This article is reprinted from Mercer Capital’s Asset Management Industry newsletter (Q2, 2014). For a review of a prior transaction referenced in this article (Tri-State Capital’s acquisition of Chartwell Investment Partners), see the Q4, 2013 issue of Asset Management newsletter.
On July 16th, 2014 Boston Private Financial Holdings, Inc. (NASDAQ ticker: BPFH), the holding company of Boston Private Bank & Trust Company, entered an asset-purchase agreement to acquire Banyan Partners, LLC, a Registered Investment Advisor (RIA) headquartered in Palm Beach Gardens, Florida with approximately $4.3 billion in client assets. Key attributes of this deal and another recent bank acquisition of an asset manager are presented in Figure 1 below for perspective on industry pricing metrics.
Similar to the Tri-State/Chartwell deal earlier this year, management delineated how Banyan’s attributes met Boston Private’s investing criteria as shown in Table 1.
Table 2 depicts other similarities and key attributes of the Tri-State/Chartwell and Boston Private/Banyan Partners deals as banks continue to target advisors for exposure to fee income and higher margin products.
These recent deals are particularly instructive to other industry participants since, of the nearly 11,000 RIAs nationwide, approximately 80 (<1%) transact in a given year, and the terms of these deals are rarely disclosed to the public. Part of this phenomenon is attributable to sheer economics – a new white paper from third-party money manager, CLS Investments, argues that many advisors lose out financially in an outright sale of the business. Another recent publication titled "Advisors: Don't Sell Your Practice!" in research magazine ThinkAdvisor notes that many principals earn more in salary and bonuses than they would from the consideration they would otherwise receive in an earn-out payment over a period of time, as many of these deals are structured. In other words, returns on labor exceed potential returns on capital for many advisors, particularly for smaller asset managers that typically transact at lower multiples of earnings or cash flow. In these instances, an internal transaction with junior partners might make more sense for purposes of business continuity and maximizing proceeds. For larger RIAs, recent deals at 7-9x EBITDA suggest that buyers are willing to pay a little more for the size and stability of an advisor with several billion under management.
For more information or if we can assist you in any way, please feel free to contact us.
Reprinted from Bank Watch, September 2014.
Although it is difficult to discern with the ten-year U.S. Treasury presently yielding about 2.4% compared to 3.0% at the beginning of the year, many market participants believe the Federal Reserve will begin to raise the Fed Funds target rate next year. The thought process is not illogical. Consider that:
How high short-term rates may rise is unknown. (A corollary question for others is what, if anything, will the Fed do with its enlarged balance sheet as shown in Table 1.) Pimco’s Bill Gross has opined that the “new neutral” target rate will be around 2% rather than a historical policy bias of 4%. For lenders, money market funds and trust/processing companies, a hike in short rates cannot occur soon enough.
Although the Fed’s zero interest rate policy (“ZIRP”) helped reinvigorate markets, the economy and asset quality, it is increasingly weighing on revenues via depressed net interest margins (“NIM”) and post-recession profitability as shown in Table 2.
For traditional banks that primarily rely upon spread revenue, this is especially true. Funding costs cannot go lower, while asset yields remain under pressure. The asset yield story is nuanced, however. Bond portfolio yields have stabilized after years of cash flows being reinvested at lower rates. Loan portfolio yields partly depend on the mix, but the general trend since the financial crisis occurred continues to be down for two reasons. One is the reduction in the base rate (LIBOR, swap rate and 5-/10-year U.S. Treasury) that occurred during 2008-2011. Since then lower loan yields largely have reflected intensifying competition as lenders become more confident about the economy and less tolerant of holding excess amounts of liquidity and bonds. Banks have lowered or waived loan floors and have been willing to accept lower margins over the base rate to put higher yielding assets on the books. Some may recall the mantra last heard in 1993 when the Funds target was 3.0% and again in 2003 when it was 1.0%: “cash is trash.”
The other nuanced aspect of asset yields is the impact gradually improving loan growth for a broader swath of the industry has had on NIMs. Funding loan growth with excess liquidity and bonds entails a yield pick-up. What intensified competition does not show until the credit cycle turns is how much credit standards were relaxed to drive volume. Time will tell, though anecdotal stories we hear indicate there has been significant loosening of standards.
Should the FOMC follow through and raise short rates next year, most banks with a reasonable amount of LIBOR- and/or prime-based loans and non-interest bearing deposits will see revenues increase—provided deposit rates do not have to be raised aggressively and there are not too many (or too high) loan floors.
It seems like an ideal set-up for banks if the Fed will do its part. That said, we have been here before. Figure 3 reflects the forward Eurodollar curve at four separate dates: May 2009, February 2011, July 2013 and August 2014. Eurodollar contracts reflect future spot rates for U.S. dollars based upon where 90-day LIBOR is expected to settle. The contracts trade in a highly liquid market, unlike those for Fed Funds futures.
What Figure 3 shows is that the market has expected short rates to rise soon as soon as ZIRP was implemented. In May 2009, the expectation was that by late 2010 short rates would begin to rise. In early 2011, a strong fourth quarter 2010 GDP report (+3.2%) pushed contract prices down and forward spot rates sharply higher. The forward curve in July 2013 reflected higher short rates by late 2014. Currently, the forward curve projects higher short rates by mid-2015. And on it goes.
Bank executives and directors should be planning if the inevitable does not happen. Worse, what happens if rates stay low before the next recession occurs? Banks will struggle with a lower cushion in the form of pre-tax, pre-provision earnings to fund losses and/or build loan loss reserves than would be the case if short-rates and the NIM were higher. Of course, Dodd-Frank has mandated higher capital ratios to cushion losses as a perverse offset to ZIRP.
We at Mercer Capital have differing opinions about how Fed policy will evolve over the next year or two, but none of us (or you) knows for sure. Opinions are no substitute for planning. We do believe the planning process for a much longer period of ZIRP will require executives to think hard about the relevance of branch networks, the prudence of significantly shortening the duration of bond portfolios and how much credit risk is being assumed to achieve loan growth. A question that assumes more urgency is: Should the Board move sooner rather than later to sell or merge with a similar-sized institution if the Fed is not going to raise short rates (much) and thereby boost what may be an unacceptably low ROE for many banks?
We at Mercer Capital do not have the answer to every question, but we can help you ask the right questions and frame the answers in terms of thinking about shareholder value.
Reprinted from Bank Watch, August 2014.
All is never quiet on the regulatory front, and the first half of 2014 was no exception. Below is a discussion of some (but certainly not all) developments affecting financial institutions at the federal regulatory level, from QMs, TruPS CDOs, and CCAR to payday lending, mobile banking, and the fines and penalties parade.
In January 2014 the Consumer Financial Protection Bureau (CFPB) implemented new rules intended to protect consumers shopping for a home mortgage. While some of the requirements are relatively minor and ultimately lead to a “check the box” mentality, others could have a significant impact on the way banks (community banks in particular) approach this lending area, perhaps causing some to exit the business altogether. Additionally, the value of Mortgage Servicing Rights (MSRs) may be materially affected, as new regulations increase the complexity of servicing a loan.
Generally speaking, a Qualifying Mortgage (“QM”) must have the following characteristics:
A January 2014 survey of 27 mortgage originating entities conducted by the National Association of Realtors highlights just how far reaching the impact of the new QM regulations may be. For example:
The above factors will have an impact on the profitability of residential mortgage lending both from a revenue (decreased volume) and expense (higher compliance costs) standpoint.
With respect to MSRs, there are a number of new and/or enhanced rules regarding how servicers communicate with borrowers, address errors and credit payments. However, the rules that have perhaps the most impact on servicers concern the rights of borrowers facing foreclosure.
Essentially, the cost of compliance, training and systems to meet the above requirements will increase, sometimes materially, the cost of doing business as a mortgage servicer, thereby reducing profitability and thus the value of MSRs.
For banks that retain their servicing rights, they will experience an even greater hit to the bottom line, from both the QM and MSR regulations. In a time when profits are getting pinched from every angle, this is just one more profit center where management will be forced to reevaluate something that has likely worked under the status quo for so long.
On January 14, 2014, federal regulators issued an Interim Final Rule, which clarifies the portion of the Volcker Rule that affects Trust Preferred Securities (TruPS) CDOs. Initial interpretations of the Volcker Rule led industry participants to believe that rules prohibiting short-term proprietary trading by insured depository institutions would affect banks owning the majority of existing TruPS CDOs. Following a significant amount of comments from the industry against the rule as it affected TruPS CDOs, as well as pushback from members of Congress, the Interim Final Rule issued in January provided that the “covered funds” prohibition under the Volcker Rule would not apply to a CDO if:
This rule also defined Qualifying TruPS Collateral as any subordinated debt instrument or trust preferred security that:
On April 7, 2014, the Federal Reserve Board, in consideration of comments received, announced that banking entities would have two additional one-year extensions to conform their ownership interests in and sponsorship of certain collateralized loan obligations (CLOs). Only CLOs in place as of December 31, 2013, that do not qualify for exclusion under the final rule for loan securitizations would be eligible. Of note, the rules in their current state do not exclude CLOs, as they do with most TruPs CDOs, but rather simply give banks additional time to come into compliance.
The Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR), as well as annual stress testing mandated by the Dodd-Frank act, focuses almost exclusively on the largest banking institutions. Much has been written about the results of these tests, including the Fed’s objection to five of the 30 participants’ capital plans. Of those, four were based on qualitative concerns that centered on the institution’s planning process and ability to forecast revenue and losses.
Based on the announced results of the 2014 CCAR, the 30 participating firms are expected to distribute 40% less than projected net income from second quarter 2014 through first quarter 2015 (in other words, an aggregate payout ratio of 60%). The institutions have a combined $13.5 trillion in assets, or approximately 80% of all U.S. bank holding company assets. It is worth noting that any limitations placed on an institution’s ability to return capital to shareholders will affect the ability to raise capital, the required rate of return of capital, and thus the valuations of banking stocks. Although smaller institutions which face less scrutiny over their capital plans will be less impacted from a valuation standpoint, the influence of the valuation multiples for the largest banks on the overall market for bank stocks cannot be underestimated.
In the first quarter of 2014 the Federal Reserve Board of Governors, the FDIC and the OCC issued final supervisory guidance for stress testing for institutions with less than $50 billion but more than $10 billion in assets. Although this size range still does not encompass the typical community bank, it does demonstrate the tendency for regulatory guidance and the expectations of regulators to “trickle down” to smaller institutions over time. The guidance document discusses supervisory expectations for DFA stress test practices and offers additional details about the methodologies that should be employed, and is likely worth the 69-page read. The document can be found in the March 2014 press release section of the FDIC website, located here (http://www.fdic.gov/news/news/press/2014/pr14019.html).
The CFPB thus far in 2014 has shown a particular interest in the operations of payday lenders and other nonbank lending institutions. The agency conducted a survey, the results of which it provided in a March 25 press release, that contained a number of findings regarding the payday lending market, including:
It is unclear if what the CFPB study refers to as “fees” is actually interest charged on the loans, as the press release makes no mention of interest or interest rates otherwise. The press release notes that “with a typical payday fee of 15 percent, consumers who take out an initial loan and six renewals will have paid more in fees than the original loan amount.” The press release also states that “the CFPB has the authority to oversee the payday loan market,” presumably quieting any in the industry who may question the agency’s authority over this market, and also making clear the agency’s intent to pursue regulations in this area.
In addition to payday lending, the CFPB also looked at other nonbank institutions, including debt collection agencies and consumer reporting agencies (aka credit bureaus), and found evidence that “many companies had systemic flaws in their compliance management systems, such as consistently failing to have a system in place to track and resolve consumer complaints.” None of these enforcement efforts affect the traditional banking sector directly. However, banks encounter similar issues frequently, whether with a borrower caught in a spiral of debt, attempted collections on loans, or the process by which they deal with consumer complaints. Banks also depend heavily on, and deal directly with, credit bureaus. Attention to developments in the attitude of federal regulators toward these areas can prove instructive.
On June 11, 2014 the CFPB opened an inquiry into the use of mobile financial services. The inquiry appears to focus on how the use of mobile devices for purposes of conducting financial transactions might benefit unbanked and underbanked customers, as well as what information is collected on consumers, how it is collected, and how it is disclosed. However, the inquiry also solicits feedback regarding privacy concerns and the potential for data breaches. This announcement continues the trend of an increased focus on the safety of electronic banking in general, particularly given all of the high profile data breaches for non-bank corporations in recent months.
And lastly, the various federal and state regulatory agencies continue to wield the settlement hammer. The following is a sample of penalties and fines announced in the month of June alone.
This article is not exhaustive, and no doubt new developments will continue to surface on a weekly, if not daily, basis. We encourage management teams for bank of all sizes to remain vigilant and informed on this topic. Perhaps the most fitting closing thought is “an ounce of prevention is worth a pound of cure.”
Reprinted from Bank Watch, July 2014.
Jeff K. Davis, CFA, Managing Director of Mercer Capital’s Financial Institutions Group, is a regular editorial contributor to SNL Financial. This contribution was originally published June 5, 2014 at SNL Financial. It is reprinted here with permission.
Portfolio manager Grant Williams remarked at John Mauldin’s Strategic Investment Conference in mid-May that there may be a bubble in complacency. Maybe so with the CBOE Volatility Index (VIX) below 12, high yield credit trading at tight spreads to Treasurys and other risk measures that are comparable to the period leading up to the 2007-2009 financial crisis.
The recent drop in the 10-year yield to about 2.4% from around 2.7% in late April has begun to raise questions about the economy with some investors. Bank stocks have underperformed this quarter even though the rally in bonds may produce better gains on the sale of mortgages and bonds than expected. The SNL U.S. Bank Index declined 4.9% quarter-to-date through May 30 compared to a 2.6% gain in the S&P 500. I think the complacency surrounding the prospects for most banks’ earnings is finally catching up with reality that returns are as good as they are going to get in the current low-rate, low-credit cost environment.
Investors may have a greater sense of urgency as it relates to the Wall Street banks given the widespread coverage of the decline in fixed income trading; however, the issue is not new. The Wall Street Journal’s “Heard on the Street” column on May 23 highlighted how Bank of New York Mellon Corp. and State Street Corp. disappointed investors after a run in their shares during 2013 on expectations that a more favorable rate environment would emerge and thereby drive earnings. The same could be said about Comerica Inc. and a number of other rate sensitive banks whose shares, I think, have priced in an expanding net interest margin from short-term rate hikes by the Fed.
But where the complacency may be painful is among smaller regional banks that emerged from the financial crisis as big winners. One of the hallmarks of these institutions was the acquisition of failed and troubled banks for nominal prices during 2009-2011. These acquisitions may have been cheap and even produced big bargain purchase gains, but the accounting made it tough to discern earning power. Many of these institutions still have NIMs that are significantly above peer margins due to accretion of loans that were marked down for both credit and rate characteristics. Eventually the accretion will end as discounted loans are repaid, refinanced or charged off. In some instances costs associated with collecting these loans may provide some offset, but the reality of the lending market is that new commercial and industrial and commercial real estate loans generally entail rates that are only 3% to 4%.
CIT Group Inc. provides a road map as a result of the fresh start accounting that was adopted when the company emerged from bankruptcy in late 2009. Fresh start accounting was confusing, resulting in sizable marks and accretion for both assets and debt financing. As a result, analysts struggled to get their arms around CIT’s core earnings capacity. Within the last year, the impact of fresh start accounting substantially dissipated. In the year-ago quarter the net finance margin was 4.43% as reported and 4.64% on an adjusted basis. During the first quarter of 2014 the reported and adjusted net finance margins were 3.66%. Not coincidentally, the 2014 consensus estimate declined to $3.11 per share as of May 30 from $3.90 per share a year ago. CIT’s shares have underperformed both the SNL U.S. Bank Index and the SNL U.S. Specialty Lender Index, declining more than 5% over the last year compared to gains of approximately 10% for both indexes as of May 30.
I think a similar outcome awaits a number of the 2009-2011 acquirers that still have a well above average NIM. The Street may argue that higher short rates will offset the loss of accretion income, but absent higher short rates I see this as a huge issue given my view that NIMs for most institutions are headed toward the low 3% level over the next two years. Acquisitions and loan growth, both of which utilize excess capital, can partially offset, but probably not entirely.
There are many banks that face this issue. Most have attempted to be transparent with investors. Old National Bancorp’s investor material clearly shows the difference between the first-quarter reported NIM of 4.22% and the core NIM excluding accretion of 3.36%. Hancock Holding Co. does so, too (4.06% vs. 3.37%). But are investors really processing the information and is the sell-side willing or even capable of doing so? After all, the bias for forward estimates is almost always higher. Stocks look cheaper that way. And who wants to buy shares of a bank whose earnings are going to fall?
In theory, an efficient market would discount the loss of accretion earnings if not disregard it, but I do not believe that is the case for small cap stocks with limited analyst coverage. So the punchline is this: a number of well-managed banks are poised to experience underperformance in their shares as the Street will be forced to revise lower 2015 estimates and general earning power expectations as the accounting accretion from the post-crisis deals wanes. Conversely, the low NIM banks may be poised to outperform on a relative basis, at least for a while.
Reprinted from Bank Watch, June 2014.
Promissory notes are frequently used as a funding mechanism when buy-sell agreements are triggered. However, most buy-sell agreements reflect very little thought or negotiation researching the promissory notes they contain. This checklist helps you determine if your promissory note is reasonable for all parties under reasonably foreseeable circumstances.
It’s no secret that the number of insurance agency acquisitions by banks and thrifts has declined considerably over the last ten years. According to SNL Financial, an average of 60 agencies were purchased by banks annually between 2004 and 2008. Over the next five years, the average annual tally dropped to 27. The most likely reason for this decline is the effects of the recession and less capital available for investment. Interestingly enough, however, the number of agency divestitures by banks has been fairly constant at about ten per year. In the broader market for insurance agencies/brokerages, transaction volume has only gotten more robust over the last ten years, including a record 361 deals completed in 2012. Private equity and strategic consolidators remain keenly interested in the sector.
So is there any reason for banks to care about insurance anymore? A look at the numbers from some of the leading banks in insurance suggests that there is. We screened the universe of publicly traded banks for those institutions with at least $5 million in annual insurance revenue and for which insurance operations constituted a separate reportable segment. In other words, these are banks for which insurance operations are material, but the banks themselves are not so big as to dwarf the impact of the insurance revenue. Summary statistics for the 15 banks in our insurance-focused group are detailed below. The group is fairly evenly distributed by asset size, with the exception of BBT which is presented separately.
The most striking observation is the large share of non-interest income that these banks derive from their insurance operations. A consistent theme among banks for the last several years has been pressure on service charges on deposits. In fact, over the last five years, income from this line item has actually declined by 10.5% on average for banks in the $500M-$1B asset-based UBPR aggregate peer group. The results for the next two tiers, the $1B-$3B and $3B-$5B asset groups, were average declines of 4.2% and 3.5%, respectively. Growth in insurance-related revenue averaged 6.6% annually over the last five years for the insurance-focused group. So while the insurance-focused banks face similar pressures with respect to the traditional components of non-interest income, their insurance operations have provided a surprisingly strong source of growth.
The following chart compares the growth in overall non-interest income for the insurance-focused banks and their corresponding size-based peer groups.
It is clear that for those banks already in the insurance business, the revenue derived from this segment has provided a much-needed source of non-interest income and growth in an otherwise difficult operating environment. And for banks searching for new sources of non-interest income, insurance may offer a compelling opportunity.
What are the key factors to consider when purchasing an agency? First, we would suggest that the investment not be predicated solely on the basis of the cross-selling opportunities. Questions about whether the bank can provide leads to the agency (and vice versa) are important and meaningful, but should you as a buyer pay upfront for these things? A better way to approach the issue is to look for an agency with a stable, recurring revenue stream that can contribute to non-interest income and help diversify the bank’s earnings. An agency that already has an existing client base and recurring commissions can then be leveraged to achieve synergies with the bank.
The insurance business is a personal, sales-oriented business. Revenue is primarily commission-based, and growth is driven by rate (hard vs. soft market) and exposure units (volume). The biggest expenses are people, including commissioned producers to sell business and a quality support staff to service the business and provide customer service and claims support if necessary. Margins in the industry vary by size and product focus, but for the insurance-focused bank group, the average after-tax margin on insurance revenue was approximately 9.0% in 2013. The preferred metric in the agency/brokerage industry is EBITDA margin (earnings before interest, taxes, depreciation, and amortization), which certainly sounds out of place in the banking world, but is nevertheless the base upon which performance is assessed and deals are struck. EBITDA margins for the insurance segments in the bank group highlighted above range from the mid-teens to mid-twenties. Average return on equity for insurance agencies is also higher than for banks because the businesses do not require a large balance sheet. For example, the median return on equity over the period 2009 through 2013 for banks with assets of $1-$10 billion was 6.9% per SNL Financial, compared to 13.6% for the five largest publicly traded insurance brokers.
Other key considerations when evaluating potential agency acquisitions include concentrations (customer/producer/carrier), technology and compliance issues, and cultural fit. Concentrations add risk, especially if a large portion of the business resides with one key producer or owner. For bank acquirers especially, technology and privacy compliance issues could also create unanticipated challenges post-transaction if certain systems and procedures are not thoroughly investigated in due diligence. Cultural fit is hard to define but can either speed along the integration/transition process or threaten to derail it altogether.
How much should a bank pay for an agency or book of business? Rules of thumb can be dangerous, especially those metrics based on revenue, which ignore profitability. Most buyers and sellers tend to focus on adjusted EBITDA for the most recent year or perhaps a pro forma to normalize for non-recurring expenses and income. Transactions are more often than not structured as asset purchases and frequently involve multi-year earn-outs. Purchase prices usually involve a large upfront payment, followed by earn-outs based on future profitability or client retention targets. Because key owners and producers are often asked to stay on for a transition period post-sale, earn-outs serve the dual function of protecting the buyer and motivating the seller by providing for enhanced proceeds if the acquired agency performs above expectations.
Expanding into the insurance business might not be the best option for all banks but it’s clearly an avenue for growth and income diversification for those that can spot the opportunity. Once a platform bank agency is established, the existing regional and community bank branch footprint can be used to expand the model and grow the business. That’s an advantage that potential non-bank acquirers do not have. So while the transaction statistics might suggest that bank-owned agencies are a thing of the past, the performance of banks already in the business indicates that the model works – and that valuable opportunities may reside just down the street.
Mercer Capital provides the insurance industry with corporate valuation, financial reporting, transaction advisory, and related services. To discuss your needs in confidence, please contact us.
Reprinted from BankWatch, May 2014.
Z. Christopher Mercer, ASA, CFA, ABAR, founder and CEO of Mercer Capital, presented this keynote presentation to the American Academy of Matrimonial Lawyers and the AICPA 2014 Bi-Annual Joint Conference. The big five issues presented are:
Also touched on was the topic of marketability discounts.
In a low interest rate environment coupled with rising capital requirements, many banks are turning their attention to asset management firms and trust companies to improve ROE and diversify revenue. Although deal terms are rarely disclosed, the table below depicts some recent examples of this trend with pricing metrics where available.
While multiples for activity metrics (AUM and revenue) can be erratic and tend to vary with profitability, EBITDA multiples are often observed in the 10x-15x range for public RIAs with their private counterparts typically priced at a modest discount depending on risk considerations, such as customer concentrations and personnel dependencies.
Powered by a fairly steady market tailwind over the last few years, many asset managers and trust companies have more than doubled in value since the financial crisis and may finally be posturing towards some kind of exit opportunity to take advantage of this growth. Despite the richer valuations, banks and other financial institutions are starting to take notice for a multitude of reasons:
Still, there are often several overlooked deal considerations that banks and other interested parties should be apprised of prior to purchasing an asset manager or trust company. We’ve outlined our top three considerations when looking to purchase these kinds of businesses in today’s environment:
Perhaps because of these considerations, it is estimated that less than 1% of the 11,000 RIAs and independent trust companies transact in a given year. Still, with an aging ownership demographic and uniquely attractive business model to many prospective buyers, it is reasonable to assume that more asset managers and trust companies will transact in the coming years.
Mercer Capital provides asset management, trust companies, and investment consultants with corporate valuation, financial reporting valuation, transaction advisory, portfolio valuation, and related services. For more information, please contact us.
It appears that Mr. Koons’ careful estate planning, involving a significant sale and redemption transaction of business operations to provide liquidity and flexibility in his later years, was disrupted by an untimely death. While estate planning professionals can hardly advise against a premature passing, the disruption here highlights the importance of starting early with business valuation input to help avoid a complex confluence of strategic transactions within a narrow time frame.
The Court rejected the Estate’s claim seeking a 31.7% marketability discount applied to a Revocable Trust’s ownership interest in a family-owned Limited Liability Company. The Estate’s expert calculated a marketability discount through a regression analysis. It was his opinion that a substantial risk existed that the Trust’s contemplated redemptions of Member Interests, contracted for as part of a planned redemption, might not be consummated. The contemplated redemptions would place the Trust in a voting control position.
The Court agreed with the IRS expert’s conclusion that the referenced redemption offers were binding contracts and were expected to be consummated. The lower risk implicit in the likelihood of a transaction, in context with the implicit voting control position, resulted in the IRS marketability discount of 7.5%, which was accepted by the Court.
The Court also held that claimed interest expense in the amount of $71,419,497 on a $10,750,000 loan from CI LLC to the John F. Koons III Revocable Trust is not deductible to the Estate as an essential expense. The Trust had borrowed the $10.75 million from the LLC in order to pay estate taxes.
Background
John Koons III (the “decedent” or “Koons”) died on March 3, 2005. At issue before the court was the value of his interest in his Revocable Trust (the “Trust’), as well as the deductibility of claimed interest expense on a loan which was incurred by the Trust to make payments on the estate tax liability.
In 1934, the father of John Koons III began buying shares in the Burger Brewing Co., which owned and operated a Cincinnati brewery. The decedent also purchased shares and later became the company’s president and CEO. Under Koons’ leadership, the company began bottling and distributing Pepsi soft drink products in the 1960s. In the 1970s the company stopped brewing beer altogether, and changed its name to Central Investment Corp. (“CIC”). Diversifying its business further, it expanded into the business of selling food and drinks from vending machines.
In 1997, CIC was in a dispute with PepsiCo about whether CIC had the exclusive right to sell Pepsi fountain syrup directly to restaurants, movie theatres, and other customers in its territory. Litigation ensued, and PepsiCo eventually suggested that the lawsuit could be settled if CIC exited the Pepsi system. CIC negotiated with PepsiAmericas, Inc., (“PAS”), the nation’s second largest Pepsi-Cola bottling company. Negotiations were expanded to include the sale of CIC’s vending-machine business.
In preparation for the sale of its soft drink and vending machine business, Central Investment LLC (“CI LLC”) was set up in August 2004 as a wholly owned subsidiary of CIC, to receive all the non-soft-drink and non-vending-machine assets. Koons and his children owned the same percentage in the newly-formed CI LLC as they did in CIC. However, the children were required to approve the sale transaction. Further, their interests in CI LLC were subject to redemption agreements within 90 days of the PAS transaction.
The PAS sale transaction was effected on January 12, 2005.
On February 27, 2005 (approximately four days before the valuation date), the last of the four children signed her letter offering to redeem their respective interests in CI LLC. Mr. Koons died on March 3, 2005. Mr. Koons had already transferred his interests in CI LLC to his Revocable Trust. At his death, the Revocable Trust had a total 50.50% interest in CI LLC, which included a 46.94% voting interest and a 51.59% nonvoting interest. The net asset value of CI LLC at the date of death was $317,909,786.
The children’s redemptions scheduled as part of the sale transaction took place on April 30, 2005 (approximately two months after the valuation date). With redemptions complete, the Trust (by then a Trust Under Will) owned a 70.42% voting interest and a 71.07% nonvoting interest in CI LLC.
On February 28, 2006 (approximately one year after the valuation date), the Trust borrowed $10.75 million from CI LLC to facilitate payments for Estate Tax liabilities. The Trust received a promissory note in the amount of $10,750,000 at 9.5% annual interest, with the principal and interest due in 14 equal installments of approximately $5.9 million each between August 31, 2024 and February 28, 2031. The terms of the loan prohibited prepayment. The total interest component of the 14 installments was $71,419,497. The proceeds of the loan would be used to make a payment toward the estate and gift tax liabilities.
The parties agreed that the value of the Revocable Trust’s interest in CI LLC was less than the pro rata asset value. The parties also agreed that the difference was due to the lack of marketability of the interest in CI LLC as compared to the marketability of CI LLC’s assets. However, the parties disagreed on the magnitude of the marketability discount.
The Estate’s expert considered the Trust’s ownership interest in CI LLC as it existed on the date of death, i.e., a total 50.50% interest (comprised of a 46.94% voting interest and a 51.59% nonvoting interest). He developed a marketability discount through a regression analysis, and concluded that a 31.7% marketability discount was appropriate considering, among other factors, substantial risk existed that the redemptions of the children’s interests might not be consummated. Of course, the redemption of the children’s interests were accomplished soon after the valuation date, which resulted in the Trust owning a 70.42% voting interest and a 71.07% nonvoting interest in CI LLC.
The IRS expert believed that the redemptions of the interests of the four children would occur, and such redemptions would increase the voting power of the Trust’s interest to 70.42%. In determining a marketability discount, he considered the following characteristics of the Trust’s total 50.50% interest in CI LLC:
The IRS expert opined that a 5 -10% marketability discount was warranted. Within the 5 -10% range, he thought that 7.5% would reflect a reasonable compromise between a buyer and a seller.
The Court analyzed the two approaches to the marketability discount, highlighting that a key difference was the assumption of whether or not those scheduled redemptions would occur. The Court agreed with the IRS expert’s assumption, applying a 7.5% marketability discount, based on the following points:
To raise money to pay for the Estate tax liabilities, the Trust borrowed $10.75 million from CI LLC in 2006. Because the installments were deferred for over 18 years, the interest component of the installments was high: it totaled $71,419,497.
According to the Court, administration expense deductions against the gross estate are limited by regulation to such expenses as are actually and necessarily incurred in the administration of the decedent’s estate, such as the collection of assets, payment of debts, and distribution of property to persons entitled to it. Expenditures not essential to the proper settlement of the estate, but incurred for the individual benefit of the heirs, legatees, or devisees, may not be taken as deductions.
The Court concluded it was not necessary for the Trust to borrow the $10.75 million from CI LLC in order to pay the federal tax liabilities:
It appears that Mr. Koons’ careful estate planning, involving a significant sale and redemption transaction of business operations to provide liquidity and flexibility in his later years, was disrupted by an untimely death. The consideration of a loan component extending the life of the estate for many years beyond the date of death was an over-reach, and possibly could have been addressed after the redemption transaction. Furthermore, that redemption transaction clearly put the Trust in a voting control position. The IRS and the Court considered that contractual obligation to be a driving factor, thereby limiting the marketability discount. That controlling interest position would also likely have been addressed in a future estate planning strategy.
While estate planning professionals can hardly advise against a premature passing, the disruption here highlights the importance of starting early with business valuation input to help avoid a complex confluence of strategic transactions within a narrow time frame.
M&A activity in the U.S. (and globally) has accelerated in 2014 after years of gradual improvement following the financial crisis. According to Dealogic, M&A volume where the target was a U.S. company totaled $1.4 trillion YTD through November 10, the highest YTD volume on record and up 43% from the same period last year. Excluding cross-border acquisitions, domestic-only M&A was $1.1 trillion, which represented the second highest YTD volume since 1999 and up 27% from last year. Healthcare and telecommunications were the first and second most targeted sectors.
The improvement has taken a long time even though corporate cash is high, financing costs are very low and organic revenue growth in most industries has been sluggish. Aside from improving confidence, another key foundation for increased M&A activity fell into place in 2013 when equity markets staged a strong rally as the S&P 500 rose 30% (32% with dividends) and the Russell 2000 increased 37% (39%). The absence of a meaningful pullback in 2014 and a 12% advance in the S&P 500 and 2% in the Russell 2000 have further supported activity.
The rally in equities, like low borrowing rates, has reduced the cost to finance acquisitions because the majority of stocks experienced multiple expansion rather than material growth in EPS. It is easier for a buyer to issue shares to finance an acquisition if the shares trade at rich valuation than issuing “cheap” shares. As of November 24, the S&P 500’s P/E based upon trailing earnings (as reported) was 20.0x compared to 18.2x at year-end 2013, 17.0x at year-end 2012 and 14.9x at year-end 2011. The long-term average P/E since 1871 is 15.5x (Source: http://www.multpl.com).
High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares have to be issued to achieve a targeted dollar value. As such, it is no surprise that the extended rally in equities has supported deal activity this year. However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be as obvious as it seems, even when the buyer’s shares are actively traded.
Our experience is that some, if not most, members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”
A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.
Key questions to ask about the buyer’s shares include the following:
The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile.
We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business. Feel free to contact us to discuss your situation in confidence.
On January 7, 2014 Tri-State Capital Holdings, Inc. (NASDAQ ticker: TSC), the holding company of Pittsburgh-based TriState Capital Bank, entered a definitive asset-purchase agreement to acquire Chartwell Investment Partners, L.P., a Registered Investment Advisor (RIA) in the Philadelphia area with approximately $7.5 billion in assets under management (AUM). Unlike most acquisitions of closely held RIAs, the terms of the deal were disclosed via a conference call and investor presentation; the details of which are outlined below.
In the call and presentation, management delineated how Chartwell’s attributes met Tri-State’s investing criteria (as shown below). Many of these features are what makes many asset managers (not just Chartwell) so appealing to both banks and non-banks – growth potential, fee income exposure, high margins, scalability, operating leverage, adhesive clientele base, and minimal capital requirements. Few businesses possess all these characteristics, making many investment advisors like Chartwell the focal point of would-be acquirers with capital to spare.
Of the nearly 11,000 RIAs nationwide, typically less than 100 (<1%) transact in a given year, and the terms of these deals are very rarely disclosed to the public. Perhaps the biggest obstacle to effectively acquiring these businesses is the difficulty and uncertainty involved with ensuring that an asset manager’s clients, staff, and operational autonomy will be preserved post transaction. In a business totally dependent upon the investing acumen and long-term client relationships of a few key individuals, executive retention is critical yet often elusive if the firm’s independence is compromised by a prospective acquirer.
Because of these circumstances, the transactions that do take place are often complemented with contingencies based on staff and client retention with some part of the consideration structured as an earn-out to ensure financial performance holds up post transaction. Tri-State’s acquisition of Chartwell contains all these provisions and relatively favorable pricing, making it a viable prototype for deal structure in asset manager transactions.
Although RIA acquisitions have been relatively scarce in recent years, the outlook is perhaps more optimistic for 2014 as AUM balances and valuations at all-time highs may induce an aging ownership base to exit the business. With so much at stake, prospective buyers and sellers should utilize the Tri-State-Chartwell acquisition blueprint in negotiating a successful transaction for both parties.
To discuss a transaction or valuation need in confidence, contact us at 901.685.2120.
This presentation, excerpted from Mercer Capital’s 2014 session at the Acquire or Be Acquired Conference sponsored by Bank Director magazine, focuses on the opportunities and challenges of the acquisition of an asset management firm by a bank.
Presented January 27, 2014
An acquisition of a non-depository, such as an insurance agency, specialty finance company, trust company, or asset management firm, by a bank is an important decision. This presentation was presented at the 2014 Acquire or Be Acquire conference sponsored by Bank Director magazine and discusses the unique opportunities and challenges of such acquisitions.
Presented January 27, 2014
While many banks chafe under tightening regulatory policy directed by the Federal Reserve and other agencies, the Fed’s monetary policy has, however, created favorable conditions for equity investors. Likewise, the Fed’s monetary policy has compressed spreads on credit-sensitive assets and negated the return on holding liquidity. From bank management’s perspective, these conditions have led to continued deterioration in asset yields, pressure to extend loan portfolio durations, and few remaining alternatives to reduce funding costs. In sum, the Federal Reserve and other agencies have created conditions that complicate bank managers’ decision making – namely, greater regulatory burdens and the effects of a prolonged low interest rate period. However, the Fed’s monetary policy also has created conditions ripe for expansion of banks’ stock prices.
For 322 banks traded on the NYSE, NYSE MKT, and NASDAQ, the median calendar year 2013 shareholder return (that is, stock price change plus dividends) was 38%. As indicated in Chart 1, only eight banks (2% of the population) suffered a negative return in 2013, with nearly one-third (32%) enjoying a total return exceeding 50%.
Chart 1: 2013 Total Return
The market performance is particularly striking when viewed relative to revenue growth in 2013, measured by the change in year-to-date recurring revenue between the year-to-date period ended September 30, 2013 and the comparable prior year period. Approximately one-half of the publicly traded banks experienced declining revenue in 2013, as illustrated in Chart 2. Many of the banks reporting faster revenue growth rates completed an acquisition.
Chart 2: YTD 2013 Revenue Growth (Through 9/30/13)
While revenue growth was difficult in 2013, banks had further opportunities to reduce credit-related costs, leading to some increase in net income. SNL Financial’s estimates suggest that “core” net income (that is, excluding certain non-recurring revenue and expense items) expanded a median of 8% for the population of publicly-traded banks in the trailing twelve month period ended September 30, 2013.
In performing a post mortem on a concluded year, it is often instructive to separate banks experiencing positive and negative returns, and then search for common characteristics distinguishing the two groups. In 2013, however, the “winner” and “loser” analogy appears less descriptive of the year. Therefore, we adopt the terms “winners” and “lesser winners.”
Market performance in 2013 cut across all asset size categories (see Table 1). Favorable performance for the subset comprised of banks with assets between $5 and $10 billion (return of 47%), along with the attendant expansion of price/earnings and price/tangible book value multiples, has provided this group a strong currency to undertake merger and acquisition activity in 2014.
Table 1
A strategy of purchasing banks with lower price/tangible book value multiples at year-end 2012 would have served investors well in 2013, as banks with year-end 2012 price/tangible book value multiples of less than 75% outperformed in 2013 (per Table 2). In addition to being potentially more leveraged to improving economic conditions (due to their more fragile asset quality), banks with lower price/tangible book value multiples benefited from greater M&A activity, more open capital markets, and investors’ desire for higher “beta” securities.
Table 2
Perhaps the most meaningful demarcation between the winners and lesser winners is evident in revenue or loan growth rates. As indicated in Tables 3 and 4, total returns exceeded 40% only for the subset of banks with revenue growth exceeding 5% between the September 30, 2013 year-to-date period and the comparable prior year-to-date period.
Table 3
Table 4
Several of the top performing banks in 2013 were active acquirers during the year. However, it was difficult to ascertain a relationship between acquisition activity and market returns, as suggested by Table 5. Thus, it remains incumbent on acquirers to maintain pricing discipline, such as by using their higher pricing multiple stocks to acquire smaller banks at lower multiples, and/or to demonstrate how the acquisition would benefit the acquirer’s profitability growth.
Table 5
In recent prior years, market returns often were correlated with non-performing asset ratios or changes in NPA ratios. This trend was less evident in 2013, as the winners included banks with NPAs less than 1% or greater than 10% of loans and other real estate owned.
Table 6
Market prognosticators are not predicting a reprise of 2013’s performance in 2014. In fact, returns comparable to 2013 would cause price/earnings multiples materially to exceed historical averages, without accelerating earnings growth. Analysts’ EPS estimates available at year-end 2013 suggest growth on the order of 7% in fiscal 2014, with improvement to 11% in fiscal 2015. In addition, consensus estimates for the S&P 500 index predict appreciation on the order of 5% to 6%. These estimates appear consistent with lower, but still positive, returns in 2013.
Potential challenges in 2014 include:
Mercer Capital assists banks, thrifts, credit unions, and other depository institutions with significant corporate valuation requirements, transactional advisory services, and other strategic decisions. We pair analytical rigor with industry knowledge to deliver unique insight into issues facing depositories. To discuss a transaction or valuation issue in confidence, please contact us.
Following a series of large bank acquisitions in the late 1990s that did not live up to expectations, one institutional investor was quoted over a decade ago as saying fairness opinions were not worth the three dollar stationery they are written on. The portfolio manager was expressing disappointment with a bank that was in his fund that had announced a large transaction. Institutional investors are sophisticated investors. For those that do not like a major corporate decision, the “Wall Street Rule” can be exercised: sell the position.
Boards of directors on the other hand rely upon fairness opinions as one element of a decision process that creates a safe harbor related to significant decisions. Fairness opinions are issued by a financial advisor at the request of a board that is contemplating a significant corporate event such as selling, acquiring, going private, raising dilutive capital, and/or repurchasing a large block of shares. Under U.S. case law, the concept of the “business judgment rule” presumes directors will make informed decisions that reflect good faith, care and loyalty to shareholders. Directors are to make informed decisions that are in the best interest of shareholders. Boards that obtain fairness opinions are doing so as part of their broader mandate to make an informed decision.
The fairness opinion states that a transaction is fair from a financial point of view of the subject company’s shareholders. The opinion does not express a view about where a security may trade in the future; nor does it offer a view as to why a board elected to take a certain action. Valuation is at the heart of a fairness opinion, though valuation typically is a range concept that may (or may not) encompass the contemplated transaction value.
In addition, process can be an important factor in assessing fairness. This is especially true when a company is contemplating selling. Our lay-person view of case law is that boards have some flexibility around marketing a company when entering into a merger that is structured as a stock swap because shareholders will swap common shares; however, when the predominant consideration to be received is cash there is a presumption that an auction was conducted to obtain the best value. Other factors that may be considered include financial interests of insiders, the ability of an acquirer to obtain financing to close, the investment attributes of the buyer’s shares after giving effect to the merger for such factors as relative valuation compared to peers, dividend paying capacity, trading volume, and dilution or accretion to earnings per share and book value per share.
Fairness opinions are typically issued by investment bankers who arranged a transaction; however, because most of their fee is contingent upon the successful closing of a transaction, the lead banker’s opinion has always had some taint even if the consensus is that a transaction is a good deal. In 2007, the Financial Industry Regulatory Authority (“FINRA”) issued Rule 2290, which requires the issuer of a fairness opinion to disclose such conflicts.
It is probably not a coincident that transparency that is promulgated by Rule 2290 has led to more litigation. The New York Times noted on March 8, 2013, that “once you’ve announced a deal, you are likely to get sued.” Academics Matt Cain of the University of Notre Dame and Steven Davidoff of Ohio State University published research in February 2013, that 59% of all takeovers announced during 2005-2012, over $100 million with an offer price of at least $5 per share, involved litigation.
Pre-crisis, approximately 40% of the announced mergers entailed litigation; since 2008 the litigation rate has exceeded 84% each year. The average complaints per transaction were five, and 50% involved multi-jurisdictions. The median attorney fees to settle when disclosed were $595 thousand in 2012, which was within the $528 thousand to $638 thousand median band since 2006. “Disclosure-only” settlements (i.e., adding disclosures about the transaction to the proxy statement) accounted for 88% of the settlements in 2012 vs. 12% for settlements that increased the consideration or reduced the termination fee. In 2005 and 2006, “disclosure-only” settlements were only 64% and 58%, respectively.
The current poster-child for financial advisor conflict is a March 7, 2014, opinion by Vice Chancellor Travis Laster of the Delaware Court of Chancery regarding the acquisition of Rural/Metro Corporation by an affiliate of Warburg Pincus LLC on June 30, 2011, for $17.25 per share in cash. The Court’s decision walks through a minefield of a poorly structured sales process, a skewed valuation, inadequate oversight of the fairness opinion process, and advisor and director conflicts.
Although the acquisition price represented a 37% premium, the Court found that RBC Capital Markets as financial advisor to Rural/Metro allowed its interest in pursuing (unsuccessful) financing roles to the buyer of Rural/Metro and a competitor that was on the block to negatively impact the sales process to the detriment of the shareholders. RBC stood to make upwards of $55 million in financing fees, which were 11x its advisory fee. The board was not informed of the conflicts, and some members of the board were viewed as conflicted and disinterested. Further, the valuation was found to be “belated and skewed” such that the valuation was pushed lower to conform to the proposed acquisition price. The directors settled before the trial for $6.6 million, while secondary advisor Moelis & Company settled for $5 million. In October, the Court found RBC Capital Markets liable for $76 million in damages based upon his finding that the company’s value was $21.42 per share.
In the case of Rural/Metro, the second fairness opinion from a financial advisor that was not conflicted did not negate the factors that resulted in the Court’s view that shareholder value was not maximized; rather, the Court focused on the how the conflicts and faulty board oversight harmed shareholders. That said the competing interests in Rural/Metro point to why corporate transactions increasingly include a second (or third) fairness opinion from a financial advisor that does not stand to benefit from a success fee or fee from arranging financing. Boards that recognize conflicts and which actively manage the transaction process may strengthen their position of having made an informed decision to thereby ensure their actions meet the standards of care, loyalty and good faith.
Mercer Capital is an independent valuation and financial advisory firm. We render hundreds of valuation opinions each year and are regularly engaged by boards to evaluate significant transactions. As part of our financial advisory practice, we regularly issue fairness opinions on behalf of boards that are involved in transactions that span a range of purposes, though M&A is the most common. If your firm is contemplating or has initiated a significant transaction, we would be glad to discuss the matter in confidence.
Reprinted from Bank Watch, December 2014.
When announcing its decision to initiate the taper process with a reduction of $10 billion in monthly bond purchases on December 18, 2013, the Federal Reserve emphasized “forward guidance” that the fed funds target rate will remain unchanged at 0% to 0.25% for an extended period. As a result, capital markets may remain well bid with below average volatility and credit spreads that remain relatively tight in a very low rate environment.
One permutation of the Fed’s policy is that adding leverage to corporate balance sheets is inexpensive even though the ethos post-crisis is de-leveraging among consumers and corporations. It is especially inexpensive if borrowing is obtained via a bank revolver with a multi-year commitment and 30-day LIBOR as the base rate. According to Thomson Reuters, leveraged loan issuance (debt > 4.0x EBITDA) was $1.14 trillion in 2013, up from $664 billion in 2012. About two-thirds of the issuances were attributable to refinancing activity vs. one-third of “new money” issuances.
Private equity investors have taken note and have been the primary force behind an increase in dividend recaps that gained traction in 2012 as firms borrowed from banks and the corporate bond market to fund large distributions. As shown in Figure 1, the trend has continued in 2013, though it has slowed the past few months. Dividend recapitalizations totaled $50 billion in 2013 compared to $47 billion in the 2012. It may be that the pick-up in IPOs and perhaps a hoped for increase in M&A by private equity investors has led to a little bit lower dividend recap activity lately.
Dividend recaps can be an attractive transaction for a board to undertake to unlock value, especially since multiples for many industries have recovered to pre-crisis levels while borrowing rates are very low and most banks are anxious to lend. In addition, dividend recaps allow privately held businesses to convert “paper” wealth to liquid wealth and thereby facilitate diversification.
Dividend recaps raise solvency and possibly fairness issues if an alternative transaction was under consideration. In a future edition of the Transaction Advisor we will take a look at solvency specific issues. Nevertheless, given the implications of a recap transaction a financial advisor’s views should be solicited as part of a board’s duty to its shareholders to make an informed decision.
Merger related accounting issues for bank acquirers are often complex. In recent years, the credit mark on the acquired loan portfolio has often been cited as an impediment to M&A activity as this mark can be the most critical component that determines whether the pro-forma capital ratios are adequate. As economic conditions have improved in 2013, bank M&A activity has also picked up and we thought it would be useful to take a look at the estimated credit marks for some of the larger deals announced in 2013 (i.e., where the acquirer was publicly traded and the reported deal values were greater than $100 million) to see if any trends emerged.
As detailed below, the estimated credit marks declined during 2013 with only one deal reporting a credit mark larger than 4% after the first quarter of 2013 compared to all deals being in excess of 4% in the first quarter of 2013. The reported estimated credit marks for 2013 were also generally below those reported in larger deals in 2010, 2011, and 2012 when the estimated credit marks were often in excess of 5%.
This trend reflects a number of factors including most notably:
Mercer Capital has provided a number of valuations for potential acquirers to assist with ascertaining the value and estimated credit mark of the acquired loan portfolio. In addition to loan portfolio valuation services, we also provide acquirers with valuations of other financial assets and liabilities acquired in a bank transaction, including depositor intangible assets, time deposits, and trust preferred securities.
Feel free to give us a call to discuss any valuation issues in confidence as you plan for a potential acquisition.
Business owners seldom think about a valuation strategy for dealing with the IRS on gift and estate tax matters. Many owners ignore the importance of estate tax planning, which can also be called lifetime planning. Lack of vision or short-sightedness on planning can be damaging to family wealth and succession.
There is a demographic bubble involving ownership of closely held business interests held by baby boomers. This will bring a huge amount of wealth into the estate tax pipeline over the next two decades. Business owners should contemplate three things:
The old strategy goes like this: “Let’s try to value things as low as possible and with as little documentation as possible, thereby saving money. If questions are raised, we’ll try to negotiate a reasonable settlement.”
This strategy often results in loggerhead positions that lead to protracted negotiations, Tax Court, or unreasonable settlements. At the very least, dealing with the IRS in this fashion is quite disruptive to families and businesses. A different strategy seems more appropriate in today’s environment. Recognize first that if you own a successful closely held business, you, your heirs, and/or your advisors will be dealing with the IRS regarding estate tax matters. Therefore, your “IRS strategy” might be composed of the following:
If your business appraiser’s valuation report is well-supported and reasonable in its conclusion, you have little reason to negotiate with the IRS until credible evidence calling for a different conclusion is provided. An estate tax return for a substantial estate which is submitted without a supporting appraisal is an invitation for the IRS to negotiate for higher taxes.
Absent the business valuation, you will have little basis to argue your original position. If you and the IRS reach an impasse and both sides then are required to obtain an appraisal, your appraiser’s independence can be called in question, particularly if the conclusion is supportive of your original position. If the conclusion is not supportive, you have an entirely different set of problems. Further, rest assured that valuations prepared under the threat of immediate litigation tend to be more expensive than those prepared in the ordinary course of business. Finally, know with certainty that the negotiation process with the IRS is costly in terms of business time, personal time, and mental energy, not to mention valuation, legal, and accounting fees.
Remember the old adage, “It is always better to do things right the first time.” Add to that, “It is always more expensive in terms of time, energy, and resources to fix what could have been done right the first time.”
If you own a business or serve as a professional advisor to business owners, engage a competent business appraiser when the need arises. Mercer Capital is one of the largest and most respected business valuation firms in the nation. Give us a call at 901.685.2120 to discuss your valuation issues in confidence.
In this second part of a two-part series, we have collected eight examples of mistakes that valuation experts have made, as reported in federal courts tax decisions (see Value MattersTM, Issues No. 4, 2013 for “16 Mistakes to Avoid in Valuations: According to the Tax Court.”) It is important to note that there are two sides to every story, and courts do not always get it right. For this reason, we do not name any valuators in this collection of mistakes to avoid.
In Freeman Estate v. Commissioner (T.C. Memo 1996-372), the taxpayer’s valuator failed to ask the subject company’s president whether he had plans for an IPO. In the Tax Court’s opinion:
The corporation had an initial public offering of stock in June 1990, at a price of $10 per share. The possibility of an initial public offering was discussed at a meeting of the board of directors of the corporation on August 24, 1989. In his report, [the valuator] states specifically that (1) during his interview with Bernard V. Vonderschmitt, president … he did not inquire as to whether, on October 22, 1989, the corporation had any plans for a public offering of stock, and (2) he did not consider the potential for a public offering in carrying out his valuation assignment.
Petitioner has cited to us no authority prohibiting an inquiry into plans for a public offering. We assume that a potential purchaser would be interested in such plans and might pay a premium depending on her judgment of the likelihood of such an offering.
Likewise, in Bennett Estate v. Commissioner (T.C. Memo 1993-34), the Tax Court criticized a valuator for failing to investigate as would a hypothetical willing buyer:
Compounding this shortcoming is [the valuator’s] exclusive reliance upon the numbers listed on Fairlawn’s balance sheets with no further investigation or due diligence. [The valuator] himself acknowledged at trial that a hypothetical willing buyer would look behind the balance sheet numbers in evaluating their correctness and in applying valuation methods. Although [the appraiser] stated that he was not able to obtain requested documents from Fairlawn, we feel that [he] did not perform sufficient due diligence in this matter.
It is imperative that the valuator document all due diligence efforts in the valuation report, because the valuator may not get a chance to do so on the witness stand. Include unsuccessful efforts to obtain important information, with a legitimate explanation of why the effort failed (See, e.g., Winkler Estate v. Commissioner, T.C. Memo 1989-231).
Another example of lack of due diligence, as well as incorrectly written descriptive report, is where the valuator failed to make relevant inquiries in Ansan Tool and Manufacturing Co. v. Commissioner (T.C. Memo 1992-121).
[The valuator] had not discussed Mario Anesi’s departure from petitioner with management to determine whether customers would leave or stay with petitioner. It is also unclear how [he] determined that only 10 percent of sales would be lost if Mario Anesi competed against petitioner, nor why the 10 percent loss would be limited solely to the first year after he left petitioner.
A dilemma inherent in retrospective valuations is that life and business carry on after the valuation date. Consequently, the post-valuation-date events and cycles become known to valuators during the valuation process. The uncertainties, economic or otherwise, that exist on the valuation date can be lost when subsequent reality becomes visible and measurable. The problem that occurs when future expectations blend into history is that events subsequent to the valuation date are not supposed to be considered in a valuation, except to the extent that such events and conditions could have been knowable or reasonably foreseen.
A valuator’s observations and perspective could potentially be influenced by subsequent events. This can be equally true of the information and feedback provided by the various stakeholders to a valuation event. The question often becomes whether that information was knowable as of the valuation date. Love Estate. v. Commissioner (T.C. Memo 1989-470) is instructive on this issue:
… after Mrs. Love’s death, Praise was determined to be in foal. Surely, this increased her value considerably. Respondent’s expert assumed for the purpose of his valuation that Praise was pregnant at the date of Mrs. Love’s death, although it was impossible to ascertain pregnancy on that date. A hypothetical willing buyer would not have been aware that Praise was in foal. The report of respondent’s expert, therefore, contravenes the regulations by making use of hindsight.
A tax valuation is made as of a certain date; for example, date of death or date of a gift. Generally, a valuator should only consider circumstances in existence on the valuation date and events occurring up to that date. The courts, however, have allowed evidence of subsequent events if those events were reasonably foreseeable as of the valuation date (Spruill Estate v. Commissioner, 88 T.C. 1197 (1987)).
Valuators sometimes have to rely on the work of other valuators whose work may be in progress at the same time. In Cloutier Estate v. Commissioner (T.C. Memo 1996-49), a valuator lost credibility for failing to follow up on a work-in-process:
[O]ne of the appraisals on which [the valuator] purported to rely was merely a draft of an appraisal, and [the valuator] never spoke to the author concerning the author’s completion of that draft or about any of the information contained therein.
In Ford Estate v. Commissioner (T.C. Memo 1993-580), the taxpayer’s expert used historic book value of assets in the net value approach, even though asset appraisals had been obtained and were available. The Tax Court said:
[P]etitioner’s expert valued the assets of each company using unadjusted book value, thereby undervaluing the assets themselves. Petitioner’s expert generally used historic book value as a factor in his formula, notwithstanding that petitioner had obtained appraisals as of the valuation date for certain of the Ford companies’ assets, namely, the real estate owned by Ford Mercantile and Ford Dodge, the securities issued by unrelated entities that were owned by Ford Mercantile, Ford Dodge, Ford Real Estate, and Ford Moving, as well as the cars, trucks, trailers, and securities issued by unrelated entities that were owned by Ford Van.
In Haffner’s Service Station, Inc. v. Commissioner (T.C. Memo 2002-38), a valuator used data that was subject to an explicit warning by the publisher of the data:
[The valuator] acknowledged at trial that the general data was unreliable, he stated specifically that he knew that Robert Morris’s publication warns readers explicitly that the data is not statistically accurate and should not be relied upon or used in a legal proceeding. [The valuator] attempted to rationalize his reliance on the Robert Morris compilation by stating: “Unfortunately, I had to use what was available. It was … the best stuff around. I have to concede that they’re flawed.” We find this attempt unavailing.
The market approach is premised on the use of sales that occur reasonably close to the valuation date. In Hagerman Estate v. United States (81 AFTR2nd Par. 98-771(C.D. III. 1998), the court pointed out:
He relied particularly on Sale 2 finding the subject farm was of the same value. Unfortunately for Plaintiffs, the sale price for Sale 2 was as previously indicated 20 years outdated. Clearly, [the valuator’s] valuation of Farm 4 is seriously flawed.
In Jann Estate v. Commissioner (T.C. Memo 1990-333), a valuator referred to a Standard Industrial Code in his report, but failed to identify what category that number referred to:
[The valuator’s] report referred to comparable companies but did not identify them; did not state whether [he] used average earnings or a weighted average earnings in his analysis; referred to a standard industrial classification number but did not identify it; and did not explain how he arrived the price-earnings ratio of 9.8.
The last mistake on this list, fittingly, is from Hinz Estate v. Commissioner (T.C. Memo 2000-6), in which the valuator apparently neglected to proofread his report, and the Tax Court socked it to him: When asked why his expert witness report relies on a statute that had been repealed years earlier, [the valuator] replied as follows:
“I think this is boilerplate that was put in by my secretary over the last–ever since 1992, and I have never taken it out.” Also, in some instances, the textual descriptions of properties in [the valuator’s] written report did not match the properties listed in the accompanying matrix. It was as though [the valuator] had revised parts of a draft of his report but inadvertently kept parts of former drafts that no longer fit the revised draft.
In this article, we presented eight mistakes made by valuation experts, as reported in federal courts in tax decisions. Just because one judge in one case calls something a mistake doesn’t make it a mistake in all cases. But we think the above examples are indeed instructive in most valuation situations.
L. Paul Hood, Jr., Esq.
The University of Toledo Foundation
paul@acadiacom.net
Timothy R. Lee, ASA
Mercer Capital
leet@mercercapital.com
Note: This article originally appeared in the September/October 2013 issue of The Value Examiner. It was adapted from Chapters 17-18 of A Reviewer’s Handbook to Business Valuation by L. Paul Hood, Jr., and Timothy R. Lee, (John Wiley & Sons, New Jersey, 2011). For book details, see www.mercercapital.com or http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470603402.html.
This article has been adapted from the post “Bill Gross, Carl Ichan and Share Repurchases,” which originally appeared November 7, 2013 in the “Nashville Notes” blog on SNL.com. Republished with permission.
Many bank analysts have been arguing that investors should buy bank stocks because capital is building faster than it can be deployed. The Federal Reserve, unlike during the pre-crisis era, is governing the amount of capital returned to shareholders. Basel III is another governor, especially given the enhanced leverage ratio requirement large U.S. banks are facing.
But are buybacks a good idea for bank managers today? I question the wisdom of many of the repurchases that are occurring when bank stocks are trading at price-to-earnings ratios in the mid-teens and at 1.5x to 2.0x price to tangible book value. The bane of buybacks, and M&A for that matter, is the human propensity to engage in risky behavior at the top of the market when all is well and risks seem minimal.
Share buybacks are not high finance. They use excess capital or cheap debt to fund the repurchase of shares. From a flow-of-funds perspective, repurchases also support share price — especially for small-cap banks that are thinly traded. Nevertheless, I do not think it is simply a constant P/E ratio and higher EPS from a reduced share count that yields a higher stock price. Value matters as well for repurchases.
Ideally buybacks will occur when a stock is depressed, not when it is pressing a 52-week or multiyear high because the Fed has had the monetary spigots wide open for five years. The majority of publicly traded banks today are producing a return on tangible common equity in the range of 9% to 15%. If the shares are trading at 1.5x to 2.0x tangible book value, the effective return for new money is about 6% to 8% (based on the return on tangible equity divided by the price-to-tangible book value multiple) if the bank can reinvest retained earnings at a comparable return on tangible equity. Of course, returns could increase, but that seems doubtful to me when the mortgage refinancing boom is over, loan yields are grinding lower, and credit costs for many banks are low.
Banks that repurchased shares in 2012 have seen varied results. It may be that banks producing the lowest returns, such as First Horizon National Corp., acquired shares in 2012 at a bargain price compared to banks that trade at higher multiples, such as Bank of Hawaii Corp.
JPMorgan Chase & Co. is an unanswered question too. Repurchases made in 2012 may prove to be money well spent provided it is not going to be needed to shore up capital for litigation-related losses. JPMorgan’s 2012 repurchases occurred at an average price of $42.19 per share, which was a modest premium to tangible book value. Today, the shares trade around $52, even though the company’s outlook may be cloudier than it was in 2008.
CapitalSource Inc., Huntington Bancshares Inc., Fifth Third Bancorp and KeyCorp appear to have spent excess capital well in 2012 given a combination of low valuations and adjusted returns in the low teens. The home run among the group is CapitalSource, which repurchased 17.2% of its year-end 2011 shares during 2012 for an average price of $6.91 per share and has bought back 7.0% of its year-end 2012 shares during 2013 for an average price of $9.14 per share. The company subsequently agreed to be acquired by PacWest Bancorp on July 22. Its share price was $13.11 at the closing bell Nov. 4.
Having capital and the willpower not to repurchase requires discipline. It is also a tacit admission by the management team that the company’s shares may be over-valued.
So what is the alternative in the context of capital, profitability, and growth “in that order,” as ex-Whitney Holding Corp. CEO Bill Marks used to say?
One option is to sit on capital waiting for the inevitable cyclical downturn, though that may be a long wait given the lack of loan growth and Fed actions that are indirectly supporting credit quality.
A second option is to do acquisitions using excess capital and richly-valued shares.
A third option is to return capital via special dividends. However, Wall Street has never been as excited about special dividends compared to buybacks because they are one-time events with no impact on EPS or market demand.
If the Fed manages to engineer further appreciation in asset prices, including bank stocks, the sector may see more boards electing to use special dividends to return capital — provided the Fed is agreeable.
Mercer Capital has three decades of experience of advising banks, non-depository financial institutions and corporations in matters related to share repurchases, capital planning and valuation for a variety of purposes. Whether considering an acquisition, a sale, or simply planning for future growth, Mercer Capital can help financial institution accomplish their objectives through informed decision making.
For more information on this topic, please see “Community Bank Stress Testing.”
The following article provides an illustrative example of the primary steps to construct a “top-down” portfolio-level stress test.
While this step will vary depending upon a variety of factors, one way to determine your bank’s economic scenario could be to look to utilize the supervisory scenarios announced (in November 2012) by the Federal Reserve for the stress tests of the largest financial institutions in the U.S. While the more global economic conditions detailed in the supervisory scenarios may not be applicable to community banks, certain detail within the scenarios presented could be useful when determining the economic scenarios to model at your bank. Consider the following U.S. economic conditions included in the scenarios presented by the Federal Reserve:
Based upon these scenarios, one might then decide to consider applying the following two scenarios within your community bank’s stress test:
This step entails segmenting the loan portfolio into smaller groups of loans with similar loss characteristics. One way cited in the OCC guidance is to segment the loans through Call Report categories in Schedule RC-C (such as construction and development, agricultural, commercial real estate, etc.). Additional segmentation may be needed beyond Call Report categories to address other key elements such as risk grade, collateral type, lien position, loan subtype, concentration risk and/or the vintage of the loan portfolio (i.e., loans primarily originated pre- or post-financial crisis). Other assets that could decline significantly in value, such as the investment portfolio and/or other real estate owned, may also need to be considered. Further, certain loans (or segments of loans) such as larger, higher risk grade loans may need to be segregated as they lend themselves to a more “bottom up” type of analysis (i.e., evaluated individually to determine their likely loss rate in a stress environment).
Once the assets have been segmented appropriately, the next step involves estimating the potential loan losses over a two-year stress test horizon (or potentially longer) for the entire loan portfolio. In order to estimate the losses, the OCC guidance suggests using the bank’s historical default and loss experience during prior recessions or financial stress periods as a starting point. Beyond that, the bank may also look to outside references for ranges of loss rates for community banks during stress periods and/or certain other peer average loss rates during financial stress periods.
Let’s assume that the subject bank is headquartered in Chicago, has $500 million in loans, and has experienced historical loss rates moderately in line with its peers (one comprised of banks located in the same geographic area and the other consisting of banks located throughout the U.S.). To estimate the appropriate loss rates during the stress periods, one might then consider annual charge-off rates as a percentage of average loans of the two peer groups for each loan portfolio segment (Construction & Development segment shown below).
The following table details a hypothetical example of estimating loan portfolio stress period losses (loss rates shown for the C&D portfolio are based on Figure 1 while loss rates for the other segments are for illustrative purposes only).
Now that the loan portfolio losses have been determined, the next step entails estimating the potential impact on net income from the scenario(s) analyzed previously. Estimating pre-provision, pre-tax income in the different scenarios can be tricky as the impact of higher non-performing assets on revenue (i.e., nonaccrual loans) and expenses (i.e., collection costs) should be considered. Further, the impact on liquidity (i.e., funding costs) and interest rate risk (i.e., net interest margin) should also be considered.
Once pre-provision, pre-tax income has been determined the next step entails estimating the appropriate provision over the stressed period. The provision can be broken into two components: the provision necessary to cover losses estimated in Figure 2 and the portion of provision necessary to maintain an adequate allowance for loan losses (ALLL) at the end of the two-year period. When determining the portion of provision necessary to maintain an adequate ALLL at the end of the stress period, management should consider that stressed environments may increase the need for a higher ALLL. Finally, the income tax expense/benefit arising from the estimate of pre-tax income should be applied.
The following table details an example of this step.
Other key considerations here might include: How will loan migrations in the different scenarios impact pre-provision net income? How might the economic scenarios forecast impact pre-provision net income? How will the elevated level of losses over the stress periods impact the provision necessary to maintain an adequate ALLL? How will the losses impact the bank’s tax expense/benefit?
This step entails estimating the bank’s capital ratios at the end of the stressed period. To accomplish this, the estimated changes in equity, Tier 1capital, average assets, and risk-weighted assets during the stressed period should be considered.
The following table details an example of this step.
Other key considerations here might include: What are the potential impacts on capital and risk-weighted assets from Basel III? What is the projected balance sheet growth/contraction over the stressed period?
Loan growth continues to remain a struggle for community banks as loan demand remains weak in most regions. Based on Call Report data as of June 30, 2013 for approximately 3,750 banks with assets between $100 million and $5 billion, more than 50% of banks reported lower loan balances in 2010 and 2011. In 2012 and year-to-date in 2013, approximately 40% of banks have reported lower loan balances.
Community banks as a group reported negative median loan growth in 2010 and 2011. Beginning in 2012, loan growth resumed, with the community bank group examined realizing median growth of 2.2%. Year-to-date through June 2013, median growth was 1.1%, or 2.2% annualized, on pace with the 2012 growth figure. The low level of growth in loan portfolios is well below the historical average, including prior recessions. During the 2001-2002 recession, for example, median loan growth was approximately 7.5% for the community bank sample.
The modest loan growth realized in 2012 and year-to-date in 2013 has been spread across portfolio sectors, with all non-agricultural loan categories up 6.8% at June 30, 2013 from year-end 2011. Within the non-ag categories, 1-4 family mortgages were up 6.4%, CRE loans were up 7.4% with most of the increase in nonowner-occupied CRE loans, and commercial/industrial loans were up 11.3%. Construction and development credits were the only sector that saw declines in the last 18 months, with total C&D loans down 4.9% from year-end 2011.
An analysis of mortgage data by SNL Financial indicates that residential loan growth has been consistent across the country, with 932 of the 955 metro areas with available data reporting increases in originations.1 The analysis by SNL looks at comprehensive data filed by lenders pursuant to the Home Mortgage Disclosure Act for the 2012 fiscal year. The analysis shows the largest increases in mortgage lending activity in the areas that were hardest-hit by the recession, including Orlando, Phoenix, Las Vegas, Detroit, and Sacramento, which all posted growth in mortgage lending over 75% in 2012. Overall, funded mortgage loan volume was up 43% from 2011, increasing from $1.5 trillion to $2.1 trillion for the metro areas included in the data set.
For the community bank sample, total growth in single-family mortgages was slower than the aggregate mortgage data for all institutions, with loan volume up 6.5% for the 2012 fiscal year, indicating that the majority of loan growth, at least in the residential mortgage sector, was led by larger institutions.
1 “Loan Growth Spanned Entire US in 2012,” by Sam Carr and Fox, Zach. Published by SNL Financial, October 3, 2013.
Business valuation textbooks, training manuals, and conference presentations may do a good job of teaching the right ways to conduct valuations. But in some respects the most authoritative teacher of what is right and, just as importantly, what is wrong is the decision of the court in a dispute over the value of a privately held business or shares thereof.
In this article we have collected 16 examples of mistakes made by valuation experts, as reported in federal courts in tax decisions. It is important to note that there are two sides to every story, and courts do not always get it right. For this reason, we do not name any valuators in this collection of mistakes to avoid.
No matter how “correct” your conclusion of value is, the court may not accept it if you do not provide sufficient details and explanations about how you arrived at that conclusion. Another valuator should be able to replicate your work after reviewing your report or work-papers. In Winkler Estate v. Commissioner (T.C. Memo 1989-231. See also Former IBA Business Appraisal Standards Sec. 1.8. See also True Est. v. Comr., T.C. Memo 2001-167, aff’d., 390 F. 3d 1210 (10th Cir. 2004), the Tax Court provided perhaps one of the best arguments for a free-standing, comprehensive appraisal report:
Respondent’s expert appears to be extremely well qualified but he favored us with too little of his thought processes in his report. In another area, for example, his report briefly referred to the projected earnings approach, but the discussion was too abbreviated to be helpful. His testimony on the computer models he used, while unfortunately never developed by counsel, suggested that a lot of work had been done but simply not spelled out in his report. That may also be the case in his price-to-earnings computations, but the Court cannot simply accept his conclusions without some guide as to how he reached [them].
What constitutes the proper valuation discount is essentially case-by-case factual issue. Valuation discounts can be factored in as an element of the discount rate (sometimes characterized as implicit treatment) or applied as direct adjustment(s) to value after the enterprise level value has been determined. As such, pure reliance on case law for determination of valuation discounts is inadvisable, particularly when the economics, facts, and circumstances of the precedent cases do not reasonably parallel those of the subject interest. Nevertheless, some valuators have resorted to reliance on case law for determination of valuation discounts. In Berg Estate v. Commissioner (T.C. Memo 1991-279), the Tax Court was unimpressed with this practice:
The fact that petitioner found several cases which approve discounts approximately equal to those claimed in the instant case is irrelevant.
Very few things look worse for a valuator than when he or she cannot find information that the opposing valuator finds. This happened in Barnes v. Commissioner (T.C. Memo 1998-413):
[Valuator A] used the market or guideline company approach to estimate the value of Home and Rock Hill stock, but he excluded three companies that [Valuator B] used as comparables because he did not have their market trading prices as of the valuation date. In contrast, [Valuator B] apparently easily obtained the stock prices by contacting the companies.
It is important to explain any assumptions that you make in a valuation report. In Bailey Estate v. Commissioner (T.C. Memo 2002-152. See also, for example, NACVA/IBA Professional Standards Secs. IV(G)(9) and V(C)(11)), the Tax Court criticized the appraiser for failing to do so:
[He] offered no explanation or support for any of the many assumptions that he utilized in the just-described analysis. Nor did he offer any explanation or support for his conclusion that the discount related to stock sale costs should be 6 percent. An expert report that is based on estimates and assumptions not supported by independent evidence or verification is of little probative value or assistance to the Court.
It is essential that you include a significant discussion in the valuation report of how you weighted products of various multiples in your conclusion of value. This did not happen in True Estate v. Commissioner (T.C. Memo 2001-167, aff’d., 390 F. 3d 1210 (10th Cir. 2004)), as the Tax Court pointed out:
[The valuator’s] report’s guideline company analysis was even more questionable. It provided no data to support the calculations of … pretax earnings and book value for either the comparable companies or True Oil. Further, [he] did not explain the relative weight placed on each factor….Without more data and explanations, we cannot rely on [his] report’s valuation conclusions using the guideline company method.
Where different valuation methods yield differing indications of value, you must be very clear about how you use them to arrive at a conclusion of value.
It sometimes is tempting to simply weight the indications equally. What is more important, however, is to have an explanation for the weighting of the indications of value, whatever they might be. In Hendrickson Estate v. Commissioner (T.C. Memo 1999-278. See also Pratt with Niculita, Valuing a Business, 5th Ed., McGraw-Hill, NY, 2008, pp. 477-482), the Tax Court criticized the work of a valuator who simply gave the indications of value equal weight without bothering to explain why.
(Editor’s note: Some valuation books include complete chapters on reconciling the three approaches (market, asset, and income). An example is Chapter 15 of The Market Approach to Valuing Businesses, 2nd Edition, by Shannon P. Pratt and Alina V. Niculita. Wiley, NJ, 2006.)
You cannot simply pull a capitalization or discount rate out of thin air; you must justify it. This seems to have been an issue in Morton v. Commissioner (T.C. Memo 1997-166):
[The valuator] testified that venture capitalists generally require between 30- and 60-percent return, and that his 35 percent discount rate was “conservative.” However, [he] did not provide any objective support, either at trial or in his expert report, for selecting a discount rate in this range.
You are usually required to include the names of guideline companies in the valuation report. This was not done in Jann Estate v. Commissioner (T.C. Memo 1990-333. See also AICPA Statement on Standards for Business Valuation, Paragraph 61), where the Tax Court pointed out:
[The valuator’s] report referred to comparable companies but did not identify them; did not state whether [he] used average earnings or a weighted average earnings in his analysis; referred to a standard industrial classification number but did not identify it; and did not explain how he arrived the price-earnings ratio of 9.8.
In True Estate v. Commissioner (T.C. Memo 2001-167, aff’d., 390 F. 3d 1210 (10th Cir. 2004)), the Tax Court criticized one of the taxpayer’s valuators, stating:
[He] provided no data showing: (1) How he computed the guideline company multiples or the Belle Fourche financial fundamentals, (2) which of three multiples he applied to Belle Fourche’s fundamentals, or (3) how he weighed each resulting product. Without more information we cannot evaluate the reliability of [his] results.
In Newhouse Estate v. Commissioner (94 T.C. 193 (1990)), the Tax Court concluded:
None of respondent’s expert witnesses testified that they would have advised a willing buyer to use the subtraction method in deciding the value of the stock. None could testify that they had ever advised the use of the subtraction method in advising buyers or sellers of closely held stock in any comparable situation.
The work of valuators and appraisers must be independent, which means having no personal interest in the company being valued or the outcome of litigation. In fact, appraisers usually must certify that they are independent. (See for example 2010-2011 USPAP Ethics Rule line 207, NACVA/IBA Professional Standards Sec. II(J), Former NACVA Professional Standards Sec. 1.2(k), ASA BVS Sec. III(A), Former IBA Business Appraisal Standards Section 1.3, and AICPA Statement on Standards for Valuation Services Paragraph 15.)
In McCormick Estate v. Commissioner (T.C. Memo 1995-371), the Tax Court noted the following about a lack of independence:
Petitioners’ proffered ‘expert’ was John McCormick III, son of petitioner.
In Cook Estate v. Commissioner (86-2 USTC Par. 13.678 (D.C. W.D. Mo. 1986)), the Tax Court disregarded testimony of a person who was too close to the action:
[The appraiser’s] valuation of the stock at issue is not persuasive because of his self-interest. [He] is….president of Central Trust Bank…and the co-executor of Howard Winston Cook’s estate.
In Bennett Estate v. Commissioner (T.C. Memo 1993-34), the Tax Court felt that the IRS appraiser failed to properly characterize the subject company:
…in his report, [the valuator] should have characterized Fairlawn as a corporation actively engaged in commercial real estate management rather than wholly as an investment or holding company.
Contradicting your own assertions without adequate explanation can undermine your authoritativeness, whether it’s done within a single valuation report, or from one report to another, or between writings of various kinds. For example, assumptions used in more than one valuation approach, within a single report, must be consistent. That rule was violated in Bell Estate v. Commissioner (T.C. Memo 1987-576):
Furthermore, the rates of return applied by [the valuator] in the excess earnings method bore no relationship to the capitalization rate [he] used in the capitalization of income stream method. We believe his choice of varying rate indicates a result-oriented analysis. An appropriate capitalization rate is determined by the comparable investment yield in the market not by the choice of a valuation method. [The valuator] made little effort to identify comparable investments.
Any significant discrepancy between your report and your testimony can compromise your credibility, as the Tax Court demonstrated in Moore v. Commissioner (T.C. Memo 1991-546):
First, his report and trial testimony are inconsistent in that they indicate different methodologies for valuing the partnership interests. The report indicates that he valued the interests by discounting the fair market value of the business to reflect the lack of control and illiquidity associated with the minority interests. His trial testimony indicates that he valued the partnership interests under the procedure prescribed in Rev. Rul. 59-60, 1959-1 C.B. 237.
Valuators must use commercially available data consistently as well. In Klauss Estate v. Commissioner (T.C. Memo 2000-191), the Tax Court said that:
[The valuator] testified that it is appropriate to use the Ibbotson Associates data from the 1978-92 period rather than from the 1926-92 period because small stocks did not consistently outperform large stocks during the 1980s and 1990s. We give little weight to [his] analysis. [He] appeared to selectively use data that favored his conclusion. He did not consistently use Ibbotson Associates data from the 1978-92 period; he relied on data from 1978-92 to support this theory that there is no small-stock premium but use an equity risk premium of 7.3 percent from the 1926-92 data (rather than the equity risk premium of 10.9 percent from the 1978-92 period.
In Caracci v Commissioner (118 T.C. 379 (2002), rev’d 456 F. 3d 444 (5th Cir. 2006)), the Tax Court used the valuator’s past writings against him in the selection of a price-to-revenue multiple:
Moreover, in an article published [in Intrinsic Value] in the spring of 1997, [the valuator wrote] that for the prior two years, a standard market benchmark for valuing traditional visiting nursing agencies, such as the Sta-Home tax-exempt entities, was a price-to-revenue multiple of .55. We fail to understand why the Sta-Home tax-exempt entities had a much lower multiple of 0.26.
There may be a legitimate basis for valuing the same interests using different methods in sequentially issued reports. But in True Estate v. Commissioner (T.C. Memo 2001-167), the Tax Court found that the valuator’s inconsistent application of valuation methodology was a problem, commenting:
[His report] calculated the equity value of Dave True’s 68.47 percent interest in Belle Fourche on a fully marketable non-controlling basis without first valuing the company as a whole. This significantly departed from the initial…report’s guideline company approach, which first valued the company on a marketable controlling basis, and then applied a 40 percent marketability discount. Even though both reports used the guideline company method, we believe the approaches were substantially different and find it remarkable that both reports arrived at the same ultimate value of roughly $4,100,000 for Dave True’s interest. This suggests that the final…report was result-oriented.
Finally we have an example of inconsistent use of pre- and post-tax figures. In Dockery v. Commissioner (T.C. Memo 1998-114. See also ASA BV Sec. IV(JV)(D)), the valuator:
[M]isapplied the price/earnings capitalization rate of 5 used in Estate of Feldmar to convert Crossroads’ weighted average earnings, in that the Court in Estate of Feldmar applied the capitalization rate to post-tax earnings and [the valuator] applied it to pre-tax earnings.
In Hall Estate v. Commissioner (92 T.C. 312 (1989)), the Tax Court determined that the valuator had incorrectly defined cash flow:
In its application of the discounted future cash flow valuation, [he] incorrectly defined cash flow as net income plus depreciation, omitting consideration of deferred taxes, capital expenditures, and increases in working capital.
In Heck Estate v. Commissioner (T.C. Memo 2002-34), the Tax Court determined that the IRS appraiser defined the term “guideline company” too narrowly:
[The appraiser] argues that only companies that are ‘primarily champagne/sparkling wine producers like Korbel’ constitute permissible guideline companies. Because no such publicly traded company existed, Dr. Bajaj rejected the market approach. We find [the appraiser’s] approach to be unduly narrow (in theory), in light of the case law cited in the text.
The buyer and seller in the fair market value calculus must be hypothetical. In Simplot v. Commissioner (249 F. 3d 1191 (9th Dir. 2001)), the Ninth Circuit called down the Tax Court for failing to adhere to this standard, noting:
The Tax Court in its opinion accurately stated the law: ‘The standard is objective, using a purely hypothetical willing buyer and willing seller….The hypothetical persons are not specific individuals or entities.’ The Commissioner himself in his brief concedes that it is improper to assume that the buyer would be an outsider. The Tax Court, however, departed from this standard apparently because it believed that ‘the hypothetical sale should not be constructed in a vacuum isolated from the actual facts that affect value.’ Obviously the facts that determine value must be considered.
The facts supplied by the Tax Court were imaginary scenarios as to who a purchaser might be, how long the purchaser would be willing to wait without any return on his investment, and what combinations the purchaser might be able to effect with Simplot children or grandchildren and what improvements in management of a highly successful company an outsider purchaser might suggest. ‘All of these factors,’ that is, all of these imagined facts, are what the Tax Court based its 3 percent premium upon. In violation of the law the Tax Court constructed particular possible purchasers.
It is not unusual for a business valuator to rely in part on the efforts of a colleague, often a real estate or other personal/tangible property appraiser. The relying valuator cannot blindly rely on the work of others, but must make some baseline assessment of the accuracy and completeness of the other appraiser’s work. In Northern Trust Co. v. Commissioner (87 T.C. 349, aff’d sub nom. Citizen’s Bank & Trust v. Commissioner, 839 F. 2d 1249 (7th Cir. 1988)), the Tax Court criticized a valuator’s opinion, noting:
[He] explained that he relied on the opinion of several local real estate appraisers [but admitted that those appraisers] never viewed the property prior to determining the appropriate adjustments. Indeed, the record contains no evidence explaining the basis of these adjustments.
You have a duty to investigate or otherwise inquire about research, studies, reports, and other information on which you rely. In Kraft, Inc. v. Commissioner (T.C. Memo 1988-511. See also 94-1 USTC Par. 50,080 (Cl. Ct. 1994)), the court criticized the use of incomplete data:
Foremost is that the data used by [the valuator] from Table No. 58 of the Pitcher Report, included in Exhibit 208, and used in the ‘Knutson formula,’ cannot reasonably be construed to represent conditions in milk markets elsewhere in the United States, or even within the New York City metropolitan area. It is true that the Pitcher Report was a detailed study of the milk market in New York State, rich with anecdotal stories and complex analyses of a very troubled industry crying for help from its elected and appointed government officials. Nonetheless, the data used by [the valuator] was only for the New York City metropolitan area; it did not include data gathered from dairies statewide, from other New York State cities, and from the larger NYC metropolitan area dairies. The failure to include data from the larger dairies is significant.
In Wall v. Commissioner (T.C. Memo 2001-75), the Tax Court had this to say about the valuator’s narrow selection of multiples:
It did not use all the guideline company multiples but instead picked and chose among the lowest ….[The valuator’s] use of the two or three lower multiple companies is inconsistent with the conclusion expressed elsewhere in her report that, even after the decline in Demco’s earnings had been taken in account, Demco’s profitability and risk levels were close to or at the industry norm. It also may be inconsistent with her conclusion that the seven companies she identified as comparable were in fact comparable to Demco.
In Gallo Estate v. Commissioner (T.C. Memo 1985-363), the Tax court was even more pointed in its cherry-picking criticism:
In valuing Gallo under each of the five methods based on comparables that he used, [the valuator] assigned to Gallo ratios that would result in the highest possible valuations. [His] method was pervasive and absolute: he made no real attempt to compare Gallo with any of the individual comparables. Even if Gallo were an above-average company, which is was not when ranked among the comparables, it would be unreasonable to expect Gallo to be most attractive with respect to each and every ratio. None of the 16 comparables was so positioned.
In this article we presented 16 kinds of mistakes made by valuation experts, as reported in federal courts in tax decisions. Just because one judge in one case calls something a mistake doesn’t make it a mistake in all cases. But we think the above examples are indeed instructive in most valuation situations.
L. Paul Hood, Jr., Esq.
The University of Toledo Foundation
paul@acadiacom.net
Timothy R. Lee, ASA
Mercer Capital
leet@mercercapital.com
Note: This article originally appeared in the July/August 2013 issue of The Value Examiner. It was adapted from Chapters 17-18 of A Reviewer’s Handbook to Business Valuation by L. Paul Hood, Jr., and Timothy R. Lee, (John Wiley & Sons, New Jersey, 2011). For book details, see www.mercercapital.com or http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470603402.html.
The market for corporate loans and high yield bonds remains torrid in spite of the move higher in intermediate- and long-term Treasury rates since May. Leveraged loan issuance totaled $736 billion through August vs. $387 billion last year-to-date. High yield bond issuances totaled $208 billion, up from $189 billion. The majority of activity reflects refinancing-related volume rather than new money borrowing. A sub theme within the refinancing trend is the dividend recap. This presentation examines the pros and cons of such transactions that unlock value for equity holders, create incremental risk for lenders, and the importance of solvency opinions as part of the process.
Presented September 17, 2013