In the last few weeks, I presented at two events geared towards helping community banks achieve better performance: the Moss Adams Community Banking Conference in Huntington Beach, California and the FI FinTech Unconference in Fredericksburg, Texas. The FI FinTech Unconference had a recurring visual theme of the buffalo, which struck me as an insightful image for a FinTech conference.
Much of the discussions at both conferences focused on the ability of community banks to adapt, survive, and thrive rather than thin out like the once massive North American buffalo herd. Both events had several presentations and discussions around FinTech and the need for community banks to evolve to meet customer expectations for improved digital interactions. Beyond thinking that I will miss the great views and weather I had for both trips, I came away with a few questions bankers should consider.
Larger banks are taking market share from smaller banks and have been gathering assets and deposits at a faster pace than community banks (defined as banks with less than $10 billion of assets) the last few decades. For example, banks with assets greater than $10 billion controlled around 85% of assets in mid-2018 compared to 50% in 1994. This is a significant trend illustrating how much market share community banks have ceded. Further, larger banks are producing higher ROEs, largely driven by higher levels of non-interest income (~0.90% of assets vs ~0.55%) and better operating leverage as measured by the efficiency ratio (~59% vs ~66%). The larger banks may widen their lead, too, given vast sums that are being spent on digital enhancements and other technology ventures to improve the client experience.
Most community banks are producing an ROE below 10%—an inadequate return for shareholders despite low credit costs. As a result, the critical role that a community bank fills as a lender to small business and agriculture is at risk if the board and/or shareholders decide to sell due to inadequate returns. Confronting this challenge requires the right team executing the right strategy to produce competitive returns for shareholders. FinTech solutions, rather than geographic expansion through branching and acquisitions, may be an option if FinTech products and processes can address areas where a bank falls short (e.g., wealth management).
Many community bank cost structures are wed to physical branches while customers— especially younger ones—are increasingly interacting with institutions first digitally and secondarily via a physical location. This transition is occurring at a time when core deposits are increasing in value to the industry as interest rates rise. In response, several larger banks, such as Citizens Financial, have increased their emphasis on digital delivery to drive incremental deposit growth. Additionally, as funding costs increase, some FinTech companies are being forced to consider partnerships with banks. Thus far, the digital banking push and the formal partnering of FinTech companies and banks are incremental in nature rather than reflective of a wholesale change in business models. Nonetheless, it will be interesting to see whether community banks can adapt and effectively use technology and FinTech partnerships to compete and win retail deposit relationships in a meaningful way.
Against this backdrop, I see four primary steps to developing a FinTech framework:
The things that banks can do right now to explore FinTech opportunities are:
Mercer Capital can help your bank craft a comprehensive value creation strategy that properly aligns your business, financial, and investor strategies. Given the growing importance of FinTech solutions to the banking sector, a sound value creation strategy needs to incorporate FinTech.
We provide board/management retreats to educate you about the opportunities and challenges of FinTech for your institution. We can:
We are happy to help. Contact us at 901.685.2120 to discuss your needs.
Originally published in Bank Watch, October 2018.
This presentation, originally delivered by Z. Christopher Mercer, FASA, CFA, ABAR at the Fairfax Bar Association’s Annual Conference in October 2018, discusses the intrinsic value standard of value in Virginia divorce-related valuations of closely held business assets. Additionally, this presentation also covers developing valuation multiples with credibility.
ASU 2016-01 shook up financial reporting at the beginning of the year, as companies scrambled to determine compliance with the new requirements for reporting equity investments.
The rise of corporate venture capital over recent years largely flew under the accounting radar until this update took effect, creating significant volatility for many corporate investors in their reported earnings as they were required to recognize the gains and losses from investments previously held at cost.
Now that the initial shock has worn off, CFOs may be able to rest a little easier, but they shouldn’t forget about the requirements under ASU 2016-01 entirely.
Even if the company elected the measurement alternative that allows for the investment to be reported at cost, don’t forget about the requirement for impairment testing that goes along with it. Some companies may choose to perform the initial Step Zero analysis internally before engaging a valuation firm to navigate the rest of the process, while others turn over the entire process to a valuation professional.
“An entity may elect to measure an equity security without a readily determinable fair value [and that does not qualify for the practical expedient]…at its cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.”
ASU 2016-01 Paragraph 321-10-35-2
Originally appeared in Mercer Capital’s Financial Reporting Update: Goodwill Impairment
A qualitative approach to test goodwill for impairment was introduced by the Financial Accounting Standards Board (“FASB”) when it released Accounting Standards Update 2011-08 (“ASU 2011-08”) in September 2011 as an update to goodwill impairment testing standards under Topic 350, Intangibles—Goodwill and Other. ASU 2011-08 set forth guidance for an optional qualitative assessment to be performed before the traditional quantitative two step goodwill impairment testing process. This preliminary qualitative assessment is known as “Step Zero.” The goal of Step Zero is to simplify and reduce costs of performing the traditional quantitative goodwill impairment test process.
According to ASU 2011-08, Step Zero allows entities “the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.”
Step One is required only if the qualitative assessment supports the conclusion that it is more likely than not (i.e., likelihood greater than 50%) that the fair value is less than the carrying value. Otherwise, Step One of the goodwill impairment testing process is not required. Alternatively, Step Zero can be skipped altogether, and the traditional quantitative goodwill impairment test can be performed beginning with Step One.
The standards update release by FASB outlines the individual qualitative categories of the assessment. Specific qualitative events and circumstances to be evaluated include the economy, industry, cost factors, financial performance, firm-specific events, reporting unit events, and changes in share price.
ASU 2011-08 defines industry events and circumstances as follows:
“Industry and market conditions such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers), a change in the market for an entity’s products or services, or a regulatory or political development.”
The process of evaluating an industry involves assessing each of these stated events and circumstances since the previous reporting period and determining how they affect the comparison of fair value to carrying value. By comparing current conditions to the prior period, an analysis of relative improvement or deterioration can be made concerning each industry factor and the industry as a whole.
Increasing multiples, share prices, financial metrics, and M&A activity indicate that an industry is improving and suggests that it is more likely than not that the reporting unit’s fair value is greater than its carrying value. Decreasing multiples, share prices, financial metrics, and M&A activity indicate the industry is weakening and suggests that fair value may be less than the reporting unit’s carrying value.
An analysis of the S&P 1500, an index that includes approximately 90% of the market capitalization of U.S. stocks, reveals the prevalence of impairment in different industries. For example, of the companies reporting goodwill on their balance sheets, 25% of telecommunication, 17% of consumer staples, and 14% of consumer discretionary companies recorded goodwill impairment charges in 2017.
On the other hand, the more robust performance of financial, information technology, and real estate companies is manifest in that only 4% of companies reporting goodwill in each industry recorded a goodwill impairment charge in 2017.
Further analysis indicates that companies in the energy and telecommunication industries are currently more likely to be potential impairment candidates as 20% and 38%, respectively, of companies reporting goodwill have cushions (the amount by which market value of equity exceeds book value of equity) of less than 25%. Deterioration in the operating environment of these industries may result in an increase in goodwill impairment charges. Industries with fewer impairment candidates at the moment include real estate, utilities, and industrials.
Industry considerations are particularly important to the qualitative assessment and provide valuable insight on the potential for impairment. The qualitative assessment is especially valuable in industries that are performing well as it is less likely that goodwill is impaired.
Step Zero provides the opportunity to perform a preliminary qualitative analysis to determine the necessity of performing the traditional two step goodwill impairment test and can lead to a simpler, more efficient impairment testing process.
The analysts at Mercer Capital have experience in, and follow, a diverse set of industries. We help clients assemble, evaluate, and document relevant evidence for the Step Zero impairment test. Call us today so we can help you.
Originally appeared in Mercer Capital’s Financial Reporting Update: Goodwill Impairment
Earlier this year, we considered the impact of the Tax Cuts and Jobs Act of 2017 (“TCJA”) on purchase price allocations. In this article, we turn our focus to the impact of the TCJA on goodwill impairment testing. Changes to the tax code will affect both the qualitative assessment (often referred to as Step Zero) and quantitative impairment test.
Companies preparing a qualitative assessment are required to assess “relevant events and circumstances” to evaluate whether it is more likely than not that goodwill is impaired. ASC 350 includes a list of eight such potential events and circumstances.
The same features which, on balance, have made it more likely that reporting units will garner a favorable qualitative assessment also contribute to the fair value of reporting units under the quantitative assessment.
The Tax Cuts and Jobs Act of 2017 is a material factor to be considered in both qualitative and quantitative assessments of goodwill impairment in 2018. While the provisions are not uniformly favorable to higher valuations, the balance of factors suggests that goodwill impairments will be less likely in the coming impairment cycle. To discuss how the new tax regime affects your company’s goodwill impairment more specifically, please give one of our professionals a call.
Originally appeared in Mercer Capital’s Financial Reporting Update: Goodwill Impairment
When testing the goodwill of a reporting unit for impairment, the order of operations matters. Because the units themselves may contain assets subject to impairment testing, it is important to first reflect accurate carrying values for those assets before testing the goodwill of the unit overall.
If the goodwill of the unit is tested before a write down of certain of its assets occurs, there may be increased risk of inaccurately allocating impairment between the assets and goodwill of the unit. Similarly, failing to address the order of testing could lead to the false conclusion that the goodwill of a reporting unit is impaired, when there is really only impairment of its underlying identifiable assets. These errors occur when the unit’s fair value of goodwill is compared to an inaccurately high carrying value that results from failing to adjust asset values first.
According to the AICPA Accounting & Valuation Guide: Testing Goodwill for Impairment [paragraph 2.57], the order of impairment testing should be as follows:
Financial statement preparers should not neglect the proper order of impairment testing to ensure current allocation of impairment.
Originally appeared in Mercer Capital’s Financial Reporting Update: Goodwill Impairment
A logical fallacy occurs when one makes an error in reasoning. Causal fallacies occur when a conclusion about a cause is reached without enough evidence to do so. The cum hoc (“with this”) fallacy is committed when a causal relationship is assumed because two events occur together.
When it comes to financial reporting, an example of this fallacy would be assuming that goodwill cannot be impaired unless the company’s shares are trading below book value. This is a tempting fallacy–especially as the U.S. economy is continuing a long expansion, companies are posting solid earnings, and valuations are reaching new highs. The S&P 500 increased 19% in 2017 and the Nasdaq was up 28%. In these market conditions, goodwill impairment probably does not seem like a pressing concern. After all, goodwill is considered impaired only when fair value drops below carrying value, right? While this is true, accounting standards require that goodwill be tested for impairment at the reporting unit level. Impairment relates to a reporting unit’s ability to generate cash flows. This means that a company’s goodwill can be impaired at the reporting unit level, even as its stock trades above book value.
This was the case for multinational conglomerate General Electric last year. GE had a tumultuous 2017 as the company’s CEO and CFO departed, the dividend was cut, and a corporate restructuring was announced. The salient event for the purposes of this article is a $947 million impairment loss recorded in its Power Conversion Unit during the third quarter of 2017. This unit is what became of GE’s 2011 $3.2 billion acquisition of Converteam, an electrical engineering company. According to the company’s 2017 annual report, the causes for this impairment included downturns in marine and oil and gas markets, pricing and cost pressures, and increased competition. GE’s stock felt the turmoil, falling 42% in 2017. Shares traded at $17.25 at their lowest point, implying a market capitalization of $150.5 billion. But even at this point, GE’s stock was not trading below book value ($64.3 billion at the end of 2017). GE’s market value exceeded book value of equity by $86.2 billion. So while impairment and market value/share price are related, it is not safe to assume that there is no impairment if the stock trades above book value.
Another notable example is CVS Health. The company made headlines with one of the largest mergers of the year when it announced the acquisition of insurer Aetna, Inc. for $69 billion in December 2017. A smaller, less widely reported transaction transpired in November when the company announced the sale of its RxCrossroads reporting unit to McKesson Corp. for $735 million. This unit was part of CVS’s 2015 acquisition of nursing home pharmacy Omnicare, Inc. and provided reimbursement assistance and sales operation support, among other services. In the second quarter of 2017, CVS recognized a $135 million impairment charge related to this reporting unit. As with GE, CVS never traded below book value. CVS stock declined approximately 8% in 2017 and hit a low of $66.45 on November 6. The market capitalization at this point was approximately $67.7 billion. The book value of CVS equity was $34.9 billion at September 30, 2017 and
$37.7 billion at year-end.
The above examples expose the fallacious idea that a company can avoid impairment charges simply because its stock trades above book value. That is not to say that there is no relationship between the two; an impairment charge can certainly signal the market and affect share price, or a decline in share price may foreshadow an impending impairment charge. Because goodwill must be tested for impairment at the reporting unit level, impairment may occur even when the company’s market cap exceeds book value.
Originally appeared in Mercer Capital’s Financial Reporting Update: Goodwill Impairment
The intersection of family and business generates a unique set of questions for family business directors. We’ve culled through our years of experience working with family businesses of every shape and size to identify the twelve questions that are most likely to trigger sleepless nights for directors. Those questions are:
The 12 Questions That Keep Family Business Directors Awake at Night summarizes some of our thoughts, experiences, and insights around each question and suggests possible next steps.
Perhaps more importantly, though, it is an invitation to join our ongoing conversation about the questions family business directors need to think about. That conversation continues on our blog, Family Business Director, where we explore these and other topics of interest to family business directors.
Mercer Capital provides sophisticated financial advisory services to family businesses, including:
Valuation of a business can be a complex process requiring certified business valuation and/or forensic accounting professionals. Valuations of automobile dealerships are unique even from valuation of manufacturing, service, and retail companies. Automobile dealership valuations involve the understanding of industry terminology, factory financial statements, and hybrid valuation approaches. For these reasons, it’s important to hire a business valuation expert that specializes in automobile dealership valuation and not just a generalist business valuation appraiser.
Unlike most valuations used in the corporate or M&A world, cash flow metrics such as Earnings Before Interest, Taxes, and Depreciation (“EBITDA”) are virtually meaningless in automobile dealership valuations. Instead, this industry communicates value in terms of Blue Sky value and Blue Sky multiples. What is Blue Sky value? Any intangible/goodwill value of the automobile dealership over/above the tangible book value of the hard assets is referred to as Blue Sky value. Typically, Blue Sky value is measured as a multiple of pre-tax earnings, referred to as a Blue Sky multiple. Blue Sky multiples vary by franchise/brand and fluctuate year-to-year.
Another unique aspect of automobile dealership valuations is the reported financial statements. Unlike valuations in other industries where the preferred form of financial statements might be audited/compiled or reviewed financial statements, most reputable valuations of automobile dealerships rely upon the financial statements that each dealer reports to the franchise/factory, referred to as Dealer Financial Statements. Why are Dealer Financial statements preferred? Dealer Financial statements provide much more detailed information pertaining directly to the operations of the dealership than any audited financial statement. Valuable information includes the specific operations and profitability of the various departments including, new vehicle, used vehicle, parts and service, and finance and insurance. Each department is unique and has a different impact on the overall success and profitability of the entire dealership. Automobile dealerships are required to report these financial statements to the factory on a monthly basis. However, an experienced business valuation expert knows to request the 13th month dealer financial statements. If a year only has twelve months, then what are the 13th month dealer financial statements? The 13th month dealer financials typically include the year-end tax adjustments such as adjusting the value of new/used vehicles to fair market value by reflecting current depreciation and other adjustments.
The asset-based approach is a general way of determining a value indication of a business or a business ownership interest using one or more methods based on the value of the assets net of liabilities. Asset-based valuation methods include those methods that seek to adjust the various tangible and intangible assets of an enterprise to fair market value. In automobile dealership valuations, the asset method is utilized to establish the fair market value of the tangible assets. This value is then combined with a Blue Sky “market” approach to conclude the total fair market value of the automobile dealership.
The income approach is a general way of determining a value indication of a business or business ownership interest using one or more methods that convert anticipated economic benefits into a single present amount.
The income approach can be applied in several different ways. Valuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market.
How is the income approach unique to the automobile dealership industry? First, projections are rarely produced or tracked by automobile dealers, so historical capitalization methods are mostly used. Second, most automobile dealerships are dependent on the national economy, and sometimes to a larger degree, their local economies. This is important because business appraisers need to analyze and understand the dependence of each dealership to the national and local economy which usually affects the seasonality/cyclicality of operations and profitability. Once again the automobile dealership is unique in that it can experience seasonal/cyclical fluctuation in a given year, or more importantly, it fluctuates over a longer period of more like five-to-seven years.
The market approach is a general way of determining the value indication of a business or business ownership interest by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.
Market methods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Consideration of prior transactions in interests of a valuation subject is also a method under the market approach.
In the automobile dealership industry, traditional market approaches are basically meaningless. While there are a few publicly traded companies in the industry, they are large consolidators and own numerous dealership locations of many franchises in many geographic areas. Private transactions exist, but generally not in a large enough sample size of the particular franchise to provide meaningful comparisons.
So, how does a business valuation expert utilize the market approach in the valuation of automobile dealerships? The answer is a hybrid method utilizing published Blue Sky multiples from transactions of various franchise dealership locations. Two primary national sources, Haig Partners and Kerrigan Advisors, publish Blue Sky multiples quarterly by franchise. As discussed earlier, these multiples are applied to pre-tax earnings and indicate the Blue Sky or intangible value of the dealership. When combined with the tangible value of the hard assets determined under the Asset Approach, an experienced business valuation expert is able to conclude a total value for the dealership using this hybrid approach and communicate that result as a multiple of Blue Sky that will be understood and accepted in the industry.
Normalizing adjustments adjust the balance sheet and income statement of a private company to show the financial results from normal operations of the business and reveal a “public equivalent” income stream. Some typical areas of potential normalization adjustments in the automobile dealership industry include, but are not limited, to the following.
Most dealerships report the value of their new and used vehicle inventories on a Last-In, First-Out (“LIFO”) basis. LIFO accounting allows the dealership to reduce the value of their inventories and pay fewer taxes. General valuation theory calls for inventories to be restated at First-In, First-Out (“FIFO”) basis. The FIFO adjustments affect both the balance sheet and the income statement. The inventory adjustment on the balance sheet generally raises the value of the inventory. On the income statement, the inventory adjustment affects the cost of goods sold, and ultimately, the gross profit margin.
Like all valuations, the compensation of the officer/dealer is important. Typically, a business valuation expert will review actual compensation paid and determine a replacement or market equivalent compensation level.
Most automobile dealership entities contain the operations of the dealership only and not the underlying real estate. Typically, the underlying real estate is owned by the dealer in a related entity. As such, the dealership pays rent to the related party entity. It’s important for the business valuation expert to determine if the rental rate paid is equivalent with a market rental rate. Often, this rental rate is set to create additional profitability at either the dealership entity or the real estate entity.
Most factory dealer financial statements list the dealership’s actual working capital, along with the requirements from the factory. It’s important for the business valuation expert to assess whether the dealership has adequate working capital, or perhaps an excess or deficiency.
As discussed earlier, most dealerships do not own the underlying real estate. In those cases, most dealerships still report some cost value of land or leasehold improvements on their factory dealer financial statements.
It’s important for the business valuation expert to determine who owns the real estate, and if not owned by the dealership, the value of the land and leasehold improvements needs to be adjusted, reflecting the true value of the tangible assets of the dealership.
Failure to properly assess and make this adjustment will skew the implied Blue Sky multiple on the concluded value for the dealership.
Most factory dealer financial statements have a line item on the income statement for other income items/additions. This category can be a sizeable number for a dealership depending on its sales volume and level of profitability. The business valuation expert should determine the items that comprise this category and how likely they are to continue at historical levels.
Some common items that appear in this category include factory dealer incentives on sales volume levels for vehicles, factory dealer incentives for service performance, document/preparation fees on the sale of new and used vehicles, and additional costs for financing and other services sold as a part of the vehicle transaction referred to as PACKs.
The valuation of automobile dealerships can be more complex than other valuations due to their unique financial statements, varying cost structures and profitability of departments, different terminology, and hybrid valuation methods.
Hiring a business valuation expert that specializes in this industry rather than a generalist business valuation appraiser can make all the difference in providing a reasonable valuation conclusion.
Originally published in the Value Focus: Auto Dealer Industry Newsletter, Year-End 2017.
An eSports team can make money in a variety of ways, including broadcast revenue, sponsorships, merchandise sales, and subscriptions. The sources of revenue are detailed below.
As shown in the chart above, sponsorships and advertising account for the bulk of revenue for eSports. According to Patrik Sättermon (Fnatic’s Chief Gaming Officer), “[I]t is estimated that around 95% of the money generated by our eSports teams comes directly from sponsorship deals.” The novelty of eSports has attracted many well-known sponsors; however, teams have struggled to make sponsorships a sustainable source of revenue. The relatively short life of popular games proves to be an impediment to sustained sponsorship. A game might be highly popular currently but within a year fade from public interest.
IT/Computer related sponsorships are the most common in the eSports industry as gaming equipment and accessories are prominently displayed during events. For example, HP and Intel agreed to sponsor Activision Blizzard’s Overwatch League. As part of the agreement, competitors will exclusively use HP’s OMEN gaming PCs and displays.
From a valuation perspective, consistent recurring revenue is a benefit to the value of a company. Sponsorships can provide long-term recurring revenue to an eSports teams.
eSports broadcasting on TV is still in its infancy as broadcasters look for eSports content that will appeal to their target demographics. ELEAGUE, an eSports content and live tournament brand, has a broadcasting deal with TBS that shows Street Fighter V and Counter Strike: Global Offensive (“CS:GO”) on TV. The recently formed Overwatch League (“OWL”), will be broadcast on the ESPN, Disney, and ABC family of networks. Perhaps most importantly, a broadcast TV deal does not cancel existing distribution agreements such as broadcasts on Twitch that were already in place.
While game developers and league creators are able to come to broadcast agreements, it is more difficult for eSports teams. eSports teams generally do not share in broadcast revenues as those agreements are negotiated between game developers/league creators and the broadcasting entities.
As mentioned in our eSports industry overview, consumer spending on eSports merchandise remains relatively low. eSports teams offer apparel, accessories, and gaming equipment through their team websites. From a valuation perspective, merchandise sales can be a source of supplemental income. However, merchandise sales would not have a significant impact on the valuation of an eSports team because the revenue tends to be small and non-recurring.
Prize money typically does not go to eSports teams, but rather, to individual team members who are competing. While the team does not receive the money, being successful in tournaments is a good way to generate brand awareness.
As the eSports industry expands, so have prize pools for tournaments. In August 2018 Vancouver hosted The International 8 – the eighth annual Dota 2 championship tournament. The total prize pool of $24.8 million sets the record for largest single tournament prize pool in eSports history. The International prize pool compared to other notable sports events from 2018 is presented below.
Perhaps the most interesting note from the $24.8 million prize pool for The International is that approximately 94% was crowdfunded. Every-day Dota 2 players purchased Battle Passes that offer event-exclusive features and rewards. One-fourth of each Battle Pass was added to the prize pool.
Team Liquid officially opened a new training facility March 7, 2018, in Santa Monica, California. The facility not only provides a dedicated practice area for Team Liquid members but also houses the company’s content production team, 1UP Studios. “Teams in the [U.S.] have traditionally operated out of ‘gaming houses’ where players and coaching staff for a team live and practice in a single residential home.”
The development of a dedicated training facility represents a shift away from the current model. The training facility has provided another stream of revenue for Team Liquid as they were able to sell naming rights to the facility to gaming PC brand Alienware for $4.5 million. Team Liquid’s CEO Steve Arhancet indicated the team spent over $1.5 million in building the training facility.
Generally speaking, eSports teams owning their training facilities is a recent trend. As eSports continue to grow, it is likely we will see more sales of naming rights for facilities.
The table below shows the top teams based on prize money earned as well as four other notable teams.
Luminosity Gaming ranked number 29 in terms of prize money earned among eSports teams. However, Luminosity also boasts arguably the most well-known eSports player in the world, Tyler Blevins (aka Ninja). Ninja recently revealed that he makes $500,000 per month from his more than 160,000 paid Twitch subscribers. On Twitch, streamers net $3.50 per subscription, which costs subscribers $5.00 per month. Twitch subscribers receive access to exclusive badges and ad-free streams.
Having high-profile players on the roster can increase the visibility of an eSports team and therefore lead to more followers and eventually subscribers. Subscriptions are another source of recurring revenue for a team.
As with any business, there is a cost to generating revenue. eSports teams get most of their revenue from sponsorships. In order to attract sponsors, teams must perform well at tournaments and events as well as be highly visible to consumers. Typical expenses for an eSports team include player salaries, administrative personnel salaries, player housing expenses, training facility rent or operating expense, and equipment/accessory expense.
In 2017, Jerry Jones acquired an ownership interest in Complexity Gaming. Shortly thereafter, the team was moved to The Star in Frisco. The Star happens to be the Dallas Cowboys World Headquarters. The plan is for Complexity to build a “state-of-the art operations center and global headquarters including offices, production studios, and industry leading training facilities.”
Complexity are not the only team to take advantage of common ownership with another pro sports team. In April, Team Dignitas spent time with Philadelphia 76er trainers and nutritionists in order to prepare for the Intel Extreme Masters in Poland.
There are numerous ways for an eSports team to make money. In general, the most common source of revenue is sponsorships. In order to increase sponsorships eSports teams need to perform well in the tournaments they enter. Merchandise sales, prize money, and broadcast revenue are other ways eSports teams can make money. Most eSports teams have similar expenses so profitability of a specific team usually depends on performance at the top line.
Chris Mercer, founder of Mercer Capital, states the two primary factors in the value of a business are risk and growth. eSports teams with a significant amount of recurring revenue (through sponsorships, subscriptions, etc.) are less risky than teams that have less consistent revenue sources (prize money, merchandise sales). The less risky an entity, the greater the value of that entity.
Originally published in Mercer Capital’s eSports: Business Models whitepaper.
Many family offices are built from the success of once fledgling businesses that many would now know as household names. Successor generations seek to maintain and build that wealth through prudent investments in equities, fixed income, and private equity investments in mature companies. In recent years, however, family offices have started taking notes from their entrepreneurial beginnings and are investing more in early-stage ventures. Though more often seen as LPs in traditional venture capital funds, family offices are also increasingly taking on the role of direct—and sometimes lead—venture investors.
An analysis from Crunchbase News shows the progression of family office venture investment over the last few years. While this is a small sample, it helps demonstrate the growing trend. Crunchbase also notes several prominent family venture-backed exits including Twilio, Okta, Bitly, and Workday.
We have previously analyzed the rise of corporate venture capital and its effect on the funding landscape. So what does the increase in family office investors mean for venture capital? Here are a few of the characteristics that make venture investments from family offices unique.
Despite an industry focus on the new wealth being built in the technology hubs of the U.S., abundant sources of potential investment lay in family offices all over the country. Family office investors are likely to source deals through their personal networks and professional ties with local business activity. Family offices typically take an active interest in each portfolio company and, therefore, may be likely to invest their capital in local ventures in order to better stay up-to-date with company developments. In order to maintain this involvement, a board seat may also be one of the requirements when a family office joins the cap table.
Whether they hold a share of the original family company or a subsequent business investment, family offices often have a stake in mature industry players. Because of previous work within the space or an inside vantage point from an ownership position, family offices can often lend industry insight. They may also possess a unique perspective for identifying startups that could disrupt, or partner with, the incumbents in the industry. Family office investors typically enter with strategic motivations for investing, not just the lure of large returns.
The primary focus of family offices is to preserve and grow capital for multiple generations. Family offices are, therefore, usually able to adopt a very long-term view of their overall portfolio. However, it should not be mistaken that family offices are willing to have their capital tied up forever. Like any other investment firm, family offices develop objectives and exit expectations for their various investments.
As family offices join the landscape of non-traditional investors in venture capital, startups may find that they have more options when it comes to funding. We expect to continue to see an increase in the diversity of funding sources, with cap tables boasting a combination of traditional, corporate, and family investors.
Originally published in Portfolio Valuation: Private Equity & Venture Capital Marks & Trends, Third Quarter 2018.
The focus on the EBITDA of private companies is almost ubiquitous among business appraisers. This session addresses the relationship between depreciation (and amortization) and EBIT as one measure of relative capital intensity. This relationship, “the EBITDA Depreciation Factor,” is then used to convert debt-free pre-tax (i.e., EBIT) multiples into corresponding multiples of EBITDA. Mercer presents analysis that illustrates why the pervasive rules of thumb suggest that many private companies were worth 4.0x to 6.0x EBITDA, plus or minus, have had such stickiness. He will then address the likely impact of the Tax Cut and Jobs Act on private company enterprise value multiples. This session suggests a methodology based on the Adjusted Capital Asset Pricing Model, whereby business appraisers can independently develop EBITDA enterprise value multiples under the Income Approach and includes private and public company market evidence
With the Fed positioned to hike the Fed Funds and IOER rates several more times following the September meeting, it is a good time to look at the recent trend in core deposit values. Mercer Capital previously published articles on core deposit trends in 2016 just before the November election, and again in October 2017.
Coming out of the recession, the prolonged low interest rate environment held values of core deposit intangible assets acquired in bank transactions at historical lows. Deposit premiums paid in transactions likewise remained below pre-recession levels. Following the 2016 election, amid expectations of stronger economic growth and rising rates, core deposit values and deposit premiums both saw some modest increases by the fourth quarter of 2017. Three rate hikes by the Fed in 2018 have driven rates sufficiently high that banks are now beginning to price deposits more competitively as liquidity tightens.
Using data compiled by S&P Global Market Intelligence, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through August 2018. CDI values represent the value of the depository customer relationships obtained in a bank acquisition. CDI values are driven by many factors, including the “stickiness” of a customer base, the types of deposit accounts assumed, 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 Global Market Intelligence’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, or to non-retail funding sources such as listing service or brokered deposits which are excluded from core deposits when determining the value of a CDI.
Current CDI values reported in acquisitions remain well below long-term historical average levels, averaging approximately 1.5% in the 2017-2018 timeframe compared to averages in the 2.5%-3.0% range in the early 2000s. Chart 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 has become more costly in recent years, CDI values have generally ticked up as well. However, despite remaining above post-recession average levels, CDI values in the second and third quarters of 2018 (through August) have lagged the broader trend in interest rates with some decline in CDI values observed in these quarters. In addition to a flattening yield curve, some of the easing in CDI values in recent months may result from increasing deposit costs which reduces the value of deposits relative to other funding sources. Despite Fed increases in interest rates since late 2015, deposit costs have lagged the broader trend of rising interest rates (Chart 3).
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 (Chart 4). 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 (Chart 5).
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 asset quality in the acquired loan base, unique synergy opportunities anticipated by the acquirer, etc. 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.
Deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values, rising more substantially in the post-recessionary period and continuing to improve through the year-to-date 2018 period as a result of improvement in deal values. Despite improved deal values, current deposit premiums in the range of 12% remain well below the pre-financial crisis levels when premiums for whole bank acquisitions averaged closer to 20% (Chart 6).
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 are up from the 2.0-4.0% range observed in the financial crisis, but have remained in the 4.0-5.5% range since 2017, as shown in Chart 7.
For more information about Mercer Capital’s core deposit valuation services, please contact us.
Originally published in Bank Watch, September 2018.
1 S&P Global Market Intelligence defines core deposits as, “Deposits, less time deposit accounts with balances over $100,000 and foreign deposits if available or deposits, less all deposit accounts with balances over $100,000 and foreign deposits.”
Struggling to find a page-turning read for that late summer beach escape? May we recommend the 184 pages of blissful decadence that comprise the Internal Revenue Service’s August 2018 Notice of Proposed Rulemaking (NPR) regarding the Qualified Business Income (QBI) deduction under the Tax Cuts & Jobs Act (TCJA). Like a tightly wound murder mystery, the regulations weave a complex web. Tax code sections take the place of characters, the regulation’s intricacies unspooling as the narrative continues, relationships between Tax Code sections becoming (somewhat) clearer as the story (i.e., the regulation) progresses. As the NPR continues its inexorable march, certain storylines (i.e., planning opportunities) are forestalled, yet the NPR creates a glimmer of other opportunities.1
Bank shareholders are eligible for the 20% Qualified Business Income deduction.2 Intrigued? If so, the story continues.
Before examining the NPR, several tax-related trends are evident in 2018 regulatory filings.
Despite the attention it receives, tax reform is not solely responsible for improving bank profitability in 2018. Table 1 illustrates that pre-tax return on tangible common equity (ROATCE) has expanded in 2018, consistent with widening net interest margins for many banks and constrained credit costs. Effective tax rates declined from approximately 30% in the first half of 2017 to 21% in the comparable 2018 period, allowing banks to leverage the 50 to 100 basis point pre-tax ROATCE expansion into 150 to 200 basis points of after-tax ROATCE expansion.
Table 2 indicates conversion activity from C corporation to S corporation status. Following tax reform, conversions increased significantly, as 53 banks changed their tax status in the first six months of 2018 versus nine in the prior year period. Nevertheless, this represents only a sliver of the approximately 2,000 banks taxed as S corporations. Several large S corporation banks elected to be taxed as C corporations in 2018; as a result, banks collectively holding $44 billion of assets converted in 2018, relative to only $5 billion in the prior year period.
After passage of tax reform, some observers speculated that more conversion activity from S corporation to C corporation status would occur in states with relatively high personal tax rates, due to the $10 thousand limitation on the deductibility of state and local taxes. However, this trend is not yet apparent in conversion activity, as the states experiencing the most conversion activity include jurisdictions with both higher and lower personal tax rates.
While more banks converted from S corporations to C corporations in 2018, relatively few did the reverse. As indicated in Table 3, nine banks converted from a C corporation to an S corporation in the first half of 2018, relative to 14 such conversions in the first half of 2017.
Third, tax reform may influence banks’ investment portfolio positioning. While portfolio allocations reflect many factors, Chart 1 suggests that tax reform has affected investment strategies. Municipal securities remained relatively stable throughout 2017 at 28% of total securities; however, the proportion of municipal securities dropped to 26.9% at March 31, 2018 and 26.5% at June 30, 2018. This trend is consistent with our experience, where banks are not liquidating municipal securities due to tax reform but, at the margin, may prefer taxable alternatives for new purchases.
Internal Revenue Code Section 199A provides a 20% deduction against the income reported by owners of sole proprietorships, partnerships, and S corporations. If only tax code provisions could be described in one sentence, though. The deduction may be taken against income generated by a Qualified Trade or Business (QTB). A QTB, in turn, is any business, other than a Specified Service Trade or Business (SSTB).
In addition, certain W-2 income and asset limitations exist that may limit the 20% deduction. Lastly, individuals with income below certain levels may escape the SSTB and W-2 income/asset limitations; therefore, these owners would receive the 20% deduction whereas owners with higher incomes would not. The NPR provides guidance regarding, among other items, the definitions of QTBs and SSTBs.
While banks definitely are eligible for the 20% Qualified Business Income deduction, several other items covered by the NPR may be of interest to bankers.
An entity must be a Qualified Trade or Business to receive the 20% QBI deduction. From the TCJA, however, it was unclear if a QTB must be a “Section 162 trade or business.” While the Internal Revenue Code and regulations contain various definitions of a “business,” Section 162 contains a relatively restrictive definition. Unfortunately for taxpayers, the NPR adopts the Section 162 definition.
While Section 162 has existed for many years, the regulations and case law interpreting the provision remain somewhat vague. One significant concern is that certain real estate entities will not be deemed Section 162 trades or businesses, therefore becoming ineligible for the 20% QBI deduction. For example, entities holding properties subject to triple net leases may face difficulties meeting the Section 162 requirements. From a credit standpoint, banks should be aware that tax savings expected by owners of certain real estate entities may not materialize.
Entities providing professional services generally are deemed SSTBs. The business reality, though, is that some companies provide both a tangible product (like a widget) and services that would meet the definition of an SSTB (such as educational services regarding widgets). Will a company offering some consulting services, no matter how small a share of revenues, be deemed an SSTB? Under the TCJA, it was unclear. The NPR creates a de minimis exception for companies with small amounts of service revenues, although the thresholds appear relatively low to us.
The TCJA also includes a “catch-all” provision deeming as SSTBs any businesses for which the reputation or skill of its owners or employees is a principal asset. This broad provision potentially captures a large swath of small businesses; for example, the reputation of a restaurant’s chef may result in the restaurant being deemed an SSTB. This result appears inconsistent with the TCJA’s statutory intent, and the NPR significantly limits the scope of the catch-all provision.
Commentators noted that the TCJA created a tax planning opportunity for businesses deemed SSTBs. For example, consider a law firm that owns a building in which it operates. The law firm is an SSTB and its partners ineligible for the 20% deduction. The partners could transfer the building to a new real estate holding company, which is not deemed an SSTB. Therefore, the law firm partners have shifted income – via rent payments from the law firm to the real estate holding entity – from the SSTB (the law firm) to an entity qualifying for the QBI deduction (the real estate entity).
Alas, the IRS cracked down on the “crack and pack” strategy. The NPR provides that income from a commonly-controlled entity that provides services to an SSTB is ineligible for the 20% deduction. However, the NPR may not entirely foreclose on all planning strategies. While the NPR limits the QBI deduction for commonly-controlled entities, commonality is deemed to exist if the businesses share 50% or more ownership. Therefore, the law firm may transfer its building to an entity owned equally by the law firm partners, an accounting firm’s partners, and a physician group. Since common control does not exist (i.e., neither the attorneys nor the accountants nor the physicians control more than 50% of the real estate firm’s ownership), the owners of the various services firms would be eligible for the 20% deduction on the real estate entity’s earnings. To bankers, business reorganizations triggered by the deduction limitations applicable to SSTBs may trigger lending requirements.
Like a good novel, the NPR’s “plot” is not fully resolved – some questions remain unanswered and multiple interpretations of other provisions are possible. Perhaps a sequel to the NPR is in order.
Originally published in Bank Watch, August 2018.
1As for literary criticism, Mercer Capital does not render tax or legal advice, and readers should consult with appropriate professionals regarding the application of Section 199A to any specific circumstances.
2 To expound upon our arbitrary one sentence limitation, it was relatively clear in the Tax Cuts & Jobs Act that bank shareholders are eligible for the 20% Qualified Business Income deduction, but the August 2018
NPR confirms this eligibility.
This presentation will review the factors that impact bank valuations in the private, public and M&A markets and look at how the pricing cycle has evolved the past 25 years and ask the question: how is it different this time?
Jeff K. Davis, CFA, Managing Director of Mercer Capital’s Financial Institutions Group, delivered this presentation at the 2018 Bluegrass Community Bankers Association Convention on August 27, 2018.
eSports is a rapidly expanding industry that has drawn viewers and investments alike. The introduction of streaming platforms as well as the improvement in mobile technology has allowed the industry to grow from its arcade hall beginnings in the 1970s to competitors streaming games to millions of viewers globally. In addition to being highly visible (192 million frequent viewers in 2017), the eSports industry is also lucrative ($906 million projected industry revenue in 2018).
Sprouting from humble beginnings, researchers trace the roots of the eSports industry to informal competitions held at video game arcades in the 1970s. One of the first breakthroughs came in 1980 when Atari’s National Space Invaders Championship drew 10,000 participants across the U.S. As a spectator sport, eSports first took off in South Korea, when cable networks broadcast StarCraft tournaments in the early 2000s. By 2004, StarCraft stadium events in South Korea drew 100,000 fans. In the U.S., the coming of age moment arrived in 2013 when 13,000 people flooded the Staples Center to watch the world championship final of League of Legends.
The eSports industry has experienced rapid growth in recent years. According to data from Newzoo, an eSports researcher, the global eSports audience totaled 204 million in 2014. Approximately 56% (114 million) were considered frequent viewers/enthusiasts while the remaining 44% (90 million) were categorized as occasional viewers. By 2017, the global audience grew to 335 million, a compound annual growth rate of approximately 36% and the viewership ratio was approximately the same (57% categorized as frequent viewers/enthusiasts and 43% as occasional viewers).
The number of frequent viewers grew at a compound annual growth rate (CAGR) of 36% from 2014 to 2017 and is projected to grow at a CAGR of 12.5% to 2021.
By comparison, occasional viewers grew at a CAGR of 35% from 2014 to 2017 and are projected to grow at a CAGR of 15% to 2021.
The primary delivery method for eSports is Twitch, a livestreaming video platform owned by Twitch Interactive, a subsidiary of Amazon. Twitch was introduced in 2011 and, as of February 2018, the platform has 2 million monthly broadcasters and 15 million daily active users. Twitch operates like traditional television in that the broadcasters can be “channels” that are not necessarily broadcasting 24/7, differentiating it from on-demand platforms like YouTube and Netflix.
Twitch is unique in its ad revenue model, which supports the livestreaming aspect of the platform. The top 17,000 streamers, which include professional eSports players, participate in an ad-revenue-sharing program, where the players, not Twitch, decide in real time when the ads run during their streaming sessions. For example, a top eSports player might practice on Twitch and draw thousands of viewers then when the player takes a quick break, he asks viewers to watch an ad. Despite encroaching competition from YouTube, Twitch out-streams other platforms and, given its momentum, it continues attracting sponsors to reach the growing audience.
Like traditional sports, eSports have occasional tournaments that draw big audiences. In 2017, the Intel Extreme Masters (IEM) in Katowice, Poland drew 46 million unique viewers. IEM featured three games with a total prize pool of $688,750. This viewership figure was exceeded only by the Super Bowl, which drew 111.3 million U.S. viewers in 2017.
By comparison, the 2017 baseball World Series had average viewership of 18.7 million U.S. viewers over seven games. Therefore, the average viewership of the 2017 World Series would rank 14th on a list of worldwide eSports tournaments ranked by viewership from 2012 to 2017. The 2017 NBA Finals, which featured the Golden State Warriors against the Cleveland Cavaliers for the 3rd year in a row, averaged 20.4 million U.S. viewers over a five game series. The 2017 Stanley Cup Final trailed the other three major sports with average viewership of 4.6 million in the U.S. over six games.
To underscore the growing popularity of eSports, the combined average viewership of the championship series for three of the major sports in the United States was less than the viewership for one eSports tournament (IEM) in 2017.
The large tournament viewership has attracted the attention and dollars of global brands. Coca-Cola sponsors the League of Legends World Championship, one of the largest global eSports competitions. Since 2006, Intel has sponsored Intel Extreme Masters alongside the Electronic Sports League (ESL), the longest running eSports tournament in the world. To support the growing demand, investments in eSports sponsorships will continue to rise.
Since its introduction on July 25, 2017, Fortnite has become a global phenomenon. As of June 3, 2018, Fortnite ranked as the top game watched on Twitch with 4.43 million hours watched. Counter-Strike: Global Offensive ranked second with 2.7 million hours watched (approximately 40% less hours watched than Fortnite). Other games ranking in the top 10 include: League of Legends, Dota 2, IRL, PlayerUn- known’s Battlegrounds, Overwatch, Hearthstone, Path of Exile, and FIFA 18. Releases of new games can attract viewers to those games. A challenge for Twitch broadcasters is to be up-to-date on new games so that viewers don’t get bored with older games.
Newzoo defines industry revenue as the amount generated through the sale of sponsorships, media rights, advertising, publisher fees, tickets, and merchandising. Global eSports revenues are projected to reach $906 million in 2018. North America is projected to account for approximately 38% ($345 million) of global eSports revenue in 2018. Global revenue for eSports is projected to reach $1.65 billion in 2021.
Despite the tremendous growth, eSports fan spending is lower than traditional sports. According to Newzoo, eSports enthusiasts spent an average of $3.64 per person compared to basketball fans who spent an average of $15 per person. The primary factor for this gap is that eSports content is largely available for free and spending on merchandise remains relatively small.
Originally named BlueStar Sports, Stack Sports began in April 2016 with the goal of transforming youth sports. With this goal in mind, Stack has acquired 20 companies as of July 2018 in order to provide a variety of services. Services provided by Stack Sports include league and competition management, athlete and team solutions, event solutions, brand advertiser solutions, and payment solutions. The company’s various tools include building team websites, online registration for leagues and tournaments, and software that analyzes game day video.
The accompanying chart was compiled using data from Crunchbase and shows Blue Star/ Stack acquisitions from May 2016 to February 2018.
Uinkrn is a Seattle based eSports betting startup. Founded in 2014 as a platform for eSports betting, Unikrn has since added hosting physical tournaments to its services. Mark Cuban, owner of the Dallas Mavericks is among the investors in the company.
ChallengeMe.gg is an eSports matchmaking service headquartered in Berlin, Germany. While an exact dollar amount was not disclosed, Unikrn CEO Rahul Sood said it was “a multi-million dollar acquisition.”
Headquartered in Mumbai, Nazara aims to create a full eSports system including competitive online and offline play, localized leagues, and global events. Nodwin Gaming was started in 2014 and has exclusive rights for ESL (Esports League) in India, the Intel Extreme Masters qualifiers for India, and the Electronic Sports World Cup India Qualifiers. In acquiring a majority stake in Nodwin, Nazara hopes to leverage Nodwin’s relationships to create an Indian eSports ecosystem. India’s eSports audience is still developing with only 2 million enthusiasts and an additional 2 million occasional viewers according to market researchers Frost & Sullivan and Newzoo.
Multiplay is a division of UK-based Game Digital. Multiplay provides server hosting for games such as Titanfall 2, Day Z, Rocket League, and Rust. The terms of the deal provide that Unity pay $22.7 million at the time of acquisition (November 2017) and $2.5 million in July 2019. The Multiplay division includes a digital business and an eSports and events business.
The growth of eSports has attracted the attention from high profile investors. For example, in November 2017 Jerry Jones along with John Goff acquired the eSports team Complexity. Complexity was founded in 2003 by Jason Lake and currently competes in six games: CS GO, DOTA 2, Call of Duty, Rocket League, HearthStone, and Gwent. Complexity will move facilities to The Star, which also houses the Dallas Cowboys World Headquarters in Frisco, Texas.
Magic Johnson and motivational speaker Tony Robbins partnered acquire ownership interest in Team Liquid, an eSports team based in Santa Monica, California. Another former Laker, Shaquille O’Neal is a co-owner of NRG eSports. The teams mentioned above compete with other eSports teams from around the world in various tournaments held throughout the year.
Esports is a relatively new industry with potential. Advances in streaming and mobile technology have allowed the industry to expand in recent years. Newzoo projects the global eSports audience will be approximately 557 million in 2021, a compound annual growth rate of 14.4% from 2016. In addition to a growing global audience, Newzoo projects global revenue for the eSports industry to reach $1.65 billion by 2021, a CAGR of 27.4% from 2016.
The potential growth has drawn interest from a wide range of investors as approximately 84% of 2021 global revenue is projected to be from brand investments such as media rights, advertising, and sponsorship.
Mercer Capital will continue to follow the industry and discuss the valuation issues facing the industry in future articles.
Originally published in Mercer Capital’s eSports: An Emerging Industry whitepaper.
After a slow start, M&A activity among U.S. commercial banks and thrifts picked up to the point where 2018 should look like recent years. Historically, approximately 2% to 4% of the industry is absorbed each year via M&A. Since 2014, the pace has been at or slightly above 4% as a well performing economy, readily available financing, rising stock prices for bank acquirers, and strong asset quality and earnings of would be sellers have supported activity.
There were 140 announced transactions according to S&P Global Market Intelligence through early July, which equates to 2.4% of 5,913 FDIC-insured institutions that existed as of year-end 2017. The average assets per transaction based upon YTD activity was $656 million, which is below the 28 year average of $1.1 billion.
Pricing has trended higher as measured by the average price/tangible book value (P/TBV) multiple, which increased to 172% in 2018 from 164% in 2017 and about 140% in 2014-2016 before the sector was revalued after the national election on November 8, 2016.
The median P/E based upon trailing 12 month earnings increased to 26x in 2018 from 23x in 2017 and 21x in 2016; however, the 2018 P/E based upon trailing 12 month earnings does not reflect a full year impact of the reduction in the top marginal federal tax rate to 21% from 35% that occurred on January 1. The adjusted P/E assuming the lower tax rate was in effect for 2017, too, is around 20-22x.
Lower tax rates notwithstanding, it appears that buyers are still paying roughly 9-13x pro forma earnings assuming all expense savings are fully realized, a level of pricing that we believe has existed for many years excluding periods when industry fundamentals are stressed. For example, Fifth Third Bancorp (FITB) estimates the $4.6 billion consideration to be paid to MB Financial (MBFI) shareholders equates to 16.4x consensus 2019 earnings and 9.6x assuming all expense savings realized in 2019 (which will not be the case due to the phase-in lag).
Dig deeper and, of course, there is more to the pricing story. The reduction in tax rates has had a material impact on profitability. Depending upon the index bank stocks rose 25-30% in the three months after the national election on November 8, 2016, on the expectation of what has mostly played out: a reduction in corporate tax rates, less regulation, higher short rates and faster economic growth.
The improvement in public market multiples has supported expansion of M&A multiples when the majority of the consideration consists of the buyer’s common shares. As shown in Table 1, the median P/TBV and P/E ratios for transactions announced in the 20 months since the election were 173% and 23.0x compared to 147% and 20.3x for the 20 months ended November 8, 2016. Multiple expansion is even more pronounced when only 2018 deals are considered because the YTD median P/TBV and P/E multiples are 193% and 25.4x.
Not surprisingly (to us), the median multiples for cash deals did not rise as much, increasing to 141% after the election compared to the 20 month pre-election median of 123%. Cash did not inflate in value over this period like public market bank stock valuations; hence, the only meaningful factor that drove the limited improvement in cash acquisition multiples was the increase in ROE.
In addition, cash activity slowed post-election because buyers and sellers waited to see if would be sellers’ earning power would increase from a reduction in corporate tax rates, which was not confirmed until late 2017. Transactions in which the primary form of consideration consisted of the buyer’s common shares did not have to wait for the tax issue to be resolved because buyer and seller both faced the issue.
M&A is largely a story of the consolidation of the small banks by large community and small regional banks. Two decades ago the theme was the same, but overlaid was the formation of the nationwide and multi-region franchises through mega-mergers such as NCNB/Bank of America and Wells Fargo/Norwest.
Since the financial crisis, activity has mostly been confined to small deals with deal values a fraction of the pre-crisis and especially pre-2000 amounts. Annualized year-to-date deal value is $33 billion, which compares to approximately $26 billion annually during 2015-2017. By comparison, the value of announced transactions in 1997 and 1998 were many multiples greater at $97 billion and $289 billion, respectively.
During the past five years, there only have been 10 deals that exceeded $2 billion of consideration and 22 deals in which the consideration exceeded $1 billion. As shown in Table 2, the two largest transactions involved Canadian banks, while three involved the large Ohio-based banks.
Change may be afoot, however. Fifth Third’s $4.6 billion pending acquisition of MB Financial is its first bank acquisition since 2008, and it was announced a couple of days before President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act. Among other things, the financial deregulation law moved the SIFI asset threshold from $50 billion to $100 billion and provided significant relief for institutions such as Fifth Third that fall within the $100 billion to $250 billion asset bucket.
Notably, during the past five years only CIT Group crossed the prior $50 billion SIFI threshold via acquisition, and apparently did so at the urging of regulators who wanted CIT to shore up its deposit funding.
We look for more activity among mid-sized regional banks that are near or over $50 billion of assets; however, deal activity among the very largest banks is off the table given the $250 billion asset threshold for the global SIFI designation and the 10% nationwide deposit market share cap if pierced via acquisition.
The potential fly in the ointment to the robust bank M&A environment is the flattening yield curve and the attendant underperformance of bank stocks this year. If bank stocks lag and valuations compress further, then it may be difficult for buyers to meet inflated seller expectations that rarely take into account downward moves in buyers’ share prices.
The adage banks are sold rather than bought is largely true, meaning most banks transact when the sellers are ready to do so. Sometimes that occurs after years of planning; sometimes it occurs unexpectedly when another institution makes a casual inquiry.
Mercer Capital has over three decades of experience as a financial advisor helping institutions navigate the process as buyer and seller. Even if your board has no interest in selling (or buying) we would be happy to present an overview to your board about the lay of the land as it relates to the public market, M&A market and what actions your board might consider to enhance value. Please call if we can be of assistance.
Originally published in Bank Watch, July 2018.
For years, cases such as Bertuca1 and Barnes2 governed the landscape on the issue of marketability in the valuation of marital assets in Tennessee family law cases. Specifically, Bertuca involved a company called Capital Foods which held several McDonald’s franchise locations. In the decision, Bertuca did not allow for a discount to be taken for the lack of marketability for a nonpublicly traded company and offered the following reasoning:
“…no indication…has any intention to sell…thus, the value of the business is not affected by the lack of marketability and discounting the value for nonmarketability in such a situation would be improper.”
While Barnes involved a dental practice, the Court offered a similar explanation for excluding a discount for lack of marketability:
“…inappropriate because no sale was ordered and there [was] no indication in the record that the Husband ha[d] any intention of selling his minority stock.”
Both cases focused on the lack of an actual/imminent sale rather than the lack of marketability of these two underlying companies when compared to a publicly traded equivalent. The cases also left business valuation appraisers in a quandary, since this treatment of the lack of marketability didn’t seem to match the fair market value standard. The fair market value standard, discussed in Revenue Ruling 59-60, discusses the relevance of a willing buyer and a willing seller and also allows for potential discounts for lack of control and lack of marketability, where applicable.
So what has changed now? In April 2017, House Bill 348 was passed by the Tennessee legislature. This Bill amends the Tennessee Code Annotated Title 36, Chapter 4 (TCA 36-4-121), relating to the equitable division of marital property. Specifically, this Bill allows for “considerations for a lack of marketability discount, a lack of control discount, and a control premium if any should be relevant and supported by the evidence for such assets” “without regard to whether the sale of the asset is reasonably foreseeable.”
Effective July 2017, discounts for lack of marketability can now be considered in the valuation of assets in family law disputes. As with the valuation itself, it’s important to hire an accredited/credentialed business valuation appraiser to assist in the determination, documentation and support of any discounts for lack of control and marketability, along with any applicable premiums.
1 Bertuca v. Bertuca, No. M2006-00852-COA-R3-CV, 2007 WL 3379668 (Tenn Ct. App. Nov. 14, 2007).
2 Barnes v. Barnes, No. M2012-02085-COA-R3-CV (Direct Appeal from the Chancery Court for Bedford County No. 27833, April 10, 2014).
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2018
Valuation of a business can be a complex process requiring certified business valuation and forensic accounting professionals. Valuations of a closely held business in the context of a divorce are typically multifaceted and may require forensic investigative scrutiny for irregularities in the financials that may insinuate dissipation of business/marital property. Business valuations are a vital element of the marital dissolution process as the value of a business, or interests in a business, impact the marital balance sheet and the subsequent allocation/distribution of marital assets.
To begin, the financial expert will request certain information and interview management of the Company. Information requested typically includes:
The financial expert must assess the reliability of the documentation and decide if the documents appear thorough and accurate to ultimately rely on them for his/her analysis. The three approaches to value a business are the Asset-Based Approach, the Income Approach, and the Market Approach.
The asset-based approach is a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities. Asset-based valuation methods include those methods that seek to write up (or down) or otherwise adjust the various tangible and intangible assets of an enterprise.
The income approach is a general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount.
The income approach can be applied in several different ways. Valuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market.
The market approach is a general way of determining a value indication of a business, business ownership interest, security or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities or intangible assets that have been sold.
Market methods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Consideration of prior transactions in interests of a valuation subject is also a method under the market approach.
A proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations.
Does it make a difference in value per share if you own 10% or 75% of a business? You bet it does. A 10% interest is a minority interest and does not enjoy the prerogatives of control. How does this affect value per share? The minority owners bear witness to a process over which they may have no control or discretion. In effect, they often play the role of silent partners; therefore, the fair market value per share of a minority owner is likely worth less per share than the shares of a 75% owner.
Likewise, a minority owner of a private business likely does not have a ready market in which to sell their interest. Minority ownership in a publicly traded company enjoys near instantaneous liquidity such as trading stock on organized and regulated exchanges. The unique uncertainties related to the timing and favorability of converting a private, minority ownership interest to cash gives rise to a valuation discount (lack of marketability discount) which further distances the minority owner’s per share value from that of a controlling owner’s value per share.
The following chart provides perspective of the various levels of value. In most cases a valuation is developed at one level of value and then a discount or premium is applied to convert to another level. These discounts are known as discounts for lack of control and lack of marketability. Knowing when to apply such adjustments and quantifying the size of these adjustments is no simple matter, requiring the need for a credentialed business valuation professional.
Normalizing adjustments adjust the income statement of a private company to show the financial results from normal operations of the business and reveal a “public equivalent” income stream. Keep in mind the levels of value in business valuation, discussed above. In creating a public equivalent for a private company, another name given to the marketable minority level of value is “as if freely traded,” which emphasizes that earnings are being normalized to where they would be as if the company were public, hence supporting the need to carefully consider and apply, when necessary, normalizing adjustments. There are two categories of adjustments.
These adjustments eliminate one-time gains or losses, unusual items, non-recurring business elements, expenses of non-operating assets, and the like. Examples include, but are not limited to:
These adjustments relate to discretionary expenses paid to or on behalf of owners of private businesses. Examples include the normalization of owner/officer compensation to comparable market rates, as well as elimination of certain discretionary expenses, such as expenses for non-business purpose items (lavish automobiles, boats, planes, etc.) that would not exist in a publicly traded company.
For more, refer to our article “Normalizing Adjustments to the Income Statements” and Chris Mercer’s blog.
The process of valuing a business is complicated and the financial expert, during the course of his/her analysis, must consider various levels of value, normalization adjustments, as well as methods of valuation to most appropriately conclude on the business.
Valuations of a closely held business in the context of a contentious divorce can be especially multifaceted and may require additional forensic investigative scrutiny for any irregularities in the financials that may insinuate dissipation of business/marital property in anticipation of the divorce and valuation. Examples may include, but are not limited to:
It is important to consider these types of situations if only one spouse is involved with the operations and management of the company, otherwise referred to as the “in-spouse.” That spouse may, or may not, have been altering the financial position of the business in anticipation of divorce and a potential independent business valuation. The services of a financial expert can be vital to you and your client in such matters, as the accuracy of the valuation may impact the equitable distribution of the marital assets.
If suspicions do not necessitate forensic services, perhaps only a business valuation scope is necessary. Furthermore, if the business or an interest was recently bought or sold, if it was recently appraised, or if its value is in a financial statement or a loan application, that information may go a long way in establishing the value of the business (if both parties feel that this value is a fair representation). However, since a business valuation report and expert witness are admissible in court as evidence and since the value of a business or interest impacts the marital balance sheet and the subsequent asset distribution, it may be exceedingly beneficial to hire a professional for evidentiary support.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2018
On May 15, the AICPA’s Financial Reporting Executive Committee released a working draft of the AICPA Accounting and Valuation Guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. The document provides guidance and illustrations for preparers of financial statements, independent auditors, and valuation specialists regarding the accounting for and valuation of portfolio company investments of venture capital and private equity funds and other investment companies. The comment period ends August 15, 2018.
Weighing in at nearly 650 pages, the guide defies quick summary. As noted in the preliminary “Guide to the Guide” section, different chapters in the working draft are likely to be of greater interest to some groups of intended users than others. In this introduction to the Guide, we provide a brief overview of the chapters and appendices with which PE and VC managers should develop familiarity.
The Guide distinguishes between the economic and non-economic rights typical of senior classes of preferred stock. Analysts generally value the economic rights attached to different share classes using one of four methods: scenario-based methods, the option pricing method, the current value method, or the hybrid method. The Guide provides a comprehensive overview of the relative strengths and weaknesses of these methods and describes which circumstances are most conducive to the use of each.
Chapter 10 of the Guide discusses the calibration framework and provides examples of how initial valuation assumptions used in valuing a debt or equity investment in a business can be calibrated with the original transaction price and subsequently adjusted to take into account changes in the subject investment and market conditions at the measurement date. When subsequent funding rounds take place, calibrating to the most recent transaction is typically most relevant, and the Guide outlines six different types of transactions and the process of potentially inferring value from these types of transactions.
The primary purpose of backtesting is to assess and improve the valuation process going forward. The Guide provides an overview of the backtesting process and advice on how to identify and evaluate factors that can contribute to a difference in value for a particular investment between the measurement date and event date. The final section of Chapter 11 provides nine examples illustrating the backtesting process across different types of investments and under various scenarios.
In short, the new Guide is a welcome addition to the resources available for fund managers in developing reliable fair value measurements for portfolio investments. We expect that having a common set of acknowledged best practices will promote efficiency in the preparation and auditing of fair value measurements. We will provide more detailed comments on specific elements of the draft Guide in the coming weeks. In the meantime, please do not hesitate to call us to discuss how any element of the new Guide may affect your portfolio valuation process.
This article originally appeared in Mercer Capital’s Portfolio Valuation Newsletter, Second Quarter 2018.
I recently attended FinXTech, an industry event where the hosts at Bank Director bring together FinTech founders and bank directors and executives for productive conversations about the road ahead as partners (and competitors).
Those discussions occurred against a backdrop in which FinTech, as a concept to enhance the customer experience and to drive operating efficiencies, is widely accepted by bank management, shareholders, and regulators. How “FinTech” is implemented varies depending upon resources. As shown in the Table 1, there has been no surge of M&A in which banks buy FinTech companies. Only nine of 276 transactions announced since year-end 2016 entailed a bank or bank holding company acquirer. KeyCorp, which has been one of the nine active FinTech acquirers, announced in June 2018 that it would acquire digital lending technology for small businesses built by Chicago based FinTech company Bolstr. At best, activity can be described as episodic as it relates to bank acquisitions, which appears to be designed to supplement internal development.
The very largest banks such as JPMorgan Chase & Co. are spending billions of dollars annually to upgrade technology—a level of spending that even super regional banks cannot match. In contrast, community and regional banks have been left scratching their heads about how to address FinTech-related issues when money is a constraining factor.
During the FinXTech 2018, the focus shifted from the potential disruption of a bank’s franchise by FinTech to the potential to partner with FinTech companies, which stood out to me as a marked change from prior years.
Both banks and FinTech companies realize that they need each other to some degree. For banks, FinTech offers the potential to leverage innovation and new technologies to meet customer expectations, enhance efficiency, and compete more effectively against the biggest banks. For FinTech companies, the benefits from bank partnerships can include the potential to leverage the bank’s customer relationships to scale more quickly, access to funding, and regulatory/compliance expertise. Several examples of successful partnerships between banks and FinTech companies were highlighted at the FinXTech event. (You can read more about some of them here.)
The FinTech/Bank partnership theme also was evident in GreenSky’s recent IPO, a FinTech company based in Atlanta. GreenSky arranges loans primarily for home improvement projects. Bank partners pay GreenSky to generate and service the loans while the bank funds and holds the loans on their balance sheet. As more partnerships emerge, it will be interesting to see if FinTech impacts the valuation of banks that effectively leverage technology to achieve strategic objectives such as growing low-cost core deposits, opening new lending venues, and improving efficiency. One would think the answer will be “yes” if the impact can be measured and is meaningful.
Another trend to look for will be whether smaller banks become more active as investors in FinTech companies. For the most part, investments by community and regional banks in FinTech companies remains sporadic at best even though FinTech companies raised nearly $16 billion of equity capital between year-end 2016 and June 2018 in both private and public offerings. An interesting transaction we observed was a $16 million Series A financing by Greenlight Financial Technology, Inc., a creator of smart debit cards, in which the investors included SunTrust Bank, Amazon Alexa Fund, and $619 million asset NBKC Bank, among others.
FinXTech 2018 included several sessions related to due diligence for FinTech partnerships; however, with limited M&A and investing activity by banks there was little discussion about valuation issues, which can be challenging for FinTech companies and differs markedly from methods employed to value a bank.
Not surprisingly, we have lots of thoughts on the subject.
With the emerging partnership theme from FinXTech 2018 in mind, view our complimentary webinar “How to Value an Early-Stage FinTech Company.” Additionally, if you have questions, reach out to one of our professionals to discuss your needs in confidence.
Originally published in Bank Watch, June 2018.
As family businesses evolve, the family’s leaders need to determine the appropriate relationship between membership in the family and ownership in the business. As the third, fourth, and subsequent generations of the family reach adulthood, it becomes increasingly likely that the interests of at least some family members will diverge from the interests of the business.
Family businesses can adopt one of two broad strategies to address this situation:
Neither strategy is inherently superior to the other. We discussed the benefits (and challenges) of developing positive shareholder engagement in a prior article. In this article, we focus on the second strategy.
In this article, we focus on voluntary, rather than involuntary, sales of shares. Involuntary sales of shares include those triggered by, and governed by, the relevant terms of the company’s buy-sell agreement. You can find a brief overview of the issues associated with buy-sell agreements here.
In some families, selling shares in the family business is perceived as nothing short of treason. Yet, there are often legitimate reasons for family members to sell shares in the family business, such as a desire for diversification, proceeds to start a new business venture, or funding education or other major life events.
In our experience, the desire of family shareholders for liquidity (whether full or partial) can usually be traced to some form of “clientele” effect. The clientele effect names the fact that a company’s shareholder base is not monolithic: different shareholders have different portfolios, risk preferences, income needs, and expectations. In multi-generation family businesses, we find the clientele effect to be common. As the family grows numerically and spreads out geographically and occupationally, it is only natural for shareholders no longer to look so much alike. Differing shareholder needs and preferences are not wrong, but when treated as such, the resulting suspicion can lead to resentment, open conflict, and in too many cases, litigation.
Shareholder clienteles can form along many different potential axes: kinship, geography, employment status, etc. To illustrate the concept, consider the economic role the family business can fulfill in different households, as depicted in the following chart.
It is only natural that family members in the upper right quadrant view the family business very differently from their cousins or siblings in the lower left quadrant. Those in the upper right quadrant are likely to be very risk-averse, desiring preservation of capital and the current level of dividends above all else. Shareholders in the lower left quadrant will much more closely resemble public market investors, supporting corporate strategies that enhance returns at acceptable risk levels.
For public companies, the clientele effect sorts itself out because shareholders self-select; if the attributes of the company don’t align a shareholders preferences and risk tolerances, it is very easy for the shareholder to sell their holdings and find assets that are a better fit. For family businesses, however, things are not nearly so tidy.
Faced with multiple shareholder clienteles, family business leaders can seek to adopt distribution and reinvestment policies that accommodate as many shareholders as possible. Or, the family can adopt a formal share redemption or liquidity program with a view to providing shareholders greater flexibility in tailoring the economic benefits of family membership to the unique circumstances of their particular household.
While every shareholder liquidity program is unique, there are certain formal elements that all plans, whether formal or informal, must have.
The following table summarizes the various consequences of the different pricing options:
There is no inherently “right” choice for the price to be used in a liquidity program. The company’s directors should weigh the consequences of the various options noted above against the objectives of the liquidity program for the family.
An effective and sustainable liquidity program should be predictable. Predictably is achieved by having clearly-defined terms that are well-understood by all interested parties, and having regular appraisals of the company’s shares prepared by a qualified independent business valuation expert. A qualified business appraiser will perform periodic valuations on a consistent basis, taking into account the financial performance of the family business, fundamental changes in the operations and outlook for the business and the industry, as well as relevant market changes. At the direction of the company, valuations can be prepared at any (or all) of the three levels noted above.
Implementing and liquidity program increases the importance of shareholder education. If family shareholders are going to have the ability to sell shares, they need to do so on an informed basis. It is essential that selling shareholders have a firm grasp of the company’s financial performance and strategy, and understand the key factors that drive the valuation.
Liquidity programs are not cure-alls, but when carefully designed and implemented, they can relieve many of the pressure points that face growing multi-generation family businesses.
On December 22, 2017, President Trump signed The Tax Cuts and Jobs Act, which resulted in sweeping changes to the U.S. tax code. The Act decreased the corporate tax rate to 21% from 35%, in addition to modifying specific provisions around interest, depreciation, carrybacks, and repatriation taxes. The change in tax rate will have the biggest impact on purchase accounting.
When we evaluate prospective financial information, a lower tax rate will result in higher after-tax earnings. The value of the tax shield created by depreciation and deductions will be influenced by both the lower corporate tax rate (which reduces the tax shield’s value) and accelerated depreciation of qualifying capital equipment purchases (which increases the tax shield’s value). In most cases, a lower tax rate will increase cash flows, increasing the internal rate of return on acquisitions for a given purchase price. On the other hand, if lower tax rates drive higher purchase prices, internal rates of return may be unchanged. In terms of the weighted average cost of capital (WACC), the lower tax rate actually increases the after-tax cost of debt. Keeping other inputs constant, this modestly increases WACCs.
Under the relief from royalty method, after-tax royalties avoided increase as the tax rate falls. However, the tax amortization benefit (TAB) component of the intangible value also declines as a result of the lower tax rate, which serves to partially offset the increase in after-tax cash flows.
In a scenario analysis used to value a noncompete agreement, a lower tax rate will again decrease the tax amortization benefit. Since both scenarios under the with and without approach will reflect the same tax rate, the impact of the new lower rate will be muted. As a result, the fair value of noncompete agreements may well be somewhat lower under the new tax rate.
The cost approach, which is often used to value assets such as the assembled workforce or some technologies, the impact depends on whether a pre-tax or after-tax measurement basis is used. If fair value is measured on a pre-tax basis, the fair value of such assets is unaffected. If measured on an after-tax basis, costs avoided net of tax will be higher under lower tax rates, although this gain will be offset somewhat by the decrease in the TAB.
The impact of the tax rate on assets valued under the Multi-Period Excess Earnings Method (MPEEM) is more ambiguous since two key elements will be affected – the contributory asset charges and the tax rate used to derive after-tax cash flows. On the cash flow side of things, the lower tax rate will result in higher cash flow but a lower TAB. As far as contributory assets are concerned:
The net impact of a lower tax rate on goodwill will vary by transaction. If the lower tax rate results in a higher transaction price, the aggregate increase in fair value will likely result in a larger allocation to goodwill. If, instead, the lower tax rate increases the projected IRR on a transaction, the impact on residual goodwill is harder to predict and will depend on the composition of the assets acquired.
The changes to corporate taxes under the new bill are wide-ranging. In addition to the effect of lower rates discussed in this article, fair value specialists need to be alert to how other specific provisions of the bill may influence individual companies.
Having gone through a few of these, sometimes differences arise between expectations or estimates prior to the transaction and fair value measurements performed after the transaction. An example is contingent consideration arrangements – estimates from the deal team’s back-of-the-envelope calculations could vary from the fair value of the corresponding liability measured and reported for GAAP purposes. To the extent amortization estimates are prepared prior to the transaction, any variance in the allocation of total transaction value to amortizable intangible assets and non-amortized, indefinite lived assets – be they identifiable intangible assets or goodwill – could also lead to different future EPS estimates. While most of the time our clients approach these allocation exercises with an open mind, sometimes bridging these differences – surprises, really – can take a bit of time and effort.
There is no universal practice we have observed. Some clients come to us with no priors, so to speak. Others will have prepared some figures – maybe placeholder-type numbers, or maybe something with a bit more underlying analysis – for tax planning or other purposes. The level of detail can also vary and may or may not include specific splits among the various types of identifiable intangible assets. Going back to the theme of sources of surprises, however, the allocation itself is only one aspect of transaction due diligence. Whether or not allocations are prepared in advance, buyers will have engaged in some form of financial modeling prior to the close of transactions.
The opportunity to think through and talk about some of the unusual elements of the more involved transactions can be enormously helpful. We view the dialogue we have with clients during the process as a particularly important part of the project. So, obviously, a process that starts early allows all involved more space to examine transaction items together, loop in not just FP&A and corporate development personnel but also folks from the technical teams as necessary, ask questions, and evaluate potential solutions and/or approaches. We would hope this deliberative process results in a more robust – well-reasoned and well-supported – analysis that is easier for the external auditors to review, and stands the test of time requiring fewer true-ups or other adjustments in the future. Surprises are difficult to eliminate, but as they say, forewarned is forearmed. A head-start is a luxury we are not always going to have, but we certainly like it when we get lucky on that front.
As part of our full suite of services, we handle a number of different kinds of special projects that corporate finance departments may be looking to outsource, completely or partially. For example, our firm helps clients think through certain financial or strategic questions – what level of cash flow reinvestment will best balance competing shareholder interests? Or, what is the appropriate hurdle rate when evaluating projects for capital budgeting exercises? In other instances, we perform financial due diligence and quality of earnings analyses for some transactions.
When it comes to purchase price allocations, however, most of the time clients contact us well after the transaction has progressed or closed. Over time, discussions with some of our clients have shifted a bit from providing fair value measurements exclusively on the back-end of transactions to getting a bit of preview as companies think through the transactions. To revisit an earlier question, we would like to think that our purchase price allocations are better – more robust, fewer surprises – when we have also worked with the clients before the close of the transactions on elements like some financial due diligence or contingent consideration estimates, or even broader corporate finance studies.