As expected after lackluster job gains in May, the Federal Open Market Committee declined to raise the Fed Funds target at the latest policy meeting on June 15th. While the majority of policymakers still expect the Fed to boost rates twice before the end of this year, the number of officials who forecast just one rate hike increased from one to six from the previous forecasting round in March. In addition, Fed officials lowered their expectations for future years, now expecting the fed funds rate to rise to 1.6% by year-end 2017, down from the 1.9% estimate in March, and 2.4% in 2018, down from the previous estimate of 3.0%. During a press briefing on June 3rd, members of the Economic Advisory Committee of the American Bankers Association said they still expect the Fed to boost rates twice before the end of this year, but after years of speculation regarding timing of rate increases, when that will happen remains anyone’s best guess. The bond market never believed the forecasts.
Rate increases are long awaited by community bankers as banks are facing profitability challenges. Net interest margins continue to compress and loan growth remains stymied by intense competition for high quality loans. Margin relief remains out of the grasp of most community banks, absent further rate hikes beyond the December 2015 hike. After rebounding modestly in the third and fourth quarter of 2015, the median net interest margin of community banks (defined as those with assets between $100 million and $5 billion), ticked down modestly in the first quarter of 2016 as intense competition for quality loans drove down loan yields and the decline in long-term rates put downward pressure on securities’ yields (Charts 1 and 2).
Overall, median net interest income continued to increase as growth in loans offset margin compression, but intense competition raises concerns over how much credit standards have been relaxed to drive loan growth.
Although the majority of banks’ balance sheets are poised to take advantage of rising rates, the lift to net interest margins is dependent on asset yields rising faster than the cost of funds (Chart 3).
While deposits costs essentially reached a floor several quarters ago, data suggests the threat of rising deposit rates may limit margin expansion in a rising rate environment. As shown in Chart 4, the percentage of banks reporting quarter-over-quarter increases in the cost of interest bearing deposits has been trending upward over the last eight quarters. In a higher rate environment, customers are more likely to shop around for higher rates. The increase observed in interest bearing accounts could reflect the fact that higher loan growth has compelled some banks to raise rates or perhaps an effort to build goodwill with customers in anticipation of rising rates and increased rate sensitivity. For banks with asset sensitive balance sheets, the benefit of rising interest rates will be greater the stickier low cost deposits are.
While net interest margin is a key metric for banks, focusing on other drivers of profitability is one way to combat margin compression in the face of further delays in interest rate hikes or upward pressure on deposit costs. Consider the following:
Mercer Capital has a long history of working with banks and helping to solve complex problems ranging from valuation issues to considering different strategic options. If you would like to discuss your bank’s unique situation in confidence, feel free to contact us.
An expert deposition is a formal proceeding. I can only speak from my own experience in having my deposition taken and in attending a number of depositions of other experts or parties to various matters. There is one thing that is true in the majority of expert depositions I have seen. The opposing attorney prepares for the deposition. In one deposition, the opposing counsel had his outline of questions to ask me contained in a three-ring notebook. I couldn’t be sure, but it appeared to have more than 50 pages of typewritten questions.
If opposing counsel is going to prepare for your deposition as an expert witness, it is equally critical that you prepare as well. Preparation for an expert deposition entails a number of activities:
The central idea behind preparing for an expert deposition is to be sure that the expert is as ready as possible. Preparation is essential for experts to give good depositions.
Mercer Capital brings analytical resources and over 35 years of experience to the field of dispute analysis and litigation support. We assist our clients through the entire dispute process by providing initial consultation and analysis, as well as testimony and trial support. Please contact us to discuss your needs in confidence.
Peter Mahler reported on a recent New Jersey appellate level case focusing on the application of a 25% marketability discount in a statutory fair value determination in his New York Business Divorce blog. The New Jersey Appellate Division issued an unpublished decision in Wisniewski v. Walsh, 2015 N.J. Super. Unpub. LEXIS 3001 [App. Div. Dec. 24, 2015]. The case is interesting in that it attempts to determine a marketability discount in relationship to the “bad behavior” of a selling shareholder.
The Wisniewski case has a long and tortuous history dating back to the mid-1990s. The case involves a successful family-owned trucking business founded by the father in 1952. Three siblings, Frank, Norbert, and Patricia owned the business equally following the father’s death. Frank assumed leadership of the business by 1973, and Norbert and Patricia’s husband also worked in the business. In 1992, Frank was sentenced to a prison term, leaving Norbert in charge of the business. Norbert stopped paying certain bills that had customarily been paid for Patricia and her husband, and diverted certain revenues from a business owned by Patricia to one in which she had no interest. In addition, even after Frank’s return, Norbert tried to exclude Patricia from a real estate deal that she ordinarily would have participated in.
The litigation began around 1995. Interestingly, the trial court held that Norbert was an oppressing shareholder, and none of the parties contested that finding or the court’s later decision that Norbert should be bought out. Hold that thought, because it becomes a key factor in the court’s determination of statutory fair value. I can only call the concluded marketability discount in the matter a “bad behavior” discount.
The court’s valuation was determined through two trials in 2007 and 2008. Roger Grabowski of Duff & Phelps was retained by Frank and Patricia (the company) and Gary Trugman of Trugman Valuation Associates was retained by Norbert. I have been unable to locate the trial court’s decision in that matter, and so I can only write about the valuation from the perspective of the appellate decision.
The trial court issued opinions in October 2007 and July 2008, which explained how and why the trial judge concluded that the fair market value of Norbert’s interest was about $32.2 million. We learn in the appellate decision that the trial court applied a separate 15% “key man” discount “to account for Frank’s importance.” If the conclusion was $32.2 million for Norbert’s interest, then the value before the discount was about $37.9 million ($32.2 / (1 – 15%)). No marketability discount was applied by the trial court. This would place an implied value of the trucking business at about $114 million.
We do not know the conclusions of either Grabowski or Trugman that were considered by the trial court. According to the appellate decision, the trial judge found Trugman’s discounted cash flow analysis more credible than Grabowski’s market approach. However, the trial judge used assumptions suggested by Grabowski for certain normalizing adjustments to operating expenses for Trugman’s discounted cash flow method.
There was an appeal of the trial court’s decisions in 2007 and 2008. The appellate court, in a decision issued April 2, 2013, held in part that “the trial judge erred in not applying a marketability discount” and remanded “for the fixing and application of a marketability discount to the extent not already subsumed in the judge’s findings…”
The 2015 appellate decision states regarding the remand to the trial court in 2013:
On remand, Judge Hector R. Velazquez briefly contemplated that the record might need to be supplemented with expert testimony pertaining to the narrow issues presented, but ultimately decided against it; none of the parties quarrel with that approach now. Left to resolve the matter on the record developed after the first remand, Judge Velazquez heard oral argument and issued an opinion on October 16, 2013, concluding that a discount for marketability was not embedded in the prior valuation and that a discount of twenty-five percent should be applied. He entered a second amended final judgment to that effect on January 7, 2014.
And of course the parties appealed and cross-appealed.
The appellate decision was issued December 24, 2015. To cut to the chase, the appellate court found “no merit” in the appeal and affirmed Judge Velazquez’ 2014 opinion. The appellate decision recounts that Norbert was found to be an oppressing shareholder. This turns out to be an important point, because in New Jersey, the marketability discount is typically reserved for “extraordinary circumstances” involving inequitable or coercive conduct on the part of the seller, who is Norbert in this case.
The issue on appeal was whether the trial judge had erred in application of the 25% marketability discount because marketability may already have been considered in Trugman’s DCF analysis. The key facts relating to the marketability discount question, as best I can glean them from the 2015 appellate decision, include:
The appellate court notes the trial court’s decision:
Judge Velazquez concluded, based on that record, that although Trugman and Grabowski had considered several of the same factors in formulating their discount rate and marketability discount, respectively, that Trugman had made no adjustment for marketability in building up his discount rate — in short, the judge concluded that no marketability discount was embedded in his evaluation. The judge rejected both expert opinions, moreover, in selecting an appropriate discount, and fixed the rate at twenty-five percent.
It gets more interesting for valuation professionals. The appellate court reasoned that a marketability discount was necessary because of Norbert’s bad behavior towards his fellow shareholders (there was never a finding that his behavior harmed the company in any way).
The second trial judge rejected application of a marketability discount following our first remand. He considered Frank’s criminal conviction, a factor Grabowski suggested would reduce the company’s value, but noted that while the company endured a lull during Frank’s absence, it resumed its growth on his return with no apparent hindrance attributable of his criminal history. Neither that nor any other circumstance, the trial judge at the time reasoned, justified application of the discount.
Although the reasoning was sound for the most part, we reversed because the judge at the time failed to consider that Norbert’s oppressive conduct had harmed his fellow shareholders and necessitated the forced buyout…[paraphrasing the New Jersey Supreme Court in Balsamides under similar circumstances]. …[A]bsent the application of a discount, the oppressing shareholder would receive a windfall, leaving the innocent party to shoulder the entire burden of the asset’s illiquidity in any future sale. Equity demanded application of the discount, or else the statute would create an incentive for oppressive behavior. (emphasis added)
The appellate decision restated some of Judge Velazquez’ logic in making the following point:
On remand, Judge Velazquez determined on the existing record that a marketability discount was not already embedded in the valuation. He recounted that the discount rate Trugman build up included a size premium and an adjustment for a series of company-specific factors including the company’s reliance on Frank, its customer concentration in the retail industry, and high debt. Although Grabowski had considered similar factors in formulating his marketability discount, the judge concluded that Trugman had certainly “utilized them in a different way” than to adjust for any lack of illiquidity. (emphasis added)
As a business appraiser examining this case from business and valuation perspectives, the economic logic for applying a 25% marketability discount by the court is considerably strained. If a group of risk factors are considered in the DCF method that lower value in the context of that method, it is difficult to see how their further consideration for the application of an additional marketability discount is not double-counting. However, the appellate court addressed this issue as follows:
Grabowski analyzed a handful of the same factors, among many others, in formulating his marketability discount, but, in contrast, focused on the inherent liquidity of closely-held companies and the anticipated holding period for a rational investor in this company. There was no clear indication in the record, then, that Trugman and Grabowski had accounted for the same risks relative to marketability, such that application of a separate marketability discount would cause double counting. (emphasis added)
In the light of day, it would seem that there is double-counting to the extent that both appraisers considered the same factors that would reduce each of their values, even if they used those factors in different ways. And note that the original trial judge had already allowed for a key man discount of 15%, which occurred, obviously, after the experts had testified and provided their evidence. This discount, which certainly pertains to the “marketability” of a business, is substantial discount that had already been considered in the trial court’s conclusion. It just wasn’t labeled as a marketability discount.
What it seems that we have in Wisniewski v. Walsh is a situation that is a business appraiser’s nightmare. At the original valuation trial, the court held that there should be no marketability discount. That was appealed. The appellate court then remanded back to the trial court for the application of a marketability discount to the extent that one was not already embedded in Trugman’s DCF analysis. The trial judge then, based on logic outlined above, concluded that no marketability discount was embedded in the DCF analysis and that the appropriate punitive marketability discount was 25%. This was appealed, and in this current appellate decision, the trial court’s marketability discount is affirmed.
I have no problem if a court of equity wants to penalize a party for oppressive behavior to other shareholders. That is certainly one of the jobs that courts of equity are called upon to do in appropriate circumstances. And that discount can be zero, 10%, 20%, 25% or anything the court determines is appropriate in a specific case.
I do have a problem with a court making an “equitable” decision and then trying to justify that decision based on parsing of valuation evidence.
Assume an appraiser provided a valuation in another New Jersey statutory fair value matter involving the oppressive behavior of a selling shareholder named John. Let’s say that the value conclusion for the interest before the application of a “bad behavior discount” was $100 per share. The appraiser then concludes as follows:
Based on my analysis of John’s bad behavior, I believe that a marketability (bad behavior) discount of 20% is appropriate.
The appraiser might be thrown out of court. His opinion would certainly be given no weight. How then, is an appraiser to respond when the ultimate marketability, or bad behavior, discount will be determined by a judge who is responding to the equities of a matter? After all, valuation evidence pertaining to the marketability of a company or of an interest in a company has absolutely nothing to do with the behavior of any shareholder.
Let’s look further at the appellate decision and we will see that the trial court’s conclusion has nothing to do with the economics of the trucking business in Wisniewski.
The Court noted in Balsamides, supra, 160 N.J. at 377, 379, that marketability discounts for closely-held companies frequently ranged from thirty to forty percent, though the Court explained that selection of an appropriate rate, and the applicability of a rate in the first place, must always be responsive to the equities of a given matter.
Judge Velazquez properly rejected from the outset Norbert’s suggestion that the marketability discount be set at zero percent. Indeed, we had already decided that a marketability discount was required and Judge Velazquez was bound by our mandate.
After carefully canvassing the record, Judge Velazquez came to the conclusion that selecting a thirty to forty percent rate as described in Balsamides would excessively punish Norbert, the oppressing shareholder, beyond what the equities of this case required and, in light of the company’s past financial success and anticipated continued future growth, stood to “give the remaining shareholders a significant windfall.”
In choosing an appropriate marketability discount after rejecting portions of both expert opinions on the issue, Judge Velazquez acknowledged our Supreme Court’s advice in Balsamides that such discounts frequently ranged from thirty to forty percent, but noted that other studies supported a broader range, reaching as low as twenty percent. He alluded to authorities from other jurisdictions approving the application of a wide range of discounts, sensitive to the equities of each individual case, and to our decision in Cap City Products Co. v. Louriero, 332 N.J. Super. 499, 501, 505-07 (App. Div. 2000), allowing application of a twenty-five percent discount. (emphasis added)
If trial courts determine marketability discounts as bad behavior discounts, there really is no way that business appraisers can provide meaningful information to a court. If the court’s concern is one of “the equities” in a matter rather than in determining the fair value or the fair market value of a business or interest in a business, then there is little that appraisers can do to help. In Wisniewski, the application of a marketability discount flowed, not from the lack of marketability of the trucking business, but from the bad behavior of Norbert. Neither Trugman nor Grabowski had a chance in that determination. All we can say is that the court’s ultimate conclusion for the bad behavior (marketability) discount fell within the range suggested by Trugman (0%) and Grabowski (35%) and had nothing to do with the relative marketability of the business at hand.
Mahler concluded similarly in his blog post:
If you ask accredited business appraisers whether the determination of a marketability discount rate for the shares of a particular closely-held company should be based on case precedent involving other companies, I think the vast majority will answer “no.” I wrote a piece on that very subject last year, quoting from the IRS’s DLOM Job Aid and experts in the field. Yet cases such as Wisniewski point the other way, effectively encouraging advocates and judges to select a rate within a self-perpetuating, “established” range of case precedent based as much if not more on the “equities” of the case than the financial performance, prospects, and liquidity risks of the company being valued. It’s not for me to say whether appellate courts and legislatures should decide as a matter of policy to incorporate into fair value determinations equitable considerations based on the good or bad conduct and motives of the litigants toward one another. But I am saying that if that’s the way it’s going to be, there’s an associated cost in the form of greater indeterminacy in fair value adjudications which makes it harder for lawyers and valuation professionals to advise their clients and to reach buyout agreements before they ripen into litigation.
Readers can see the bad news in this appellate decision in Wisniewski. The good news, I guess, it that most statutory fair value cases do not involve bad behavior on the part of a selling shareholder.
It has been an interesting few weeks for FinTech. Coming off recent years where both public and private FinTech markets were trending positively, the tail end of 2015 and the start to 2016 have been unique as performance has started to diverge. The performance of public FinTech companies has been relatively flat through the first quarter of 2016 (see Public Market Indicators on page 3 of the First Quarter 2016 FinTech newsletter), and signs of weakness have been observed in alternative/marketplace lending, as well as some of the more high profile FinTech companies that have gone public recently. The median return of the FinTech companies that IPO’d in 2015 was a decline of 16% since IPO (through 3/31/16). For perspective, Square, OnDeck, and Lending Club are each down significantly in 2016 (down 28%, 53%, and 64%, respectively from 1/1/2016 to 5/18/2016). Also, the broader technology IPO slowdown in late 2015 has continued into 2016 and no FinTech IPOs have occurred thus far in 2016.
However, optimism for FinTech still abounds, and the private markets continue to reflect that with robust investor interest and funding levels. In 2016, 334 FinTech companies raised a total of $6.7 billion in funding in the first quarter (compared to 171 companies raising $3.2 billion in the first quarter of 2015), and Ant Financial (Alibaba’s finance affiliate) completed an eye-popping $4.5 billion capital raise in April.
While the factors driving this divergence in performance between public and private markets are debatable, the divergence is unlikely to continue indefinitely. A less favorable public market and less attractive IPO market creates a more challenging exit environment for those “unicorns” and other private companies. Headwinds for the private markets could develop from more technology companies seeking IPOs and less cash flow from successful exits to fund the next round of private companies.
Consequently, other strategic and exit options beyond an IPO should be considered such as partnering with, acquiring, or selling to traditional incumbents (banks, insurers, and money managers). The potential for M&A and partnerships is even more likely in FinTech, particularly here in the US, due to the unique dynamics of the financial services industry including the resiliency of traditional incumbents and the regulatory landscape. For example, consider a few of the inherent advantages that traditional banks have over non-bank FinTech lenders:
At the same time that FinTech companies are increasingly considering, or being forced to consider, strategic options beyond an IPO, traditional incumbents are starting to realize that they must develop a strategic plan that considers how to evolve, survive, and thrive as technology and financial services increasingly intersect. For example, a number of banks are looking to engage in discussions with FinTech companies. A recent survey from BankDirector noted that boards are focusing more on technology with 75% of respondents wanting to understand how technology can make the bank more efficient and 72% wanting to know how technology can improve the customer experience.
FinTech presents traditional financial institutions with a number of strategic options, but the most notable options include focusing on one or some combination of the following: building their own technology solutions, acquiring a FinTech company, or partnering with a FinTech company. One area where we have started to see more FinTech partnerships and M&A already start to play out is wealth management and the industry’s response to robo-advisory. Robo-advisers were noted by the CFA Institute as the FinTech innovation most likely to have the greatest impact on the financial services industry in the short-term (one year) and medium-term (five years). Consider the following announcements in this area over the last few years; on the acquisition front, BlackRock’s acquisition of FutureAdvisor in August 2015, Invesco’s acquisition of Jemstep, and Ally Financial’s acquisition of TradeKing in April 2016. On the partnering front, Motif and J.P. Morgan announced a partnership in October 2015, UBS announced a major partnership with SigFig in May 2016, and Betterment and Fidelity announced a partnership in October 2014. Community banks will also have an opportunity to enter the robo-advisory fray as Personal Capital announced a partnership with Alliance Partners that will allow over 200 community banks offer digital wealth advisory tools.
While we do not yet know which strategy will be most successful, discussions of whether to build, partner, or buy will increasingly be on the agenda of boards and executives of both financial institutions and FinTech companies for the next few years. The right combination of technology and financial services through either partnerships or M&A has significant potential to create value for both FinTech companies and traditional financial institutions. Any partnership or merger should be examined thoroughly to ensure that the right metrics are utilized to examine value creation and returns on investment.
Transactions and significant partnerships also have significant risks and potential issues will need to be discussed. For example, significant issues with M&A and potential partnerships can include: execution and cultural issues, shareholder dilution, whether the partnership is significant enough to create shareholder value and provide a return on investment, contingent liabilities, and regulatory pressures/issues. These issues must be balanced with the potential rewards, such as customer satisfaction/retention, shareholder value creation, and return on investment.
If you are interested in considering strategic options and potential partnerships for your financial institution or FinTech company, contact Mercer Capital. Financial institutions represent our largest industry focus for over thirty years. We have a deep bench with experience with both FinTech companies and traditional financial institutions (banks, asset managers, and insurance companies). This uniquely suits us to assist both as they explore partnerships and potential transactions.
On May 23, Ares Capital (ARCC) announced the acquisition of fellow business development company, or BDC, American Capital (ACAS) in a cash and stock deal valued at $4.0 billion. The deal is notable from several perspectives. First, the transaction brings closure to the ACAS saga. Second, the deal includes third-party support from ARCC’s management company. Finally, the transaction structure allowed ARCC to raise nearly $2.0 billion in new equity without diluting NAV per share, despite ARCC shares trading at an 8% discount to NAV prior to the announcement.
Prior to the 2008 recession, ACAS was one of the two largest BDCs. The other, Allied Capital, was acquired by ARCC in 2010. As shown in Figure 1, ACAS’ share price was (literally) decimated during the recession, losing over 90% of its value during 2008 and 2009.
During 2011, ACAS elected to be taxed as a C corporation rather than a registered investment company, or RIC. No longer subject to RIC distribution requirements, ACAS embarked on an aggressive strategy of asset rationalization, debt reduction, and share repurchases. Having suspended dividend payments in 2010, reported NAV per share increased from $10.71 at the end of 2010 to $20.14 at March 31, 2016 (an annualized growth rate of 12.8%).
Over that period, the price/NAV ratio for the shares increased from 70.6% to 77.6%, resulting in a compound annual return for shareholders of 14.8% via a combination of growth in NAV and multiple expansion. The announced purchase price of $17.40 per share, an 11.4% premium to the May 20 closing price, brings the compound annual return up to 17.2%. As shown in Figure 2, the increase in NAV per share reflected not only undistributed operating earnings and asset gains, but also the accretive impact of share repurchases below NAV (cumulative impact of $3.19 per share). With shares trading at persistent discounts to NAV, ACAS repurchased nearly 35% of its outstanding float during the period.
In sum, the positive shareholder returns for ACAS over the period, which beat those of ARCC and its peer BDCs, is a reminder that growth is not the only route to generating shareholder returns. While the company’s investment portfolio shrunk nearly 40%, pursuit of the best risk-adjusted returns delivered a positive outcome for ACAS shareholders.
The total reported transaction consideration of $17.40 per ACAS share includes $2.45 per share from the sale of the company’s American Capital Mortgage Management subsidiary prior to transaction close. Of the net purchase price of $14.95, ARCC is providing only $13.75, with the BDC’s external manager Ares Management (ARES) picking up the remaining $1.20 per ACAS share, or $275 million. In addition, ARES pledged to a management fee waiver of $10 million per quarter for the ten quarters following the transaction close. The waiver works out to approximately 0.725% of ACAS’ reported assets of $5.5 billion, or half of ARES’ base management fee of 1.45%. The present value of the fee waiver (at a 12% discount rate) is approximately $86 million, and will accrue to the benefit of both ARCC and ACAS shareholders.
The topic of BDC management fees has been the subject of much comment over the past few years. The transaction structure for this deal highlights the attractiveness of the anticipated management fee stream to ARES (as well as, potentially, other strategic benefits accruing to the broader Ares platform as a result of the transaction).
From the perspective of ARCC shareholders, the contribution by ARES represents approximately $0.65 per share of NAV accretion, and makes the economics of the transaction considerably more palatable. Relative to the pro forma investment portfolio of $13.2 billion, the prospective fee concession represents approximately 30 basis points of incremental return on assets and 55 basis points of incremental return on equity.
New share issuance is the only sustainable growth mechanism available to BDCs. With share prices mired at discounts to NAV for almost two years, BDCs have been generally been unable to issue new shares absent shareholder authorization, resulting in stagnant balance sheets given leverage restrictions and a statutory requirement to distribute at least 90% of taxable income as RICs. With depository institutions less inclined – or able – to make the sort of leveraged loans that BDCs specialize in, the perceived opportunities for BDCs are potentially substantial, but without access to fresh capital, BDCs have been unable to capitalize.
Prior to the transaction announcement, ARCC shares traded at 92% of NAV, compared to 78% for ACAS. ARCC shareholders would likely have been disinclined to approve a dilutive issuance of 110.8 million shares (which would have resulted in a dilutive impact of $0.34 per share). However, since the shares were issued in exchange for ACAS shares trading at a yet deeper discount, the issuance looks to be potentially accretive to NAV per share. (ACAS management indicated that it may take a couple quarters for NAV per share accretion to be realized).
With no obvious triggers for share prices to resume trading at premiums to NAV beyond a pick-up in the economy and a corresponding narrowing of credit spreads, acquisitions like this may be the best available strategy for more favored BDCs to unlock incremental capital and generate balance sheet growth.
At the close of trading on the first day following the announcement, market response to the transaction has been uninspiring, with ARCC shares trading down 2.4%, and ACAS shares closing at $15.72 per share, or nearly 10% below the nominal deal value of $17.40 per share. Whether this reflects uncertainty regarding the deal actually closing or a lack of enthusiasm for ARCC shares as currency, investors seem unimpressed thus far. A cynic might point out that ARES shareholders (up $0.02) seem unfazed, suggesting that the value of the incremental management fee stream outweighs the deal contribution and prospective fee concession.
The Ares management team has proven adept at managing through various credit cycles and has the experience of folding in the substantial Allied acquisition in 2010. If this deal closes, the pro forma company will be in a class of its own as measured by size, at approximately twice the size of the next largest BDC. Whether the envisioned benefits of scale will accrue to the ARCC shareholders remains to be seen.
This article was originally published in the October 2014 issue of ABJ Journal.
Chapter 11 reorganization affords a financially distressed or insolvent company an opportunity to restructure its liabilities and emerge as a sustainable going concern. Once a petition for Chapter 11 is filed with the bankruptcy court, the company usually undertakes a strategic review of its operations, including opportunities to shed assets or even lines of businesses. During the reorganization proceeding, stakeholders, including creditors and equity holders, negotiate and litigate to establish economic interests in the emerging entity. The Chapter 11 reorganization process concludes when the bankruptcy court confirms a reorganization plan which specifies a reorganization value and which reflects the agreed upon strategic direction and capital structure of the emerging entity.
In addition to fulfilling technical requirements of the bankruptcy code and providing adequate disclosure, two characteristics of a reorganization plan are germane from a valuation perspective:1
Within this context, valuation specialists can provide useful financial advice in order to:
The value of a business under the liquidation premise contemplates a sale of the company’s assets within a short period. Inadequate time to place the assets in the open market means that the price obtained is usually lower than the fair market value.
In general, the discount from fair market value implied by the price obtainable under a liquidation premise is directly related to the liquidity of an asset. Accordingly, valuation analysts often segregate the assets of the petitioner company into several categories based upon the ease of disposal. Liquidation value is estimated for each category by referencing available discount benchmarks. For example, no haircut would apply to cash and equivalents while real estate holdings would likely incur potentially significant discounts, which could be estimated by analyzing the prices commanded by comparable properties under a similarly distressed sale scenario.
ASC 852 defines reorganization value as:2
“The value attributable to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. This value is viewed as the value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after restructuring.”
Reorganization value is generally understood to be the value of the entity that emerges from the bankruptcy proceeding under a going concern premise of value. Typically, the largest element of the reorganization value is the business enterprise value of the emerging entity. Reorganization plans primarily make use of the discounted cash-flow (DCF) method under the income approach to measure the business enterprise value of the emerging entity. The DCF method estimates the net present value of future cash-flows that the emerging entity is expected to generate. Implementing the discounted cash-flow methodology requires three basic elements:
The sum of the present values of all the forecasted cash-flows, including discrete period cash-flows and the terminal value, provides an indication of the business enterprise value of the emerging entity for a specific set of forecast assumptions. The reorganization value is the sum of the expected business enterprise value of the emerging entity, plus proceeds from the sale or other disposal of assets during the reorganization, if any. During the reorganization proceeding, different stakeholders may independently develop distinct estimates of the reorganization value to facilitate negotiations or litigations. The confirmed reorganization plan, however, reflects the terms agreed upon by the consenting stakeholders and specifies either a single range of reorganization values or a single point estimate.
Bankruptcy courts may permit certain post petition liabilities to facilitate the operation of the petitioning business during the reorganization process. In conjunction with the reorganization plan, the courts also approve the amounts of allowed claims or interests for the stakeholders (creditors or equity holders) in the restructuring entity. The reorganization value is the value of the total assets of the emerging entity and represents all of the resources available to meet the post petition liabilities, and allowed claims and interests called for in the confirmed reorganization plan.
In principle, a confirmed reorganization plan should not lead to a liquidation or further restructuring in the foreseeable future. A cash-flow test evaluates the viability of a reorganization plan following the conclusion of the restructuring under Chapter 11 protection.
The first step in conducting the cash-flow test is to identify the cash-flows that underpin the reorganization plan. Conceptually, these cash-flows are available to service all the obligations of the emerging entity. As a matter of practice, since the reorganization value is usually developed using the DCF method, establishing the appropriate stream of cash-flows is often straightforward. Valuation analysts then need to model the negotiated or litigated terms attributable to the creditors of the emerging entity. In practice, this involves projecting interest and principal payments to the creditors, including any amounts due to providers of short term, working capital facilities.
Finally, the cash-flow test also documents the impact of the net cash-flows on the balance sheet of the emerging entity. This entails modeling changes in the asset base of the company as portions of the expected cash-flows are invested in working capital and capital equipment, as well as changes in the debt obligations of and equity interests in the company as the remaining cash-flows are disbursed to the capital providers. A reorganization plan is generally considered viable if such a detailed cash-flow model indicates solvent operations for the foreseeable future.
Managers of companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities — evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders — while continuing to operate the business. For this reason, it is common for a company that has filed for Chapter 11 to seek help from outside third party specialists to formulate a reorganization plan that can facilitate a successful navigation through the bankruptcy court. Valuation specialists can provide useful advice and perspective during the negotiation of the reorganization plan. The specialists can also help prepare the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court.
1 Accounting Standards Codification Topic 852, Reorganizations (“ASC 852”). ASC 852-05-8.
2 ASC 852-10-20
We observed last spring that 2015 would likely mark a turning point in portfolio valuations with the degree of difficulty likely to increase during the year. With the Q4 earnings season for BDCs complete, we take an opportunity to check in on portfolio marks and market sentiment over the year. The key takeaway from the year is that the valuation perspectives of investors and portfolio managers began to diverge.
The following chart depicts our benchmark loan mark for the past three years. After the sharp decline in 3Q15, the fair value of the benchmark loan fell again in the fourth quarter, falling from 93.9% of principal to 92.6%.
As we have noted on numerous occasions, the fair value of actual loans is determined by a host of issue-specific factors in addition to the market-wide indicators captured in the benchmark loan. However, for broad portfolios of loans, it does provide a measure of sensitivity of fair value to changes in credit spreads.
For BDCs, the benchmark loan fair value has been correlated to investor sentiment regarding BDC portfolio values. The next chart compares the benchmark loan fair value to a price index of a group of the largest BDCs over the period. Since BDC balance sheets are levered, the sensitivity of BDC share prices to the value of loan portfolios is magnified.
Since fair value is intended to reflect a market participant perspective, one would expect portfolio marks and investor perspectives to reconcile over time. However, current BDC share prices imply an even more dim view of BDC portfolio asset values on the part of investors than that indicated by our benchmark loan index. This would seem to suggest one of two potential scenarios: (1) investors have over-reacted to the impact of credit-spread widening on loan portfolio values, or (2) investors have adopted a skeptical posture toward the underlying credit quality of BDC portfolios. We do not hazard a guess at this point as to which will prove to be the more accurate explanation.
Table 1 summarizes 2015 market returns for 18 of the largest BDCs.
Total returns were negative for 11 of the BDCs analyzed, with share prices declining for all but one. Falling share prices were attributable to lower NAVs (median decrease of 1.6%) and shifting investor sentiment, with price/NAV ratios posting a median decrease of 9.7% for the year.
On December 31, 2015 BDC balance sheets, reported portfolio fair values stood at 96.7% of amortized cost. Investors, however, seem to be marking the portfolios a bit lower, with the median price/NAV ratio for the group at 0.87x. Current dividend yields suggest that, at least for some names, the sustainability of current payouts is being questioned; beyond direct credit concerns, this may also be weighing on BDC share prices.
During the fourth quarter, the BDCs in Table 1 reported aggregate fair value writedowns of just over $1.0 billion, or 2.5% of beginning cost basis. As noted in Table 2, the writedowns for individual BDCs ranged from 7.7% for beleaguered TICC to 0.6% for tech-focused HTCG. Only one BDC, GBDC, reported a net writeup during the quarter.
It is interesting to note that the BDCs with the lowest marks at the beginning of the quarter took, on average, larger writedowns during the quarter than those with higher marks. The nine funds with the highest ratios of fair value to cost basis at September 30, 2015 (median: 100.1%) reported a median writedown of 2.1% during 4Q15, while the bottom half (funds with a median ratio of fair value to cost basis of 96.5%) reported a median writedown of 3.3% during the quarter.
Asset mix varies among the portfolios analyzed. For example, significant unrealized gains on equity positions within a portfolio can have a material effect on the overall portfolio mark. As shown in Table 3, non-preferred equity positions for industry leader ARCC accounted for just 4.7% of the total portfolio at amortized cost. However, ARCC reported fair value of that portion of the portfolio at nearly 1.5x cost, for a total unrealized gain of over $200 million, which raised the overall effective mark on the portfolio from 96.6% to 99.0% of amortized cost.
If 2015 was the year of increasing degree of valuation difficulty, perhaps 2016 will be the year in which we learn whether portfolio managers have been able to stick their valuation landings, or if portfolio marks will be subject to continuing market skepticism in coming quarters. In the end, the market perspective wins – BDC share prices will either recover to levels consistent with December 31, 2015 marks or the portfolio marks will trend toward the market-implied levels. Time will tell.
While there is no legal requirement for community banks to perform stress tests, recent regulatory commentary suggests that community banks should be developing and implementing some form of stress testing on at least an annual basis.
The benefits of stress testing include enhancing strategic decisions; improving risk management and capital planning; and enhancing the value of the bank. However, community bank stress testing can be a complex exercise for a bank to undertake itself. There are a variety of potential stress testing methods and economic scenarios for the bank to consider when setting up their test. In addition, the qualitative, written support for the test and its results is often as important as the results themselves. For all of these reasons, it is important that banks begin building their stress testing expertise sooner rather than later.
Whether you are considering performing the test in-house or with outside assistance, this webinar will be of interest to you. This webinar:
Jay D. Wilson, CFA, ASA, CBA, presented this Mercer Capital sponsored webinar on March 1, 2016.
While there is no legal requirement for community banks to perform stress tests, recent regulatory commentary suggests that community banks should be developing and implementing some form of stress testing on at least an annual basis.
The benefits of stress testing include enhancing strategic decisions; improving risk management and capital planning; and enhancing the value of the bank. However, community bank stress testing can be a complex exercise for a bank to undertake itself. There are a variety of potential stress testing methods and economic scenarios for the bank to consider when setting up their test. In addition, the qualitative, written support for the test and its results is often as important as the results themselves. For all of these reasons, it is important that banks begin building their stress testing expertise sooner rather than later.
Whether you are considering performing the test in-house or with outside assistance, this webinar will be of interest to you. This complimentary webinar:
Jay D. Wilson, CFA, ASA, CBA, presented this Mercer Capital sponsored webinar on March 1, 2016.
The valuation of sports properties is often perceived as one of the most exciting areas of the appraisal profession. Sports business mandates constitute an amalgam of traditional valuation approaches applied to a specialized industry niche possessing its own distinct value drivers and considerations.
Sports property valuations may be required in a variety of situations, including:
While the purchase and sale of professional sports franchises and arenas constitute the most visible event necessitating the participation of an experienced valuator, the foregoing situations also can give rise to valuation mandates. For example, in 1994, the Toronto Maple Leafs NHL franchise and the arena in which the team played, Maple Leaf Gardens, were owned by a public company, Maple Leaf Gardens, Limited, which was being taken private. Consequently, the fairness opinions that had been prepared in connection with this going-private transaction were called into question by The Public Guardian and Trustee of Ontario and the Attorney General for Ontario. A vigorous litigation ensued, in which the valuation professionals played a central role.
As is the case with many businesses, shareholder agreements can necessitate valuation mandates, as sports teams and arenas are often owned by numerous individuals and/or corporations. For example, at the date this was written, the Calgary Flames NHL franchise was held by over two dozen owners, and the Green Bay Packers NFL team was owned by several thousand individuals, most of whom were members of the local Wisconsin community.
Both friendly transactions and acrimonious disputes among shareholders occurring under such shareholder agreements will typically require the involvement of one or more valuation professionals to determine the value of the entity holding the sports-related assets (or interests therein).
Income tax and estate planning also constitute frequent sources of valuation work involving sports organizations. Those sports properties that have been owned by families will often, at some point, require valuations to be performed for intergenerational transfers of ownership among family members. Moreover, considering the significant appreciation in value experienced by professional sports franchises around the globe during the past few decades, owners of sports properties eventually may need to contend with capital gains-related issues. Valuation professionals often provide integral assistance in this process.
Insolvency or restructuring involving either a professional sports organization or one of the owners thereof is another event that will frequently necessitate the expertise of business valuators. For example, in the 1990s, there were several high-profile bankruptcies of English Premier League football (i.e., soccer) organizations that occurred after several previous rounds of financing had been obtained. At every step of the way, from the initial financing to the restructuring or asset liquidation process, business valuations are typically required to provide an indication of worth of the sports franchise and related properties.
The valuation of professional sports properties provides an excellent illustration of the difference between price and fair market value in a “real world” setting. As valuation professionals are well aware, there are generally two distinct sets of circumstances where the value of a business is determined:
Notional Market Valuation. Fair market value, fair value or some other legislated or defined value is often notionally determined in the absence of an open-market transaction. The value standard most frequently applied in notional market valuations is “fair market value.” The generally accepted definition of this valuation term by North American courts is:
The (highest)1 price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
Open-Market Transaction. Price is negotiated between a vendor and a purchaser acting at arm’s length. The term “price” is defined as “the consideration paid in a negotiated, open-market transaction involving the purchase and sale of an asset.”
In a sports market context, sentimental value may occasionally represent a component of price. This concept is evidenced by a sports team owner who is an extremely wealthy individual and does not view the acquisition of a sports team from an economic perspective but rather as a “trophy.” An investment involving sentimental value, in other words, may be ego-driven in nature and made by a purchaser who is willing and able to absorb significant losses.
Special interest purchasers are often present in the marketplace for professional sports properties. Special interest purchasers are generally defined as: “acquirers who believe they can enjoy post-acquisition economies of scale, synergies, or strategic advantages by combining the acquired business interest with their own.” Examples of these types of purchasers are large companies possessing broadcasting, media and entertainment operations that can avail themselves of synergies presented by controlling assets relating to professional sports organizations. In recent years, a number of such companies have successfully acquired professional sports properties in order to benefit from the content provided to the purchaser’s media distribution network.
In the sports business world, both of the above sets of circumstances are frequently encountered. As is illustrated below, there may be significant differences between fair market value and price. For example, fair market value typically assumes the following conditions exist:
In contrast, the price determined in an open-market transaction may be influenced by the following considerations:
As is the case with most businesses, a sports franchise’s value is derived from its future benefits, such as revenues, EBITDA and net cash flow. Among the factors influencing the perceived future benefits for a sports franchise include its management team, trademarks, brands and logos, customer “fan base” relations, customer contracts (e.g., season tickets, corporate boxes, personal seat licenses), player relations and contracts, broadcasting contracts, arena ownership or lease agreements, team-alliance synergies, local demographics (e.g., population size, wealth, popularity of sport), etc.
Simply put, the fundamental goal for a sports team owner is to maximize the number of fans in the seats (or viewing the matches via broadcast media), and the goal for an arena/ stadium owner is to minimize the number of “dark nights” in which no event is occurring in the building.
Admittedly, while future benefits often cannot be measured with absolute certainty, franchise values will change in a manner commensurate with perceived increases and decreases in such benefits. In the sports business world, while no single approach or formula can be used to determine the value of sports properties in every situation, different approaches and methods have been adopted for estimating future benefits and franchise/asset values.
In sports business valuations, the Market Approach is often frequently utilized, considering the active market that exists for many professional sports properties. In the Market Approach, the subject sports property is compared to similar properties by performing a detailed analysis of prior transactions involving similar sports properties and/or in the ownership of the subject sports franchise or asset.
In analyzing transactions in sports properties, aside from reviewing the amount and structure of the transaction price, it is frequently necessary for the valuation professional to identify and quantify key organizational elements that generate value for the subject professional sports club, such as (but not limited to) management team and personnel, corporate operations, finance and technology.
It is a sports business paradigm that the management team should, in maximizing franchise value, maintain and enhance the quality of the team brand. Such brand value enhancement may be performed in a variety of ways, including winning on-field victories and championships, attracting individual “marquee” players, fostering positive community relations and developing a robust tradition ultimately bestowing “iconic” status on the sports franchise.
For example, the valuator should examine the quality of the management team, employees and players, focusing on the club’s ability to retain talent and expertise (on the field, among the coaching staff and in the front office). In order to enhance value, the sports organization should possess the potential to develop future leaders (for both players and management), avoid labor actions (e.g., strikes, lockouts), motivate commitment in its players and employees to the club’s culture and ethics, and strengthen relationships among management, players and employees.
In assessing value of sports franchises in a transactional setting, the valuation professional should also examine the ability of the organization to maximize the potential of its corporate operations. For example, the franchise organization should constantly strive to improve capacity utilization wherever possible (e.g., selling out games, maximizing advertising and media revenue). Recent revenue maximization trends by franchise owners in this context have included selling advertising on fixed or rotating panels in close proximity to playing surfaces, inside arena corridors, on building exteriors and on game tickets. Sports team management should also be seeking to optimize other areas of business potential (e.g., creation of team-alliance synergies, increase in the number of official sponsors or partners with the club, etc.).
Moreover, the sports organization should periodically assess what investments are required to expand or improve fixed-asset infrastructure (e.g., addition of seats, creation of premium or “club” seat categories, addition or expansion of facility restaurant, bar, concessions and parking facilities). Management should also be cognizant of ways to strengthen the franchise’s market position in the presence of other forms of entertainment competing for the same consumer, media and advertising spending sources.
The valuation professional must examine the ability of the sports organization to maximize the value of its intangible assets. Aside from traditional items such as the franchise logo, influencing the popularity of merchandising and licensing revenues, in recent years, savvy sports-marketing experts have derived new sources for professional sports franchises to obtain revenues, notably the leasing of stadium/arena naming rights. Typically, building naming rights are leased for several million dollars annually for terms of 10 to 20 years; these stable revenues often flow directly to the bottom line of the club/building owner.
Furthermore, in transactional contexts involving professional sports organizations, the valuation professional should assess the financial strength of the subject business. In particular, the valuator needs to place particular emphasis on the extent to which leverage has been (or may be) utilized to finance capital assets and franchise operations. Other financial issues should be reviewed, including the club’s ability to recognize and maximize all revenues (i.e., deferred revenues) from an accounting standpoint and to depreciate or amortize the franchise itself, player contracts, capital assets, etc. If the franchise is being positioned for sale, it may be desirable for the club to “clean up” the balance sheet, (e.g., eliminate redundant assets such as excess cash, marketable securities, non-operating real estate, inter-company or shareholder loans), adjust overvalued assets and other reserves in order to present the sports business’ true earning power, accelerate the collection of accounts receivable, etc.
Finally, sports business valuation experts have increasingly focused on a franchise’s ability to enhance value through the creative use of technology. In recent years, technology has been utilized by sports team owners through innovations such as the use of web-based resources featuring fan club sites and live or archived game broadcasts. Many sports business experts predict a proliferation of fee-based broadcasts of matches and related content through television, Internet audio and video, as well as mobile phone media. Other uses of technology that may create franchise value relate to the extent to which technology can be implemented to improve communications (e.g., within the internal organization, with the fan base and among the league and its members).
Both of the concepts of price and fair market value are often influenced by numerous value drivers that relate specifically to professional sports franchises. Among the frequently encountered examples of “external” value drivers (over which a franchise owner exerts little, if any influence) are included, but are by no means restricted to:
Moreover, included among the various salient “internal” value drivers over which a franchise owner typically possesses some ability to influence are:
Interestingly, two factors that do not always constitute significant value drivers for a sports franchise are the win-loss record of the club, as well as the individual players comprising the team. The impact of possessing (or lacking) either championship trophies or superstar players must be assessed by the valuation professional as to the incremental contribution of each to the value of a particular sports organization.
Among the important items on the expense side of the income statement that may materially impact the value of a professional sports franchise are included player salaries, which are, in turn, influenced by permitted contractual increases, free agency, union collective bargaining agreements, long-term injuries to or retirements of players, etc.
Franchise owners who do not own the stadium/arena facility will also be subject to leases for building rental, as well as possibly leases for concessions, merchandising and/or parking facilities. Moreover, some teams, such as Canadian NHL franchises, must contend with material foreign currency risk, as their revenues will be received in the local currency while some of their expenses (e.g., player salaries) may be denominated in a foreign currency. Finally, the ability of a sports club to claim amortization expense on its franchise cost, player contracts and capital assets will impact its fiscal situation, as well as its operating cash flows.
While the sports business field may be a source of some exciting mandates for the valuation practitioner, as the above narrative indicates, sports properties encompass a highly specialized segment of our profession that is subject to its own distinct challenges.
This article originally appeared in Wolters Kluwer’s Business Valuation Alert, January 2015.
Drew Dorweiler, MBA, CPA, ABV, CBV, ASA, CBA, CFE, CVA, FRICS, is Managing Partner at IJW Co.
Don Erickson, ASA, is Managing Director of Mercer Capital.
1 The word “highest” is added to the Fair Market Value definition in Canada.
Like most professional services firms, much of the value of an insurance agency lies in its customer base, workforce, and the intangible factors that drive growth and margin. But not all insurance agencies are created equal. The recurring revenue streams, low fixed asset intensity, and favorable financing characteristics have drawn the interest of industry consolidators, private equity investors, financial institutions, and other participants, leading to a robust transaction environment. Join Lucas as he reviews the valuation methodologies and drivers of value for insurance agencies and brokerages.
Lucas M. Parris, CFA, ASA, presented this webinar sponsored by Business Valuation Resources on January 19, 2016.
Texas energy companies continue to cut jobs at a shocking rate. According to the Houston Business Journal, nearly 40,000 people working for three of the world’s largest oilfield services firms have lost their jobs in the last six months, and even more layoffs are anticipated in the near future. Cuts have also occurred in the upstream and manufacturing sectors.
Halliburton Co. has already cut 9,000 jobs, which amounts to 10 percent of its workforce. Schlumberger Ltd. has cut 20,000 jobs, which is approximately 15 percent of its workforce, and Baker Hughes Inc. has cut 10,500 jobs, which accounts for 17 percent of its workforce. All of these companies also reported losses or a significant decrease in earnings for Q1.
In the upstream sector, Newfield Exploration Co. has announced that it plans to merge two of its units and close its Denver office. Hercules Offshore Inc. has cut its workforce by almost 40 percent, and Linn Energy LLC plans to close its Denver office, eliminating 52 jobs in the process.
For oilfield service providers, recent job cuts have been largely unavoidable. Oil prices have been declining in recent months, leading to significant revenue loss for companies in this sector. In fact, the Wall Street Journal reports that prices for U.S.-traded crude oil reached a six-year low in mid-March of this year.
For companies in the upstream sector, however, layoffs may not have been a necessity. These companies have not been affected by oil price declines as dramatically as oilfield service providers, so it’s possible that they are simply using the declines as an excuse to “shed fat” and boost efficiency.
Layoffs may impact a company’s performance and value in a number of ways. Some of the possible effects of layoffs include:
The immediate effect of job cuts on company values is undoubtedly negative. However, cuts are often made in the hope that lower overhead costs and increased efficiency will eventually boost profits and, hence, the company’s overall worth. Thus, the effect of these cuts on the future of Texas energy companies remains unknown.
This is not the first time oil prices have dropped enough to have a noticeable impact on the industry. After peaking in 1980, crude oil prices fell steadily for the next six years. The demand for oil was greatly reduced, and businesses in this industry were losing money. In response, they cut back on exploration and drilling significantly, leading to tens of thousands of layoffs.
Oil prices eventually rebounded after the 1980s oil glut. However, because companies had laid off so many workers, they were not prepared to handle the boom that followed. This caused a number of problems for companies in the industry, as they were forced to scramble for employees with the experience and expertise necessary for success in the open positions. Unfortunately, many of the best workers had left oil for good, and potential recruits were wary of joining an industry that seemed so volatile.
In light of this history, some companies with cash reserves are attempting to curb the number of job cuts in order to prevent staffing issues when prices improve. However, for many of the smaller companies, layoffs are unavoidable.
No one can say for certain what the future holds. If the market rebounds quickly, companies that have implemented heavy job cuts may find themselves struggling. If prices remain low, however, companies in this industry that have tried to curb job cuts may have no choice but to cut even more workers loose. Regardless of what happens, achieving a complete recovery from this crisis will not be easy.
This article was originally published in Valuation Viewpoint, May 2015.
2015 was a strong year for FinTech. For those still skeptical, consider the following:
One of the more notable FinTech events in 2015 was Square’s IPO, which occurred in the fourth quarter. Square is a financial services and mobile payments company that is one of the more prominent FinTech companies with its high profile founder (Jack Dorsey, the Twitter co-founder and CEO) and early investors (Kleiner Perkins and Sequoia Capital). Its technology is recognizable with most of us having swiped a card through one of their readers attached to a phone after getting a haircut, sandwich, or cup of coffee. Not surprisingly, Square was among the first FinTech Unicorns, reaching that mark in June 2011. Its valuation based on private funding rounds sat at the top of U.S.-based FinTech companies in mid-2015.
So all eyes in the FinTech community were on Square as it went public in late 2015. Market conditions were challenging then (compared to even more challenging in early 2016 for an IPO), but Square had a well-deserved A-list designation among investors. Unfortunately, the results were mixed. Although the IPO was successful in that the shares priced, Square went public at a price of $9 per share, which was below the targeted range of $11 to $13 per share. Also, the IPO valuation of about $3 billion was sharply below the most recent fundraising round that valued the company in excess of $5 billion.
In the category its great pay if you can get it, most Series E investors in the last funding round had a ratchet provision that provided for a 20% return on their investment, even if the offering price fell below the $18.56 per share price required to produce that return. The ratchet locked in through the issuance of additional shares to the Series E investors. The resulting dilution was borne by other investors not protected by the ratchet.
On the flip side the IPO was not so bad for new investors. Square shares rose more than 45% over the course of the opening day of trading and then traded in the vicinity of $12 to $13 per share through year-end. With the decline in equity markets in early 2016, the shares traded near the $9 IPO price in mid-February.
IPO pricing is always tricky—especially in the tech space—given the competing demands between a company floating shares, the underwriter, and prospective shareholders. The challenge for the underwriter is to establish the right price to build a sizable order book that may produce a first day pop, but not one that is so large that existing investors are diluted. According to MarketWatch, less than 2% of 2,236 IPOs that priced below the low end of their filing range since 1980 saw a first day pop of more than 40%. By that measure, Square really is a unique company.
One notable takeaway from Square’s experience is that the pricing of the IPO as much as any transaction may have marked the end of the era of astronomical private market valuations for Unicorn technology companies. The degree of astronomical depends on what is being measured, however. We have often noted that the headline valuation number in a private, fundraising round is often not the real value for the company. Rather, the price in the most recent private round reflects all of the rights and economic attributes of the share class, which usually are not the same for all shareholders, particularly investors in earlier fundraising rounds. As Travis Harms, my colleague at Mercer Capital noted: “It’s like applying the pound price for filet mignon to the entire cow – you can’t do that because the cow includes a lot of other stuff that is not in the filet.”
While a full discussion of investor preferences and ratchets is beyond the scope of this article, they are fairly common in venture-backed companies. Recent studies by Fenwick & West of Unicorn fundraisings noted that the vast majority offered investors some kind of liquidation preference. The combination of investor preferences and a decline in pricing relative to prior funding rounds can result in asymmetrical price declines across the capital structure and result in a misalignment of incentives. John McFarlane, Sonos CEO, noted this when he stated: “If you’re all aligned then no matter what happens, you’re in the same boat… The really high valuation companies right now are giving out preferences – that’s not alignment.”
A real-world example of this misalignment was reported in a New York Times story in late 2015 regarding Good Technology, a Unicorn that ended up selling to BlackBerry for approximately $425 million in September 2015. While a $425 million exit might be considered a success for a number of founders and investors, the transaction price was less than half of Good’s purported $1.1 billion valuation in a private round. The article noted that while a number of investors had preferences associated with their shares that softened the extent of the pricing decline, many employees did not. “For some employees, it meant that their shares were practically worthless. Even worse, they had paid taxes on the stock based on the higher value.”
As the Good story illustrates, the valuation process can be challenging for venture-backed technology companies, particularly those with several different share classes and preferences across the capital structure, but these valuations can have very real consequence for stakeholders, particularly employees. Thus, it is important to have a valuation process with formalized procedures to demonstrate compliance with tax and financial reporting regulations when having valuations performed. Certainly, the prospects for scrutiny from auditors, SEC, and/or IRS are possible but very real tax issues can also result around equity compensation for employees.
Given the complexities in valuing venture-backed technology companies and the ability for market/investor sentiment to shift quickly, it is important to have a valuation professional that can assess the value of the company as well as the market trends prevalent in the industry. At Mercer Capital, we attempt to gain a thorough understanding of the economics of the most recent funding round to provide a market-based “anchor” for valuation at a subsequent date. Once the model is calibrated, we can then assess what changes have occurred (both in the market and at the subject company) since the last funding round to determine what impact if any that may have on valuation. Call us if you have any questions.
After weak broad market performance in the first quarter of the year and slow advances during the summer, U.S. stocks generally saw amplified returns in the fourth quarter of 2015. The largest banks (those with over $50 billion in assets) generally performed in line with broad market trends, but most banks outperformed the market with total returns on the order of 10% to 15% for the year (Figure 1).
Bank stock performance improved markedly in the fourth quarter as speculation following the FOMC’s September meeting suggested rate increases may begin in the fourth quarter. In mid-December, the FOMC met again and, after seven years of its zero interest rate policy, announced an increase in the target fed funds rate. The shift in monetary policy is expected to gradually improve strains on banks’ net interest margins and should be most apparent for banks with more asset-sensitive balance sheets, though community banks that may have made more loans with longer fixed terms or loan floors may experience some tightening in the short term.
Bank returns generally averaged around 0% to 30% in 2015, though 17% of the U.S. banks analyzed (traded on the NASDAQ, NYSE, or NYSE Market exchanges for the full year) realized negative total returns. These included banks continuing to deal with high levels of NPAs; banks that are located in oil-dependent areas such as Louisiana and Texas; and some banks that have been active acquirers that missed Street expectations. On the other end, a few high performers in 2015 include merger targets as well as banks that have seen more success from acquisition activity (Figure 2).
One of the primary factors contributing to stronger returns in 2015 was loan growth. Banks with loan growth over 10% exhibited above-average returns, while those with slower growth tended to exhibit lower returns, with the exception of banks that shrank their portfolios during the year, though for these banks the higher returns likely reflected prior years’ underperformance that was priced into the stocks (Figure 3).
Asset-sensitive banks also outperformed in 2015. While asset sensitivity is difficult to evaluate from publicly available data, we measured asset sensitivity by the proportion of loans maturing or repricing in less than three months from September 30, 2015, relative to total loans (both obtained from FR Y-9C filings). Limiting the analysis to publicly traded banks with assets between $1 billion to $5 billion reveals that the most asset sensitive banks returned about 16% in 2015, or 400 basis points more than less asset sensitive banks (Figure 4).
Though the smallest banks generally realized the highest returns in 2015, pricing multiples were strongest for banks with assets between $1 and $10 billion, which generally saw better profitability than the smaller banks. Year-over-year, pricing multiples generally remained flat from 2014 (Figure 5).
Mercer Capital is a national business valuation and financial advisory firm. Financial Institutions are the cornerstone of our practice. To discuss a valuation or transaction issue in confidence, feel free to contact us.
When Energy Future Holdings (“EFH”) and certain of its subsidiaries entered into a pre-arranged reorganization under Chapter 11 of the U.S. Bankruptcy Code on April 29, there were (and remain) a myriad of issues that require resolution for the largest generator, distributor and retail electricity provider in Texas. How should debtor-in-possession (“DIP”) financing be allocated? How and when will restructuring priority be given to various creditors? Is a “tax-free” spin of Texas Consolidated Energy Holdings (“TCEH”) a viable option? What is to be done about Oncor? The list goes on. At the heart of those questions, and of the bankruptcy, are valuation issues that have and likely will continue to permeate throughout the process.
What is EFH – and more specifically its subsidiaries TXU Energy, Luminant and Oncor – worth? That’s the $42 billion question. Valuation professionals can utilize a number of tools at their disposal to attempt to answer that question, including income methods such as discounted cash flow analysis and market methods such as comparative transactions and publicly traded peer analysis. How those methods are applied, along with their underlying economic and financial assumptions, will be closely examined and almost certainly challenged among the stakeholders.
At issue are EFH’s three distinct business units: (i) Luminant which is the merchant power unit; (ii) TXU Energy which is the retail electric unit, and (iii) Oncor’s power delivery business. Luminant and TXU Energy are unregulated, while Oncor is regulated.
A few of the critical existing and potentially emerging valuation issues in EFH’s Chapter 11 process include things like (i) premises of value, (ii) regulatory issues as they pertain to pricing and rate setting, (iii) consolidated vs. non-consolidated restructuring scenarios and (iv) development of projections and cash flows. All of these issues have interplay with each other and they are certainly not exclusive when it comes to valuation considerations for as complex an organization as EFH. In addition we will look to instructive prior electric company bankruptcies, such as Mirant and Dynegy, to help navigate these waters as well.
“Being in bankruptcy is like being in a fishbowl,” said Sander “Sandy” Esserman, a partner at Stutzman, Bromberg, Esserman & Plifka who was involved in the Mirant Corporation bankruptcy. One of the most meaningful and thematic aspects stakeholders and observers will be viewing in that fishbowl will be the standard of value lens that one peers through. Standard of value considerations will be front and center at EFH’s division Texas Competitive Electric Holdings (“TCEH”), where creditors are disputing EFH’s restructuring strategy that could wipe out billions of dollars of debt.
There are two premises of value to consider: fair market value and reorganization value. The fair market value standard is more of an as-is where-is proposition, which posits that the value of a company is a reflection of what the current marketplace will pay for it.
This standard is used (often successfully) in reorganization plans and liquidation scenarios where a sale of assets or companies is a viable and appropriate solution to the parties. This could be unlikely in EFH’s situation.
According to EFH management, under certain scenarios, a Section 363 sale could trigger tax liabilities of over $6 billion. However, in the midst of Chapter 11 reorganizations, fair market value has been criticized as overemphasizing the “stigma” of bankruptcy, and thus undervaluing a debtor. Esserman concurred that undervaluation can happen, citing American Airlines and Lyondell as examples of companies that emerged out of Chapter 11 and quickly saw stock prices (and thus enterprise values) increase.
The other key standard is reorganization value, which can be defined as the enterprise value of the reorganized debtor. This more futuristic premise takes into account the effects of the bankruptcy process and its benefits to the value of the debtor(s). The difficulty of this can be in its proper application and timing. The Mirant bankruptcy, whereby the court issued an exhaustive memorandum opinion on the valuation efforts, put significant weight on the reorganization value standard and, as such, utilized exit financing and non-distressed equity returns as assumptions in its valuation opinion. This is almost certainly the posture that unsecured creditors will be taking in regard to EFH.
One of the negotiated items pre-bankruptcy was whether or not to consider a “consolidated” bankruptcy for EFH, meaning including Oncor in the plan.
This is an important consideration. Oncor is not a debtor in the Chapter 11 case, but its value is a relevant component to the restructuring. TXU is Oncor’s largest customer, and it is regulated by the Public Utility Commission of Texas (“PUC”). Due to its regulated status, Oncor is restricted from making distributions to EFH under certain conditions.
Oncor also has an independent board of directors, not to mention certain structural and operational aspects used to enhance Oncor’s credit quality – known as “ring-fencing” measures that further isolate it from EFH. That said, Oncor is profitable and distributions represent an all-important cash inflow to EFH as a means to fund creditors, perhaps as adequate protection to secured creditors or as payment to unsecured creditors.
The rates set by the PUC impact those measures. This brings about the question of where will the influence of the bankruptcy court end and the regulatory authorities begin? Actions by one may or may not influence the other. We do not pretend to know or even want to speculate on what will transpire in respect to this, but however those rates and dividends out of Oncor change, it will impact the value to EFH and its creditors.
The competitive side of EFH’s business, TCEH, is in a highly competitive business that buys and sells a commodity product. Its rates are not set and have fluctuating inputs that have significant impact on valuations.
How the marketplace views Luminant and TXU Energy is different than how it views Oncor, so it might make sense to treat each entity individually, with separate cash flow projections, pricing and market assumptions. That said, there are other consolidated, multi-faceted public electric companies that may provide good valuation benchmarks.
It is notable that in the Mirant bankruptcy the court considered and utilized public comparable companies. However, with the specific structural, tax and regulatory issues involved with EFH and its subsidiaries, one has to be careful not to generalize comparative aspects of these companies, which the Mirant court emphasized.
When private equity investors KKR, TPG and Goldman Sachs bought EFH in 2007 for more than $8 billion in equity, it was widely seen as a bullish take on natural gas prices. Back then, investor projections anticipated rising Henry Hub prices. They were wrong. EFH characterized its misfortune this way in their first day motions: “In October 2007, the main ingredients for EFH’s financial success were robust and steady economic growth…natural gas prices that were not expected to significantly decline over the long term. Since 2007, however, overall economic growth was reduced…and wholesale electricity prices have significantly declined.”
New discoveries, hydraulic fracturing and the 2008 recession all led to a drop in natural gas prices. The challenge that needs to be undertaken now is attempting to project prices in today’s environment as these prices form the baseline for any financial or discounted cash flow analysis. Coal prices play a meaningful role as well.
Opinions vary widely on this and therein it is perhaps the most challenging valuation aspect in this entire case. Where will natural gas prices go? Some parties are more optimistic than others and this optimism could fuel the basis for competing reorganization plans. For EFH’s part, it would not surprise people if management took a conservative view on gas prices, having already been burned on prior projections. The stakes are high. Cash flow sensitivity to even slight variations in assumed prices could mean the difference between an unsecured creditor being made whole or getting very little.
One path the court could take is having industry subject matter experts help key industry variables and form a baseline for a projection. The underlying assumptions in the cash flow projections would be ultimately built upon those assumptions.
Even if agreement is reached there, the bottom line cash flow could still vary widely based on cost structure, rates of return and future tax benefits from prior net operating losses (TCEH reported $3.0 billion of pre-tax losses in 2013). The net operating losses, depending on what reorganization plan the court adopts, could prove to be an enormous swing factor as well. They could possibly be worth billions under one scenario or they could potentially be worthless depending on the tax treatment of the plan.
Valuation issues are front and center of the EFH bankruptcy. How the ultimate reorganization plan plays out will be critical. Many valuation aspects can be structured in a settlement. However, even in bankruptcy environments, there are economic, financial and market issues that still fuel the undergirding drivers to maximizing value for all stakeholders. No investor wants the short end of a stick. Depending on how the valuation issues play out there might be a chance that EFH has a long enough stick for everyone to grasp. Time will tell.
This article was published in The Texas Lawbook on July 10, 2014.
Anybody who has been to a gas pump in the last several months can tell you that the energy industry is currently in the throes of change. Prices are falling to lows that they haven’t seen in almost a decade and the industry itself is being impacted in a large number of different ways. The changing face of economics and the marketplace has presented an entirely new set of challenges that businesses will have to adapt to in order to thrive well into the future.
Another significant change that will impact the oil and gas industries in 2015 and beyond has to do with current market fluctuations that will affect profitability. It’s no secret that oil prices started plummeting in 2014 and show no signs of slowing down. Bernstein Research, for example, estimates that a full 1/3 of all shale projects in the United States become unprofitable once prices fall below $80.
This is a case-by-case basis, however, and is not blanket fact. The Bakken formation in North Dakota, for example, will still be profitable so long as prices do not fall below $42 per barrel – according to the IEA. ScotiaBank’s own research indicates that prices have to stay between $60 to $80 per barrel for the Bakken formation to remain profitable.
A large part of the reason why oil prices are continuing to fall has to do with two other significant changes that are impacting the industry: namely, changes to the total amount of oil that the United States and Canada are producing, as well as changes to the demand for oil in areas of the world like Europe and Asia.
According to the International Energy Agency (also commonly referred to as the IEA), shale production in the United States is expected to shift dramatically in the coming years. In scenarios both where oil prices remain roughly where they are and where they continue to fall even farther, the IEA predicts that shale production will still continue to grow, just at a much slower rate than it has been in the last several years. To put that into perspective, production is still expected to increase an additional 950,000+ barrels per day throughout the entirety of 2015.
Another important factor to consider has to do with infrastructure with regards to existing investments. There are a large number of energy companies that have already paid a great deal of money purchasing land, obtaining necessary permits and performing other tasks necessary to drilling. Even if oil prices continue to fall, these companies can’t necessarily curb back on their production or they fear losing an even greater investment than initially feared. In these types of situations, the true “break even” price in production varies depending on the operator and their tolerance versus the amount of debt that they’ve taken on. Even still, it may be too early to tell in many cases how firm those tolerances really are.
The boom in increased oil production in the United States and Canada has created something of a tricky situation for the industry as a whole. After sinking a huge amount of money into infrastructure over the last several years, businesses now have to contend with falling prices that show no signs of slowing down. In order to adapt they will have to look for ways to embrace new technology and streamline production in order to stay profitable well into the future and to break through into a bold new era for the industry as a whole.
This article was originally published in Valuation Viewpoint, January 2015.
In recent court testimony, Bank of America – Merrill Lynch (“BoA”) revealed its bid book (“Project Claret”) prepared for potential buyers of a NBA franchise, the Los Angeles Clippers (“Clippers”). We are going to analyze elements within the Project Claret document with a particular focus on the revenue estimate of the local media contract renewal in 2014.
Let’s look at BoA’s estimate of local media revenues primarily related to television content. BoA forecasted television rights payment in June 2014 year-end at $25.8 million from the current contract projecting it to $125 million for a new local media contract. Michael Ozanian of Forbes recently estimated the 2014 new contract amount to most likely be closer to $75 million. I agree with Mr. Ozanian for the following reasons:
Therefore, how much will the Clippers realistically get in 2014 with the new contract? $75 million is approximately 68% of our estimated Lakers deal amount and seems generous based on the raw ratings numbers. However, if we utilize the Forbes estimate of $75 million in 2014 and the other BoA revenue estimates for game admissions ($62.3 million) and other team revenue ($136.8 million), the total revenue estimate for the Clippers would be $274.1 million in 2014 versus the $324.1 million utilized in BoA Project Claret.
If one assumes a multiple of 5x revenues, which is the high end of multiples paid for an NBA team to date, the indicated enterprise value estimate is $1.370 billion, a far cry from $2 billion. Additionally, many times when dealing with estimates of future results (in this case an estimate of future revenue) the valuation multiple applied should be lower than actual transaction multiples. These multiples are calculated based on historical revenues, which are usually lower than future estimates.
It seems clear to us that based on the data available the $2 billion price from Steve Ballmer is a good deal for the Sterling Trust.
This article was originally published in Valuation Viewpoint, August 2014.
From 2000 to 2005, Major League Baseball teams were selling for much less than National Football League teams, i.e., typically under $200 million. Most of the MLB teams were showing losses at the time, and there was limited interest in buying the teams that did come up for sale. But the buying and selling environment changed dramatically in 2012, with the Los Angeles Dodgers selling for over $2.15 billion in a spirited auction with sixteen initial bidders.1
What has caused this explosion in MLB prices and do these high prices make sense?
In this article, I attempt to answer this question as I discuss MLB franchise price/value changes in the last fifteen years and whether these dramatic jumps in prices/values make economic/market sense.
First, I illustrate actual transaction prices for MLB teams in the early 2000s. I then show the significant increases—starting in 2008—leading to the blockbuster $2.15 billion Dodgers deal in 2012.
I then demonstrate the value changes published by Forbes Magazine and discuss key economic changes in the industry (i.e. MLB) that have contributed to these price jumps of twice—and sometimes three times—the 2005 prices for MLB franchises.
Finally, I explore the actual financials for the Texas Rangers and a history of the prices paid for the Rangers over the years.
For definition purposes, when we discuss values, we are always discussing enterprise (equity + debt), not equity values, and when we discuss revenue multiples, we are discussing total revenues from team/franchise and stadium interests, but excluding regional sports network (RSN) interests.
As Chart 1 shows, enterprise prices for MLB teams from 2000 to 2005 were less than $200 million, except for the 2004 Dodgers deal, which came in at $430 million. In 2006, two transactions increased to the low $400 million range. In 2008, a San Francisco Giants deal indicated $700 million, and the Chicago Cubs in 2009 were sold for over $800 million. In 2009 during the “Great Recession,” a smaller market team, the San Diego Padres, transacted at $500 million. Also in 2009, the Texas Rangers sold at $595 million during a bankruptcy bidding war. Finally, the chart shows the big jump with the bankruptcy auction prices of the L.A. Dodgers and their stadium and land at $2.15 billion in 2012.
Unlike entities in other industries, major league sports teams are usually valued using a market approach rather than an income approach. Most of their enterprise values are referenced as a multiple of team and stadium revenues.
The multiples in revenues paid for actual transactions in the early 2000s were in the 2.0 times to 2.5 times range, but recent deals have been over 4.0 times revenues. The recent 4.0 times multiple reflects anticipated growth in revenues since sophisticated and well-heeled buyers are anticipating significant future revenue growth.
In Table 1, Forbes estimates are developed by Forbes editors utilizing public sources, their proprietary methods of estimating team revenues and expenses, and their judgment as to the valuation multiple to be applied to their revenue estimates.3
By 2014 (see Table 2), Forbes average MLB value estimate had jumped to $811 million and had a 3.3 times multiple. The values ranged from $2.5 billion for the Yankees to $485 million for the Tampa Bay Rays.
The average revenue estimates for the league have only increased from $183 million to $237 million or thirty percent. Yet the average valuation multiple increased from 2.6 times to 3.3 times causing the average team value to increase sixty-four percent. What caused this significant increase? The answer: potential for increased local revenues due to an explosion in media rights fees.
As mentioned earlier, recent media rights fees for local broadcasts of MLB teams have increased three to five times that of older contracts. These older contracts may have been ten years in length, but the new ones can be in force as long as twenty-five years.
Unlike the total revenues for NFL teams and, to a lesser extent, those of the NBA, local media rights fees make up the majority of revenues for MLB teams. In many markets, the content providers (cable and satellite companies) are vying for a unique live product that can differentiate them in the marketplace. This competition has caused bidding wars for TV and other media rights to MLB teams.
The largest current local MLB media contract was negotiated by the L.A. Dodgers and was recently approved by MLB. In this contract, the L.A. Dodgers will reportedly receive $6 billion after a revenue-sharing split with MLB. This equates to an average of $240 million a year over twenty-five years. The old Dodgers contract was approximately $50 million dollars in its last year.
The next highest are the Texas Rangers and the Houston Astros at $80 million a year on average. In addition, the national TV MLB has jumped also—see Table 3.
It should be noted that part of the massive increase in payments to the L.A. Dodgers by Time Warner Cable is covered by Time Warner’s plan to pass the costs on to other pay TV providers, including Direct TV, Dish Network, Charter Communications, and Cox Communications.
Currently, Time Warner Cable and their providers are deadlocked on the price increases they will pay for airing the L.A. Dodger games. The providers contend that Time Warner’s cable price for their L.A. Dodger sports channel is too high. How this negotiation is settled will affect prices other providers pay nationwide. For example, the Houston Astros RSN has not been picked up by many of the local providers and the RSN has been forced to file for bankruptcy.
Table 4 shows the changes in the MLB National media contracts with the various networks. We note that the ESPN contracts increased from $296 million a year to $700 million a year. The Fox contract increased from $257 million a year to $525 million a year, etc. In short, the new national contracts increased by 120 percent from the other contract.
At the height of the recession, the San Diego Padres sold for $500 million in 2009. It resold in 2012 for $800 million due primarily to a major jump in a local media contract.
Are the teams making so much money that they warranted such a much higher price based on profits? The answer, surprisingly, is “no, not really.”
The Texas Rangers sale in 2009 to the highest bidder out of bankruptcy court7 is a good example (Table 5).
Note that these numbers were prior to any regional media contract increases now scheduled to begin with the 2015 season.
Also note that annual amounts shown in the both the local and national contracts are averages and the initial year of the contract is usually much less than the average price shown.
All teams are subject to a player salary cap, which come with significant penalties if violated. So conceptually, if your revenues go up $50 million in a particular year, that amount could fall to the bottom line. How much is $50 million of profit worth to buyers whose primary value driver is not cash flow? It could be $500 million. It could be $1 billion. Which then causes people to wonder how much profit do these teams actually make?
The answer is that many lose money—some significant amounts. Many people ask why anyone would pay these amounts to buy teams if they do not make a reasonable profit.
There are two main answers to that:
The Texas Rangers also provide a good example of transaction price changes in the MLB. Table 6 shows the transactions in the team since 1974.
Please note that in the $595 million 2010 transaction, the team was making very little money and with signing bonuses deducted, was not cash flow positive. What is the value of this team, considering such facts?
The intensity of local revenues for MLB has created a perfect storm for MLB teams as the media engages in a buying frenzy for live local sports entertainment.
Multiples of 4.0 times revenues are now becoming the new normal versus 2.0 times prior to 2006 driven by local revenue growth with media leading the way. Media contracts are increasing three to five times the annual amounts negotiated in the early to mid-2000s. The outlook for increased local media contracts will create new and higher MLB club transactions for years to come.
But what about value creation? In the case of the Dodgers, if their media revenue increases up hypothetically $200 million a year from the previous contract, how much increase in value will that create? Could it be an extra billion dollars or more? At the end of the day, these local media contract increases, coupled with the new increased national media contracts, generally tend to support the new much higher level of MLB prices.
Obviously, the smaller markets do not enjoy the same increases as the major markets like Los Angeles and New York, etc., but their new contracts will increase in multiples of older contracts i.e., from $15 to $20 million a year to $50 million plus as media providers compete for the exclusive content that live sports provides.
This article was originally published in The Value Examiner, September/October 2014.
When it comes to the four major league sports (NFL, MLB, NBA, NHL), the NBA and MLB have had less success in Canada vs. the USA, primarily due to demographics. With the exception of Toronto, most of the cities tend to be smaller and have fewer corporate headquarters relative to U.S. cities. Currently there is only one NBA and one MLB team in Canada, both in Toronto.
There is one major league sport, however, that is thriving in Canada, the National Hockey League (“NHL”). The NHL teams in Vancouver, Calgary, Edmonton, Winnipeg, Ottawa, Toronto and Montreal are doing very well. In fact, they’re doing much better on average than their U.S. counterpart cities that have much larger populations (i.e. Dallas and Atlanta which is now a former NHL city). So much so that one may say there are really two NHLs, the Canadian NHL and the U.S. NHL.
How can that be?
Let’s look at the estimated 2013 franchise values of the teams as published by Forbes magazine. Three of the seven Canadien teams are in the top four of league franchise values. The Toronto Maple Leafs are first at $1.2 billion, the Montreal Canadiens third at $775 million and the Vancouver Canucks fourth at $700 million. The NHL league average is $413 million. The remaining Canadian teams are valued as follows:
Our home team, the Dallas Stars, comes in at $333 million and the Columbus Blue Jackets rank last at $175 million.
Now some interesting numbers: the seven Canadian teams feature values averaging $595 million, while the 23 American NHL teams average $358 million. That’s a little over half of the Canadian teams.
How can the New York Islanders, with a metropolitan statistical area (“MSA”) population of 19.9 million, be worth $195 million, while the Winnipeg Jets, with an MSA population of 0.7 million, are valued at $340 million? Additionally how can Vancouver, with a MSA population of 2.3 million, be valued at $700 million? The franchise value relationship with MSA population does not directly correlate. How can this be?
The answer is the popularity of hockey in Canada has no comparison to most U.S. cities. Hockey is the national sport of Canada. Kids grow up playing it, watching it and living it. That culture creates much greater revenue and profits for their teams. This can be demonstrated by analyzing the national television revenues and the local revenues of NHL teams.
The U.S. has a population of 319 million people vs. 35 million for Canada, yet the national TV rights for the NHL in Canada was recently won by Rogers Communications for $5.2 billion over 12 years, or an average of $433 million a year. This compares to the $2 billion, 10-year NBC U.S. deal which averages $200 million per year. In addition, 65% of the Canadian national TV rights will be shared with the 23 U.S. teams. It is interesting that a country with one-tenth the population gets about 2.2 times the national TV revenues compared to the U.S. and then has to share with the U.S. teams.
Local TV rights are retained by the teams, as are other local revenues from suites, sponsorship and ticket revenues. Here again, the Canadian teams far outshine the U.S. teams. Forbes estimates the average NHL ticket prices in Canada for six out of the seven teams was $70 for non-premium tickets. Forbes estimated that small markets, Edmonton and Calgary, each had $1.6 million in annual ticket revenues. Compare that figure with the New York Rangers ticket revenue of $1.8 million, and that comparison is shocking (if that is not shocking to you, please compare populations of the three cities). Additionally, local television viewing shows the same type of comparisons as national TV viewing. Therefore, smaller Canadian markets like Vancouver will have multiples of local TV revenue when compared to a larger U.S. market, like Dallas.
In conclusion, after considering the numbers, it is hard to make a case for franchise value comparison between Canadian and U.S. NHL teams. Clearly, the economics indicate there are two different NHLs.
This article was originally published in Valuation Viewpoint, October 2014.
In a recent article Mark Cuban commented how media revenues will push National Basketball Association (“NBA”) valuations far higher than they are currently. “If we do this right, it’s not inconceivable that every NBA franchise will be worth more than $1 billion within ten years,” he was quoted as saying. While that observation could be on the money, it’s not the only engine that drives NBA team values. NBA franchises are unique properties that are often among the most attractive and reported upon assets in the US (and globally for that matter thanks to Mr. Prokhorov). The undergirding economics of these teams are complex and nuanced. When value drivers align, good things happen and value is unlocked. Like a flywheel with momentum, certain dynamics can push values upward quickly. However, the same dynamics can push the flywheel off its hinges, bringing values crashing down. It’s an exciting property that doesn’t always follow the path of conventional valuation theory, which might be a reason why a Maverick like Mark Cuban loves it so much.
NBA franchise values have recently gone in an upward direction as evidenced by the Sacramento Kings’ $534 million sale in January 2013. That’s quite a figure for the 27th ranked metropolitan statistical area (“MSA”) in the country. This transaction is especially fascinating in light of the Philadelphia 76ers (5th largest MSA) selling for only $280 million just 18 months earlier. What fuels such a vast difference? We explore three issues that contribute considerably to these variances – media rights, arena lease structure, and the NBA’s collective bargaining agreement (“CBA”). Some of these factors are more within an owner’s control than others, but all of them contribute to situational changes that valuations hinge upon. We’ll also explore the tale of two transactions: the 76ers and Kings, to see why and how these factors influence the purchase price.
It is important to note the majority of NBA team revenues come from local sources, (i.e. game day revenues and local media contracts). The most dynamic (and thus value changing) of these sources in the past few years has been local media rights. National media revenues in NBA are significant but are a much lower percentage of total revenues than the biggest league in North America, the NFL. According to Forbes, the 30 NBA teams collectively generated $628 million from local media last season (about $21 million average per team). In addition, national revenues from ESPN, ABC & TNT total $930 million per year and these deals expire in 2015-2016. It’s a relatively balanced mix compared to the other major leagues. NHL & MLB’s media revenues are more locally focused, while the NFL is nationally dominated.
Basketball’s popularity has grown in recent years. This, coupled with intense media competition for quality live content, has fueled increased media contracts in many markets at unprecedented levels (300% to 500%) over prior contracts.
Live sports programming has a relatively fixed supply and is experiencing increased demand from networks looking for content those viewers will watch live. This commands higher advertising dollars compared to content that is consumed over DVRs and online forms (Netflix, Hulu Plus, Amazon Prime, etc.). Content providers also covet the low production costs and favorable demographics of younger fans. These factors, among other variables, have helped fuel the rapid price increases for sports media rights.
Recently, new media rights contracts across all sports programming have soared to record high annual payout levels. The NHL signed two new TV deals in April 2011 which more than doubled the league’s previous annual payouts with an upfront payment of $142 million. Even the media rights for Wimbledon have seen an increase in the amount of suitors. The NBA’s current national deal expires in a couple of years (2016). Many people expect that the next deal’s value will at least double the current agreement. [Side note: In negotiations that date back to the 70’s ABA/NBA merger, two brothers – Ozzie and Daniel Silna, received a direct portion of the NBA’s national TV revenues – in perpetuity. That’s right…perpetuity. In January 2014 they agreed to a $500 million upfront payment from the NBA and a pathway to eventually buy them out completely. The old transaction has withstood litigation and it has been termed as ‘the greatest sports business deal of all time’]
At the local level, in 2011 the Los Angeles Lakers signed the richest television deal in the NBA which dwarfs other teams. The contract reportedly averages $200 million per year for 20 years. The upper tier NBA franchises historically have received $25 to $35 million annually. Some big market teams have expiring contracts in the next few years, such as the Mavericks. While bidding has not yet begun, it’s reasonable to expect Mr. Cuban and his Mavericks to anticipate a healthy bump in rights fees in the future assuming good counsel and creative structuring.
How did these factors translate to the Kings and 76ers? Even with substantial MSA differences, they were at opposite ends of the media spectrum. The Kings’ deal with CSN California expires after this season, which put ownership in strong position to negotiate a new deal at the time of the transaction. The 76ers signed a 20 year contract in 2009 with Comcast Sports Net, which was reported by Forbes to be “undervalued” from the 76ers perspective, reportedly paying the team less than $12 million the season prior to purchase. That’s quite a difference and it almost surely played a pertinent role the Kings’ and 76ers’ valuations.
In the NBA, game day and arena revenue typically make up the lion’s share of a franchise’s income. These revenue streams filter up from a multitude of sources. Aside from regular ticket sales there are club seats, suites, naming rights, parking, concessions, merchandise, and sponsorship revenue. In addition there are non-game revenues such as concerts, events and meetings. On the expense side there’s rent (fixed or variable), revenue sharing (or a hybrid arrangement), capital expenditures, maintenance, overhead allocation and more. All of these aspects are negotiable among the business, municipal, and legal teams involved.
Arena deal structures vary across the board. For example, the Detroit Pistons own The Palace at Auburn Hills while the Golden State Warriors are tenants at Oracle Arena (probably until 2017/2018 anyway). Most arena structures involve some form of public/private partnership. One common theme is public ownership, usually financed via local bonds, with the sports franchise as a tenant paying rent of some form. The chief aspect to consider for legal teams is how to structure agreements for the various revenue streams, expense and capital items.
Historically, some of the most negotiated aspects to the arena lease are how proceeds from certain items as defined by the CBA are allocated. For example, while players as a group receive a flat percentage of basketball related income (“BRI”), they receive reduced percentages of others, such as luxury suites and arena naming rights. This nuance represents an opportunity for team ownership to retain a larger portion of these revenues and legal teams to employ shrewd negotiating tactics. In addition, as the arenas age and significant maintenance costs are required, cost sharing between the public/private partnerships can become an issue. Lease structure also can make outright ownership of a stadium appear less attractive without a partner to share or bear costs.
Again as we examine the Kings and 76ers a contrasting picture emerges. Prior Kings’ ownership (the Maloofs) and the city could not reach an agreement on a new stadium lease after nearly a decade of negotiations. Initially there was a buying group that planned to move the team to Seattle, but then, new local ownership purchased the team (with substantial input from the NBA). This agreement included an agreement for a new $447 million stadium (the majority funded publicly) and a guarantee to keep the team in Sacramento. This new deal was reported to be more favorable to ownership and gives the franchise an opportunity to attract more fans and create refreshed revenue channels. The 76ers on the other hand had already been locked into a long term lease at less favorable terms that were more geared towards revenue sharing with Comcast. Again, the Kings’ new opportunity appears more attractive than the 76ers existing arrangement.
On December 8, 2011, after a 161 day lockout, the NBA and its player union reached a new collective bargaining agreement. This agreement brought about meaningful changes to the salary structures, luxury tax, BRI, and free agency (among other things). Although the CBA is not under direct control of a franchise owner, its impact on competiveness, team operational strategy and expense management is significant.
The changes were important for owners, who had reportedly lost over $300 million annually as a group in the three prior years to the negotiations. From a valuation perspective three items deserve focus: (i) length, (ii) BRI, and (iii) luxury tax provisions. Prior to the agreement, there was a great deal of uncertainty as to how negotiations would play out. Uncertainty infers risk and where there’s more risk, values usually fall. The 10 year agreement (with a 2017 opt-out) brings stability to both players and owners as to what operating structure they can plan for the near to intermediate term future. In addition, BRI revenue splits to the players were lowered from 57% of BRI to around 50% for most of the contract. This split brings cash flow relief (but not competitive relief) to owners across the league. Lastly, the luxury tax structure became much more punitive for big-spending owners, like Cuban. In fact, it economically functions similarly to a hard salary cap that the NFL and NHL employ. In light of this change, NBA franchises have committed an enormous amount of time and resources to understand and execute an appropriate competitive strategy. The luxury tax provisions even the competitive playing field for smaller market teams such as Sacramento and the Memphis Grizzlies (who sold for a reported $377 million in October 2012) and constrains the spending of larger market teams such as the Mavericks, Lakers or Knicks.
How did this facet play out with the Kings and 76ers? All one needs to know is that the 76ers were sold before the new CBA was agreed (Summer 2011) to and the Kings were sold after the CBA was in effect (January 2013). Timing, coupled with the Kings small market status, has an increasingly positive effect on them compared to the 76ers. Advantage: Kings.
NBA franchise values are on the rise. There is a buzz around the league that if there were teams on the market the price would be robust right now. The values are driven by a number of different factors (TV, arena rights, CBA), some that cannot be controlled by owners and their advisory teams, but others that can be. Don’t be fooled by market size. A value creation scenario can occur in almost any market. In one of the smallest markets in the country, Tom Benson paid more for the Hornets than Josh Harris’ group did for the 76ers. However, owner involvement, savvy counsel and careful negotiations are a must; because as some transactions have shown, there are no guarantees.
This article was originally published in The Texas Lawbook in March 2014.
Statistics can be deceptive. The bank M&A market in 2015 could be described as steady, bereft of any blockbuster deals. According to SNL Financial 287 depositories (253 commercial banks and 34 thrifts) agreed to be acquired in 2015 compared to 304 in 2014 and 246 in 2013. Since 1990, the peak in M&A transactions occurred in 1994 (566) followed by 1998 (504). For those who do not remember, 1998 was the blockbuster year when NationsBank/Bank of America, Norwest/Wells Fargo, Bank One/First Chicago NBD and SunTrust Banks/Crestar Financial among others agreed to merge (Figure 1).
There has been a cumulative impact of M&A activity over the years. As of September 30, 2015, there were 6,270 insured depositories compared to about 18,000 institutions in 1985 when interstate banking laws were liberalized. M&A activity when measured by the number of transactions obviously has declined; however, that is not true on a relative basis. Since 1990, the number of institutions that agreed to be acquired in non-assisted deals ranged between 1.4% (1990) and 4.6% (1998) with an overall median of 3.2%. Last year was an active year by this measure, with 4.4% of the industry absorbed, as was 2013 (4.5%).
What accounts for the activity? The most important factors we see are (a) good asset quality; (b) currency strength for many publicly traded buyers; (c) very low borrowing costs; (d) excess capital among buyers; and (e) ongoing earnings pressure due to heightened regulatory costs and very low interest rates. Two of these factors were important during the 1990s. Asset quality dramatically improved following the 1990 recession while valuations of publicly traded banks trended higher through mid-1998 as M&A fever came to dominate investor psychology.
Today the majority of M&A activity involves sellers with $100 million to $1 billion of assets. According to the FDIC non-current loans and ORE for this group declined to 1.20% of assets as of September 30 from 1.58% in 2014. The most active subset of publicly traded banks that constitute acquirers is “small cap” banks. The SNL Small Cap U.S. Bank Index rose 9.2% during 2015 and finished the year trading for 17x trailing 12 month earnings. By way of comparison, SNL’s Large Cap U.S. Bank Index declined 1.3% and traded for 12x earnings. Strong acquisition currencies and few(er) problem assets of would-be sellers are a potent combination for deal making.
Earnings pressure due to both the low level of rates (vs. the shape of the yield curve) and post-crisis regulatory burdens are industry-wide issues. Small banks do not have any viable means to offset the pressure absent becoming an acquirer to gain efficiencies or elect to sell. Many chose the latter. The Fed may have nudged a few more boards to make the decision to sell by delaying the decision to raise short rates until December rather than June or September when the market expected it to do so. “Lift-off” and the attendant lift in NIMs may prove to be a non-starter if the Fed is on a path to a one-done rate hike cycle.
As shown in Figure 2, pricing in terms of the average price/tangible book multiple increased nominally to 142% in 2015 from 139% in 2014. The more notable improvement occurred in 2014 when compared to 2013 and 2012, which is not surprising given the sharp drop in NPAs during 2011-2013. The median P/E multiple was 24x, down from 28x in 2014 and comparable to 23x in 2013. The lower P/E multiple reflected the somewhat better earnings of sellers in which pricing was reported with a median ROA of 0.65% compared to 0.55% in 2014. Although the data is somewhat murky, we believe acquirers typically pay on the order of 10-13x core earnings plus fully-phased-in, after-tax expense savings.
Figure 3 provides perspective on pricing based upon size and profitability as measured by LTM ROE. Not surprisingly, larger and more profitable companies obtained better pricing in terms of the P/TBV ratio; however, as profitability increases the P/E multiple tends to decline. That is not surprising because a higher earning bank should have fewer issues that depress current earnings.
The other notable development in 2015 was the return of non-SIFI large banks to the M&A market after largely being absent since the financial crisis as management and regulators sorted through the changes that the Dodd-Frank Act mandated. BB&T Corporation, which is among the very best acquirers, followed-up its 2014 acquisitions for Bank of Kentucky Financial Corp. and Susquehanna Bancshares with an agreement to acquire Pennsylvania-based National Penn Bancshares. The three transactions added about $30 billion of assets to an existing base of about $180 billion. Other notable deals included KeyCorp agreeing to acquire First Niagara ($39 billion) and Royal Bank of Canada agreeing to acquire City National Corporation ($32 billion). Also, M&T Bancorp was granted approval by the Federal Reserve to acquire Hudson City Bancorp ($44 billion) three years after announcing the transaction.
To get a sense as to how the world has changed, consider that the ten largest transactions in 2015 accounted for $17 billion of the $26 billion of transaction value compared to $9 billion of $19 billion in 2014. The amounts are miniscule compared to 1998 when the ten largest transactions accounted for $254 billion of $289 billion of announced deals that year.
Law firm Wachtell, Lipton, Rosen & Katz (“Wachtell”) noted that with the approval of several large deals this year there is more certainty to the regulatory approval process and there is no policy to impede bank mergers x-the SIFI banks. A key threshold for would-be sellers and would-be buyers from a decision process has been $10 billion of assets (and $50 billion) given enhanced regulatory oversight and debit card interchange fee limitation that applies for institutions over $10 billion. Wachtell cited the threshold as an important consideration for National Penn’s board in its decision to sell to BB&T.
There were a couple of other nuances to note. While not always true, publicly-traded buyers did not receive the same degree of “pop” in their share prices when a transaction was announced as was the case in 2012 and 2013. The pops were unusual because buyers’ share prices typically are flat to lower on the news of an announcement. Several years ago the market view was that buyers were acquiring “growth” in a no-growth environment and were likely acquiring banks whose asset quality problems would soon fade.
Also, the rebound in real estate values and resumption of pronounced migration in the U.S. to warmer climates facilitated a pick-up in M&A activity in states such as Georgia (11 deals) and the perennial land of opportunity and periodic busts—Florida (21). The recovery in the banking sector in once troubled Illinois was reflected in 25 transactions followed by 20 in California.
As 2016 gets underway, pronounced weakness in equity and corporate bond markets if sustained will cause deal activity to slow. Exchange ratios are hard to set when share prices are volatile, and boards of sellers have a hard time accepting a lower nominal price when the buyer’s shares have fallen. Debt financing that has been readily available may be tougher to obtain this year if the market remains unsettled.
Whether selling or merging, we note for the surviving entity a key goal should be something akin to Figure 4 in which there is shared upside for both the acquirer’s and seller’s shareholders (assuming a merger structured as a share exchange). A well-structured and well-executed transaction can improve the pro forma bank’s profitability and growth prospects. If so, all shareholders may benefit not only from EPS accretion, but also multiple expansion.
We at Mercer Capital have over 30 years of experience of working with banks to assess transactions, ranging from valuation to issuing fairness opinions in addition to helping assess the strategic position (e.g., sell now vs. sell later). Please call if we can help your institution evaluate a significant corporate transaction.
Although farm income is projected to decline for a second consecutive year in 2015, farmers and the broader agricultural industry have had a great run since the Great Recession. The agricultural lending industry? Not so much.
Call it one of the age old conundrums of being in the business of lending money – those to whom you feel most comfortable lending are the least likely to need your services. Such has been the case for several years in the broader agricultural economy. Sure, there have been some farmers and ranchers willing to take advantage of low interest rates to increase leverage and enjoy the associated higher returns on equity and a larger fixed asset base with more profit potential. However, the painful deleveraging associated with the Great Recession left no sector of the economy untouched. Agricultural producers were no exception, with many eschewing debt in favor of fiscal conservatism.
This conservatism among most farmers is contrasted with foreign investors seeking U.S. assets and institutional investors who drove land prices to record level in many areas by 2013. The prices paid implied these investors were oblivious to generating an acceptable return. Elevated land prices have led to concerns among some that lenders could be exposed should land prices fall sharply with a secondary impact on production-related collateral values in a replay of the 1980s bust in the farm sector following the inflation and borrowing binge that occurred during the 1970s.
As for production-related lending, record yields and crop prices left many producers so flush with cash that borrowing needs declined. Data from the Federal Reserve Bank of Kansas City reveals a steadily declining trend in operating loan volumes at commercial banks over the 2009 to 2012 period (Figure 1). The second half of 2012 showed a rapid rise in loan volumes, but since then agricultural production loans have grown at a relatively slow pace – until recently, that is.
A number of factors have finally reversed course, leading to a notable uptick in demand for financing and an expectation that ag production loan demand will remain strong in the near- term. While real estate agriculture loans also have increased, lending dollar volume in that area has been influenced by the substantial increase in farmland values in recent years. The discussion which follows focuses on production, or operating, lending.
Several years of record crop yields and high commodity prices left farmers and ranchers with little need for operating loans. However, crop receipts are expected to decline by approximately 6% in 2015 and livestock receipts are expected to decline 9%. These declines will be modestly offset by an increase in direct government payments and other income. However, input expenses should remain stable, primarily reflecting higher costs for livestock purchases and labor offset by lower energy costs, leading to an expected 36% decline in net farm income. This decline comes on the heels of a 26% decline in 2014 (Figure 2).
Throughout 2014 producers had the luxury of strong balance sheets, allowing them to avoid significant operating debt despite the downturn in net income for that year. However, during 2015 the cash cushions built up during the commodity boom will begin to be depleted, leaving many producers with little choice but to finance short-term capital investment and input costs with borrowings.
The average effective interest rate on non-real estate bank loans to farmers declined from 5.6% in 2008 to 3.8% in 2014, but has shown two consecutive quarter over quarter increases (albeit modest) in the first half of 2015 and measured 4.1% in second quarter 2015. One possible explanation for this slight uptick is that as demand has picked up banks have regained the smallest amount of pricing power. Alternatively, it may be the case that the average borrower credit profile has deteriorated slightly as the industry comes off its highs from the recent commodity pricing boom.
Despite the low rates, ag production loans can be very attractive from an interest rate risk standpoint, as most of the loans renew annually allowing for more rapid adjustment when rates (finally) begin to rise. That said, oftentimes collateral used for non-real estate agricultural loans is less desirable, thus increasing the risk of the loan if it were to fail.
There is an argument to be made that all of the factors affecting loan volume mentioned above are just noise, and producers are simply doing what mainstream America has been doing with residential mortgages for years – locking in these once-in-a-lifetime rates while they still can. The share of floating rate loans made by banks for non-real estate agricultural purposes fell to at least a 15-year low (60%) in the first quarter of 2015. Although it increased to 70.8% in the second quarter, that level remains well below the average exhibited since 2000.
Fixed rate loans are most commonly used for non-feeder livestock production and machinery and equipment, while floating rate loans are more common for shorter-term financing used for feeder livestock (typically sold to a feedlot within one year of age) and current operating and production expenses (including crop production).
The amount of debt supporting the U.S. agricultural system is vast, and commercial banks are by no means the only player in town. The Farm Credit System (FCS), for example, funds approximately 39% of all U.S. farm business debt (according to the USDA) and commercial banks must compete with farm credit system banks for all types of agriculture and in all 50 states. While Call Report data compiled by the Federal Reserve Bank of Kansas City shows rapid recent growth in non-real estate ag lending at commercial banks, financial data from FCS paints a slightly different picture.
Figure 3 shows steady total FCS loan growth since 2001. However, loan growth in the first half of 2015 was nearly flat, and production and intermediate term loans actually declined relative to year-end 2014. FCS states this decline was driven by borrowers’ tax planning strategies at the end of 2014, resulting in significant repayments in early 2015, as well as a high level of seasonal pay-downs in the first quarter. It’s difficult to draw the conclusion, however, that this data indicates a shift in market share away from FCS toward commercial banks, given classification, measurement and timing differences. It’s worth noting that FCS relies primarily on the public debt markets for its balance sheet funding and these costs increased modestly in the first half of 2015 relative to the same period in 2014.
Another source of credit for the agricultural industry is financing provided by heavy equipment dealers and manufacturers. Equipment loan volume can be influenced by commodity cycles somewhat differently than for other operating loans. Producers generally prefer to invest in new equipment when times are good and net incomes are strong, electing to postpone larger capital purchases and make do with aging equipment in times of falling incomes. This effect has played out in the first part of 2015, with rather significant sales declines in what is normally an active period of highly seasonal buying patterns (Figure 4).
Since peaking in late 2009, delinquency and charge-off rates on ag production loans held by commercial banks have fallen consistently and dramatically, and for second quarter 2015 measured 0.81% and 0.09% (seasonally adjusted), respectively. Asset quality data from FCS exhibits a similar trend. As shown in Figure 5, delinquencies and charge-offs tend to be closely correlated with the health of farm balance sheets, which is not surprising.
We note an interesting trend since the end of 2012 in which this relationship appears to have broken down. Farm debt to equity ratios are increasing, while delinquencies and charge-offs continue to decline. Is this a harbinger of things to come? It’s probably too soon to tell, as the agriculture industry is highly susceptible to completely unpredictable events, such as weather patterns, and the health of the overall global economy (also not an easy prediction these days). One thing is certain, the trend is not sustainable indefinitely.
Another issue with the comparability of recent trends to previous points in the long-term historical agriculture cycle is the impact that the dramatic increase in land values has had on farm equity since 2009. A portion of the rise in debt to equity ratios in recent periods is not due to an increase in debt, but rather recent declines in land values (falling asset values will increase debt/equity ratios, all else equal). If land values continue to decline from their historical highs (which most reliable sources predict), and farm debt continues to increase (which all of the factors discussed above would indicate) then leverage ratios will be further strained in the coming quarters and years. Current charge-off rates are de minimis to the point where an increase in asset quality issues related to agricultural production loans will be easily absorbed by all but the most concentrated ag lenders. That said, it bears watching to see if these trends become more sustained and have deeper implications for both agricultural lending and the broader agricultural economy.
In contemplating August’s market activity, our thoughts drifted to Roman times. In 45 B.C., the Roman Senate honored Julius Caesar by placing his name on the month then known, somewhat drably, as Quintilis. Later, the Senate determined that Augustus Caesar deserved similar recognition, placing his name on the month after July. But this created an immediate issue in the pecking order of Roman rulers – up until then, months alternated between having 30 and 31 days. With July having 31 days, poor Augustus’ stature was diminished by placing his name on a month having only 30 days. To rectify this injustice, the Senate decreed that August also have 31 days, accomplished by borrowing a day from February and shifting other months such that September only had 30 days (to avoid having three consecutive 31-day months).
We provide this historical interlude to illustrate that, while July and August now are equivalent in terms of the number of days, the market environment in these two months during 2015 bore few similarities. In August, volatility returned, commodity prices sank, and expectations of Federal Reserve interest rate action in September diminished.
Most broad stock market indices declined between 6% and 7% in August, taking the indices generally to negative territory year-to-date in 2015. As indicated in Figure 1, except for the largest banks, publicly-traded banks generally outperformed the broader market, both year-to-date in 2015 and in August specifically.
For the year, banks benefited from several factors. First, investors appear to expect that rising interest rates will, if not enhance banks’ earnings, at least prove to be a neutral factor. Other sectors of the market, though, may be less fortunate, as companies face higher interest payments or other adverse effects of higher interest rates. Second, banks generally reported steady growth in earnings per share, as assisted by a benign credit environment.
Within any index, though, the performance of individual companies may vary greatly. Seeking to isolate factors influencing the August market performance, we focused on publicly-traded banks with assets between $500 million and $5 billion. Given the market backdrop, these 212 banks performed relatively well in August, with a median share price depreciation of only 1.1% (see Figure 2). For the year, the median bank reported a 2.9% increase in its stock price.
While linking company-specific factors to market performance during a volatile period is difficult, we identified three groups of banks that underperformed in August:
Several risks that influenced August’s volatility have not dissipated, including uncertainty surrounding China’s opaque (and potentially over-leveraged) economy and the effect of any Fed policy tightening. Analyst estimates for 2016 EPS often suggest favorable growth over 2015, and such estimates bear watching to the extent that the recent market volatility spills over into the real economy.
Despite much commentary about the significant economic and regulatory headwinds impacting community banks, profitability is on the mend. Community bank earnings improved in the trailing twelve months ended June 30, 2015 with net income up 14% to $17.6 billion compared to $15.5 billion in the twelve months ended June 30, 2014.1 Nearly 60% of community banks reported higher profitability based upon annualized first half 2015 net income compared to 2014 levels. The number of unprofitable banks also declined to 41 in the second quarter of 2015, compared to 109 in 2014 and 167 in 2013. The median return on assets (ROA) for community banks was up to 0.96% (annualized based upon the first half of 2015), which was the highest level since 2008.
As detailed in Figure 1, key contributors to improving earnings were higher net interest income and lower loan loss provisions. Loan growth drove the improvement in net interest income as 84% of community banks reported loan growth in the trailing twelve month period, with the median community bank’s loan growth rate reported at 7.2%. Loan growth offset net interest margin (“NIM”) compression as NIMs were at their lowest level over the 10-year historical period. As the Federal Reserve’s zero-interest rate policy (“ZIRP”) grinds on, asset yields continue to compress while funding costs have essentially reached a floor. One interesting item to gauge in future quarters is how much interest rate and credit risk is being taken by community banks to grow loans and earnings.
Another sign of improving community bank health is that deal activity is up from recent prior periods as shown in Figure 2. Price/earnings multiples have also improved in recent periods (Figure 3) and appear to be relatively in line with long-term trends at approximately 20x. Price/tangible book multiples are still below longer-term trends, largely reflecting that although improved from the Great Recession returns on assets and equity remain below pre-financial crisis levels.
While it is difficult to tell whether community bank earnings have peaked and how long this cycle may last, improving profitability expands the strategic options available to community banks. A recent article by SNL Financial noted that a number of community banks are looking to sell as earnings may have plateaued. While selling is one option available to community banks in this environment, the range of strategic options available is much broader than that. A well-rounded strategic planning session should include an assessment of the bank’s unique strengths, weaknesses, and opportunities as well as a review of the bank’s performance and outlook relative to both its history and peers. Then, a broader discussion of a range of options that can deliver growth and enhance shareholder value should be discussed. Those other options could include organic and/or acquisitive growth and other ways to provide liquidity and enhance returns to shareholders such as special dividends, share repurchases, management buy-outs, and employee stock ownership plans.
Founded in 1982, in the midst of and in response to a previous crisis affecting the financial services industry, Mercer Capital has witnessed the industry’s cycles. Despite industry cycles, Mercer Capital’s approach has remained the same – understanding key factors driving the industry, identifying the impact of industry trends on our clients, and delivering a reasoned and supported analysis in light of industry and client specific trends.
Mercer Capital has experience facilitating strategic planning sessions for community banks and providing a broad range of specialized advisory services to the sector. Contact us to discuss scheduling a strategic planning session or your institution’s specific needs in confidence.