This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. To view or download the original report as a PDF, click here.
The correlated indication of value is a value that is arrived at through some reasonable, well-articulated, replicable, and credible process of selection, averaging or otherwise, of the total valuation evidence generated from the valuation methodologies employed. Correlating a valuation conclusion that subsumes all the information, processes, analyses, and market evidence in a valuation engagement is no simple task. The term used by some appraisers for the resulting valuation distillation is “correlated indication of value.” For valuations in which the value methodology directly results in the value definition specified in the engagement, the correlated indication of value may represent the final conclusion of value. For cases in which the value definition differs from the direct results of valuation methodology, the correlated indication of value is typically adjusted by valuation discounts or premiums (typically the former) to develop the value definition specified in the engagement. Figure 1 depicts the typical correlation framework. There are numerous variations and potential interjecting steps and adjustments.
In operation, developing a correlated indication of value may appear reasonably straightforward (sometimes it is), but the considerations in the process can reach back to the smallest of details and considerations in the underlying valuation methodologies. A brief review of the global valuation approaches provides a good review for the subsequent observations. Figure 2 presents the three valuation approaches.
The following provide some global considerations used by many appraisers to navigate the correlation process (which is not to say all are best practices).These points are not listed in any order of significance because the priority of consideration changes with every appraisal.
These considerations are based on experience, observations of public and private markets over time, and a dose of informed judgment; differences, both semantic and substantive, can exist from one appraiser to the next. One could ask: When should a valuation not reflect balanced consideration of all approaches and methods? The right answer is – never. It is always helpful to assess the value indications from all approaches and methods in the context of one another. However, consideration and direct reliance are different things. In many cases, there is simply not ample information, market evidence, or cause to develop values under each approach.
Appraisers owe the users of their reports a credible explanation of where reliance was placed and in what proportion. There are times when financial information and valuation evidence suggest that brevity is the high road and that too much analysis along lines that are ultimately not relied upon in the valuation is confusing or misleading. Appraisers simply must use the judgments extended them by the appraisal standards to present a complete picture of the relevant methodological landscape. However, appraisers and their audiences benefit from the use of a core set of processes and considerations for deriving and displaying the correlation of value.
The table in Figure 3 is provided for perspective. We note that the valuation of most business enterprises is ultimately driven by the economic returns generated on the assets that comprise the business. As such, the income approach is the primary indicator of value in most business appraisals where the business is a going concern and not simply a fund of underlying net assets. Unfortunately, the income approach can be difficult to model in certain circumstances such as a recession.
For ESOP appraisals, the above perspectives can be shift based on the comfort and confidence of the appraiser/trustee in the company’s ability to maintain a sustainable ESOP benefit. Repurchase obligations ultimately require cash flow. Depending on the overall design and management of the ESOP plan, appraisers and trustees are cautioned when relying on asset-based value indications without taking into consideration the ability of the company to sustain the asset base when cash flows fall short of servicing the ESOP’s needs, let alone the needs of the business. ESOP companies that experience a decline in business activity and which have little prospects of recovering to past performance levels (or worse, remaining a going concern) should likely include consideration of a liquidation premise. The liquidation premise is often developed and studied using an asset value perspective, adjusted for the time-value and liquidation consequences that could befall the assets as they are sold. Such a premise need not be a death sentence for the ESOP or the Company, but may relevant to consider during a time of reorganization for the sponsor company.
When businesses are displaying significant volatility and/or a fundamental change in business posture (particularly on the downside), appraisers and trustees are encouraged to communicate about the underlying methodology and the potential need to redefine the level and premise of value for the appraisal. Such changes could materially rebalance the consideration of the underlying approaches and methods toward the conclusion.
Following are some typical examples of a correlated indication of value. We have provided differing examples based on varying scenarios. The numerical values and weights are for demonstration purposes; the weights applied are not based on any rigid formula and will vary for each appraisal based on the totality of underlying factors for each appraisal.
Example 1 in Figure 4. Small to medium service business; stable market, consistent performance and expectations; valuation definition is FMV minority interest, correlated value before discount for lack of marketability.
Example 2 in Figure 5. Small distribution business; challenging market conditions and sub-par expectations; company owns real property and other fungible assets; valuation definition is FMV minority interest, correlated value before discount for lack of marketability.
Example 3 in Figure 6. Large producer of value-added capital assets; stable markets and expectations; advanced financial management and capital resources; value definition is FMV minority interest, correlated value before discount for lack of marketability.
In Figure 6, we can see that the income approach was allocated two-thirds of overall weighting. Looking deeper, if the GPCM exclusively considered cash flow calculations (say net earnings and EBITDA), then income measures were effectively weighted 100 percent in the overall valuation; the only difference being the specificity of the market evidence used to value the income and cash flows.
For cases in which the GPCM is used, there may be reasons that some calculations should receive greater underlying consideration than others (say capitalized book value rather than EBITDA). This may simply be a variation of the same theme of shifting weights between asset-based and income-based methods to address issues related to business and economic cycles.
Variations on these examples are almost endless. There are often circumstances in which value indications vary greatly and require thoughtful explanation about why a value that appears at one end of a spectrum was exclusively weighted.
In some cases, a simple average might be appropriate but appraisers should be cautious when averaging a potentially non-meaningful indication with a meaningful indication.
Rarely does the averaging of an unreliable indication make the end result correct unless additional explanation and support are provided about how the resulting correlation relates to the most meaningful valuation evidence.
Accordingly, a relative value analysis, as in Figure 7, may be a useful tool in helping explain how each indication relates to other indications. Let us expand on the third example with some additional information to see how the various indications compare to each other. Such a comparison could be used in an iterative fashion to reach a final weighting scenario as well as to provide support for the conclusions reached in the report. Note that the relevant comparisons are being made at the marketable minority interest level of value.
At the marketable minority interest level of value, the subject’s relative value measures can be directly compared to the relative value measures of the guideline public companies.
Relative value assessments that compare subject valuation results to peer valuation evidence must be performed using an appropriate and comparative level of value for both the subject and the peer.
Section 5 of Revenue Ruling 59-60 addresses the weight to be accorded to various factors in an appraisal. In the context of an operating company appraisal, judgment is required to reconcile what may be diverging indications of value among the various valuation approaches (or even methods within a single approach or method).
Although averaging widely diverging indications of value from various valuation methods may be appropriate in a particular valuation, appraisers should assess why such large differences exist. Do indications from the market approach suggest that assumptions made in methods within the income approach be revisited? Or do the results from an income approach shed light on the appropriate fundamental adjustment (or selection of guideline companies)?
Within the market approach, indications of value can vary widely, depending on the financial measure capitalized. The appraiser may glean hints with respect to the weight to a particular indication by considering why such differences occur. Differences between indications derived from capitalized net income and EBIT are a function of the financing mix.
Differences between indications derived from EBIT and EBITDA may reveal varying degrees of asset intensity. Capitalized revenue measures provide a view of “normalized” margins – are the margins of the subject company likely to improve or deteriorate? Finally, capitalizing measures of physical volume (number of subscribers or units sold, for example) could reveal unit-pricing disparities between the subject and the selected guideline companies.
There can be no fixed formula for weighing indications of value from various valuation methods. Responsible appraisers, recognizing this, should apply common sense and informed judgment in developing a correlated indication of value.
Given the potential diversity of valuation evidence and methodology in most business appraisals, a well-reasoned and adequately documented process is required to support the initial and final valuation conclusions derived in a business valuation. In this publication we provided insight on the functional processes and analytical considerations underlying the determination of a correlated indication of value. Additionally, we discussed methods and perspectives that can be used to justify the underlying methodology and valuation evidence relied upon while providing relative value observations to support the reasonableness of a valuation conclusion.
This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. To view or download the original report as a PDF, click here.
There is a protracted and clouded legacy of information and dogma surrounding the universe of discounts and premiums in business valuation. It seems logical enough that as elements of business valuation, the underlying quantification and development of discounts and premiums should be financial in basis, just as other valuation methods are founded on financial principles. Much of the original doctrine surrounding the determination of discounts and premiums was based on reference to varying default information sources, whose purveyors continue the ongoing compilation of transaction evidence (public company merger and acquisition activity, restricted stock transactions, pre-IPO studies, etc.). After begrudging bouts of evolution, there has been maturation toward more disciplined and methodical support for valuation discounts and premiums. Perhaps as the state of the profession concerning discounts and premiums has progressed, so, too, has the divide in skill and knowledge among valuation practitioners become wider. Certainly this seems to be the case regarding many users and reviewers of appraisal work (ostensibly the legal community, the DOL and the IRS).
There remains ample debate concerning numerous issues in the discount and premium domain. Unfortunately, in the quest for better clarification on the determination of discounts and premiums there has developed an arms’ race of sorts. Despite the emergence of compelling tools and perspectives, no method or approach appears to have the preponderance of support in the financial valuation community. Nowhere is this truer than with the marketability discount (also known as discount for lack of marketability or DLOM). Within the ESOP community much of the confusion over DLOMs is mitigated due to the presence of put options designed to ensure reasonable liquidity for ESOP participants. However, in the ESOP community a legacy of concern over control premiums has now become an acute issue as stakeholders and fiduciaries have increasing concerns regarding flawed valuations and prohibited transactions.
Regarding the concept of control premiums and minority interest discounts (also known as “lack of control discounts”), there is less conflict and more uniformity on how and when these discounts are used in a business appraisal. That is not to say that differences among appraisers don’t exist regarding certain issues. For purposes of establishing a platform to converse on valuation discounts and premiums, let us use the conventional levels of value framework to anchor the discussion. Figure 1 provides structure about where the traditional valuation discounts and premiums are applied in the continuum of value.
The integration of the basic income equation of value into the levels value chart results in the equations and relationships shown in Figure 2. It is here that we can begin to understand that valuation discounts and premiums are not devices in and of themselves. Each is the product (consequence) of the relationships among and between the underlying modeling elements that constitute financial valuation(cash flow, risk and growth). We note that the conceptual core of the mathematical relationships is generally centered on the freely traded world of the public stock markets, which is characterized as the “marketable minority” level of value (enjoying readily achievable liquidity in a regulated, timely, and efficient market). Although other levels of value can be directly observed in various markets, the marketable minority interest level of value characterizes the empirical world from which most valuation data and observations are made (i.e., Ibbotson).
The take away from the relationships depicted in Figure 2 is that risk is negatively correlated to value (the universal reality of the time value of money) and that cash flow and the growth rate in cash flow are positively correlated to value. According to the preceding relationships, a control premium only exists to the degree that control investors reasonably expect some combination of enhanced cash flows, lower risk, or superior growth in cash flow, all as a result of better financial and operational capacity (financial control). Taking the financial control relationships one step higher via specific synergies results in a strategic control premium (which is not considered within the continuum of fair market value and generally exceeds adequate consideration for ESOP transaction purposes).
Conversely, a marketability discount exists to the degree that investors anticipate subject returns (yield and capital appreciation) that are sub-optimal in comparison to the returns of a similar investment whose primary differentiating characteristic is that it is freely traded (also known as liquid). That is to say, minority investors (buyers and sellers) in closely held businesses that have investment-level considerations such as higher risks, lower yield, and/or lower value growth require some measure of compensation to compel a transaction in the subject interest. Otherwise, the investor would seek an alternative.
What is a control premium? The American Society of Appraisers (ASA) defines a control premium as an amount or a percentage by which the pro rata value of a controlling interest exceeds the pro rata value of a non-controlling interest in a business enterprise, to reflect the power of control. In practice, the control premium is generally expressed as a percentage of the marketable minority value.
Based on this definition, it might seem that no controlling interest valuation can be developed without an explicit quantification to increase a value that is initially developed using a marketable marketable-minority interest level of value. This might be true in for circumstances in which the control value is not the direct result of the underlying methods. The fact is that most controlling interest value appraisals are developed based on adjustments and methods that result directly in the controlling interest level of value. Therefore, no explicit control premium is required. Consequently, the appraiser cannot explicitly define the magnitude of the control premium in the appraisal.
In many cases, the appraiser may state that no control premium is added because all the features and benefits of control have been captured in the earnings adjustments and/or through other modeling assumptions in the underlying methods. We have seen numerous situations in which an appraiser was accused of failing to develop a control valuation because there is no explicit control premium applied to the correlated value or to the individual methods that are weighed in the correlation of value. Archaic though it may be in the context modern valuation practice, such accusations still exist even when the valuation features all the perfunctory control adjustments and treatments. For cases in which normalization and control adjustments were applied to cash flows and other elements, the additional application of a discrete control premium implies that there are further achievable control attributes. In such cases the control premium is likely quite small in comparison to typical published measures. If control adjustments are applied and a control premium is also applied, there is a potential overstatement in the valuation. This type of circumstance is a hot bed issue with the Department of Labor as such treatments could be the underpinning of a prohibited transaction. Appraisers and trustees are cautioned about the potential for double counting when applying an explicit control premium.
The primary published source for control premium measurements is Mergerstat Review,published annually by Mergerstat FactSet. Mergerstat Review reports control premiums from actual transactions based on differences between public market prices of minority interests in the stock of subsequently acquired companies prior to buyout announcements and actual buyout prices. It is worth noting that Mergerstat’s analysis indicates that higher premiums are paid for public companies than for private concerns because publicly traded companies tend to be larger, more sophisticated businesses with solid market shares and strong public identities. From a levels-of-value perspective, most of the transactions reported in Mergerstat Review are believed to contain elements of strategic value, which explains the relatively high level of control premiums cited therein. This strategic attribute of the data also makes it potentially troublesome when relied upon in ESOP appraisals.
Noteworthy is the now widely accepted presumption that public stock pricing evidence is reflective of both the marketable marketable-minority and controlling financial interest levels of value. Referring to the expanded levels of value chart, minority interest discounts and financial control premiums are thought to be much lower in comparison to annually published data in Mergerstat Review. Thus, the two central boxes in the four-box vertical array of the expanded levels of value chart are essentially overlapping as in Figure 3.
The parity of value between financial control and marketable minority requires a few assumptions: normalized earnings adjustments are required, and these adjustments include some considerations that certain appraisers believe are not part of the minority interest equation (namely owners’ and executive compensation). We believe that return on labor and return on capital are reasonable to segregate in valuations based on all levels of value. However, there may be differences between financial control and marketable minority valuations based on enterprise capital structure. There may be some consideration for the lack of liquidity to both control and minority investors when adjusted income streams overstate the real economic cash flows available for distribution or other shareholder-level benefits (including cash flows necessary to sustain an ESOP). There may be some justifiable difference in value for situations in which the valuation subject’s capital structure appears more conservative than its peers. However, wanton manipulation of capital structures (for example, in the development of a weighted average cost of capital or WACC) in deriving the cost of capital is a frequent source of error in appraisals using a discounted future benefits (DFB) method. Such errors can lead to under- or over-valuation.
Most appraisals that employ a controlling interest level of value definition do not (or should not) display a discrete or explicit control premium. That is because the adjustment processes underlying most individual valuation methods provide for the full consideration of control and thus do not require or justify further adjustment in the form of an explicitly applied control premium. So, despite the lack-of-control form that many control appraisals have, there is ample structure within the methodologies to capture the substance of a control premium. The following perspective plays off the basic equation to business valuation as well as the levels of value chart that depicts the relationships between risk, growth, and cash flow as one moves up and down the levels of value conceptual framework.
What is a minority interest (lack of control) discount? The ASA defines a minority interest discount as the difference between the value of a subject interest that exercises control over the company and the value of that same interest lacking control (but enjoying marketability). In practice, the minority interest discount is expressed as a percentage of the controlling interest value. A minority interest is an ownership interest equal to or less than 50 percent of the voting interest in a business enterprise (or less than the percentage of ownership required to control the assets and/or the discretionary expense structure of a business).
As with the control premium, the minority interest discount is infrequently called upon in the valuation (as an explicit treatment) of most operating businesses because the majority of methodologies used to value nonmarketable minority interests results in an initial value at the marketable minority interest level of value. Accordingly, only a discount for marketability is required to derive the end nonmarketable minority valuation result.
Minority interest discount discounts are a more common feature in the valuation of certain types of investment holding entities such as limited partnerships. This is because such entities have highly diverse purposes versus the relatively narrow operating focus of most operating business models. As such, the assets owned by the entity are generally best appraised by a specialty appraiser or from direct observation of market evidence concerning the asset. That being the case, most such entities are valued using an asset-based approach, which inherently captures the controlling interest level of value for the underlying assets. This makes it necessary for the business valuation to be adjusted first for lack of control considerations and second for lack of marketability concerns. Additionally, in cases involving operating business that hold operating and/or non-operating real property assets, such assets may need to be appraised by an appropriate expert and adjusted with a minority interest discount when integrated into the minority interest enterprise value of an operating business.
Although minority interest considerations are captured in the majority of appraisals by reference to returns on marketable interest investments in the public marketplace, there are techniques for developing the discount. One such method involves mathematically imputing the discount based on an assumed control premium. Other methods involve observations of securities trading values in the context of the valuation of the issuer’s underlying assets, such as the case with closed closed-end funds and other securities in which underlying assets have an observable value that can be compared to the security’s trading price.
The following formula provides an expression of the percentage minority interest discount as a function of an assumed percentage control premium. Although the expression is useful in identifying the minority interest discount as a percentage of an assumed or developed measure of control value, it is rarely used in a direct sense in the valuation of minority interests.
In the valuation of minority interests in asset investment entities (limited partnerships et al.) that are invested in various classes of assets, many appraisers look to the observed discount to net asset value (NAV, the market value of a fund’s asset holdings less its liabilities) that closed-end funds (CEF) typically trade at as evidence of an applicable minority interest discount for a subject partnership or similar ownership interest. As a general rule, CEFs report their net asset values and the price-to-NAV relationship typically reflects a discount. Observed discounts to NAV reflect the consensus view of the marketplace toward minority investments in the underlying portfolios of securities. That is, the discounts are illustrative of the market’s discounting of fractional interests in assets, making them somewhat comparable to a minority interest in an entity that is heavily invested in other assets (such as marketable securities and other asset classes).
Discounts to net asset value for closed-end funds have been consistently observable for many years. The precise reasons for such discounts are subject to debate, but common attributes include the following factors:
Although closed-end funds may not be directly comparable to the subject interest in an appraisal, the discounts typically observed are evidence of the market’s discounting of portfolios of generally liquid securities, and, therefore, offers valid indirect evidence of minority interest discounts applicable to asset-holding entities and operating businesses.
The ASA defines a marketability discount as an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Augmenting the consideration of marketability is the concept of liquidity, which the ASA defines as the ability to readily convert an asset, business, business ownership interest, security, or intangible asset into cash without significant loss of principal. Lack of marketability and lack of liquidity overlap in many practical regards. However, lack of liquidity is often attached to a controlling interest, while marketability discounts are used to describe minority interests.
Despite the proliferation of marketability discount studies and models, most models fall into one of three primary categories. These categories are based on the underlying nature of the analysis or evidence from which each model emanates. They include market-based perspectives (commonly referred to as benchmark analysis), options-based models, and income-based (rate of return) models. Although it is not our place to define a given model as the model, we do recognize that some models (or perspectives) provide general guidance for the appraiser regardless of the specific model employed. The following is a list of the so-called Mandelbaum factors, which are derived from the Tax Court’s ruling in Mandelbaum v. Commissioner (T.C. Memo 1995-255, June 12, 1995). In essence, these factors serve a similar guidepost for the assessment of marketability, as does Revenue Ruling 59-60 for the valuation of closely held interests in general.
This list extends to considerations beyond the pure question of marketability. However, the ruling is instructive in its breadth. The Mandelbaum process is characterized by many appraisers as a qualitative or scoring procedure.
However, most of the parameters are mathematically represented by financial elements and assumptions under the income- and options-based models. Such parameters are also used, to the degree possible, in searching out market evidence from restricted stock transactions, which are documented in varying degrees by numerous studies over several decades.
Benchmarking analysis relies primarily on pre-IPO studies and restricted stock transactions. In essence, benchmarking calls for the use of market-based evidence to determine a lack of marketability discount. Some appraisers have pointed out the oxymoron of benchmarking (market transactions) analysis for use in determining marketability discounts.
On the same note, other appraisers cite the restricted stock studies for capturing market evidence that at its core demonstrates the diminution to value associated with illiquidity. Imputed evidence concerning the implied rates of return for restricted stock lends support for more specific analyses within certain marketability models.
Options-based models, most of which are derivations and evolutions of the Black Scholes Option Model, are based on assessing the cost to insure future liquidity in the subject interest. Rate return models are based on modeling the expected returns to the investors as a means for determining a valuation that results in an adequate rate of return given the investment attributes of the subject interest.
There is no one method that is acknowledged as superior to all others. Indeed, virtually every method employed in the valuation universe has been challenged or debated in the courts as well as by and among the professional ranks of appraisers.
Perhaps the best approach, stemming from a review of the IRS’s DLOM Job Aid, which was discovered and published a few years ago, is the use of multiple disciplines in a fashion consistent with the breadth of valuation approaches called for in business valuation (principally the income and market approaches).
Notwithstanding the previous perspectives on DLOMs and the methods and processes for developing them, most ESOP appraisals that involve a minority interest definition of value reflect a relatively minimal DLOM of 5-10%. This is due to the obligatory put option feature required for qualified retirement plans holding closely held employer stock.
The virtual guarantee of a market for the ESOP participants’ interests is believed to all but eliminate the DLOM. The consensus treatment from most appraisers is that a DLOM applies and is relatively small (say 5-10%) but not 0%.
Some appraisers use the DLOM as a proxy for concerns about future liquidity as it relates to the sponsor company’s ESOP repurchase obligation. If a business is floundering, has a significant bubble of participants requesting near-term liquidity, has pour cash flow, has limited financial resources or financing options, and/or any other underlying fundamental challenge, some appraisers will use a DLOM to reflect this concern.
DLOMs quantified in the correct fashion may indeed be a viable approach to capturing the cash flow needed to service repurchase obligations and the associated effect on the sustainable ESOP benefit (the stock value). However, many appraisers use a more direct and explicit approach to studying and treating the repurchase obligation by iterating the associated expense into the valuation modeling (generally using an income method).
The expense is determined through a repurchase obligation study which informs trustees, sponsors, and plan administrators what measure of cash flow will service the foreseeable needs of the plan. To the degree that the assumed ongoing retirement plan funding is insufficient to service the obligation, an additional expense may be applied or a single present-value adjustment may be quantified to adjust the total equity value of the business.
The application of a discount or premium to an initial indication of value is an often controversial and necessary input to the valuation process. Fortunately, appraisers are equipped with numerous income and market methodologies to derive reasonable estimates of the appropriate discount or premium for the subject interest.
As with the determination of the initial indication of value, it is ultimately up to the valuation analyst to choose the appropriate methodology based on the facts and circumstances of the subject interest.
None of the available methodologies are perfect, and all of them are subject to varying degrees of criticism from the courts and members of the appraisal community. Critics of the various market approaches often cite the lack of contemporaneous transaction data that are rarely comparable or applicable to the subject interest.
Arguments against the income methodologies often focus on the model’s inputs, particularly the holding period assumption, which is typically uncertain for most private equity investments.
The number of discount methodologies and their respective criticisms will, in all likelihood, continue to expand into the foreseeable future. It is ultimately up to the appraiser to consider the various options and determine the appropriate model or study applicable to the subject interest.
There are no hard-and-fast rules or universal truths that are applicable to all appraisals when it comes to the selection of an appropriate discount methodology. Appraiser judgment is ultimately the most critical input to any valuation, particularly in regard to the application of an appropriate discount methodology or control premium.
Admittedly, the number of discount methodologies and their corresponding criticisms can be a bit overwhelming to anyone unaccustomed to reviewing or writing business valuation reports.
At the end of the day, the most important thing to keep in mind is how reasonable the discount (or premium) is in light of the liquidity and/or ownership characteristics of the interest being appraised.
An appraisal may have carefully considered all the pertinent discount methodologies and their criticisms, but if the ultimate conclusion is not reasonable or appropriate for the subject interest, it will probably not hold up in court or communicate meaningful information for the end user of the report. Appraisers should investigate the reasonableness of their conclusions when preparing valuation reports and related analyses.
Many investors, analysts and business appraiser’s believe1 that publicly traded price multiples / minority equity value multiples can be used to estimate enterprise value, control level value of a business, or by simply applying an incremental premium for control to a selected publicly traded minority multiple. Typically this method can be done by using a sample of comparable publicly traded companies, observing a range of P/E2 multiples and selecting a multiple within the range or typically by analyzing enterprise transaction multiples. At this point, a simple premium for control is applied and market value of debt is added to arrive at an enterprise value.
For example, if a sample of comparable publicly traded companies has a P/E multiple range of 10x to 14x and the appraiser selects 12x, he would then apply a premium for control of 25% (historically observed average in studies), add the market value of debt and arrive at an enterprise value multiple north of 15x earnings.
However, this mathematical calculation many times is not a supportable method to estimate a marketplace transaction for enterprise value.
As business appraisers, our job is to “Mirror the Marketplace” when valuing businesses. In doing so, the above methodology and the implicit assumption made is that minority value serves as a reasonable baseline, or starting point, for enterprise value. Very few appraisers understand that the most accurate explanation of the relationship between minority value and enterprise value is that there is no functional relationship between minority multiples and enterprise value.
Why is this explanation true?
The reason is based on stock market dynamics and trading history, but primarily because: The economic and financial drivers that influence an enterprise buyer are fundamentally different than a minority buyer. List of drivers for the typical minority buyer:
The opposite is often true for the enterprise buyer. These factors have a significant and dramatic impact on enterprise value. As a result, there are times when a minority price pro-rata can significantly exceed what a prudent enterprise level buyer will pay, pro-rata, for a company. Vice versa, there are times when the enterprise value can be much more than the amount indicated by an application of an average premium for control percentages.
A publicly traded restaurant company operated 22 locations across the U.S. After a brief due diligence period, it was discovered that two of these locations generated 3x to 4x the profit of an average company store, 40% of the total company annual cash flow and had short-terms remaining on their leases (3 and 5 years). These two locations were also unique in they were located in a resort area, with a landlord who had a history of increasing rent dramatically, to “milk out” the excess profits, after the initial lease period. This piece of information was not known to the public as it was a trade secret of the landlord and lessor, but not shared with the public. Therefore, it was likely that the future profits of the restaurant company from current stores would go down significantly at the end of the current lease period. As a consequence, the value, and its associated multiples, to a prudent enterprise buyer would be substantially less than the minority multiples observed in the public market.
In contrast to the above case study, there are other times when new products are coming online with risk and growth prospects that are not reflected in current or historical earnings. As a consequence, when the new products hit the market, the earnings may jump and significantly increase the enterprise value above and beyond the observed minority price.
As a result of the above Case Study, it is clear that an appraiser must go through a proper due diligence process to understand of the impact of the cost, income, and market approach to truly understand the enterprise value of a company. It is also clear that assuming a publicly traded minority value as a reasonable basis to calculate enterprise value can lead to a significant error in due diligence and negatively impacts the credibility of an enterprise value opinion.
This article was originally published in Valuation Viewpoint, July 2014.
1 Based on studies and articles
2 Price to Earnings Ratios
When WADL-TV 38 founder Franklin Z. Adell died, he left behind what would prove to be a complex estate. The estate, handled mostly by Adell’s son Kevin, isn’t a stranger to legal battles. In the years since Adell’s death, the heirs have faced a number of legal issues, including a dispute between Kevin and his two sisters regarding distribution of assets from the estate.
This is a bellwether case on personal goodwill and its impact on fair market value of a business. Is it worth $92 million dollars like the IRS’ initial estimate or $4.3 million dollars liquidation value as opined to in the estate’s second valuation?
This is the range of the valuation opinions on this case. The key takeaway in all of this?
Make sure your appraiser understands all key agreements because they can be critical to the value proposition.
The facts of the case are as follows: A religious non-profit corporation (The Word Network) transferred virtually all their revenues via a service agreement to a for-profit entity (STN.com, Inc.) owned 100% by Franklin Adell. This was the only customer of STN.com. Mr. Adell’s son Kevin was very active in the company and also had strong personal relationships with the trustees of the non-profit. He had no non-compete or employment agreement with the STN.com.
After his father’s death, Kevin Adell, formed a mirror corporation and all the employees but one, moved to a new corporation as did the service agreement from the Word Network and its associated revenues.
The IRS’ initial valuation assessment was $92 million dollars for the enterprise of STN.com. A national appraisal firm’s expert appraiser’s, hired by the Estate of Mr. Adell, initial assessment was $9.3 million. In this valuation, consideration was given to the personal goodwill of the son, Kevin Adell. The estate’s appraiser believed there was significant inherent risks associated with Kevin’s personal goodwill for the business which warranted a substantial discount.
In a subsequent valuation by the estate’s appraiser, he concluded that he had not fully considered the restrictive terms of the service agreement with the non-profit. In this reevaluation he concluded that a valuation of STN.com, Inc. was $4.3 million dollars. To arrive at this conclusion, he used the adjusted book value and gave no market value for intangible assets. The IRS’ expert adjusted the initial assessment of $92 million and testified that the value was $26.3 million dollars at the date of death.
The judge found that the estate’s substantially inconsistent positions regarding the valuation and therefore the burden of proof remained with the estate. Since STN was historically profitable and an economic charge of $8 to $12 million dollars for Kevin’s personal goodwill was deducted from the valuation in the first appraisal, the court concluded that the first appraisal from the estate’s expert was reasonable and selected $9.3 million dollars for the fair market value.
In summary, performing valuations for estate tax purposes is a serious matter as the audience for these reports is the IRS which will challenge an opinion of value where the facts are not clearly communicated and risk is not adequately disclosed. In the above case, an IRS challenge resulted in a trial and multiple valuations.
This is an expensive by-product of not understanding the facts of the case at the outset. An attorney and their appraiser need to fully understand the facts and key agreements driving a business in the initial phases of an engagement. This case was not unique in its complexity. The concept of personal goodwill is logical and supportable, and the valuation implications are real. The valuation impact can be significant on fair market value.
This article was originally published in Valuation Viewpoint, September 2014.
Are you considering buying or selling an operation, have a gift or estate tax issue, buying or selling a minority equity interest in an operation, or have fair value or fair market value-related financial reporting requirements for either GAAP or tax purposes?
If so, a fundamental question exists: How much is your business and assets worth? To find out, you need the experience and expertise of a business valuation expert – a business appraiser.
Small businesses and big corporations often don’t know what to expect when choosing a business appraiser. Two critical questions to ask are: (1) How do I know if they are qualified; and (2) What should an appraisal cost? Appraisers play a vital role in the market, and choosing one takes a little knowledge and lots of comparing to get comfortable with your selection.
Many business owners, attorneys and advisers aren’t sure what qualifications a trustworthy expert business appraiser should have. Just as accountants and doctors might use CPA and M.D., respectively, business appraisers often have a set of initials confirming they have received extensive training and/or have ample experience in their field. These certifications span a broad range, but they all indicate that the business appraiser knows what he or she is doing. Here’s an overview of common certifications:
Obviously these certificates have vastly different levels of experience to satisfy the designation. Be sure and know the difference when selecting your appraiser. Of course, these certifications aren’t tell-all determinants of an appraiser’s skill or qualifications. Not all ASAs are equally experienced in the same industry. Consider their work experience, industry experience and client references. Review their website and publications made by the appraiser. While experience and expertise are really important, credentialing provides added support in litigation environment before the court, the IRS or when subjected to auditor review.
Make sure that your business appraiser exercises complete objectivity when appraising your firm. An appraiser’s job isn’t to promote you, but to give an unbiased assessment of your organization’s worth. Unruly “right-hand” appraisers may overstate the value of your business for personal gain. These tactics created quite the turmoil in the late 80s real estate market. Homes were frequently overvalued, encouraging banks to hand out heftier loans. When the decade turned, the market crashed.
This is another area where certifications can help. Business appraisers with professional certifications are bound by a code of ethics that prohibits right-handing and other shady practices. Non-certified appraisers may also operate by these ethics, but it’s not guaranteed. Remember that appraisers aren’t on the side of buyers, sellers or loan officers; they work for the good of the free market. Before you sign anything, read the appraisal agreement and verify that there is an independence clause.
Depending on who you hire, a business valuation can cost between a few thousand to well into the six figures, depending upon the scope of the project. The more services you require, especially those for litigation purposes, the more your appraiser will charge. Especially in “high-stake” situations, most often litigation, the credentials, experience and expertise of your valuation expert matter. Selecting a low-cost provider is often “penny wise and pound foolish” as the results may cost more in the end. Also, keep in mind that litigation services can run hundreds of dollars per hour and can easily skyrocket if proceedings drag on.
Don’t sign a contract with the first appraiser you meet. Instead, compare estimates from a variety of sources, look at their qualifications, and evaluate what your situation requires. Projects that will receive a high level of scrutiny from auditors, the IRS, opposing council or judges will require significant documentation. However, if you’re a small business looking for an oral appraisal, fees should be lower as very little documentation (i.e. report writing) is required.
This article originally appeared in Valuation Viewpoint, October 2014.
Many situations warrant an business appraisal / valuation. Some of the most common occurrences in which a business will need to conduct a valuation include litigation matters, preparation for the sale of a business, tax purposes, buyouts of financial stakeholders, financial reporting of acquired businesses and the issuance of a business-related insurance policy.
Furthermore, conducting a business valuation takes energy and time, and should be conducted by an independent valuation specialist. Selecting a valuation specialist / business appraiser can be complex, which we discussed in a another article, “How to Choose the Best Business Appraiser.”
When beginning the process of a business valuation, a clear understanding of the owner’s bundle of rights is critical before any investigative and analytical procedures are started. After a clear scope is outlined, the analysis is ready to commence. We conceptualize the value principles of most operating businesses into three components: (1) Risk, (2) Growth and (3) Earnings. We believe these are key components of value in a business. Using these as a guide, we seek to understand the nature, history and operations of a business through the perspective and intimacy of the team operating the assets every day, management. To do so, we find it helpful to discuss the operations in the same way as management thinks about its business. We strive to understand the risks that management wants to minimize the growth opportunities that management wants to obtain and the earnings that provide the scorecard for historical operations. The following details the factors which impact these three key components of value in a business.
Risk is the measurable possibility of something happening or not happening.1 For businesses, risk can be measured in numerous ways including benchmarking against similar businesses (“guideline”) or using a more theoretical approach such as a buildup method from market observation. None of this can be done, reasonably and supportably, without understanding the key economic drivers of the business. This prerequisite entails understanding the historical and current operations, the industry and competitive environment, operating assets, liabilities (booked and/or contingent), stakeholders, growth factors and the earnings profile of the business going forward. After understanding the drivers of risk for the subject business, the same drivers may be ascertained for the guideline businesses so that a supportable comparison can be made, ideally. However, lack of publicly available information does not make this comparison simple, and professional judgment is involved. Rarely is an exact “replica” of a business found in a guideline sample. With an appropriate understanding of the risk factors, and its comparison to similar businesses, the resulting value of a business begins to form. All other factors equal, low risk translates to higher valuation and vice versa.
Business growth is primarily discussed in the context of revenues, profits, cash flows and assets. For some companies it also can include number of locations, products, contracts, square feet, customers and employees. In addition, growth on a larger, macro scale must also be considered as it applies to economies, industries, markets and populations. These areas are an example of the growth factors which can significantly impact a valuation and careful attention must be made to fully understand these factors in context. When we investigate the nature and history of the business, we find a relative context for future growth. Many times management and business owners make decisions to enhance shareholder value, which may include attaining the highest valuation possible. These decisions are most transparent in forecasts and projections. Risk is inter-related to future growth expectations. In short, considering growth in the context of risk is critical during a business appraisal. All other factors being equal, high growth translates into higher valuations and vice versa.
Earnings are naturally a key component to analyze and arguably the most important of the three. Earnings, in this context, is a broad term to discuss operating performance of a business and is inclusive of such terms as EBITDA, net income, dividends, distributions and cash flow, to name a few. Earnings are the primary financial benefit of owning a business and are indications of performance. Careful consideration of these metrics, including industry specific earnings metrics, is very important. Changes in theses metrics over time can provide clarity on operational problems and successes. In addition, appraisers may also consider the earnings of other guideline businesses in the industry. Benchmarking may provide conclusive support regarding industry specific issues in the business but also macro issues across the economy. Earnings have significant impact on businesses strategy, future investment and capital decisions. Without investigating the earnings of a business, an appraiser cannot make an informed opinion on the value of a business.
All these components can vary substantially as time passes. An appraiser cannot simply assume that growth and earnings will continue uninterrupted into perpetuity. A marketplace is organic and can change quickly. When this occurs, growth over the long term can be difficult to achieve, and people may underestimate the risk associated with high long term growth projections. Careful analysis is necessary when estimating terminal values at the end of a long term growth forecast. When it comes down to valuing a business, understanding risk, growth and earnings are paramount.
This article was originally published in Valuation Viewpoint, November 2014.
1 Barron’s Dictionary of Finance and Investment Terms
You’ve been a business executive for more than 10 years. During the last few years, you have essentially run a business as the manager of a division of a company. You have earned millions of dollars for your employer, while earning a modest salary for yourself.
“What if I started my own business?” you keep thinking to yourself. “Could I as a business owner become so successful that I can keep millions of dollars in profits for myself?”
The answer “yes” might seem obvious, but it’s not. In fact, running a division of a company and running your own company are two completely different skill sets even if both enterprises have the same number of employees.
If you want to run your own company, you are the individual who needs to raise the capital from investors to start, maintain and grow the business. That means you need an effective business plan. Here are eight tips that will help you create such a plan.
What is the market for the product and/or service you want to manufacture and/or sell? You might think that there is one because the division you are currently running is flourishing, but the market could be worse in the future. Facts from a market survey that shows your idea will succeed should be inserted into your business plan. A more pessimistic survey could convince you to work on a different product and/or service that will be marketable.
And experience. You need to know when to create a business plan and when to present it to investors. Writing a business plan when you’re a lone wolf will not be effective. You need to find a few people whom you trust to work for you. Listing their skills and accomplishments in your business plan will make it more effective. Investors are more apt to be interested in a new business with five accomplished people than one.
A business plan that, for example, claims your company will be the Facebook of businesses sounds egomaniacal. Investors might think, “If the owners of this new business are that good, what do they need me for?” They also might think you’re immature and not especially professional. The business plan should be as specific as possible about the product and/or service and why it will flourish in the marketplace.
Most investors are in a hurry. They might seem more inclined to spend a considerable amount of time reading every word of your report because of the potential financial stakes, but they’re also human beings. Generally, investors want to read a well-written report with colorful (and informative) graphs and charts. That might mean you should hire a writer, editor, and graphics designer to help devise your business plan.
Investors know a new business will take a while before it generates profits and revenues. An effective business plan will show investors that you expect losses at first. The plan should detail the extensive financial commitment you plan to make as the company is launched and realistically project when that investment will pay off. The figures are best presented in charts and graphs. “Graphs, charts, and images can help bring your concept to life,” reports “5 Tips for a Great Business Plan,” a Forbes magazine article. “Plus, it breaks up the text and helps a plan flow better.”
The business plan should detail how much money you and your partners are investing in the business and should detail how much more money you need from investors. It should also detail what the investors’ money will be spent on. Will it be on managerial salaries? Salaries for future employees? Product development? Product distribution? Investors are more apt to be willing to invest money if they know what it’s being spent on — and they might be more confident in your venture if they see that you’re willing to take financial risks.
Your business plan should include an extensive and detailed narrative, but it must also include a one- or two-page summary of the plan before the narrative. Prospective investors must be able to explain the plan to other prospective investors in one minute. An effective executive summary will help them do this, “Because bankers and professional investors receive so many business plans, they sometimes go right to the executive summary for an overall view of what your plan is all about,” reports Entrepreneur magazine in “How to Create a Business Plan Investors Will Love.”
Your attorney should help you decide the structure of your business. Should it be a corporation? A solo proprietorship? A general partnership? A limited liability company? A limited liability partnership? The attorney should help you present the advantages of the business structure you choose to the prospective investors in the business plan. And he or she should give you advice on whether any information presented in the business plan could pose a legal problem.
These eight tips are just a start. You should also consult experts such as the U.S. Small Business Administration for more advice. Good luck.
This article was originally published in Valuation Viewpoint, December 2014.
When facing a business transition, owners have two basic options. Sell the company to outside parties or to inside parties (other owners and employees). While there are numerous variations of the two, basically the owner can sell to an outside group, which may be a strategic buyer (someone in the industry already), or a financial buyer, which may be a private equity firm or other investor that wants to own the company. An internal buyer is either a sale to some or all of the employees directly, or through the use of an Employee Stock Ownership Plan (ESOP). ESOPs are usually very cost competitive and many times may pay the highest price. Sale to the employees individually is with “after tax” dollars and can be very tax inefficient.
Until 1974, Employee Stock Ownership Programs were almost unheard of. However since then, they have increased in popularity. In fact in 2014, there were 13.5 million workers in the United States who were covered under ESOPs.
There are many reasons as to why employers offer these types of programs. While some people think ESOPs are used to save companies that are about to go bankrupt, this usually isn’t the case. It’s a great way to transfer ownership from one generation to the next without needing a financing plan.
As an added benefit, these programs tend to be offered as a way to motivate and reward employees. Of course, there are the numerous tax advantages to be gained too. For the most part, market shares are given to workers and they don’t have to purchase them.
When a company chooses to create an ESOP, funds are set aside in a trust fund. The monies are used to buy new shares of stock. Additional funds are contributed to buy new shares as well as to pay back any funds that are borrowed from the ESOP to buy additional market shares. It does not matter how the company pays for the shares, the contributions are tax-deductible as long as certain requirements are met.
Within the trust there are individual employee accounts. The company, of course, decides who has the right to take part in the ESOP. For the most part, however, all employees who work full-time and are at least 21-years-old have the right. An employer decides how the market shares are distributed to each employee’s individual account, with many companies operating on a vested basis, meaning workers with more seniority are given more market shares than those who have less seniority.
Employees receive the cash value of their stocks when they leave the company (most companies mandate that the employees work for them for at least five years), or when they retire. The amount of money that they receive for the stocks is based on their fair market value at the time.
For business owners without an established plan to transfer direct ownership to either children or trusted personnel, ESOPs are a strategic way to increase direct ownership to the following generation without having to purchase it outright.
With the establishment of an ESOP, there are significant tax savings to be gained. In 1974 ERISA, or the Employee Retirement Income Security Act, created the modern ESOP as well as a whole host of other retirement vehicles that incentivize companies and employees directly through tax incentives to save money for retirement. Since the government sees a positive social purpose for ESOPs, it provides extraordinary tax incentives for an owner and a company to use an ESOP as a business succession and liquidity tool. Some of these tax advantages include: 1
In addition to the above tax benefits, offering employees company ownership helps establishes professionalism and lines up owner goals with that of the employees. First-rate job candidates are attracted to companies that they know appreciate and reward their workers. Also, when a company shows it is interested in helping its workers succeed, it’s much more likely to retain its key employees. More so is the fact that the employees will strive to make the company succeed because they will want their market shares to be worth more money.
It’s also with an ESOP that an employer can reward its workers without draining its cash flow. Instead of giving cash bonuses, market shares are issued. Furthermore, an ESOP comes with the benefit of the employer being able to strictly decide who gets the market shares and how much. With fringe benefits, specific selection is mostly prohibited.
Although an ESOP has significant tax advantages and provides a mechanism for current owners to exit the business at fair market value, the process requires the work of an experienced team in the creation and execution of an ESOP. Because of this, you should work with a group of advisors experienced in implementing an ESOP.
This article was originally published in Valuation Viewpoint, February 2015.
1Business Transition Advisors
There are number of aspects that always get immediate attention when a business is analyzed for an acquisition. These are standard elements that are practically on a default checklist of any decent due diligence team.
A number of tax traps become apparent during the process for those professionals who knows how to look for these issues. This article seeks to identify a few that commonly show up during the due diligence process of acquiring the equity of a company.
Any business that has employees has a payroll has a tax withholding liability, and many business farm this accounting work out to third parties. It’s mundane work that has little to do with core functions of most businesses, so third party accounting firms and offices get a lot of the workload. Unfortunately, they also get lump sums of money to pay for the withholding requirements as well on a monthly basis. And those pots of cash can often be very attractive to a character who wants to shave off a few percentages of the total or “lose” a monthly payment altogether. Because the IRS and tax agencies get so much withholding on a regular basis, a shorted payment or a missing amount can be overlooked for a while. However, eventually the IRS and tax agencies reconcile amounts owed and eventually target a business for an audit. Should a business be acquired before that audit happens, the review can be a painful hit of withholding due, compounded tax interest, and tax penalties.
Small businesses are notorious for having very inflated tax-deductible expenses that tend to disappear when the real accounting books are reviewed. No surprise, the IRS often casts a very pessimistic eye on small businesses as a result. If a company has a history of inflated tax returns it’s not going to become apparent unless so those same returns are examined in direct comparison to the real accounting records. Any appraiser who is aware of this relationship knows to ask for both and looks to tie out specific expense numbers accordingly. A failure to look for this kind of baggage means the new owner could be stuck with tax penalties or worse, a tax investigation for tax evasion.
Businesses are allowed to depreciate large equipment and asset purchases, but they need to be depreciated over time. Incorrect calculations on tax filings can trigger audits and corrections. However, like other tax issues, the tax agency correction can be years after the fact. These landmines often get missed unless someone actually looks at the depreciation figures filed and checks on their validity.
Tax traps don’t have to be discovered the hard way. A targeted due diligence assignment will catch these issues, specifically looking for tax problems when examining liabilities. Don’t consider an acquisition of the equity of a business without knowing the tax records have been specifically reviewed.
This article was originally published in Valuation Viewpoint, April 2015.
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.