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.
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
The M&A market for banks remains steady relative to Street expectations for a quicker pace, given well-documented earnings and regulatory challenges that smaller institutions face. Year-to-date through August 19, 2013, there were 137 announced bank and thrift transactions, which equates to about 210 deals on an annualized basis. This compares to 251 announced deals in 2012 and 178 in 2011. Pricing, as measured by the average price/tangible book multiple of 117%, is comparable to median pricing observed the past few years; however, P/E ratios have declined as earnings have recovered. The median P/E for 2013 was 23.2x, compared to 33.0x in 2012.
In particular, the specialty finance sector has seen a steady pace of transactions. According to SNL Financial, there have been 43 acquisitions of specialty finance companies year-to-date by banks and non-banks, for an aggregate value of $7.4 billion. There were 80 deals valued at $10.8 billion in 2012 and 70 deals valued at $36.0 billion in 2011. Since 2008, the average price/book multiple has ranged between 187% (2011) and 78% (2010). The median year-to-date price/book multiple was 124%, while the median P/E was 7.8x. Sector pricing averages should be taken with a grain of salt as the homogeneity in the banking sector does not apply to the same degree in specialty finance.
While interest in mortgage banking may be waning with rising rates, other specialty finance sectors, such as commercial real estate (CRE), are receiving more attention as banks and non-banks return to the sector. As an example, Capital One Financial Corporation (COF) announced on August 16, 2013 that it would acquire Beech Street Capital for an undisclosed price. Beech Street was founded in 2009 by long-time banking executive Alan Fishman along with employees from Fannie Mae, Freddie Mac, and other lenders. Beech Street focuses on multi-family lending as a Fannie Mae “Delegated Underwriting and Servicing” (“DUS”) lender. Such firms are approved to underwrite, close, and deliver most loans without a prior review by Fannie Mae. Capital One is acquiring one of the 24 designated DUS firms and will presumably gain a competitive advantage in underwriting multi-family loans at a time when the sector is benefiting from a resurgence of apartment construction.
Another transaction of note is the July 22, 2013 announcement that PacWest Bancorp (PACW) will acquire CapitalSource Inc. (CSE) for $2.3 billion of stock and cash. Pricing equated to 169% of June 30 tangible book value and 19x consensus 2013 EPS. Although CapitalSource’s primary subsidiary operated as a bank via its California industrial loan charter, the Company is more akin to a commercial finance company in a bank wrapper. PacWest will obtain a prodigious asset generator that will be funded with its core deposits.
Acquisitions of specialty finance companies by banks are not a panacea for challenges that face the industry; however, in some instances a transaction that is thoroughly vetted, well-structured, and attractively priced can provide the buyer a new growth channel while also obtaining revenue and earnings diversification. At Mercer Capital we have three decades of experience in valuing and evaluating a range of financial service companies for banks, private equity, and other investors. We would be happy to assist you in evaluating an opportunity that your institution may be considering.
Comments by Federal Reserve Board Chairman Ben Bernanke in the second quarter of 2013 resulted in significant increases in Treasury rates during the quarter, particularly for longer-term securities. In May, Bernanke testified before Congress and outlined the Fed’s eventual approach for exiting its accommodative monetary policy, which has included very low interest rates as well as purchases of mortgage-backed securities and Treasuries. Bernanke noted that the Fed would likely begin its exit strategy by gradually reducing asset purchases, prior to a focus on increasing interest rates. Prior releases by the Federal Open Market Committee indicated that rate increases likely will not begin until the unemployment rate has fallen below 6.5%, assuming inflation projections remain in line with longer-term goals. Bernanke’s comments before Congress suggest, however, that some tightening of monetary policy could come earlier, through the reduction in asset purchases. In response to Bernanke’s comments, longer-term interest rates began to tick up through May and into June.
On June 19th, Bernanke said in a press conference that the Fed could begin to reduce its asset purchases as early as the end of 2013 and could potentially cease such purchases in mid-2014. The near-term timeline for reducing asset purchases spurred a spike in interest rates that compounded the effect of the already-increasing trend in rates observed through May. Rates continued to exhibit volatility throughout the rest of June as markets reacted to Bernanke’s comments.
The interest rate increases in the latter part of second quarter resulted in the evaporation of unrealized gains in banks’ bond portfolios, which had been at very high levels given the persistently low rate environment. The table below summarizes the extent of losses in unrealized bond gains for banks in the second quarter. The number of banks with assets over $250 million reporting unrealized gains embedded in their bond portfolios fell from 1,985 at March 31, 2013 to 1,018, or 49% fewer, while the number of banks reporting embedded losses tripled from 477 to 1,427.
At March 31, 2013, banks reported unrealized gains representing an average of 1.97% of their total Available for Sale (“AFS”) portfolios. That figure declined to 0.84% at June 30, a decline in unrealized gains of 1.13% of total AFS. On average, banks lost more than 350% of reported amounts of unrealized gains embedded in bond portfolios, resulting in commensurate reductions in accumulated other comprehensive income. The impact of the lost AOCI on tangible equity, however, was moderated by the trend of improving earnings in the industry, and on average, equity capital declined by just 1%, while the average tangible equity/tangible assets ratio fell from 10.7% at March 31, 2013 to 10.5% at the end of second quarter.
The effect of volatility in unrealized bond gains may create fluctuations in tangible equity capital, but its effect on regulatory will be much more modest, given the recent issuance of the final Basel III capital rules, which require only banks with more than $250 billion in assets to include such gains in regulatory capital measures beginning in 2014. Most smaller banks will not be required to include unrealized gains in regulatory capital calculations, with the exception of banks with foreign exposures exceeding $10 billion.
Valuation of PE portfolio investments for financial reporting can be challenging for many reasons. PE investments are, by nature, illiquid. Portfolio companies are not publicly traded, and holding periods are generally long. PE investments often employ complex capital structures that include several tranches of equity, debt or hybrid securities with differing rights to intermediate and exit proceeds. In addition, derivative instruments are also popularly used in incenting management teams.
Market participants are increasingly sensitive to (the appearance of) conflicts of interest in PE valuations. In the absence of public, transparent information, investors have to rely on valuation marks provided by PE managers to assess performance, review allocations, determine compensation and fulfill their own reporting requirements. Regulatory agencies, including the SEC, are increasingly scrutinizing valuation practices within PE and other alternative investment managers.
In the absence of public price discovery, analysts must rely on or devise models to conduct valuations of portfolio companies and investments. At the same time, accounting principles prescribe maximizing the use of publicly observable inputs in the valuation models. A defensible valuation opinion needs to consider, conduct, and document a number of procedures including historical financial review, independent analysis of public guideline or comparable companies and private transactions, evaluation of acceptable and relevant income methods (capitalization or discounted cash flow), and tests for internal consistency.
Mercer Capital has years of experience in providing third-party valuation opinions on illiquid investments to PE clients’ and other stakeholders’ satisfaction. Our recent presentation, “Best Practices for Fair Value Measurement,” available at http://mer.cr/pe-val-ppt, throws some light upon a number of valuation issues specific to PE portfolios.
It is vital that analysts exercise impartiality in conducting portfolio valuations. Larger PE funds increasingly rely on valuations prepared by third-party specialists to ensure objective reporting of portfolio investments. Investor-facing groups including the Institutional Limited Partner Association, European Private Equity and Venture Capital Association, and the Alternative Investment Management Association acknowledge and recommend the use of independent third-party valuation specialists.
Contact a Mercer Capital professional to discuss your needs for independent valuation and consulting services.
In this article, we provide a broad overview of business value and why understanding basic valuation concepts is critical for business owners. Why is this valuation knowledge important? Because businesses change hands much more frequently than one might think. In fact, every business changes hands at least every generation, even if control is maintained by a single family unit.
According to statistics about business size from the U.S. Census Bureau, there are about six million businesses with payrolls (meaning these businesses employ people) in the United States.[1] A little more than three and a half million U.S. businesses have sales of less than $500 thousand. Without any disrespect, these businesses are often referred to as “mom and pop” operations because their basic function is to provide jobs for the owner(s) and sometimes a few other people.
About two million businesses have annual sales between $500 thousand and $10 million.[2] This segment of the business community is generally given credit for the majority of job growth. Only about 200 thousand businesses have annual sales exceeding $10 million.[3]
At the top of the business pyramid are public companies. Of these, as of 2012, only about four thousand have active public markets for their shares with regular stock pricing and volume information available.[4] Because of their size and visibility, this relatively small group of public companies gets the lion’s share of coverage in the business press. As a result, most of the popular business press coverage of valuation issues relates to public companies.
But most of the businesses in corporate America are closely held, or private corporations. This means that most of the business owners in corporate America are not in public companies, but in generally smaller entities owned by a single, or a small number of shareholders. Therefore, it’s important for these business owners and their advisors to have an understanding of the nature of value in these businesses.
Most business owners, and, quite often, their advisors, have inaccurate conceptions of the value of their businesses. This is not surprising, because there is no such thing as “the value” of any business. Value changes, often rapidly, over time. Yet it is important for business owners to have current and reasonable estimates of the values of their businesses for numerous reasons, including ownership transfer.
There are many reasons for ownership transfer, including:
If you don’t believe that businesses change hands, examine the Business Transfer Matrix in Figure 1.
When a business changes hands, there will be either a partial transfer of ownership (in the form of gifts, sales to employees, going public, etc.) or a total transfer of ownership (through outright sale or death).
The Business Transfer Matrix also indicates that ownership transfers are either voluntarily or involuntary because we do not always control the timing or circumstances of sale.
Unfortunately, most business owners don’t plan for the eventual transfer of their business. In our experience, most business sale or transfer decisions are made fairly quickly. In many cases, business owners never seriously contemplate the sale of their businesses until the occurrence of some precipitating event, and shortly thereafter, a transfer takes place.
The logical inference is that many, if not most, business sales occur under less than optimal circumstances.
The only way business owners can benefit is to constantly do the right things to build and preserve value in their businesses, whether or not they have ever entertained a single thought about eventual sale.
In other words, owners should operate their businesses under the presumption that it may someday (maybe tomorrow) be necessary or appropriate to sell. When the day comes, business owners will be ready – not starting to get ready and already behind the eight ball.
It is a hard truth for many business owners to learn that what they think regarding the value of their business doesn’t matter. The value of any business is ultimately a function of what someone else with capacity (i.e., the ability to buy) thinks of its future earning power or cash generation ability.
For other transactions with gift or estate tax implications or with legal implications for minority shareholders, what a business owner thinks still doesn’t matter. What then becomes important is the value a qualified, independent business appraiser or the court concludes it is worth. In so doing, the appraiser or the court will simulate the arms’ length negotiation process of hypothetical willing buyers and sellers through the application of selected valuation methodologies.
Theoretically, the value of a business today is the present value of all its future earnings or cash flows discounted to the present at an appropriate discount rate. To determine a business’s worth, determine two things: 1) What someone else (with capacity) thinks the company’s earnings really are; and 2) what multiple they will pay. Simplistically, we are saying:
Hypothetical (or real) buyers of capacity will make reasonably appropriate adjustments to the company’s earnings stream in their earning power assessments. In addition, they will incorporate their expectations of future growth in earning power into their selected multiples (price/earnings ratios). Or they will make a specific forecast of earnings into the future and discount the future cash flows to the present.
Now let’s talk a bit about the value of companies from a conceptual viewpoint by beginning with a familiar term and its definition: Fair Market Value.
A hypothetical willing buyer and a hypothetical willing seller, both of whom are fully or at least reasonably informed about the investment, neither of whom are acting under any compulsion, and both having the financial capacity to engage in a transaction engage in a hypothetical transaction
That may not sound like the real world, but it is the way that appraisers attempt to simulate what might happen in the real world in actual transactions in their appraisals.
And it is the way that business owners state in agreements – quite often in buy-sell agreements, put agreements, and other contractual relationships – that value will be determined.
Just so everything is crystal clear, this concept of fair market value can be considered on several levels.
The basic value equation is also known as the Gordon Model:
A company’s price/sales ratio is a function of the margin, say pre-tax earnings, and the appropriate multiple. If companies in the industry tend to sell in the range of 50 cents per dollar of revenue, that might be because the typical pre-tax margin is around 10% and the pre-tax multiple is about 5x.
The multiples of sales that people talk about obviously come from somewhere. Now we know where they come from.
If Value = Earning x Multiple, what about Earnings?
At the margin, if a business increases its costs at a slightly slower rate than its revenues increase, its margins will increase and there will be a multiplicative impact on earnings growth.
If a company’s margins aren’t where they need to be, a business owner should begin a conscious effort each period to hold cost increases to something under revenue increases. If this is done, single digit revenue growth can be turned into double digit earnings growth – at least until margins normalize. We call this “margin magic.” In the process, the business owner will have begun to optimize the value of the business.
Therefore, the multiple can be characterized as:
Along the road to building the value of a business it is necessary, and indeed, appropriate, to look at the business in a variety of ways. Each provides unique perspective and insight into how a business owner is proceeding along the path to being ready for sale.
So, how does a business owner look at their business? And how can advisers to owners help owners look at their businesses? There are at least six ways and they are important, regardless of the size of the business.
Why is it important to look at a company in these ways? Together, these six ways of looking at a company provide a unique way for business owners and key managers to continuously reassess and adjust their performance to achieve optimal results.
At Mercer Capital, we have provided over 8,000 valuation opinions for companies throughout the nation. Many of our client companies (which have ranged from a few hundred thousand dollars to multiple billions of dollars in value) are enormously successful enterprises.
Our successful client companies have one thing in common – they achieved their success by conscientiously working to build value over time. Success rarely comes instantly. For most companies, it comes slowly, and then only in spurts.
Successful companies manage to grow through their spurts, and then to hang on until internal and external circumstances are ripe for another spurt. In this pattern, they slowly build enterprises of substantial value.
We noted earlier that value is, theoretically, equal to the product of a company’s believable earning power and a realistic multiple applied to that earning power. Business owners need to focus on both earnings and the multiple to maximize value. They also need to understand that it can take a long time to build businesses of substantial value. However, having done so, even modest growth rates bring substantial dollar growth in value.
If you have questions about the value of your business or would like to discuss opportunities for ownership transition, please contact us.
ENDNOTES
[1] Statistics about Business Size (including Small Business) from the U.S. Census Bureau 2007. About three quarters of all U.S. business firms have no payroll. Most are self-employed persons operating unincorporated businesses, and may or may not be the owner’s principal source of income. Because nonemployers account for only about 3.4 percent of business receipts, they are not included in most business statistics, for example, most reports from the Economic Census.
[2] Ibid.
[3] Ibid.
[4] “Investors face a shrinking stock supply,” Matt Krantz, Karl Gelles and Sam Ward, USA TODAY.
For a hypothetical example to accompany this article, please see “Community Bank Stress Testing: A Hypothetical Example.”
While community banks may be insulated from certain more onerous stress testing and capital expectations placed upon larger financial institutions, recent regulatory guidance suggests that community banks should be developing and implementing some form of stress testing and/or scenario analyses. The OCC’s supervisory guidance in October 2012 stated “community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions.”1 Further, the OCC’s guidance considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.”2 A stress test can be defined as “the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making with the bank.”3
The hallmark of community banking has historically been the diversity across institutions and the guidance from the OCC suggests that community banks should keep this in mind when adopting appropriate stress testing methods by taking into account each bank’s attributes, including the unique business strategy, size, products, sophistication, and overall risk profile. While not prescriptive in regards to the particular stress testing methods, the guidance suggests a wide range of effective methods depending on the Bank’s complexity and portfolio risk. However, the guidance does note that stress testing can be applied at various levels of the organization including:
Transaction Level Stress Testing: This method is a “bottom up” analysis that looks at key loan relationships individually, assesses the potential impact of adverse economic conditions on those borrowers, and estimates loan losses for each loan.
Portfolio Level Stress Testing: This method involves the determination of the potential financial impact on earnings and capital following the identification of key portfolio concentration issues and assessment of the impact of adverse events or economic conditions on credit quality. This method can be applied either “bottom up,” by assessing the results of individual transaction level stress tests and then aggregating the results, or “top down,” by estimating stress loss rates under different adverse scenarios on pools of loans with common characteristics.
Enterprise-Wide Level Stress Testing: This method attempts to take risk management out of the silo and consider the enterprise-wide impact of a stress scenario by analyzing “multiple types of risk and their interrelated effects on the overall financial impact.”4 The risks might include credit risk, counter-party credit risk, interest rate risk, and liquidity risk. In its simplest form, enterprise-wide stress testing can entail aggregating the transaction and/or portfolio level stress testing results to consider related impacts across the firm from the stressed scenario previously considered.
Further, stress tests can be applied in “reverse” whereby a specific adverse outcome is assumed that is sufficient to breach the bank’s capital ratios (often referred to as a “break the bank” scenario). Management then considers what types of events could lead to such outcomes. Once identified, management can then consider how likely those conditions are and what contingency plans or additional steps should be made to mitigate this risk.
Regardless of the stress testing method, determining the appropriate stress event to consider is an important element of the process. Little guidance was provided although the OCC’s guidance did note that the scenarios should include a base case and a more adverse scenario based on macro and local economic data. Examples of adverse economic scenarios that might be considered include a severe recession, downturn in the local economy, loss of a major client, or economic weakness across a particular industry for which the bank has a concentration issue.
The simplest method described in the OCC guidance as a starting point for stress testing was the “top-down” portfolio level stress test. The “Hypothetical Stress Testing Example” that follows provides an illustrative example of a portfolio level stress test based largely on the guidance and the example provided from the OCC.
The answer to this question will likely depend on the bank’s specific situation. For example, let’s assume that your bank is relatively strong in terms of capital, asset quality, and recent earnings performance and has taken a proactive approach to stress testing. A well-reasoned and documented stress test could serve to provide regulators, directors, and management with the knowledge to consider the bank’s capital levels more than adequate and develop and approve the deployment of that excess capital through a shareholder buyback plan, elevated dividend, capital raise, merger, or strategic acquisition. Alternatively, let’s consider the situation of a distressed bank, which is in a relatively weaker position and facing heightened regulatory scrutiny in the form of elevated capital requirements. In this case, the stress test may be more reactive as regulators and directors are requesting a more robust stress test be performed. In this case, the results may provide key insight that leads to developing an action plan around filling the capital shortfall (if one is determined) or demonstrating to regulators and directors that the distressed bank’s existing capital is adequate. The results of the stress test should enhance the bank’s decision-making process and be incorporated into other areas of the bank’s management of risk, asset/liability strategies, capital and strategic planning.
Having successfully completed thousands of community bank engagements over the last 30 years, Mercer Capital has the experience to solve complex financial issues impacting community banks. Mercer Capital can help scale and improve your bank’s stress testing by assisting your bank in a variety of ways, ranging from providing advice and support for assumptions within your Bank’s pre-existing stress test to developing a unique, custom stress test that incorporates your bank’s desired level of complexity and adequately captures the unique risks facing your bank. Regardless of the approach, the desired outcome is a stress test that can be utilized by managers, directors, and regulators to monitor capital adequacy, manage risk, enhance the bank’s performance, and improve strategic decisions. Feel free to call Mercer Capital to discuss your bank’s unique situation in confidence.
Endnotes
1OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.
2Ibid.
3“Stress Testing for Community Banks” presentation by Robert C. Aaron, Arnold & Porter LLP, November 11, 2011.
4OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.
The Quantitative Marketability Discount Model is a shareholder-level discounted cash flow model designed to help valuation experts derive and explain a reasonable and transparent conclusion based upon the facts and circumstances of each case.
For information on the model, download the QMDM Fact Sheet.
One critical part of the valuation process is the management interview or, as it is sometimes called, the due diligence visit. The management interview provides the business appraiser with an opportunity to integrate many sources of information about a business into a logical and consistent whole. The interview also helps to complete an overall understanding of how a particular business operates. The process of preparing for and conducting a management interview requires the appraiser to develop a command of the facts and circumstances of this particular valuation case.
The specific objectives of the management interview include:
The management interview, if properly conducted, will enable the appraiser gain a more complete perspective of a business than is possible from reviewing documents alone. Ultimately appraisers have the task of understanding the risk profile of the business as a whole and the facets that compose it and of assessing the opportunity profile of business. Risk and growth assessment are both over arching (the forest) as well as the core (the trees) of the appraiser’s valuation development and reporting processes.
Appraisers are often asked why they need to pose certain questions or to collect certain data (sometimes owners and managers chafe at questions in the why and what-if categories). In fact, a good management interview likely involves a few tense moments. Einstein may have said it best when he commented, “not everything that can be counted counts, and not everything that counts can be counted.”
Most valuation firms make it policy that first-time engagements with a client company require an on-site interview. Subsequent valuations of the same business enterprise need not require a visit unless there has been a material change in the key personnel, facilities, financial performance, an extended time since the prior visit, or some other factor that, in the determination of the appraiser and/or the client, suggests something more than a teleconference and exchange of information. Special circumstances limiting the need and/or relevance of on-site visitation might include the valuation of investment vehicle entities, such as family limited partnerships or other entities that hold and manage assets that can be thoroughly studied from afar.
There are additional factors that influence the nature of the due diligence process. These may include the client’s need to address questions about the engagement, the client’s concern for engagement timing and expense, the nature of the valuation opinion, and the involvement and needs of other advisors, particularly fiduciaries.
Good interviewing, whether on-site or by other means, starts with thorough preparation. Assuming information collection is largely complete; the materials should be reviewed and organized in a fashion that facilitates productive inquiry by the appraiser and responsiveness from the interviewee. Historical financial information should be recast in a manner that allows for the examination of trend over time (say, five years) and that promotes the ability of client and appraiser to highlight potential financial adjustments. Also, the appraiser should have reviewed documents related to the business’s history, ownership, and current organizational structure. Economic data for the city, county, and region should be obtained from independent sources, as well as from the business, when available and reviewed. Also, the subject company’s marketing and web-based materials can provide a useful context for assessing the success of the report in presenting the company as it exists in the eyes of those who own and operate it. Industry vocabulary and news items can also prove helpful in assessing the company’s position within its industry and among its competitors.
Most valuation practitioners use some form of questionnaire or checklist that is structured in such a fashion as to promote coverage of the subject matter that could be reasonably expected to influence the valuation. A well-crafted valuation report will provide the reader with a thorough narrative description of the subject business enterprise and the ownership interests therein.
Identifying who should be interviewed and where interviews should be conducted is important to gaining appropriate perspective about the subject company. The nature, size, and complexity of the business enterprise generally guide the appraiser’s design of the interview process. Small businesses with concentrated operations usually do not require the appraiser to meet with more than a few select individuals or at more than a single location. Large diverse businesses with complicated operations and highly delineated senior job responsibilities may require the appraiser to meet with numerous individuals and at differing locations.
The valuation of most small, closely held businesses generally involves the interviewing of a senior, big-picture executive (president, CEO, COO) and a financial officer. In many cases additional interviews or follow-up might be conducted with an external accountant or legal advisor.
The following bullet points provide an outline of a typical management interview. For perspective, assume the subject company is a manufacturing business with $50 million in annual revenue and a single facility harboring both production and administrative departments. The budgeted time is approximately five hours, effectively a day-long interview session when coupled with the travel burden normal to most due diligence.
Experience has taught us that the overriding goal for interviewing and face-to-face meetings is to get the big picture in the words of and from the perspective of company managers and owners that know more about their industry and their operation than the appraiser ever will.
The management interview is an important part of the valuation process. Users of valuation reports should inquire into the level of due diligence used by an appraiser to ensure that confidence in the results is warranted. Some appraisers do not visit the business in the normal course of preparing appraisals. In many cases, these appraisers provide fee quotes that are considerably less expensive than other appraisers who follow due diligence procedures similar to those outlined in this article. In the case of valuations, however, as in many other areas of life, cheaper is not always better. Caveat emptor.
Mercer Capital is a national business valuation and financial advisory firm. We bring analytical resources and over 30 years of experience working with private and public operating companies, financial institutions, asset holding companies, high-net worth families, and private equity/hedge funds. Contact us to discuss a valuation issue in confidence.
Article adapted from A Reviewer’s Handbook to Business Valuation: Practical Guidance to the Use and Abuse of a Business Appraisal by Timothy R. Lee and L. Paul Hood (John Wiley & Sons, 2011)
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