and preparing the related disclosures would do well to note the line of questioning from the Division in this example, particularly the emphasis on methodology.
Live Ventures responded as follows:
“…As part of determining the value of the assets acquired, ApplianceSmart engaged an outside company, Gordon Brothers, to fair value the acquired assets…In determining the fair value of the ApplianceSmart trade name, Gordon Brothers performed a quantitative valuation using the relief from royalty methodology of the income approach…This fair value measurement methodology is premised on the assumption that an owner/operator of a company would be compelled to pay the rightful owner of the intangible asset (such as a trade name) if the owner/operator did not have the legal right to utilize the subject intellectual property. Since ownership of a trade name relieves a company from making such payments, the financial performance of the firm is enhanced to the extent that these royalty payments are avoided.”
Gordon Brothers conducted the following analysis to estimate the fair royalty rate and the fair value of the ApplianceSmart trade name, which included:
In addition to the above quantitative calculation, Gordon Brothers gave qualitative consideration to the following:
Pretty thorough response, right? Not for the Division, which came back in another comment letter (more than one year later!) asking for more explanation from Live Ventures. Remember – the original question above asks for “more detail.”
“We note your response to comment 3. Please provide more detail regarding the royalty rate for the subject trade name and respective required rates of return used in the relief from royalty calculation. In addition to quantifying the inputs, please tell us how these inputs were determined, if a range of inputs were considered, and the magnitude of the impact on the trade name value if other inputs within the range, if any, had been used.”
Concerning the selection of the royalty rate used, the Company responded:
“In evaluating the ApplianceSmart trade name, third-party royalty rates are used as a guide to establish a range of possible value. Gordon Brothers utilized the ktMINE Database to research third-party royalty rates for similar trade names, namely, storefront brands, utilized within the industry for household appliance stores. Based on their research, five comparable licensing agreements for similar trade names were found that support royalty rates yielding a median range from a low of 0.35% to a high of 1.1%, with a median range around 0.7%…After consideration of the above qualitative factors and the market-derived royalty rates, Gordon Brothers determined a 0.5% royalty rate to be reasonable in the valuation of ApplianceSmart’s trade name.
The economic value of this trade name is expressed as the present value of the expected after-tax royalty savings. Accordingly, the royalty earnings can be calculated by applying the royalty rate to the estimated sales. The royalty savings were applied to the total sales as all sales are generated under the subject trade name.
The royalty savings were further adjusted for taxes and then discounted to present value using a discount rate that reflects the risks inherent in intangible assets such as the subject. This discount rate reflects the additional risk in an investment in intangible assets versus the business as a whole.
In addition, Gordon Brothers added an amount representing the net present value of the tax savings resulting from the amortization of the value of the trade name over a 15-year period to the net present value of the after-tax royalty savings to yield an indication of Fair Value for the trade name of $2.0M.
Gordon Brothers has estimated a 20-year remaining useful life for trade name based on the nature of the industry, the length of time that the Company has been in business, discussion with Management, and the relative strength of the trade name in the marketplace…”
Concerning the selection of the discount rate use, the Company responded:
“Gordon Brothers made a determination of required rates of return based on the following assessments and assumptions.
Assets within a business enterprise have different risk, liquidity, and return characteristics. The rate of return on any particular asset is typically commensurate with its risk, with the discount rate reflecting the risk associated with the income attributable to the asset…Intangible assets in any valuation depend on the facts and circumstances of each individual valuation. Returns on individual assets are selected based upon a number of factors, including the current costs of funds, the type of asset and its liquidity, whether the asset is likely to be accepted as collateral for debt-financing purposes, whether it is a special-purpose asset or has a broader use, and discussions with asset-based lenders on current trends. In general, higher liquidity of an asset leads to increased marketability and greater acceptance as collateral, and less equity is required to finance the asset. Therefore, a more highly liquid asset will have a lower required rate of return.”
Ultimately, Gordon Brothers selected a discount rate of 18.6% for use in the relief from royalty method. We are not aware of any further communication from the Division, so presumably the additional detailed response was sufficient.
On December 31, 2020, NeuroBo Pharmaceuticals (“NeuroBo”) acquired ANA Therapeutics, Inc. (“ANA”). The ultimate purchase consideration included contingent consideration related to the achievement of certain milestone events. The Division reviewed NeuroBo’s Amendment No. 1 to Preliminary Proxy Statement on Schedule 14A, filed March 2, 2021, stating: (Click here to see full comments and responses)
“We note your disclosure on page 6 that your preliminary estimate of the fair value of the contingent consideration was approximately $4.76 million. We also note from your response that you determined that the likelihood of payment of the contingent consideration was remote and that you have excluded the contingent consideration from total purchase consideration in your analysis. Please describe to us how the fair value was determined, including how the likelihood of payment factored into the determined fair value.”
NeuroBo’s legal counsel responded as follows:
“In response to the Staff’s comment, we note that the third-party valuation was subsequently revised on April 1, 2021. The original valuation, commissioned in order to satisfy Section 3.6 of the Merger Agreement for purposes of ensuring compliance with the requirements for the tax-free nature of the exchange, valued only the contingent consideration that could potentially be triggered by the Milestone Payments. The valuation was subsequently revised in part to fully include the potential royalty payments to the ANA Equityholders as well as potential royalty payments pursuant to the YourChoice Therapeutics, Inc. License Agreement that was assumed in connection with the ANA Acquisition, which, as disclosed in the Company’s Form 8-K/A filed with the Commission on March 1, 2021, includes certain potential single-digit royalty payments and milestone payments in the aggregate amount of $19.5 million. As a result, the final fair value of the contingent consideration was ultimately estimated at $18.3 million. We have revised page 10 of Amendment No. 2 accordingly.
…The fair value of the contingent consideration in the third-party valuation was arrived at as follows:
This methodology resulted in a single-step contingent consideration value of $5.07 million, with a mean sensitivity analysis value of $18.3 million.”
Contingent consideration, also referred to as an earnout, is often valued using Monte Carlo Simulation as referred to in the response. Although other methods are acceptable, Monte Carlo Simulation is one of the most common, if not the most common, method. While not disclosed in the Company’s response, a Monte Carlo Simulation will typically consist of 100,000 or more trials based on certain parameters under which an event is likely to occur (in this case, the milestone events referred to above). The $18.3 million fair value conclusion is likely to be the average indication based on a similar number of trials.
Navios Maritime Acquisition Corporation (“Navios Acquisition”) merged with Navios Maritime Midstream Partners L.P. (“Navios Midstream”) on December 13, 2018, acquiring all of the outstanding publicly held common units of Navios Midstream. The Division reviewed Navios Acquisition’s Form 20-F for the Fiscal Year Ended December 31, 2018, stating: (Click here to see full comments and responses)
“We note that in accounting for the acquisition of the remaining interest of Navios Midstream, you recorded a bargain purchase gain. Please tell us and revise to disclose the reasons why the transaction resulted in a gain.”
Navios Acquisition’s legal counsel responded as follows:
“The amounts included in this response are expressed in thousands of U.S. Dollars in order to conform with the disclosures contained in Note 3 of Navios Acquisition’s Form 20-F. The excess of the fair value of the identifiable net assets acquired of $123,450 over the total purchase price consideration of $54,499, resulted in a bargain purchase gain in the amount of $68,951. During 2018, the publicly traded stock prices of US listed shipping companies were trading at discounts to their net asset value (“NAV”). This trading discount to NAV resulted in the recognition of a bargain purchase gain for Navios Acquisition. The purchase price and the number of shares to be issued at the closing of the acquisition was proposed in June 2018 by using a conversion rate of 0.42 of a Navios Acquisition share to one common unit of Navios Maritime Midstream Partners L.P. (“Navios Midstream”), which was based on the market share prices in June 2018, plus an implied 1% premium. The definitive agreement that validated the proposed conversion rate was signed in October 2018 between Navios Acquisition and Navios Midstream. The proposed conversion rate was accepted with no adjustments. Between the proposal date, the date of the signing of the definitive agreement and the date of closing, there was no adjustment made to the number of shares to be issued by Navios Acquisition for movement in the share price or the price of the net assets to be acquired.”
A bargain purchase may occur when the seller is motivated to sell quickly, and therefore, may not execute a formal competitive bid process or does not engage actively in negotiating with the purchaser. The parties in this example are related and may not have engaged in a typical arms-length transaction, resulting in a bargain purchase. Furthermore, the length of time between price negotiation and closing a transaction can lead to situations where the fair value of assets acquired exceeds purchase consideration. In our experience, bargain purchases are infrequent, so reviewers such as external auditors (and the SEC) expect a compelling rationale for why such gains are supportable.
As evidenced by the questions discussed above, the SEC is certainly paying attention to business combinations disclosures. This has always been the case for public entities. But even for private companies that aspire to become public one day or desire to prepare quality audited financial statements, the need for supportable and defensible fair value measurements is crucial. Our hope is that the questions and responses highlighted above will better prepare you for the level of scrutiny that often accompanies the accounting for business combinations – and may help you avoid being on the receiving end of these types of comment letters.
Mercer Capital has been helping public and private companies with valuation services around business combinations for decades. Please contact one of our professionals today with any questions or to discuss your needs in confidence.
Special thanks to J. Davis Rolfe, Jr., CPA and Kate Mabry for their contributions to this article.
It’s always fun to escape the dreary, late January weather and head to sunny, warm Phoenix to catch up with and learn from my peers at Bank Director’s Acquire or Be Acquired Conference (“AOBA”). This year the wintry weather back home resulted in a flight cancellation, allowed for an extra day of sunshine, and illustrated that most things have a silver lining if you can find it.
The 2023 version of AOBA felt bigger than ever, and it was good to see that conferences and large gatherings of industry peers can still thrive after the impacts of the pandemic. Below, I note a few themes from the conference and the sessions that I attended. For those who haven’t been to AOBA before, it is a two-and-a-half-day conference that has broadened its M&A offerings over the years to focus on a combination of M&A, growth, and FinTech strategies.
These themes stuck with me the most from the 2023 iteration.
We noted in a previous article that the 2023 deal-making outlook was challenged by the potential for heightened interest rate marks (i.e., unrealized losses in fixed-rate assets) and credit marks amidst a combination of a higher rate environment and a softening economic climate and real estate values. This theme was certainly present on the AOBA agenda as several sessions discussed the impact of unrealized bond losses as reflected in the AOCI (accumulated other comprehensive income) on banks’ balance sheets. But it also showed up in discussions of how asset sensitive vs. liability-sensitive banks will perform, the need for heightened due diligence on credit risk, and how these themes can impact capital planning, equity valuations, and M&A.
While the balance sheet theme was more prominent at the 2023 AOBA, this link between bank balance sheets, earnings, and ultimately valuation is not an entirely new phenomenon. It reminded me of one of my early bank readings as a younger analyst and how the text illustrated that banks’ balance sheets tend to drive earnings. It noted how this is a unique trait compared to companies in other industries, whose balance sheets have less of an impact on generating cash flow.
Consistent with discussions around the balance sheets, rising interest rates, and the impact on the banking industry, deposits came up time and time again in sessions. These discussions covered strategies to retain business or consumer deposits, the attractiveness of core deposits for acquirers in the current environment, how to grow deposits organically, how to acquire deposits and pay premiums, rising core deposit intangible valuations, and how to provide your customers with the technology and digital banking solutions to onboard and retain deposits more efficiently. 1
We have previously discussed banks’ potential to leverage FinTech to create value and enhance profitability and efficiency. This theme seems to grow each year at AOBA as we see more sessions on structuring and performing due diligence on FinTech partnerships. I’ve also noticed an increased interest in topics like BaaS (Banking as a Service) opportunities, digital tools from different FinTechs, and case studies on how banks have developed digital strategies or partnered with FinTechs to compete and expand in the current environment. Additionally, the number of FinTech companies attending and presenting at AOBA continues to increase.
Opportunities were plentiful for those bankers interested in a demo or introduction to some of FinTech’s offerings. In my view, one emerging theme stood out a bit more from the rest: banks developing deeper partnerships with FinTechs and eventually investing with them as partners. We have noted how valuation issues and key performance indicators (KPIs) for FinTech companies and tech-forward banks can differ from traditional bank valuation methods and KPIs. I think it will be interesting to watch this trend going forward.
While we noted the turbulence and potential headwinds for bank M&A in 2023, this could present an opportunity for some acquirers with a more long-term perspective. Traditional growth acceleration and inorganic scale strategies such as M&A were still prominent themes in many sessions, as they focused on the nuts and bolts of conventional bank M&A, valuation, due diligence, structuring, and integration. While certain themes change and evolve, the strategy to achieve greater scale and growth through M&A, and to enhance efficiency and profitability that create value over the long run, still persists.
We look forward to discussing these issues with clients in 2023 and monitoring how they evolve within the banking industry over the next year. As always, Mercer Capital is available to discuss these trends as they relate to your financial institution, so feel free to call or email.
As participants and observers in transactions, the pending acquisition of Spirit Airlines, Inc. (NYSE: SAVE) by JetBlue Airways Corporation (NASDAQGS: JBLU) offers a lot of fodder for us to comment on. In this post, we look at the fairness opinions delivered by Morgan Stanley and Barclays to the Spirit board before approving the deal and then ask a key transaction-related question.
On July 28, 2022, Spirit agreed to be acquired by JetBlue for cash consideration of $33.50 per share, or $3.8 billion. Inclusive of net debt, the transaction at announcement had an enterprise value of $7.6 billion. Deal multiples included 25.5x analysts’ consensus EPS for the next 12 months and 12.3x NTM EBITDA.
The deal value excluding ticking payments that could push the total consideration to $34.15 per share, represented a 38% premium to Spirit’s closing price on July 27 of $24.30 per share; however, the announcement was not a surprise because Spirit had been in play since February 5 when the company agreed to be acquired by Frontier Group Holding, Inc. (NASDAQGS: ULCC) for 1.93 Frontier shares and $2.13 per share of cash, which was then valued at $25.83 per share.
JetBlue subsequently made an unsolicited cash offer on March 29 (disclosed on April 5) of $33.00 per share that was rejected on May 2. JetBlue then commenced a $30.00 per share tender on May 16, noting the price was less than the $33.00 per share offer because of the board’s “unwillingness to negotiate in good faith with us.”
Ultimately, the Frontier deal was terminated on July 27, and Spirit then entered into an agreement with JetBlue that provided for the following:
The proxy statement dated September 12 enumerated the reasons the Spirit board approved the merger agreement, including the fairness opinions that opined the consideration to be received by shareholders was fair from a financial point of view to the shareholders. Interestingly, both banks were retained by Spirit in late 2019 to assist in a review of strategic options that was interrupted by COVID.
A fairness opinion provides an analysis of the financial aspects of a proposed transaction from the point of view of one or more parties to the transaction, usually expressing an opinion about the consideration though sometimes the transaction itself. Ideally, the opinion is provided by an independent advisor that does not stand to receive a success fee, especially when the transaction is a close call or involves real or perceived conflicts. In the case of the JetBlue-Spirit transaction, both Spirit advisors will receive much larger contingent fees if the transaction is consummated compared to the fixed fee fairness opinions.
Let’s look at a high-level comparison of each bank’s analysis, some of which were explicitly included in the fairness analyses and some of which were presented for reference only. (A link to the proxy statement can be found here.)
Barclays and Morgan Stanley reviewed and compared specific financial and operating data relating to Spirit with selected GPCs deemed comparable to Spirit. The following table compares the selected GPCs, the then-current multiples, the relevant multiple range, and indicated range of value for Spirit as calculated by each bank.
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Both banks relied upon management’s forecast for net income and EBITDAR; however, Morgan Stanley also considered the Street’s consensus forecast for 2023. Spirit is included in the comp group to develop the applicable multiples with both banks relying upon pricing in early February immediately before the Frontier deal was announced; however, Morgan Stanley included alternate multiples based upon Spirit’s price as of July 26 and as of July 26 based upon the change in the industry ETF (JETS) from February 4. Nonetheless, the indicated values each developed based upon management’s forecast were the same.
The opinions did not include guideline transactions, presumably because there is limited M&A data involving U.S. carriers. The most recent significant acquisitions include Northwest Airlines and Continental Airlines in 2008, AirTran Holdings in 2010, and Virgin America in 2016. Nonetheless, we find it odd that a GT analysis was not addressed in the proxy.
Both banks included a DCF analysis, a valuation method that is standard in virtually all valuation analyses. The gist of the analysis reflects the discounting of unlevered cash flows over a discrete period (2H22-2026) and the projected debt-free value of the company at the end of the projection period to present values based upon the weighted average cost of capital. Net debt is then subtracted to derive the indicated equity value.
Morgan Stanley but not Barclays derived indicated ranges of value per share by discounting management’s forecasted 2025 EBITDAR and EPS to present values based upon a 12.9% equity discount rate. If Spirit paid common dividends, the present value of the dividends through 2025 presumably would have been included, too. The analysis is similar to the DCF method except that cash flows are viewed from the perspective of what is received by shareholders compared to enterprise-level cash flows in the DCF analysis. Morgan Stanley derived a range of $24 to $43 per share based upon 5.0x to 6.5x EBITDAR and $39 to $47 per share based upon 9.0x to 11.0x forecasted 2025 EPS.
Both banks reviewed the 52-week trading history for Spirit for the period ended July 26, 2022 ($16-$29 per share) and in the case of Morgan Stanley for the 52 week period ended February 4, 2022 ($20-$40 per share). Although seemingly an important consideration for the fairness analyses, neither bank’s proxy write-up discussed the deal price premium relative to Spirit’s recent trading on a stand-alone basis or compared to M&A involving publicly traded midcap companies. The proxy did note that the board considered the premium in approving the merger agreement, however.
Both banks reviewed sell-side analysts’ one-year price targets ($24-$36 per share). Morgan Stanley discounted the price targets to a present value range of $21 to $32 per share using a discount rate of 12.9%, though the analysis was presented only for reference.
Both banks opined that, from a financial point of view, the consideration to be received by the stockholders of Spirit in the proposed transaction is fair to such stockholders. As can be seen in the graph below, the $33.50 share price falls within the range of values determined by both banks and decidedly above trading-based indications of value vs management’s forecast as reflected in the DCF valuations.
Given the price and terms of the JetBlue deal, rendering the fairness opinions appears to have been a straightforward exercise; however, one deal point a board must always consider is the ability of a buyer to close. This begs the question: Can JetBlue close the deal?
The market’s answer to the question is “no” given the deep discount Spirit trades to the acquisition price net of the approval payment. The deep discount reflects the growing likelihood that the U.S. Department of Justice will sue to block the deal because it would eliminate another low-cost carrier and position JetBlue-Spirit as the USA’s fifth-largest airline behind American Airlines, Delta Air Lines, Southwest Airlines, and United Airlines.
Among the factors the board considered that weighed against approving the deal was the risk that regulators would block the deal. These concerns were voiced by Frontier and some investors when JetBlue made its unsolicited offer nearly a year ago, but the board approved the transaction nonetheless, perhaps figuring JetBlue offered downside payments and that Frontier would still be an option if Washington nixed the JetBlue transaction.
And for what it is worth, the terminated Frontier deal would be valued around $23 per share, with its shares trading near $11 per share as of February 21.
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Timothy R. Lee, ASA is the firm’s Managing Director of Corporate Valuation services and is a member of the firm’s board of directors. He provides litigation support services in cases involving economic damages, business valuation, dissenting shareholder rights, marital dissolution, and tax matters. Tim also provides valuation and corporate advisory services for purposes including mergers and acquisitions, employee stock ownership plans, profit sharing plans, trust & estate planning and compliance matters, corporate planning, and reorganizations.
Timothy Lee: As a “late” starter in financial services, I sought a path that would leverage years of practical experience gained from real world selling and managing in my teens and 20s. Business valuation has exposed me to a great diversity of business models and allowed me to learn from the successes and challenges of our clients.
Over the years, the core valuation discipline bridged into a multi-line financial advisory practice that places me in a position to assist clients facing both difficult and opportunistic events in the lifecycle of business ownership. For me, the bet on valuation and the fortitude of nearly 30 years of financial and industry breadth has placed me and my Mercer Capital colleagues in the enviable position of offering services with uncompromising credibility and with broad ranging experience well beyond a pure-play valuation shop.
Timothy Lee: Mercer Capital offers services across three broadly defined groupings: 1) valuation for tax, financial reporting, and other compliance and corporate finance purposes, 2) dispute resolution services ranging from unmatched buy-sell functionality to expert witness services for corporate and personal litigation matters, and 3) buy- and sell-side transaction advisory services primarily covering the middle-market M&A space and including large business concerns in numerous financial and non-financial industry verticals.
My personal practice has become more focused on the diverse needs of larger private companies whose regular needs require all three service buckets in real time and where reconciling these needs is essential for ownership success and strategic execution. Organizationally and personally, we are focused on the forest of client needs, which over time have become more business and industry centered while maintaining our legacy leadership in business valuation services.
Timothy Lee: Mercer Capital has worked diligently to parlay Chris Mercer’s longstanding success in significant litigation matters into a diverse dispute resolution practice with growing depth regarding industry coverage, legal setting, and dispute scenario. Today, we have several litigation-focused senior professionals who handle everything from business-heavy marital dissolution to corporate damages and fair value matters across the country.
Like most senior professionals at Mercer Capital, my litigation involvements are generally allied to certain industries and/or are related to certain dispute scenarios. For me, industry depth is broad ranging and particularly deep in numerous areas: construction contracting, trades, and building materials; food & beverage ranging from multi-unit franchise models to alcoholic beverage distribution; equipment dealership industries including earth-moving, agricultural, and material handling networks; manufacturing industries in metal fabrication and processing; vertically integrated agricultural concerns; real estate, hospitality, and hotels; specialty chemicals; professional practices; warehousing and merchant wholesale distribution models; transportation and logistics. I also have significant experience assisting clients in buy-sell design and dispute matters offering a functional path toward collaborative resolution.
Timothy Lee: Valuation perspective and financial market comprehension are lacking among a great many business owners, boards, and management teams. Relegating valuations to critical (often stressful) events as opposed to maintaining a programmatic discipline is very much like the saying: failing to prepare is preparing to fail. Self-serving as it may sound, I see basic business valuation as an elemental and regular need of business owners.
Businesses have employees dedicated to daily cash management, inventory control, and capital investment; but owners and boards rarely seek the all-important measurement of business value. Harsh as it sounds – that is preparation to fail and an abdication of wealth accountability. Understanding business value and how it changes in response to industry, market, and organic forces is what we help business owners understand. That is the essence of the service we provide.
Timothy Lee: Well, if I am limited to just one thing, I’d have to say the excitement is one of living up to the incredible trust and responsibility of informing clients with meaningful and actionable financial information. The derivatives (now I’m cheating) of that one thing are the countless benefits I get from interacting with clients and colleagues to do meaningful work.
We recall discussions in early 2022 with clients regarding their outlook for 2022 – three 25 basis point Fed rate increases, a “more normal” operating environment following the pandemic afflicted 2020 and 2021, and stable credit quality. The latter of those three items held true, but 2022 was anything but normal. Instead of three 25 basis point rate increases, the Fed delivered seven totaling 425 basis points. The bull market was routed for both equities and, most exceptionally, bonds.
Given this backdrop, publicly-traded banks did comparatively well. The median stock price change among the 343 banks and thrifts traded on the NASDAQ and NYSE was negative 9% in 2022, relative to negative 19% for the S&P 500 and negative 33% for the NASDAQ. Further, there was more dispersion in performance during 2022.
In 2020, only 13% of publicly-traded banks reported a rising stock price during the year, whereas in 2021 only 5% of banks reported a falling stock price from year-end 2020 to 2021. That is, banks generally moved in tandem—down in 2020 and up in 2021. While not evenly balanced, 30% of banks reported a positive year-over-year stock price change in 2022 (see Figure 1). We believe this positive performance for quite a few banks in 2022 was masked by the downbeat market sentiment and warrants further investigation.
Figure 2 distinguishes shares price changes in 2022 by asset size range. The largest banks, with assets exceeding $100 billion, performed the worst in 2022, with no banks reporting share price appreciation and a median stock price decline of 22%. Smaller banks performed better, led by banks with assets between $1 and $5 billion. This stratum reported a median share price decline of only 5%, with 38% of the banks experiencing positive share price appreciation in 2022.
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While market performance remains a function of the market’s ever evolving view of a particular bank’s earning power, growth outlook, and risk attributes, we explore in this article some of the factors influencing the better and weaker performing banks in 2022.
One of the best predictors of share price appreciation in 2022 was, in fact, performance from year-end 2019 to year-end 2021. As indicated in Figure 3, banks with the strongest price appreciation during 2020 and 2021 performed the worst in 2022, while those banks that most lagged the market in 2020 and 2021 outperformed in 2022.
Some of the market leaders in 2020 and 2021 crashed out of favor in 2022, such as those embracing crypto or positioning themselves as technology leaders rather than stodgy, traditional banks. Figure 4 presents the ten banks with the largest negative returns in 2022.
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The most common question we received over the last twelve months was, “what is the effect of the unrealized securities portfolio loss on share value?” While there are possibly extenuating circumstances for some banks (see, e.g., Silvergate Capital Corp. in Figure 4), our general guidance is that the market emphasizes forward-looking earning power, not the magnitude of the unrealized loss.
Figure 5 correlates stock performance in 2022 with the magnitude of the unrealized securities portfolio loss.1 For example, banks in the first quartile had a median unrealized loss of 5% of equity.2 These banks experienced a median stock price change of negative 6%. Meanwhile, banks with the largest unrealized losses—ranging from 29% to 111% of tangible equity—reported a median stock price change of negative 5%. A more robust statistical analysis indicates a similar result; that is, virtually no relationship between the size of a bank’s unrealized securities portfolio loss and market performance in 2022.
Our view is that the unrealized loss on securities should be evaluated in the context of the entire balance sheet. We would be more concerned, from a valuation standpoint, when a large unrealized loss is coupled with a heavier exposure to fixed rate loans, particularly if the bank is facing pressure on deposit rates.
As we found out in 2022, some core deposits are more core than others. One of the strongest determinants of stock price performance in 2022 was the change in the cost of funds. We evaluated the change in the cost of funds from the first through the third quarters of 2022.3 As indicated in Figure 6, banks in the first quartile reported a median increase in the cost of funds of two basis points, whereas banks in the fourth quartile reported a median increase of 48 basis points. Further, banks in the first quartile reported a median stock price change of positive 5% in 2022, versus negative 16% for the fourth quartile banks.
An analysis of net interest margin expansion between the first and third quarters of 2022 shows a similar result. Banks in the first quartile reported a median change in NIM of six basis points and a stock price change of negative 18%, while banks in the quartile with the most NIM expansion—82 basis points for the median fourth quartile bank—eked out a 1% positive share price appreciation.
The preceding analysis masks the market’s concern for banks with tightening NIMs, however. Among the 205 banks in our analysis, eighteen reported NIM compression between the first and third quarters of 2022. These banks underperformed, with sixteen of the eighteen reporting lower stock prices in 2022 and a median stock price decline of 21%. This indicates the market’s sensitivity to NIM compression, which will be an issue for more banks in 2023 as rising deposit rates bite.
From publicly-available disclosures, it is difficult to discern the sensitivity of a bank’s assets, including both loans and securities, to rising rates. In the recent zero rate environment, pressure existed to invest in anything but short-term liquid assets. Therefore, we evaluated whether balance sheet composition could explain market performance in 2022. We could find no discernable relationship between loan/deposit ratios and market performance in 2022. However, while the evidence is somewhat weak, banks with the largest exposures to short-term liquid assets performed better in 2022.4
Figure 8 shows short-term liquid assets as a percentage of total assets. Most banks operate with short-term liquid assets in a relatively tight range (under 5% of total assets); thus, limited correlation is evident between exposure to short-term liquid assets and performance. However, a more positive relationship begins to emerge in the tail of the distribution. Banks in the fourth quartile reported liquid assets of 9.9% and a positive 1% stock price change. Narrowing the fourth quartile banks to those with liquid assets exceeding 10% or 15% of total assets results in stronger share price changes of positive 9% and 16%, respectively.
As in 2022, no doubt some newfound concerns will emerge in 2023 to drive bank stock performance. We suspect that funding cost pressure will remain an overarching concern in 2023, with true core deposits proving their value in a way not evident for years. Loan repricing will be interesting to watch. With many Prime, LIBOR, and SOFR-based floating rate loans having already repriced, further expansion in asset yields will depend on the contractual repricing periods for existing adjustable rate loans and, for newly originated loans, the “rate beta” between origination rates and broad market rates. After a long period of near nil credit losses, it would not be surprising to see some upward pressure on credit losses, although this seems likely to remain episodic in 2023. Some banks with heavier exposure to consumer loans underperformed in 2022, and it will be interesting to watch if weaknesses emerge in any segments of banks’ commercial loan portfolios in 2023.
This piece is designed to assist family law attorneys and their clients better understand tax returns because knowing how to navigate tax returns can be very useful in divorce proceedings. The information contained in tax returns can provide support for marital assets and liabilities, sources of income and potential further analyses. Reviewing multiple years of tax returns and accompanying supplemental schedules may provide helpful information on trends and/or changes and could indicate the need for potential forensic investigations.
This information originally appeared in Mercer Capital’s Family Law Valuation and Forensics Insights newsletter, a monthly publication distributed by email as well as located on our website. While we do not provide tax advice, Mercer Capital is a national business valuation and advisory firm and we provide expertise in the areas of financial, valuation, and forensic services.
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To celebrate a new year and everything that comes with new beginnings, the Mercer Capital Litigation Support Services Team has decided to start the year with a blog emphasizing the importance of the beginning of a family law engagement, defining the assignment.
In an engagement that requires a business valuation, the first step that attorneys and valuation experts should take is to define the assignment. This process involves the following:
While defining the assignment, the Standard of Value is another important consideration. Some simple questions that can help determine the standard of value include: Will the business continue to operate as a going concern or is a liquidation value more appropriate? Is “fair market value” or “fair value” required by the letter of the law for that specific engagement?
There are four standards of value that should be considered when defining a valuation assignment:
Each of these four business valuation standards may result in a different number to represent the value of the business, depending on the circumstances. Selecting the appropriate Standard of Value is crucial, and an experienced business valuation professional should be well-versed in selecting the standard of value that is most appropriate for the subject business interest being valued.
Business appraisers also refer to different kinds of values for businesses and business interests in terms of “levels of value.” As we noted in the Standards of Value section of this blog, the Fair Market Value standard of value opens the door for valuation discounts or premiums to be applied, which means that business appraisers may need to determine the appropriate Level of Value. See the chart below for the different Levels of Value that can be assigned to a valuation assignment:
To provide some examples, if the subject interest in a valuation assignment is a non-controlling minority investor, then the Nonmarketable Minority Value would likely be most appropriate. If the subject interest is a controlling owner, then the Financial Control Value could be considered. An experienced valuation expert should be able to help determine the appropriate level of value for an engagement and should also be able to quantify any Minority Interest Discount or Discount for Lack of Marketability that is deemed necessary in that engagement. Check out this blog post by Mercer Capital for a more in-depth look at the Levels of Value.
Defining the assignment in a valuation engagement can seem like a tall task but asking the right questions and having the right discussions with the right valuation expert at the beginning of an engagement can assist the process. You can think of the assignment definition process as building a road map for the valuation. Mercer Capital has extensive experience with a variety of valuation matters, including industry-expertise and complex scopes.
At this time last year, we thought bank M&A would be described as a second year of “gaining altitude” after 2020 was spent on the tarmac following the short, but deep recession in the spring of 2020. Our one caveat was that bank stocks would have to avoid a bear market following a strong performance in 2021 because bear markets are not conducive to bank M&A.
The caveat was correct. Bear markets developed in both bank stocks and fixed income that included the most deeply inverted U.S. Treasury curve since the early 1980s. Among the data points:
The outlook for deal making in 2023 is challenged by significant interest rate marks (i.e., unrealized losses in fixed-rate assets), credit marks given a potential recession, soft real estate values, and the bear market for bank stocks that has depressed public market multiples. For larger deals, an additional headwind is the significant amount of time required to obtain regulatory approval.
However, core deposits are more attractive for acquirers than in a typical year given rising loan-to-deposit ratios, the high cost of wholesale borrowings and an inability to sell bonds to generate liquidity given sizable unrealized losses. A rebound in bank stocks and even a modest rally in the bond market that lessens interest rate marks could be the catalysts for an acceleration of activity in 2023 provided any recession is shallow.
As of December 28, 2022, there have been 167 announced bank and thrift deals compared to 216 in 2021 and 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.
As a percentage of charters, acquisition activity in 2022 accounted for 3.5% 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 4,746 bank and thrift charters compared to 4,839 as of year-end 2021 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.
Also notable was the lack of many large deals. Toronto-Dominion’s (NYSE: TD) pending $13.7 billion cash acquisition of First Horizon (NYSE: FHN) represents 61% of the $23 billion of announced acquisitions this year compared to $78 billion in 2021 when divestitures of U.S. operations by MUFG and BNP and several larger transactions inflated the aggregate value.
Pricing—as measured by the average price/tangible book value (P/TBV) multiple—was unchanged compared to 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.
The median P/TBV multiple was 154% in 2022. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 134% in 2020 due to the impact of the short but deep recession on economic activity and markets.
The median P/E in 2022 eased slightly to 14.6x from 15.3x in 2021; however, buyers focus on pro forma earnings with fully phased-in expense saves that often are on the order of 7x to 8x unless there are unusual circumstances. Accretion in EPS is required by buyers to offset day one dilution to TBVPS and to recoup the increase in TBVPS that would be realized on a stand-alone basis as investors expect TBVPS payback periods not to exceed three years.
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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 2000 with the average daily public market multiple each year for the SNL Small Cap Bank Index.1 Among the takeaways are the following:
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Investors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to public market 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.
As shown in Figure 4, the average five-day premium for transactions announced in 2022 that exceeded $100 million in which the buyer and usually the seller were publicly traded was about 20%, a level that is comparable to recent years other than 2020. For buyers, the average reduction in price compared to five days prior to announcement was 2.5%. There are exceptions, of course, when investors question the pricing (actually, the exchange ratio), day one dilution to TBVPS and earn-back period. For instance, Provident Financial (NASDAQ: PFS) saw its shares drop 12.5% after it announced it would acquire Lakeland Bancorp (NASDAQ: LBAI) for $1.3 billion on September 27, 2022.
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 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 2023 assess a potential strategic transaction.
For this quarterly update, we bring together a couple of strands of our medtech and device industry practice. First, as long-term observers, public market developments in 2022 were interesting and perhaps marked an inflection point for the short to medium term. Second, in October, we attended a medtech industry conference, where we were able to gather a rich set of perspectives. The implications for some of the larger companies in the space are probably clear-cut. The downstream reverberations to private, development stage companies may be less straightforward. Nevertheless, since development stage companies are typically constrained by currently available funds and continually contemplating the next funding round, these developments are of critical importance.
A tumultuous year in the public markets is coming to a close. By the end of the third quarter 2022, the S&P 500 was down nearly 25%, marking a near-bottom for the year. The broader medtech and devices industry largely followed suit. On the brighter side, established large, diversified companies, while lagging their own previous benchmarks, outperformed the broader market. As a group, some biotech and life sciences companies (see next section) also seemed to fare relatively well. A closer look reveals that within the group some of the larger companies with more diversified revenue bases and, perhaps more importantly, profitable operations performed much better than smaller companies promising higher growth but deferred profits.
Current profitability also appeared to differentiate better stock price performers among the medical device and healthcare technology companies. At the same time, negative sentiment was more apparent for wide swathes of these two groups compared to the broader industry. It is obvious in hindsight but over the course of 2022, as interest rates rose and remained high, markets seemed to prefer existing earnings and nearer-term cash flows over future (rosier) prospects.
The shift towards more caution also manifested in other measures of market sentiment and activity. Wholesale downward revisions of earnings (growth) estimates have not occurred so far (this may yet come to pass), so much of the price decline reflects compressing valuation multiples. The pace of M&A transactions, which had gone from strength to strength during 2020 and 2021 despite myriad disruptions and distractions, decelerated significantly in 2022. By our measure, total transactions volume in the industry through the first three quarters of 2022 was roughly equal to that of just the fourth quarter of 2021. The number of IPOs also slowed to a trickle.
No industry is an island but as we and others have pointed out, several long-term trends, demographic and otherwise, suggest a favorable overall outlook for the medtech and device space. Even against the seemingly dour recent market backdrop, a multitude of attendees at the medtech conference agreed on the relative merits of the industry compared to the broader economy and market. We work with a number of development stage medtech and device companies over the course of a typical year. From that perspective, we find the long-term trends interesting because of the structural emphasis on continual innovation that improve outcomes for patients and clinicians.
A defining feature of medtech innovation funding is that it occurs over multiple tranches as the technologies and companies achieve various developmental milestones. In this context, some observations for development stage companies:
An obvious first order effect of the recent public market developments over the past year is that development stage companies should expect generally lower valuations for funding rounds (at least) over the next couple of years.
Lackluster exit activity, via either M&A or IPO, delays and/or reduces deployable capital for venture capital funds, which will make them more cautious in considering investment decisions.
The sentiment shift towards more caution is shared by all investors, although the degrees will differ. Accordingly, in addition to valuation compression, some types of companies (for example, those at the pre-clinical stage) will find fundraising to be extremely difficult.
As a corollary, investors are likely to prize clean clinical data. Companies focused on demonstrating good clinical outcomes will be better prepared for future funding rounds.
Similarly, companies that can stretch their existing funds until they can achieve a good (clinical) milestone will be better rewarded in the next funding round.
Commercial traction after hurdling regulatory approval remains an important structural consideration, especially for the non-corporate investors.
Beyond the near-term market dynamics, a key conference takeaway for us was that the medtech funding eco-system is deep and diverse. We met and heard from traditional venture capital investors, corporate investors, and folks who operate in the continuum between them. The goals for the various investors differ to some degree, with some focused on financial attributes while others (like corporate VCs) include strategic considerations in the mix. Investors with broader goals and considerations are, to an extent, less sensitive to the prevailing market conditions and can afford to take a longer-term view. Even among these investors, financial terms and preferred deal structures vary considerably.
For development stage companies contemplating fundraising efforts, a deep and diverse investor eco-system can provide plenty of optionality. In keeping with a recurring theme of this update, a note of caution – evaluating a potential funding round requires both an examination of the financial terms and an understanding of the structural features and their longer-term implications.
Mercer Capital has broad experience in providing valuation services to medtech and device start-ups, larger public and private companies, and private equity and venture capital funds involved in the sector. Please contact us to discuss how we may be of help.
In August 2022, the SEC adopted final rules implementing the Pay Versus Performance Disclosure required by Section 953(a) of the Dodd-Frank Act. These rules go into effect for the 2023 proxy season and introduce significant new valuation requirements related to equity-based compensation paid to company executives. What does this mean, and how does it apply to you? What are the requirements, and why might there be significant valuation challenges involved? We discuss all that and more below.
Advance planning and processes will be needed to establish the scope and complexity of complying with the new rules, including identifying how many equity-based awards will require updated valuations to measure the period-to-period changes.
The new disclosures were mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act and were originally proposed by the SEC in 2015. These rules will add a new item 402(v) to Regulation S-K and are intended to provide investors with more transparent, readily comparable, and understandable disclosure of a registrant’s executive compensation. The new provisions apply to all reporting companies other than (i) foreign private issuers, (ii) registered investment companies, and (iii) emerging growth companies.
The rules apply to any proxy and information statement where shareholders are voting on directors or executive compensation that is filed in respect of a fiscal year ending on or after December 16, 2022. As such, the vast majority of registrants will be required to include related disclosure for their 2023 proxy statements, though there are relaxed requirements for smaller reporting companies.
The new rules require registrants to describe the relationship between the Executive Compensation Actually Paid (“CAP”) and the financial performance of the registrant over the time horizon of the disclosure. Additional items include disclosure of the cumulative Total Shareholder Return (“TSR”) of the registrant, the TSR of the registrant’s peer group, the registrant’s net income, and a company-selected measure chosen by the registrant as a measure of financial performance. These items are to be disclosed in tabular form (based on an example included in the final rule), which is replicated below.
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The table includes the following components:
The remainder of this article focuses on the two shaded columns (c) and (e) which address Compensation Actually Paid and the valuation inputs that support these disclosures.
For each fiscal year, registrants are required to adjust the total compensation reported in Columns (b) and (d) for pension and equity awards that are calculated in accordance with US GAAP. The following table describes these adjustments in detail.
The pension-related adjustments should be calculated using the principles in ASC 715, Compensation – Retirement Benefits. The equity-based compensation adjustments will require registrants to disclose the fair value of equity awards in the year granted and report changes in the fair value of the awards until they vest. This means that it will be necessary to measure the year-end fair value of all outstanding and unvested equity awards for the PEO and other NEOs under a methodology consistent with what the registrant uses in its financial statements. For most registrants, this will be ASC 718, Compensation – Stock Compensation.
Appropriate footnote disclosure may also be required to identify the amount of each adjustment and any valuation assumptions that materially differ from those disclosed at the time of the equity grant.
The procedures used to calculate fair value will vary depending on the type of equity award.
Market condition awards come in many different flavors. Three of the most common types of plans include:
Each of the above plans has inputs and assumptions that drive the Monte Carlo simulation. When performing a subsequent year-end or vesting date fair value analysis, each of the grant-date assumptions will need to be reevaluated. For example, for a relative TSR plan with a three-year term, the subsequent year-end valuations will necessarily have shorter terms (2-year and 1-year), which will require new inputs for volatility and correlation factors. Shorter terms may make the use of option-implied volatility more relevant if sufficient market data is available.
For relative TSR plans that reference a group of companies or an index, some of the peers may have been acquired or merged in the subsequent periods. The plan documentation will often describe the steps to be taken when the composition of the peer group changes or there is a change in the benchmark index. A different group (or number) of companies will affect the correlation assumption as well as the percentile calculations in a ranked plan.
Regardless of the type of plan, it is important for registrants to understand how even a relatively simple award, if granted consistently for a period of years, can lead to a large number of Monte Carlo simulations for this initial proxy season and a significant amount of disclosure complexity.
As shown in Figure 3 below, if a company has made annual PSU grants (with a market condition) for each of the last five years, then up to eight Monte Carlo valuations could be required to calculate the CAP in each period.
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In the example above, the blue boxes indicate when a valuation of prior grants would be necessary to calculate the change in fair value for each period of the CAP disclosure. For the final period of a relative TSR market condition plan, the company could use the actual market performance of its stock (and the comparative index) to calculate the expected value of the award.
While the new SEC Pay Versus Performance disclosure rules can seem daunting, they can be managed with proper planning and a systematic approach. For the CAP disclosures, registrants need to understand the details of all equity awards that have been awarded to named executive officers (how many and what type of award). The award characteristics will determine which valuation method is most appropriate and how many valuations need to be performed.
If you have questions about the valuation techniques used for the various types of equity compensation awards or would like to discuss the process, please contact a Mercer Capital professional.
The U.S. bond market is undergoing its worst bear market in decades. Barclays U.S. Aggregate Bond Market Index produced a total return of negative 14.5% through September 30, 2022 and negative 16.0% through November 8, 2022. Excluding coupon income, the year-to-date loss was 17.2% which speaks to how low coupon income is given the nominal difference between price change and total return.
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As shown in the figure below, U.S. commercial banks have suffered unrealized losses in their bond portfolios equal to roughly 10% of the cost basis of both AFS and HTM classified portfolios as of September 30, which compares to a price reduction of 15.6% in the Barclay’s index as of quarter end.
The less-worse performance by U.S. banks likely reflects less duration than the index, which has an effective duration of 6.25 years and weighted average maturity of 8.25 years. Our observation is that for the most part outsized losses among U.S. banks reflect an outsized position in municipals and/or MBS. The index composition is heavily skewed to U.S. Treasuries and U.S. Agency obligations given the heavy issuance of government backed debt the past 15 years or so.
While management and directors at most banks are unhappy with their bond portfolios, institutional investors have taken a more nuanced view of the impact of rising rates based upon the tenor of third quarter earnings calls and the reaction of most stocks upon the release of earnings. Rising rates have supported bank earnings even though fixed-rate loan and bond portfolios are slow to reprice as floating-rate loans have repriced and banks have lagged deposit rates.
Investor concern is more focused on liquidity risks. Some (or many) banks eventually may have to raise deposit rates sharply to stem outflows and/or fund loan growth because selling bonds is not a viable option given the magnitude of unrealized losses that if realized will reduce regulatory capital.
Our prior commentary on bank bond portfolios following the release of the first and second quarter Call Reports can be found here and here.
Fixed income is undergoing one of the deepest bear markets in decades this year. There has been a lot of discussion surrounding the impact of rising rates on bank bond portfolios and bank stocks as rising rates have resulted in large unrealized losses in bank bond portfolios. My colleague, Jeff Davis, provides an update to his previous commentary on the topic based on third quarter Call Report data here.
If subjected to mark-to-market accounting like the AFS securities portfolio, most bank loan portfolios would have sizable losses too given higher interest rates and wider credit spreads; however, unrealized “losses” in loan portfolios do not receive much attention because there is not an active market for most loans unlike most bonds that populate bank portfolios. Further, accounting standards do not mandate mark-to-market for loans other than those held-for-sale.
While the trend in loan portfolio fair values is harder to examine given the lack of data, the following charts provide some perspective based on a survey of periodic loan portfolio valuations by Mercer Capital. To properly evaluate a subject loan portfolio, the portfolio should be evaluated on its own merits, but markets do provide perspective on where the cycle is and how this compares to historical levels.
Fair value is guided by ASC 820 and defines value as the price received/paid by market participants in orderly transactions. It is a process that involves a number of assumptions about market conditions, loan portfolio segment cash flows inclusive of assumptions related to expected prepayments and expected credit losses, appropriate discount rates, and the like.
The fair value mark on a subject loan portfolio includes two components – an interest rate mark and a credit mark. The interest rate mark is driven by the difference in the weighted average discount rate and weighted average interest rate of the subject portfolio. The discount rate that is applied to a subject loan should reflect a rate consistent with the expectations of market participants for cash flows with similar risk characteristics. The credit mark captures the risk that the borrower will default on payments and not all contractual cash flows will be collected.
Since the end of 2021, rising market interest rates have been the predominant factor driving the change (i.e., reduction) in loan portfolio fair values. As shown in Figure 1, the median interest rate mark for our data sample has fallen from a modest 0.55% premium at December 31, 2021 to a 5.65% discount as of September 30, 2022. While bank earnings benefit from a higher rate environment and net interest margin expansion, it takes time for the increase in market rates to be passed on to customers via higher loan rates and for lower, fixed-rate loans to roll out of the portfolio. In talking with Mercer Capital clients and in our loan portfolio valuation practice, so far it seems that banks have been unable to fully pass on the increase in rates to loan customers.
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The shift in the valuation adjustment attributable to interest rates reflects an increase in market interest rates. Figure 2 depicts the LIBOR forward curve at December 31, 2021, March 31, 2022, June 30, 2022, and September 30, 2022. Relative to December 31, 2021, forward LIBOR rates have increased 66 bps to 394 bps on average with the largest increases occurring for periods ranging from 1 to 12 months following the valuation date.
Figure 3 depicts the trend in the credit mark for our data sample relative to credit spreads. Credit spreads provide perspective on a number of factors, including where the credit cycle has been and where we may be headed.
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Over the period shown in Figure 3, credit marks peaked at the start of the pandemic given the uncertainty and expectation of higher losses on loan portfolios. Credit marks trended down from the March 31, 2020 peak through the first quarter of 2022, as did banks’ loan loss provisions, as credit quality remained stable. While credit quality continues to remain strong, both credit spreads and credit marks have ticked up in 2022 with the weakening economic outlook and concerns that the Federal Reserve’s tightening interest rate policy may trigger a sharper downturn in economic activity.
Mercer Capital has extensive experience in valuing loan portfolios and other financial assets and liabilities including depositor intangible assets, time deposits, and trust preferred securities. Please contact us if we can be of assistance.
In-person conferences are back in 2022 and so are we. Our professionals have been speaking at and attending numerous conferences, so we thought it a good idea to reflect on a few of these conferences and share selected PowerPoint decks with you. Why? Because there are valuable materials on valuation, forensic and financial topics included in these PowerPoint decks. If your organization needs a speaker at your next conference or meeting, feel free to contact us.
We hope you have enjoyed our content in 2022 and we look forward to connecting further in 2023!
In this presentation, we ask and answer the questions “what is the purpose of a business valuation?”, “when and why a valuation is needed?” and explore what to look for in a valuation expert. In addition, this presentation provides an overview of valuation approaches and common valuation discounts. Active vs. passive appreciation and personal vs. enterprise goodwill are also presented. If you need a solid valuation overview, download the deck.
Is valuation an art or a science? This presentation begins with an overview of valuation theory. In addition, we include common flaws in valuations, provides an example of double/triple counting, and includes a valuation report checklist. For more, download the powerpoint deck.
Particularly when the marital estate includes a business asset, subject to a valuation, the topic of double counting must be considered. Is the same income stream which is creating a valued asset on the marital balance sheet also being used for income determination for support? Or, has compensation and business earnings properly been allocated to the asset and to the income? Further, what if there is a carve out to personal goodwill – how, if at all, does this impact the asset division as well as the income basis for support? We address these questions in this presentation.
What are the nuances and critical issues of valuation, forensic, and other analyses for marital dissolution? In this presentation, we delve into specific issues that must be considered since they are unique to marital dissolution as well as state statute and precedent. Specifically, we touch on if a marital asset ever become a separate asset or vice-versa, personal vs. enterprise goodwill, valuation adjustments in marital dissolution engagements, double-dipping, asset tracing, and how to construct a lifestyle (pay and need) analysis.
Chris Mercer is one of the founding fathers of business valuation. Given his place in the profession, he is one of the few qualified to opine to the future of the business valuation profession. In this presentation, he begins by discussing the profession’s current realities and then ventures into what the future might hold about the profession, valuation theory, and how to reach the market.
In this presentation, our Karolina Calhoun along with Kevin Segler from Koons Fuller, covered all things related-party in divorce valuation, including entity structure issues, multi-layering with discounts, and tracing marital vs. separate asset ownership with complex multi-entity ownerships. Karolina and Kevin also discussed related parties in the business and said impact on ownership, valuation, and division – including the consideration of classes of stock in division, such as GP vs. LP or voting vs. non-voting.
David Harkins joined Karen Shapiro of Stein Sperling and Michele Laws of Turning Point Financial Group on a panel moderated by Cheryl Panther of Panther Financial Planning, to discuss the nuances of a case study presented to members of the ADFP. The case had numerous potential pitfalls with considerations for attorneys and divorce financial planners alike. Topics included business valuation, fraud, forensics, separate vs marital, etc. The crowd had numerous thought-provoking questions which led to an enlightening dialogue for all involved.
Karolina Calhoun and Audra Moncur of Wipfli, LLP tackled the questions: what is goodwill?; what is personal vs. enterprise goodwill?; and why is personal vs. enterprise goodwill important in valuations for divorce or transactions? They also presented an illustration of goodwill in transactions and presented case precedent for goodwill in divorce along with methods and considerations for determination allocation to personal and enterprise goodwill.
As we assist with complex financial and valuation issues on many Florida matters, this year we decided to sponsor and attend the AAML Florida Chapter Annual Institute. We enjoyed meeting and seeing familiar faces, and also appreciated conversations about complex valuation and financial issues. Mercer Capital’s Litigation Team looks forward to attending in future years!
Attending the Conference was:
Karolina Calhoun, CPA, ABV, CFF
November 10, 2022 | Chicago, Illinois
We were honored to be a Diamond Sponsor of the AAML Foundation Lifetime Members Luncheon, supporting the Foundation’s mission to assist families and children. Chris Mercer, Karolina Calhoun, and Scott Womack are members of the Forensic & Business Valuation Division of the AAML Foundation.
Attending the Luncheon were:
Scott A. Womack, ASA, MAFF
Karolina Calhoun, CPA, ABV, CFF
David W. R. Harkins, CFA, ABV
The AAML Florida Chapter
The AAML Florida Chapter
2022 AICPA & CIMA Forensic & Valuation Services Conference
Pictured (L-R): Bethany Hearn (CLA), Karolina Calhoun, Natalya Abdrasilova (BDM), and Nicole Lyons (WithumSmith+Brown)
2022 AAML Foundation Lifetime Members Luncheon
Pictured (L-R): Scott Womack, Karolina Calhoun, and David Harkins
2022 AAML Foundation Lifetime Members Luncheon
Pictured (;-R): David Harkins, Bill Dameworth (Forensic Strategic Solutions), Jay Fishman (Financial Research Associates), Karolina Calhoun, and Scott Womack
2022 AAML Foundation Lifetime Members Luncheon
Pictured (L-R): Paul Thiel (Northern Trust), Scott Womack, Karolina Calhoun, and David Harkins
In the year-to-date period, the KBW Nasdaq Bank Index has declined 22%, compared to a decline of 20% in the S&P 500 through October 27. Tech-forward banks have underperformed the broader banking sector, down 60% in the year-to-date period.1 This is a reversal of the trend in 2021 when tech-forward banks outperformed the broader banking sector, logging a 70% increase compared to an increase of 35% in the KBW Nasdaq Bank Index.
The tech-forward bank landscape encompasses a variety of business models but generally refers to banks utilizing technology or partnering with fintechs to deliver financial products or services. Banks that partner with fintechs are often referred to as providing “banking as a service (BaaS)”. This model involves an FDIC member bank offering bank products to fintech customers, for example, credit and debit cards or personal loans. The bank holds the deposits associated with the accounts and earns a fee based on a percentage of interchange income specified in an agreement negotiated with the fintech partner. Other models are focused on facilitating payments or providing financial services to a specific niche, such as cryptocurrency.
While the largest banks have the resources to be at the forefront of technology adoption, many smaller banks have partnered with fintechs in recent years. This is due in part to the Durbin Amendment which places limits on interchange income for banks above $10 billion in assets. In many cases, the partnerships have accelerated growth and created new income streams for the bank partners.
However, bank partners also face unique risks. As displayed in the market performance, tech-forward banks have been more volatile than traditional banks. Tech-forward bank performance has been moored, to some degree, to more volatile technology stocks, which explains the stock market outperformance in 2021 followed by a larger retrenchment in 2022. For a community bank pursuing a fintech partnership strategy, there are multiple considerations, including the following.
Many fintech partner banks have continued growing deposits this year even though most banks have seen deposit growth stagnate or turn negative in the rising rate environment. An analysis performed by S&P Global Market Intelligence showed that fintech partner banks with assets between $1 billion and $3 billion experienced deposit growth of 15% (annualized) in the first half of 2022. This compares to deposit growth of 3% for commercial banks in the same asset size range.
The deposits generated from fintech partnerships are often noninterest bearing accounts, which are especially valuable in the current rising rate environment. Bank partners earn spread income from the deposits, often holding them at the Federal Reserve due to their volatility and uncertain duration. Balances at the Fed reprice immediately with changes to the Fed’s benchmark rate.
The largest impact on the revenue side typically shows up in noninterest income. Fintech partner banks tend to have a higher ratio of noninterest income to total income relative to traditional banks as they earn a share of the interchange income. In a period of flat or declining interest rates, this diversification of revenue can help to offset net interest margin compression.
For the tech-forward banks included in Figure 1 and 2, the median ratio of noninterest income to operating revenue was 29% in the trailing twelve
While fintech partnerships can be a source of growth, bank partners should be cautious about revenue or deposit concentrations. Fintechs can grow rapidly, and, as a result, a bank partner may develop a concentration within their deposit base or revenues. Banks must periodically renegotiate contracts with fintech partners, and there is a risk that the fintech will find another bank partner or demand more favorable terms. This single event could eliminate a major source of deposits or reduce noninterest income, causing a much greater impact than the ordinary loss of traditional bank customers.
For example, Green Dot Corporation (GDOT) provides the Walmart MoneyCard product and offers other deposit account products at Walmart. Green Dot’s second quarter 10-Q discloses that approximately 21% of its operating revenue in the year-to-date period was derived from products and services sold at Walmart locations.
Regulators have stepped up their scrutiny of bank-fintech partnerships this year, focusing on risk management controls. Many banks partnering with fintechs have less than $10 billion in assets, and banks that do not currently serve fintechs may not have the necessary compliance infrastructure to effectively manage potential fintech relationships. Compliance capability must be built over a long period of time and serves as somewhat of a barrier to entry for banks desiring to pursue this strategy.
Additionally, certain fintech partnerships may present an added element of risk as the bank could be impacted by the regulatory and compliance practices of the fintechs or the evolving regulatory/compliance landscape. One recent example of this risk arose in the crypto fintech niche as the FDIC released an order to a crypto brokerage firm demanding that it cease and desist from making false and misleading statements about its deposit insurance status, while the FDIC contemporaneously issued an advisory to insured institutions regarding FDIC deposit insurance and dealings with crypto companies.2
Bank stocks’ underperformance in 2022 has largely been attributed to economic uncertainty and the potential for recession brought on by the Fed’s aggressive rate hikes. Fintech partner banks have been more volatile than the broader banking market. The business models entail certain risks, as detailed above, that do not pertain to traditional banks to the same degree. In addition, the earnings from fintech partnerships are less predictable and potentially further out in the future.
As seen in figure 3, the range of valuation multiples observed for tech forward banks is wide, with forward P/Es ranging from 6.6x to 16.1x but most trade at 7x to 9x estimated 2023 earnings. It is important to note that the banks included in the table above represent a variety of sizes, strategies and niches, so comparability may be somewhat limited. Tangible book multiples likewise exhibit a wide range, but in general are high relative to the broader banking sector. In valuing fintech partner banks, investors weigh the growth potential provided by the partnership versus the risk that earnings growth does not materialize.
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Mercer Capital has experience valuing and advising both banks and fintechs. If you are considering partnership opportunities or have questions regarding their valuation implications, please contact us.
The medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems. Medical devices range from simple tongue depressors and bandages to complex programmable pacemakers and sophisticated imaging systems. Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.
The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.
The aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices. The U.S. elderly population (persons aged 65 and above) totaled 40.3 million in 2021 (13% of the population). The U.S. Census Bureau estimates that the elderly will more than double by 2060 to 95 million, representing 23% of the total population.
The elderly account for nearly one third of total healthcare consumption in the U.S. Personal healthcare spending for the population segment was approximately $19,000 per person in 2014, five times the spending per child (about $3,700) and almost triple the spending per working-age person (about $7,200).
According to United Nations projections, the global elderly population will rise from approximately 608 million (8.2% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060. Europe’s elderly are projected to reach approximately 29% of the population by 2060, making it the world’s oldest region. While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from approximately 8% in 2015 to more than 21% of the total population by 2060.
Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $4.1 trillion in 2020 to $6.2 trillion in 2028, an average annual growth rate of 5.4%. This projected average annual growth rate is faster than the observed rate of 3.9% between 2009 and 2018. Projected growth in annual spending for Medicare (4.3%) and Medicaid (5.6%) is expected to contribute substantially to the increase in national health expenditure over the coming decade. However, growth in national healthcare spending has slowed in 2021 to 4.2%, down from 9.7% in 2020. Healthcare spending as a percentage of GDP is expected to remain virtually unchanged from 19.7% in 2020 to 19.6% by 2030.
Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures. Medicare currently provides healthcare benefits for an estimated 60 million elderly and disabled people, constituting approximately 15% of the federal budget in 2018 and is expected to rise to 18% by 2028. Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2020. Medicare also accounts for 25% of hospital spending, 30% of retail prescription drugs sales, and 23% of physician services.
Due to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $776 billion in 2020 and are expected to reach $1.5 trillion by 2030.
The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs. While political debate centered around altering the ACA has been a continuous fixture in American politics since its passing, it is unlikely that material reform to the ACA occurs in the near future under the Biden Administration. Total Medicare spending is projected to grow at 5.6% annually between 2025 and 2030, compared to year over year growth of 11.3% in 2021 and 3.5% in 2020.
The primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients). In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices. Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used). Accordingly, medical device purchasing decisions tend to be largely disconnected from price.
Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs. Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices. Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance.
The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency. In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively. A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 35.8% of payments were tied to Category 3 and 4 APMs in 2018, compared to 32.8% in 2017.
In 2020, CMS released guidance for states on how to advance value-based care across their healthcare systems, emphasizing Medicaid populations, and to share pathways for adoption of such approaches. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.
The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face similar increasing healthcare costs. A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices. Industry participants are required to report manufacturing costs, and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil. Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.
Historically, much of the growth of medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients. Successful product development usually requires significant R&D outlays and a measure of luck. If viable, new devices can elevate average selling prices, market penetration, and market share.
Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments. First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period. Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.
In the U.S., the FDA generally oversees the implementation of the second set of regulations. Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the US without prior authorization. For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.
The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S. The 510(k) clearance process may occasionally require clinical data and generally takes between 90 days and one year for completion. In November 2018, the FDA announced plans to change elements of the 510(k) clearance process. Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 10 years. In early 2019, the FDA announced an alternative 510(k) program to allow medical devices an easier approval process for manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria. The plans materialized as the Abbreviated 510(k) Program later in the year.
The premarket approval (“PMA”) process is more stringent, time-consuming, and expensive. A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical, and manufacturing data. Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days. However, the process typically takes significantly longer and may require several years to complete.
Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval. The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017. Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022. Intended to begin in 2020, negotiations for MDUFA V were delayed due to the COVID-19 pandemic. The FDA and industry groups reached a deal for MDUFA V, slated to go into effect beginning fiscal 2023, which would generate up to $1.9 billion in fees to the agency over five years. The U.S. House of Representatives passed MDUFA V in June 2022 and the Senate is expected to follow suit by September 2022.
The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations. Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.
Medical device manufacturers face a single regulatory body across the EU. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive. Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market. This CE marking verifies that a device meets all regulatory requirements, including EU safety standards. A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.
Emerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. According to the WHO, middle income countries, such as Russia, China, Turkey, and Peru, among others, are rapidly converging towards outsized levels of spending as their incomes increase. When countries grow richer, the demand for health care increases along with people’s expectation for government financed healthcare. Middle income country share, the fastest growing economic sector, increased from 15% to 19% of global spending between 2000 and 2017. As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies. According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades.
Global medical device sales are estimated to increase 5.4% annually from 2021 to 2028, reaching nearly $658 billion according to data from Fortune Business Insights. While the Americas are projected to remain the world’s largest medical device market, the Asia Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years.
Demographic shifts underlie the long-term market opportunity for medical device manufacturers. While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base. Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy. However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for
newly developed products.
The COVID-19 pandemic brought economic hardship to many. The second quarter of 2020 might go down as one of the quickest economic downturns ever recorded. However, in an effort to protect the economy, the Fed created an extremely hospitable environment for venture capital, and with the glaring supply chain issues, FreightTech became a cushy landing place for investor’s money. We have written about venture capital and FreightTech before, and it has only gotten bigger since then.
In the fourth quarter of 2020, American and European FreightTech companies raised a combined $4.1 billion from venture capitalists. This was a 21% increase quarter-over-quarter, and an increase of 49% on an annual basis. In less than twelve months, 2020 went from a dark and gloomy place for businesses to a 4th of July fireworks parade, during which $12.6 billion was poured into 555 deals in America and Europe.
The parade continued marching into 2021, with average pre-money valuations increasing by 28.4% to $30 million, and late-stage valuations increasing by 95.3% to $120 million. During these six quarters, companies like Loadsmith continued to introduce digital technologies that seek to revolutionize the brokerage industry and allow smaller brokerages and 3PLs to compete with the largest asset-based carriers.
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Self-driving trucks have also remained a point of focus. Though one of our clients maintains that self-driving trucks are “always ten years away,” they are the holy grail of FreightTech. The trucking industry has long struggled with an exodus of workers, and during COVID a large portion of its aging labor force decided to either retire due to fears of contracting the virus or moved on to less-regulated sectors. To prevent driver shortages and reduce turnover, many companies are increasing driver pay. For example, Walmart began paying their drivers $110,000 in their first year. With a fleet of 12,000 drivers, that is a very expensive endeavor, so it is no surprise that companies like TuSimple, that develop self-driving trucks, already have deals in place with ready-to-pay customers. The CEO of Werner Enterprises was quoted as saying that “We look forward to building a hybrid world where drivers continue to haul freight while autonomous trucks supplement rising demand,” showing that self-driving freight modes are no longer only a fantasy of Silicon Valley, but a future of the industry.
Despite all the positive growth between the third quarter of 2020 and the fourth quarter of 2021, the proverbial truck ran into a roadblock. As the Federal Reserve increased interest rates in its efforts to tame inflation, the first quarter of 2022 recorded decreases of 3.6% and 20.4% on a quarterly and annual basis, respectively. Startups raised only $14 billion. The number of IPO listings decreased dramatically, alongside the average valuations of FreightTech firms.
While the number of new FreightTech startups has decreased, an opportunity in the form of higher gas prices, created by the Russia-Ukraine conflict, emerged. High gas prices have made electric vehicles much more attractive both to the consumer as well as the manufacturers. Ford begun production on the first ever electric pickup truck (beating Tesla’s Batmobi…excuse me Cybertruck to the punch), and GM has promised to release its own fully electric truck in the spring of 2023. Artificial intelligence has also evolved in the FreightTech world, running robots in warehouses (which exponentially increases efficiency in over-capacity facilities) and even analyzing space and creating the mathematically most optimal way of storing items in a container for maritime shipping.
Even though the current economic outlook can appear somewhat gloomy, the transportation sector can still expect money to be available for startups, though it might be harder to get. Ryan Schreiber, Vice President of Growth and Industry for supply chain consultant Metafora stated that “One founder described it to me as saying in early ’21, if you had any revenue, you could raise and at a valuation you preferred,” compared to the current situation where “You’ve got to have a $1.5 million annual recurring revenue, and you are going to be grateful to get any valuation.” Schreiber advises FreightTech firms to not burn through their runway, and to not sell equity unless for a very good reason.
There is also good news for FreightTech entrepreneurs. A McKinsey survey revealed that 77% of supply chain executives intend on investing in supply chain visibility, among other things. That combined with the growth of the e-commerce industry, it is fair to anticipate a decent amount of investment to still be poured into the sector.
The best inventions often came from times of crisis. Nuclear fission was invented during World War II, antiseptic disinfectant was invented to stop a cholera epidemic in Germany, and in the midst of the ‘08 financial crisis, Beyonce released her hit single “Single Ladies.” So it is no surprise that the COVID-19 pandemic and the Russia-Ukraine war have sparked a new wave of innovation in the FreightTech industry. And while, perhaps, startups are no longer getting as much funding as they did in 2021, it is clear that it will remain a hot sector for as long as we face supply chain bottlenecks and restrictions.
What is normal? A question we seem to have been asking ourselves for the last few years. When it comes to making sense of the “normal” in this new day and age, we cannot offer any advice there. But we can speak on the process and importance of normalizing financial statements for a business valuation.
It is common for a business valuator to make adjustments to reported financial statements to more accurately reflect ongoing, operating cash flows of a business. These adjustments are part of the “normalization” process, with an ultimate goal of determining the earnings capacity of the business.
In litigation, when two financial experts’ valuation reports are compared, both the adjustments deemed necessary, and the dollar amount attributed to each can be a factor in the differences in valuation conclusions.
To perform an accurate business valuation, appraisers must have a clear understanding of the subject company’s true financial position and historical earnings capacity. This knowledge is vital to comprehend the company’s future income-generating ability and assess its financial performance relative to industry peers as well as its own historical performance.
Valuators obtain multiple years of financial statements (typically 5 years), most commonly the income statement and balance sheet. These statements should be analyzed thoroughly to evaluate historical operating results and the conditions under which they were achieved, accounting methods, etc. This is generally the first step in the normalization process: holistically understanding the normal operating conditions of a company in context of itself, its industry, and the grander economy, to in turn understand if any conditions are potentially present for normalizations.
Reviewing historical trends of the subject business and its peers, comparing current financial results to prior year(s), utilizing ratio and margin analysis, as well as historical common-sized statements, are all examples of procedures to examine where potential adjustments could exist. Only once the appraiser has completed the due diligence required to understand the nature of a company’s operations and the industry in which it operates, can relevant and appropriate informed adjustments be made.
While adjustments can come in many shapes and sizes, we have selected a few common and/or recent types of adjustments that we regularly encounter.
A company may receive income or incur an expense as the result of an event that is abnormal, unrelated to the company’s ordinary day-to-day operations, or unlikely to reoccur in the foreseeable future.
As we discussed earlier, a thorough understanding of what the business does operationally on a day-to-day basis can pinpoint if an expenditure can be classified as non-recurring or a regular business expense. These items are often referred to as nonrecurring, extraordinary, or unusual gains/losses often the result of events such as:
The objective of adjusting for unusual, extraordinary, and nonrecurring items is to present the financial results associated with normal operating conditions that can be indicative of future operating performance. Additionally, these adjustments enhance comparability among the subject company and guideline public companies, i.e., provide a ‘public equivalent.’
Privately held business owners may have discretion over the amount and type of compensation they receive, as well as perquisites paid for by the business such as vehicles, cell phones, travel, meals, insurance, etc. The goal is to understand the total compensation paid to management and the business owner(s) and for what roles and responsibilities.
From a business valuation perspective, we assume that a hypothetical buyer of subject company would need to pay market rates to replace subject management and/or owner(s). A review of historical salary trends for all owners, investigating potential deferral of bonus or payroll, as well as evaluating professional resources to examine the specific industry owner’s estimated compensation, is vital to determine if an adjustment is necessary.
A company may pay above or below-market rent to a related party, such as a holding company or a family member that owns the property. In this case, an appraiser may normalize rent expense to related parties by adjusting the rent expense to market rate for similar properties. By adjusting the rent to market rates, the financial statements are adjusted to be representative of a normal condition of the subject company as of the business valuation date.
In an alternative hypothetical scenario, the company may own facilities that it rents to a third party. If the company’s real estate is not related to the core operations of a business, it is a non-operating asset and should be treated as separate from the company’s operations, removed from the balance sheet, along with any loans associated on the real estate. Also, rental income and further related expenses would be removed.
Fact Pattern #1: Manufacturing company has a plant fire that destroys the factory. The company did own an insurance policy covering part of the costs to repair the plant. Any reported loss resulting from the extraordinary event, and the income recognized from the insurance payout should be normalized. Additionally, adjustments to cash may be necessary representing unusual, one-time insurance proceeds.
Fact Pattern #2: Car dealership has an investment in an unrelated company. Although the investment may provide an income stream, this income typically would not be considered to represent the company’s normal operations. As a result, the income stream could be reasonably removed, as would the asset from the book value. Following this potential methodology, this investment would be added as a non-operating asset to the estimated operating value of the subject company for an adjusted value.
Fact Pattern #3: Manufacturing company incurs significant expense to update equipment. In this example, the business cycle must also be considered. During the analysis of the industry and its corresponding business cycle, the expert finds it is common for a manufacturing company to update its productive equipment every five years. Thus, these updates could be “normal” capital maintenance or investment, and would, therefore, not need to be adjusted or excluded. Alternatively, the appraiser could ‘smooth’ out the expense, meaning removing the hit from the single year and add an average expense for the five-year period analyzed.
This is an example where the appraiser must understand the accounting used by the company – have they depreciated the full expense in Year 1? Or have they used straight-line depreciation? There are variations from company to company and this is but one of the many factors a valuator reviews during due diligence.
Normalizing financial statements is a component of the valuation process. Further, this tends to be one of the more common areas where experts may disagree.
Adjusting for significant revenue or expense items that appear to be related to the operating interests of a company requires the informed judgment of a financial expert. A competent and qualified valuation expert is necessary to the process to diligently examine the historical financial statements and further information to understand the true nature of the company’s operations.
On September 21, 2022, the Federal Reserve increased the target federal funds rate by 75 basis points, capping off a collective increase of 300 basis points since March 2022. With the expectation of additional rate increases this year, it’s a good time to evaluate recent trends in core deposit values and discuss expectations for deposit valuations in the coming months.
Mercer Capital previously published articles on core deposit trends in August 2020 during the early stages of the pandemic and again in August 2021. In those articles, we described a decreasing trend in core deposit intangible asset values. In response to the pandemic, the Fed cut rates effectively to zero, and the yield on the benchmark 10-year Treasury reached a record low. While many factors are pertinent to analyzing a deposit base, a significant driver of value is market interest rates. As shown below, we find ourselves in a very different interest rate environment today.
Using data compiled by S&P Capital IQ Pro, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through mid-September 2022. CDI values represent the value of the depository customer relationships recorded by acquirers as an intangible asset. CDI values are driven by many factors, including the “stickiness” of a customer base, the types of deposit accounts assumed, the level of noninterest income generated, and the cost of the acquired deposit base compared to alternative sources of funding. For our analysis of industry trends in CDI values, we relied on S&P Capital IQ Pro’s definition of core deposits.1
In analyzing core deposit intangible assets for individual acquisitions, however, a more detailed analysis of the deposit base would consider the relative stability of various account types. In general, CDI assets derive most of their value from lower-cost demand deposit accounts, while often significantly less (if not zero) value is ascribed to more rate-sensitive time deposits and public funds. Non-retail funding sources such as listing service or brokered deposits are excluded from core deposits when determining the value of a CDI.
Figure 2 summarizes the trend in CDI values since the start of the 2008 recession, compared with rates on 5-year FHLB advances. Over the post-recession period, CDI values have largely followed the general trend in interest rates—as alternative funding recorded by acquirers became more costly in 2017 and 2018, CDI values generally ticked up as well, relative to post-recession average levels. Throughout 2019, CDI values exhibited a declining trend in light of yield curve inversion and Fed cuts to the target federal funds rate during the back half of 2019. This trend accelerated in March 2020 when rates were effectively cut to zero.
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CDI values have showed some recovery in the past few quarters (with an average CDI value of 93 basis points year-to-date in 2022 as compared to 64 basis points for all of 2021). Despite the recent uptick, CDI values remain below the post-recession average of 1.29% in the period presented in the chart and meaningfully lower than long-term historical levels which averaged closer to 2.5% to 3.0% in the early 2000s. They are also markedly lower than one might expect, given the current cost of wholesale funding.
As shown above, reported CDI values have not increased in tandem with the recent increase in FHLB rates. The average CDI value increased just 25 basis points from September 2021 to September 2022, while the five-year FHLB advance increased a dramatic 228 basis points over the same period. In late-2018 the 5-year FHLB rate approximated the current, mid-September 2022 level, but the average CDI value at that time was 2.42% (compared to the third quarter 2022 average value of 0.75%). The CDI values in recent quarters are somewhat counterintuitive. There are likely three drivers for the relationship between recently reported CDI values and market interest rates:
Nineteen deals were announced in August and September 2022, and five of those deals provided either investor presentations or earnings calls containing CDI estimates. These CDI estimates ranged from 1.5% to 2.0%, which is more in line with the numbers we have observed in our valuation analyses. We expect CDI values to continue rising in concert with market interest rates. However, market interest rates are not the only driver of CDI value, and there are some potentially mitigating factors to CDI values in the near term.
Core deposit intangible assets are related to, but not identical to, deposit premiums paid in acquisitions. While CDI assets are an intangible asset recorded in acquisitions to capture the value of the customer relationships the deposits represent, deposit premiums paid are a function of the purchase price of an acquisition.
Deposit premiums in whole bank acquisitions are computed based on the excess of the purchase price over the target’s tangible book value, as a percentage of the core deposit base. While deposit premiums often capture the value to the acquirer of assuming the established funding source of the core deposit base (that is, the value of the deposit franchise), the purchase price also reflects factors unrelated to the deposit base, such as the quality of the acquired loan portfolio, unique synergy opportunities anticipated by the acquirer, etc. As shown in Figure 4, deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values. Deposit premiums in the range of 6% to 10% remain well below the pre-Great Recession levels when premiums for whole bank acquisitions averaged closer to 20%.
Additional factors may influence the purchase price to an extent that the calculated deposit premium doesn’t necessarily bear a strong relationship to the value of the core deposit base to the acquirer. This influence is often less relevant in branch transactions where the deposit base is the primary driver of the transaction and the relationship between the purchase price and the deposit base is more direct. Figure 5 (on the next page) presents deposit premiums paid in whole bank acquisitions as compared to premiums paid in branch transactions.
Deposit premiums paid in branch transactions have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Branch transaction deposit premiums averaged in the 3.0% to 7.5% range during 2020, up from the 2.0% to 4.0% range observed in the financial crisis. During 2021 and the first quarter of 2022, branch transaction deposit premiums averaged 2.5% to 5.25%. Unfortunately, none of the branch transactions completed in the second or third quarters of 2022 reported franchise premium data.
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Some disconnect appears to exist between the prices paid in branch transactions and the CDI values recorded in bank M&A transactions. Beyond the relatively small sample size of branch transactions, one explanation might be the excess capital that continues to accumulate in the banking industry, resulting in strong bidding activity for the M&A opportunities that arise–even in situations where the potential buyers have ample deposits.
Based on the data for acquisitions for which core deposit intangible detail was reported, a majority of banks selected a ten-year amortization term for the CDI values booked. Less than 10% of transactions for which data was available selected amortization terms longer than ten years. Amortization methods were somewhat more varied, but an accelerated amortization method was selected in approximately half of these transactions.
Transactions Completed 2008 – September 25, 2022
For more information about Mercer Capital’s core deposit valuation services, please contact a member of our Depository Institution Services Team.