In April 1999, the Tax Court issued a decision authored by Judge David Laro in KAUFMAN (ALICE FRIEDLANDER KAUFMAN v. COMMISSIONER, T.C. Memo. 1999-119, No. 17050-97 (April 6, 1999)). In that decision the appraiser for the taxpayer, Mr. Bret Tack, ASA, took it on the proverbial chin. Mr. Tack provided an appraisal of Seminole Manufacturing Company (“Seminole”) as of April 14, 1994. He concluded that the fair market value of the subject 19.9% interest of Seminole was $30.85 per share.
Mr. Tack’s conclusion was based on his overall valuation, which considered two transactions that occurred shortly after the valuation date at $29.70 per share (which were based on an appraisal rendered shortly before the valuation date). Tack’s report was reviewed harshly by the Tax Court and rejected. A decision was rendered in favor of the Internal Revenue Service.
To frame this issue, we begin with the conclusion of the Tax Court in KAUFMAN.
“Having done so [rejected Tack], we would typically proceed to value the estate’s shares on the basis of the record at hand. In the typical case, we find much information and data on the subject corporation, as well as financial studies and data which allow us to compute value and marketability discounts using MANDELBAUM (T.C. Memo. 1995-255, affd. 91 F.3d 124 (3d Cir. 1996)) [another opinion written by Judge Laro] and other factors mentioned above. The instant case, however, it atypical. Petitioners, in short, ask us to close our eyes to the inadequate record and adopt without adequate verification Mr. Tack’s conclusion and the managerial representations upon which he relied. We decline to do so. Valuation cases require that we determine a value based on the evidence at hand. Whereas we may determine a value with the assistance of experts, if we consider it helpful, we will not accept an expert’s conclusion when it is unsupported by the record. The record must be built by the parties to include all data that is necessary to determine the value of property in dispute. Valuation experts must perform unbiased and thorough analyses upon which we may rely. Where, as is the case here, the record falls short of the standard which we require, we are left to decide the case against the party who has the burden of proof. Because the petitioners bear the burden here, we sustain respondent’s determination, as modified by concessions in brief. We hold that the fair market value of the estate’s stock was $56.50 per share.”
KAUFMAN was appealed to the U.S. Court of Appeals for the Ninth Circuit, which rendered its opinion on March 15th of 2001, almost two years after the Tax Court’s decision (MORRISSEY, et. al. v. COMMISSIONER, No. 99-71013, March 15, 2001). The Ninth Circuit concluded as follows:
“The executors of the Estate of Alice Friedlander Kaufman appeal the judgment of the Tax Court assessing a deficiency of $209,546 against the Estate. We hold that the Tax Court disregarded what should have been dispositive, viz., the price at which stock owned by the Estate had traded between willing and knowledgeable buyers and sellers. Accordingly, we reverse the judgment and remand to the Tax Court for entry of judgment for the Estate.”
We originally wrote about KAUFMAN in the 1999-07 issue of E-LAW. This second E-LAW on KAUFMAN is prompted by the great Casey Stengel who, among other things, is reported to have said “It ain’t over ’til it’s over!” Mr. Tack will most likely concur. Yet unfortunately for him, having found that the dispositive evidence was disregarded, the Ninth Circuit did not address the Tax Court’s criticism of his report.
This one is probably over but, hopefully, a brief review of the issues can be helpful to business appraisers as well as to attorneys in future cases. The good news for readers of E-LAW (and us) is that our initial review of KAUFMAN identified the elements that ultimately resulted in its reversal.
KAUFMAN received a good bit of press in the valuation community, including the following:
This list is not exhaustive but suffice it to say that the KAUFMAN case was the subject of debate among appraisal professionals.
Our initial review of KAUFMAN was based solely on a reading of the case (based on our experience with this case and with numerous others, we attempt to obtain the appraisal reports when conducting in-depth case reviews). In that initial review, I suggested that there were underlying issues related to the credibility of a taxpayer’s fact witnesses in Court, the quality of the business appraisal reports, and the credibility of expert witnesses, including consistency between reports and testimony. These issues appear to have influenced Judge Laro’s opinion considerably, and the Ninth Circuit’s not at all. As noted in E-LAW 1999-07, KAUFMAN raised three important questions for consideration by appraisers.
The Ninth Circuit’s reversal of KAUFMAN was based primarily on issues 1 and 2 above, which obviously relate to the definition of fair market value. The third issue was not raised in the appellate court’s opinion.
The appellate decision consists of five pages. In that space, the Ninth Circuit got down to the issues of the case.
The subject interest of Seminole represented 19.9% of the common stock of the company. As noted above, there were two transactions approximately contemporaneous with the valuation date (of 3.25% and 4.67% interests, respectively). The transactions occurred at $29.70 per share, which was close to Tack’s conclusion, derived using normal valuation methodologies, of $30.85 per share. He concluded that “one [indication] supported the other” in his rebuttal letter (cited above). He further stated in that letter:
“Judge Laro claims that these transactions were not arm’s length. As I understand it, the term “arm’s length” refers to the relationship of the parties and not to the level of due diligence conducted by the buyers or sellers.
These transactions were certainly arm’s length in that the individuals who transacted in the shares, while distantly related, were certainly not close, could not remotely be considered as the natural objects of one another’s bounty and clearly [were] not interested in entering into a transaction in which they would be enriching the other party at their own expense.”
In my review, based on the information in the decision, I agreed with Tack. As noted in E-LAW 1999-07:
“We do not know from the record the weight attached to the transactions by Tack. But the Court disagreed with any reliance on the two transactions noted. The Court dismissed Tack’s considerations of the transactions as being indicative of fair market value. While the parties were made aware of the Merrill Lynch report’s conclusion before they sold their shares, they conducted no financial analysis, did not read the Merrill Lynch appraisal, and nevertheless engaged in the transactions based upon representation of that report’s conclusion as $29.77 per share. The Court concluded that the transactions were not arm’s length in nature, and that the parties acted without full knowledge. There was, however, no mention in the decision of compulsion on either party’s part.
From the discussion in the case, it appears that the transactions may have been what I would consider arm’s length. In the real world, arm’s length transactions do not necessarily suggest that all parties are fully informed. Appraisers and others sometimes confuse what may be arm’s length transactions where people act in their own interests and without compulsion, often without full knowledge, with the hypothetical transactional requirements of fair market value. The Court in this case appears to be requiring that a real world transaction meet the hypothetical requirements of fair market value, rather than asking whether that transaction provides evidence of fair market value. This is not a distinction without a difference.”
The Ninth Circuit decision noted the following:
“Each seller subsequently testified before the Tax Court that the price was fair and that the sale had been under no compulsion.”
And further:
“The Commissioner tries to make something out of the family connections of the sellers with the buyers. They were not especially close. Hoffman had an uncle related by marriage to Weitzenhoffer’s uncle; there is no English work to name this relationship. Branch was Weitzenhoffer’s first cousin. Each seller testified that there was no intention to make a gift to Weitzenhoffer.”
Apparently, as the judge hearing the evidence, Judge Laro had questions about the credibility of these witnesses, which was one of the underlying issues noted at the outset. But the Ninth Circuit disagreed with the Tax Court on the issue of the relevance of the transactions and considered them to be arm’s length in nature and providing “good evidence of the fair market value.” In disagreeing, the definition of fair market value was cited, and then the Court noted:
“[Definition of fair market value]. The willing buyer and willing seller are to be postulated, not as a particular named X or Y, but objectively and impersonally. As the Tax Court itself has held, the Commissioner cannot “tailor ‘hypothetical’ so that the willing seller and willing buyer were seen as the particular persons who would most likely undertake the transaction.” Actual sales between a willing seller and buyer are evidence of what the hypothetical buyer and seller would agree on. [citations omitted]
No good reason existed to reject the sales by Branch and Hoffman as evidence of the fair market value of Seminole stock on April 14, 1994. The sales took place close to the valuation date. The sellers were under no compulsion to sell. There was no reason for them to doubt Weitzenhoffer’s report of the Merrill Lynch valuation.
That the final report was delivered only in July did not undercut the weight of the formal opinion letter written in March. The sellers had no obligation to hire another investment firm to duplicate Merrill Lynch’s work.”
In the original Tax Court decision, the Court suggested that Tack “ignored the value that inured in the estate’s shares on account of the fact that Seminole was a family-owned business that was intended by the shareholders to be kept in the family.” In E-LAW 1999-07, this point was addressed in the context of the relevant restrictive stock agreement, saying:
“It appears that the Court is turning an economic disadvantage (restrictions on transfer) into an apparent advantage in the decision. In this case, the Court attributed motives to family members to buy minority stock at apparently attractive values in order to avoid shareholder litigation from outsiders. It is hard not to suggest that there is an element of family attribution in this portion of the Court’s decision.”
The concept of fair market value does not attribute value to family relationships not available to hypothetical buyers and sellers. Tack was criticized for ignoring such relationships. In reality, he looked at the evidence and found that the transactions were arm’s length. The Ninth Circuit agreed, and addressed the issue further:
“The Tax Court also engaged in the speculation that the Estate stock could be sold to a non-family member and that, to avoid the disruption of family harmony, the family members or Seminole itself would buy out this particular purchaser. The law is clear that assuming that a family-owned corporation will redeem stock to keep ownership in the family violates the rule that the willing buyer and willing seller can not be made particular. [citing ESTATE OF JUNG]. The value of the Seminole stock in Alice Friedlander Kaufman’s hands at the moment she transferred it by death cannot be determined by imagining a special kind of purchaser for her stock, one positioning himself to gain eventual control or force the family to buy him out.”
(The Tax Court was also swayed by this argument in SIMPLOT. We disagreed with it in that case, as well.)
The judgment of the Tax Court was reversed by the Ninth Circuit, and the case was remanded to the Tax Court for entry of judgment for the estate.
Another important observation was made by Paul Hood, writing in STEVE LEIMBERG’S NEWS OF THE WEEK [www.leimbergservices.com]:
“Some of the problems in this case could have been resolved if the taxpayer’s expert would have been permitted to testify on direct. Over the past few years, the Tax Court has liberalized its evidentiary rules. Now seems an appropriate time for the Tax Court to at least reconsider the “no expert testimony on direct” rule as well. Perhaps it is time for the Tax Court to consider scrapping this rule altogether.”
Thanks go to Paul for this observation about direct testimony in Tax Court. Mr. Tack would likely have been better able to present his report and major arguments in direct testimony to lay the groundwork for adversarial cross-examination. As a business appraiser who has been subjected to vicious cross-examination within moments of taking the stand, I concur with a call for reconsideration of this “no expert testimony on direct” rule.
Readers can draw their own conclusions about the Ninth Circuit’s reversal of KAUFMAN. As an appraiser and newsletter writer, let me conclude with three observations:
- Bret Tack should hopefully feel good about it, even though his name is not mentioned in the appellate decision. No expert likes to be written about in a court opinion in a fashion that can undermine his or her credibility in future engagements. His conclusion was affirmed by the Ninth Circuit, even if his report was not openly vindicated. And the Ninth Circuit’s reversal of KAUFMAN adds credence to his rebuttal of the other aspects of his appraisal criticized by the Tax Court.
- I’m glad we wrote about the case originally in an “evenhanded” manner. Our 1999 review was balanced and on point, even in the context of this reversal by the Ninth Circuit.
- And, I’m gratified that we identified the critical issues in the case and took a stand on them.
Upon first reading KAUFMAN, there appeared to be a call to a higher standard for business appraisers, and, therefore, it was discussed in the context of business valuation standards. The points made in E-LAW 1999-7 and in the article for VALUATION STRATEGIES were good but the crux of the reversal by the Ninth Circuit flowed from the definition of fair market value and an appraiser’s interpretation of how two fairly contemporaneous transactions in a private company’s stock provided evidence for the fair market value of the subject interest.
It is clear that appraisers must understand not only the definition of fair market value, but also the nuances of its implementation and interpretation. In reversing KAUFMAN, the Ninth Circuit has taken business appraisers and the Tax Court to school on this subject.
Reprinted from Mercer Capital’s E-Law Newsletter 01-03, April 9, 2001.
Family limited partnerships have become an increasingly popular estate planning tool. The partnership structure allows the donor to consolidate a portion of his or her assets into a single portfolio, manage the assets in an orderly fashion, and gift interests in the portfolio as whole (rather than gift individual assets on a piecemeal basis). The limited partnership structure allows the donor to retain significant control over the contributed assets if he or she wishes to act as general partner while providing limited liability to the transferees via the gifted limited partnership interests. This structure also provides estate and gift tax advantages versus the direct transfer of individual assets, and the gifted limited partnership interests may be subject to appropriate valuation discounts, such as a minority interest discount or a marketability discount for minority interest and lack of marketability.
In forming a family limited partnership, it is important that the triggering of investment company status be avoided. Otherwise, the donor will be forced to recognize and pay taxes on any capital gains embedded in the contributed assets. For a single donor, the primary means of not being construed to be an investment company is for less than 80% of the value of the contributed assets to consist of cash and marketable securities.
One common use of the family limited partnership is as a structure for holding and managing real estate assets. Such assets can range from a single vacation property used primarily by the family itself to multiple commercial income properties. The limited partnership agreement sets out the terms for the management of the property(ies) and the conditions under which the partnership may be dissolved. It also provides for the distribution of any excess cash flow among the various partners. The alternative would be to grant undivided interests in parcels of real estate. This approach, however, does not provide for an orderly management structure and allows the transferee the option of seeking judicial partition of the subject parcel.
As mentioned previously, valuations of the limited partnership interests may be subject to minority interest discounts and marketability discounts. In developing minority interest discounts, appraisers frequently refer to the current and historical relationship between the quoted market values versus their stated net asset values for shares of publicly traded closed-end investment companies and real estate investment trusts (REITs), or other public companies with asset structures similar to the subject. Net asset values in such cases refer to management’s estimates of the fair market values of the underlying assets, less any liabilities. Typically, shares in closed-end mutual funds and REITs trade at some discount to net asset value. The discounts incorporate, among other factors, the market’s collective assessment of built-in capital gains, capitalized operating expenses and management fees. This is the starting point for imputing an appropriate minority interest discount.
The final estimation of the discount follows from the appraiser’s evaluation of the consequences of the lack of control for the limited partner relative to the current condition and outlook for the assets in the partnership. Such control issues may include the size of the vote needed to liquidate the partnership or amend the agreement, whether or not the agreement requires the general partner to distribute excess cash, and how much discretion the general partners have in making new investments.
The size of the marketability discount for limited partnership interests is primarily a function of four factors:
Guidance as to the appropriate level of discounts is limited. It is interesting to note that recently in LeFrak v. Commissioner, T.C. Memo 1993-526, the Tax Court recently allowed a combined minority interest/marketability discount of 30% on interests in 22 apartment buildings and office buildings located in the New York City area. The interests were originally gifted as undivided interests in the various parcels of real estate but were later converted to limited partnerships. The Tax Court ruled that the gifts must be evaluated on the ownership structure in place at the time of the gift. The Tax Court implied in its opinion that had the gifts actually been valid limited partnership interests, a combined discount in excess of 30% could have been in order.
Reprinted from Mercer Capital’s Value AddedTM newsletter – Vol. 6, No. 3, 1994.
Changes in accounting standards have increased the magnitude of auditors’ exposure to fair value measurement, especially during the last five years. SFAS 157, Fair Value Measurement (subsequently codified as ASC 820), effective in late 2007, provided additional clarity regarding the definition of fair value. For example, SFAS 157 clarified the definition of a “market participant,” emphasized that fair value should consider characteristics similar to the subject asset and confirmed that fair value excludes transaction costs. In addition, the fair value option, permits entities to elect to measure many different types of financial instruments and other items at fair value. As anticipated by FASB, a significant result of the new pronouncements has been to increase the number of fair value measurements subject to audit.
Traditionally, financial statements involved primarily tangible assets and historical cost accounting; in the past decade, fair market accounting has gained in prominence due to rapid advances in technology and the development of more complex business models.1 As fair value measurements have become more prominent, so has scrutiny regarding the audit process for such measurements. There exist numerous concerns related to the challenges auditors face when dealing with fair value. The Public Company Accounting Oversight Board (PCAOB), a private-sector organization created by the Sarbanes-Oxley Act for the purpose of overseeing the auditors of public companies, performs annual inspections of public company audits. The Board’s recent investigations signal increasing scrutiny on audit procedures and findings related to fair value measurement.2
In his June 7, 2012 speech at the AICPA’s Fair Value Measurements and Reporting Conference, PCAOB board member Jay Hanson identified a series of recurring audit deficiencies discovered by the PCAOB. Cited instances included auditors’ failures to evaluate sufficiently the fair value assumptions used by issuers in a variety of circumstances. According to Mr. Hanson, auditors failed to test adequately such assumptions as forecasted revenue growth rates, operating margins, discount rates, implied control premiums, and weighted average cost of capital measures. Also, the Board identified some instances in which auditors failed to take into account the effects of contradictory evidence with regard to the reasonableness of certain significant assumptions. Other such findings reported by the PCAOB involved auditors’ failure to assess the adequacy of financial statement disclosures for hard-to-value financial instruments and to respond appropriately to valuation risk.3
A 2009 paper issued by the PCAOB highlights challenges faced by auditors in properly navigating the complexities of fair value. The paper points to the inherent uncertainties related to certain business activities and the heightened degree of judgment and subjectivity that accompany fair value measurements, especially those that are based on models.4 While balance sheets used to be dominated by “solid numbers,” they now commonly include valuation estimates that are far more difficult for accountants, auditors, and investors to comprehend. According to Hanson in his 2012 speech, “management and their accountants increasingly must tackle fair value measurements and management estimates, consistent with new accounting standards in connection with derivatives, securitizations, consolidations, debt/equity issues, revenue recognition, leases and other issues.”5 Further, the persistent challenges in the economic environment make accurate “marking to market” even more challenging. “With respect to fair value, “ the PCAOB explains, “especially in the current economic environment in which markets for certain financial instruments are not active, it may be more challenging for auditors to obtain observable evidence that supports an estimate of what a hypothetical market participant would pay for an asset at the measurement date.”6
One important takeaway is the increased importance and relevance of valuation specialists who are experts in fair value. As the use of fair value measurement has expanded, so has the need for professionals who have specialized capabilities related to the measurement of fair value and the resolution of fair value issues. According to the PCAOB, “the need for professionals with specialized skills or knowledge has increased in response to the challenges of auditing certain fair value measurements.”7 Mercer Capital has a long history of providing fair value services and has the institutional capacity to tackle even the most uncommon or complex fair value issues. Feel free to contact Mercer Capital for assistance regarding fair value measurement or fair value reporting.
Endnotes
1 “Auditing the Future,” Jay D. Hanson, AICPA Fair Value Measurements and Reporting Conference, June 7,2012.
2 Ibid.
3 Ibid.
4 “Auditing Fair Value Measurements and Using the Work of a Specialist,” PCAOB Standing Advisory Group Meeting, October 14-15, 2009.
5 “Auditing the Future,” Jay D. Hanson, AICPA Fair Value Measurements and Reporting Conference, June 7, 2012.
6 Ibid.
7 “Auditing Fair Value Measurements and Using the Work of a Specialist,” PCAOB Standing Advisory Group Meeting, October 14-15, 2009.
The rapid expansion of the financial services industry over the past two decades has given rise to a unique hybrid enterprise: the independent trust company. With roots in the departments of commercial banks, independent trust companies occupy an interesting space in the investment management community, positioned somewhere between a family office and an institutional asset manager. As a result, there really is no one-size-fits-all definition of an independent trust company, and recognition of the particular attributes of independent trust companies is significant to understanding their value.
As high net worth clients migrated from the traditional sales mentality investment approach of brokerage firms, the idea of independent investment advisors began to gain steam. The financial advisory business model transformed from cold calling staffs paid by transaction-based commissions to unbiased and credentialed professionals paid on the basis of assets under management by client bases built primarily on referrals. The popularity of Registered Investment Advisors, or RIAs, centered on the fiduciary responsibility associated with such practices, as well as the greater degree of accessibility and high touch nature of the business operations, which often originated in smaller family office operations. Additionally, the smaller size of independent advisors allowed for greater innovation and more specialized services.
The number of total investment advisors registered with the SEC expanded from 6,360 in 1999 to 8,614 in 2005 (excluding all investment advisors only required to register with their respective states). This number expanded by an additional 1,676 in 2006; however, much of this growth was largely attributable to SEC rule modifications requiring hedge fund managers to register as investment advisors. More than 90% of all RIAs reported less than 50 employees.
Assets managed by independent RIAs more than doubled from 2000 to 2006, while their share of investable assets expanded from 9.0% in 2003 to 14% in March of 2007.
Total assets under management (AUM) reported by SEC-registered investment advisors reached an all-time high of $31.4 trillion as of April 2006. Assets held in discretionary accounts grew 18% from$24.3 trillion in 2005 to $28.6 trillion in 2006.
In spite of all the changes taking place in recent years, there remains some debate regarding whether the independent trust industry is mature or evolving. On the one hand, the concept of providing comprehensive wealth management within the context of highly personalized customer service is not new, but on the other, the level of sophistication expected across the spectrum of trust services has never been higher and, indeed, seems to be growing at a rapid pace.
There are both formal and informal approaches to value, and while we at Mercer Capital are obviously more attuned to the former we do not ignore the latter. Industry participants often consider the value of investment managers in general, and independent trust companies in particular, using broad-brush metrics referred to as “rules-of-thumb.” Such measures admittedly exist for a reason, but cannot begin to address the facts and circumstances specific to a given enterprise.
As an example of this, industry participants might consider asset managers as being worth some percentage of assets under management. At one time, investment manager valuations were thought to gravitate toward about 2% of assets under management.
Understanding why such “rules of thumb” exist is a good way to avoid putting too much faith in them. During periods of consolidation, buyers often believe that the customer base of an acquisition candidate can be integrated with the acquiring firm’s existing managed assets to generate additional profits in line with industry expectations. So if the investment management industry is priced at, say, 15x earnings and profit margins are 20%, the resulting valuation multiple of revenue is 3.0x. If revenue is generated by fees priced at about 67 basis points of assets under management, then the implied valuation is about 2% of asset under management. Note, however, all the “ifs” required to make the 2% of AUM rule of thumb work.
Reprinted from Mercer Capital's Value Matters™ 2007-09, published September 2007.
For those banks considering the acquisition of a failed bank, changes to the terms of a number of FDIC-assisted transactions announced in the second quarter of 2010 should be considered prior to the preparation of bids. Summarized below are a few of the changes in terms that have surfaced in recent transactions:
Several interesting issues have emerged related to these changes and should be considered if your institution is pursuing a failed bank.
To discuss the key considerations in pre- and post-acquisition or to discuss your institution’s specific situation in greater detail, contact Andy Gibbs (gibbsa@mercercapital.com) or Jay Wilson (wilsonj@mercercapital.com) at 901.685.2120. Complete confidentially is assured.
Endnotes
1 “FDIC: Changes to Loss-Share Structure Will Take Effect in April,” by Nathan Stovall and Joe Mantone. Published by SNL Financial, LC, March 26, 2010.
2 “FDIC Moves Ahead with Creative Thinking, Cheaper Failures” by Nathan Stovall. Published by SNL Financial, LC, April 20, 2010.
3 Ibid.
4 Ibid.
Reprinted from Mercer Capital's Bank Watch, June 2010.
The S corporation status has been available to most corporations for many years. According to the Internal Revenue Service, S corporations are now the most common corporate entity.
It is increasingly rare to come across a company that qualifies to be an S corporation (and would benefit from being one) that has not gone ahead with the conversion process. That’s not to say that all companies have taken advantage of this potential benefit.
If your business continues to be structured as a C corporation it is well past time that you at least investigate the possibility of converting to S corporation status. A sub chapter S election for most companies can substantially enhance shareholder benefits, both on an interim basis and at the time of an eventual sale of the company.
These advantages can enhance after-tax proceeds to shareholders upon the sale of a business. Many transactions are structured as the sale of assets, rather than the sale of stock. Purchasing assets is generally more beneficial to the buyer and can generally lead to a maximization of the transaction price.
An asset sale of a C corporation will lead to a double layer of taxes (gains inside the company being taxed as well as taxes paid in getting the proceeds out to the shareholders).
An S corporation structure, with the single layer of taxation and the step-up in basis, typically provides more efficiency in terms of after-tax shareholder proceeds.
While the economics of an S election can be favorable, there are certain drawbacks, including:
While the above discussion outlines some of the primary advantages and disadvantages of an S election, any company considering such an election should discuss their specific considerations with their accountant or tax advisor.
If a company determines it should take advantage of its option to elect S Corporation status, a fair market value appraisal of the company is required as of the election date. If you are considering converting to an S Corporation and, therefore, require a valuation, please let us know if we can be of assistance.
Reprinted from Mercer Capital’s BizVal.com – Vol. 13, No. 1, 2001.
We believe the Quantitative Marketability Discount Model (QMDM) gained a significant amount of currency in a United States Tax Court decision – Janda v. Commissioner.1 As discussed below, although the Court took issue with the assumptions made in the use of the QMDM, it obviously carefully studied the model, and threw out the opposition’s use of the same old studies with little comment.
This is a synopsis of what we now know. The primary themes from this case are:
In Janda, the Court decided as to the value of minority interests in the common stock of St. Edward Management Co. transferred by Mr. and Mrs. Janda to their children. In 1992, St. Edward Management Co. was a small bank holding company in an agricultural community in Nebraska, and both Mr. and Mrs. Janda were employed by the bank as president and vice president, respectively. The unadjusted book value of the bank was listed at $4,518,000, and the holding company, which owned 94.6% of the bank, had 130,000 shares issued and outstanding. In November, 1992, the Jandas each made gifts representing approximately 5.27% interests in the Company to their children.
The Jandas presented a valuation report prepared by Mr. Gary Wahlgren. The IRS presented a report prepared by Mr. Phillip J. Schneider. At trial, Mr. Schneider agreed to Mr. Wahlgren’s conclusion of value on a marketable, minority interest basis of $46.24 per share, or a total value based on 130,000 shares issued and outstanding of about $6,011,000. The disagreement was over the marketability discount. Mr. Wahlgren used the QMDM and opined to a 65.77% discount, while Mr. Schneider relied upon the typical benchmark analysis and opined to a 20% marketability discount.
Mr. Wahlgren determined the applicable marketability discount using inputs to the QMDM as follows:
A quick check of our own templates confirms that these inputs imply a discount of 65.77%, as was used by Mr. Wahlgren.
Mr. Schneider opined to a 20% marketability discount based upon the following factors identified in his report:
Mr. Schneider then quoted the restricted stock studies and pre-IPO studies listed in Shannon Pratt’s “Valuing A Business”, and a few court cases.3 In other words, Mr. Schneider used the usual benchmark studies. He then stated that he believed that “a bank would be a highly marketable business and that the stock would be highly marketable.” Based upon this, Mr. Schneider concluded that a 20% marketability discount was appropriate.
Echoing Daubert, lawyers for the IRS also asserted that “there is no evidence that appraisal professionals generally view the QMDM model as an acceptable method for computing marketability discounts.” We do not agree.
We have sold over 2,700 copies of Quantifying Marketability Discounts. The QMDM has been written up in all major valuation publications. We have spoken to hundreds, if not thousands, of professionals in the appraisal community via dozens of speeches and seminars. We have used the model in thousands of appraisals. We have received hundreds of phone calls, emails, and other communications from valuation practitioners outside of Mercer Capital who use the QMDM regularly. And, yes, we have even been engaged by the Internal Revenue Service to perform valuations on their behalf using the QMDM (none of which have made it to the point of being a matter of public record).
The Court noted the IRS objection, but neither agreed nor disagreed with it. We have no interpretation regarding the inclusion of the comment in the opinion, but we are confident that the QMDM meets the challenges of Daubert.4
The Tax Court Memorandum demonstrated that the Court thoroughly studied and it appears well understood the QMDM. While the Court did not accept Mr. Wahlgren’s 65.77% discount, the Court criticized the assumptions used, not the QMDM. Citing Weinberg, the Court noted that “slight variations in the assumptions used in the QMDM model produce dramatic difference in results” and that the “effectiveness of this model therefore depends on the reliability of the data input into the model.”5
We, of course, couldn’t agree more – at least with the second comment. The model is effective when the inputs to the model are reasonable. Unreasonable inputs produce unreasonable results, just as is the case with a discounted cash flow model, a single period capitalization model, a capitalization model using publicly traded companies, etc.
However, we disagree that “slight variations in the assumptions” result in “dramatic difference[s]” in the implied marketability discount. The comment in Weinberg cannot be substantiated. Having used the QMDM in literally thousands of appraisals, we can attest that, as a valuation model, it is less sensitive than single period capitalization models or discounted cash flow models or most other valuation models. At the end of this article, we modify Mr. Wahlgren’s assumptions to reconcile with the Court’s opinion. Clearly, the change in the conclusion is proportionate to the change in the assumptions. “Slight” changes in assumptions used in the QMDM do not produce “dramatic” differences in the marketability discount.
The Court questioned whether or not it was proper to use an adjusted historical ROE to imply growth in value. It noted that Mr. Wahlgren’s build-up of the required holding period return deviated from the method discussed in Quantifying Marketability Discounts in that it didn’t include adjustments for shareholder specific risks. It did not seem to take issue with the assumed 0% dividend yield or the ten-year expected holding period.
In summary, the Court wrote “we find Mr. Wahlgren’s application of the QMDM model…not helpful in our determination of the marketability discount.” Unfortunately, the Court went on to say “we have grave doubts about the reliability of the QMDM model to produce reasonable discounts, given the generated discount of over 65%.” Obviously we would prefer this last section not be written, but we note that the argument is principally with the inputs and the level of discount reached. If by “reasonable discounts” the Court means 35% to 45%, then we are puzzled.
In the case, the Court characterizes Mr. Schneider’s use of benchmark analysis as subjective and irrelevant to the facts of the case.
“We believe that he [Mr. Schneider] merely made a subjective judgment as to the marketability discount without considering appropriate comparisons. Mr. Schneider looked at only generalized studies which did not differentiate marketability discounts for particular industries. Further, although he stated that each case should be evaluated in terms of its own facts and circumstances, Mr. Schneider seems to rely on opinions by this court to describe different factual scenarios from the instant cases and generalized statistics regarding marketability discounts previously allowed by the Court. Finally, Mr. Schneider has failed to fully explain why he believes that bank stocks are more marketable than other types of stock. We therefore are unable to accept his recommendation.”
Yet, the Court appears to be asking for a model that is results-oriented, and that would end up with a marketability discount in the range of 35% to 45%. If benchmark analysis is no good, and a marketability discount should be fact-based, then Mr. Wahlgren’s analysis should win the day hands-down. If Mr. Wahlgren’s inputs to the model were reasonable, then a 65.77% marketability discount would also be reasonable. It must be the case that the Court just disagreed with Mr. Wahlgren’s interpretation of the facts, and therefore also disagreed with the inputs to the QMDM and the resulting marketability discount.
In the end, the Court split the baby, and declared a 40% combined minority interest and marketability discount. It did not differentiate as to what portion was attributable to the minority interest discount and what portion was attributable to the marketability discount.
We are excited that the Court appears to have carefully studied and understands the QMDM. The Court also appears to have not accepted Mr. Wahlgren’s conclusion based upon the inputs used in the model which produced a 65.77% marketability discount.
We cannot comment at length on Mr. Wahlgren’s report because we have not seen it, and we do not disagree with his analysis at this point because we have no basis to do so. However, we can infer a few things from the memorandum and postulate our own analysis. Mr. Wahlgren valued the Company at a multiple of reported and adjusted book value. Then, in his QMDM analysis, he derived an expected growth in value by adjusting the historical ROE by his multiple of book. This could be considered inconsistent unless an investor expected a contraction in the valuation multiples. Instead, the market value of an entity appraised at a multiple of book value will increase at the same rate as ROE if the multiples don’t change.
In the case of St. Edward Management Company, Mr. Wahlgren capitalized reported and adjusted book values to arrive at a controlling interest value of $51.38 per share. He then applied a 10% minority interest discount to arrive at a marketable, minority interest value of $46.24, or about 1.4 times book value of $32.88 per share. If historical ROE was 13.54% and it was reasonable to expect that to continue, in ten years book value would be $117.06 per share. Assuming no changes in the multiples (none was discussed in the memo), the bank would then be valued at $163.89 per share (1.4x book value). This implies an expected growth in value at the marketable, minority interest level of 13.54% – the same as ROE. Leaving the rest of his QMDM analysis intact, and changing the expected growth in value from 9.12% to 13.54%, the implied marketability discount drops from 65.77% to 49.09%.
One more adjustment. The 1990s saw rapid consolidation in community banks, and many investors might have expected a shorter holding period on the order of, say, five to ten years. With this change, the implied marketability discount is 29% to 49%, and the average is, you guessed it, 40%, exactly what the Court ruled (albeit on a combined minority interest/marketability discount basis).
Note that these adjustments are not “slight” changes in the marketability discount analysis. We have increased the expected growth in value by 40%, and have cut the holding period as much as in half. The result is an implied marketability discount about one-third lower. The change in the marketability discount is proportionate to the change in the assumptions. It is not a “dramatic” difference resulting from “slight changes.”
In about 1990, Mercer Capital was called upon for advice regarding the value of minority interests in the stock of an attractive community bank. The closely held bank had excellent fundamentals. However, it paid no significant dividends, and the Chairman and controlling shareholder of the bank had publicly declared over and over again that the bank would not be sold until he died and not even then if he could arrange it. What stunned our client was that they had bids for the stock, at that time, for about 20% of book value. How, they asked us, could that be? The answer, of course, can be derived using the QMDM. We didn’t have the model at the time, but in retrospect it seems clear to us that the investment prospects of even an attractive closely held bank with limited liquidity prospects would result in a very, very large marketability discount. And that discount was imbedded in the bid for the minority interests in the bank at 20% of book value. This is what Mr. Wahlgren was trying to explain in his valuation, and what we will continue to do in our analyses until we see something better.
Winston Churchill once commented, “It has been said that democracy is the worst form of government except all those other forms ….”
The controversy about the QMDM may be much the same thing. On balance, the Court disagreed with Mr. Wahlgren’s use of the QMDM and seemed to be uncomfortable with the size of the marketability discount his analysis implied. We were encouraged and gratified that the Court apparently spent significant time understanding the model and devoted so much of the written opinion to it. As for the alternative, the Court dismissed benchmark analysis as subjective and irrelevant with little comment.
At the same time the Court criticized the QMDM, it reiterated the call for a fact-based valuation discount methodology.
Endnotes
1 Janda v. Commissioner, T.C. Memo 2001-24.
2 Daubert v. Merrell Dow Pharmaceuticals, Inc. 113 S.Ct. 2786 (1993).
3 Pratt, Shannon P., Reilly, Robert F., and Schweihs, Robert P., Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Fourth Edition, New York (McGraw Hill, 2000).
4 See our discussion of this in The E-Law Business Valuation Perspective 2000-10, “Rule 702, Daubert, Kuhmo Tire Co. and the Development of Marketability Discounts,” October 23, 2000.
5 Estate of Weinberg v. Commissioner, T.C. Memo. 2000-51.
Reprinted from Mercer Capital’s BizVal.com – Vol. 13, No. 1, 2001.
The quoted unit price of a publicly traded security is sometimes not definitive of fair market value for a specific block of the shares or bonds. Such a condition typically arises when the subject holding has impaired marketability. In such a circumstance the exchange quoted price of the security overstates the fair market value of the subject block. That is, the value of a block of stock or bonds may be less than the product of the number of units and the price per share or per bond in the public market. In other words, a discount (that is, a marketability discount) from the market price is indicated for the shares or bonds in the subject block.
Impairments to the marketability of the securities of public companies commonly result from the following factors:
SEC Rule 144 imposes restrictions on the resale of securities of public companies that are issued without the benefit of a registration statement. The unregistered shares of a public company must typically be held by an investor for a minimum of one year before they can be sold into the public market. After the one year holding period is satisfied, public sales of the unregistered shares are subject to volume limitations for an additional year. Sales in private placement transactions of unregistered securities to entities qualifying as sophisticated investors under SEC regulations are permitted, but the minimum holding period and volume limitations regarding resale in the public markets start anew each time the securities change hands.
Lockup agreements frequently apply to shares received by sellers in mergers and acquisitions. Such agreements specify conditions under which the subject shares may be resold and may impose outright prohibitions on any resale for some specified period.
Volume blockage issues arise when the number of shares or bonds in the subject block is large relative to the daily trading volume in the public market. Such a circumstance often implies that liquidation of the block would likely have to occur over a protracted period in order to avoid creating an oversupply which would depress the market price of the security. Liquidity may be impaired due to block size even if the subject shares are registered and no contractual restrictions on resale apply.
One, two or all three of the preceding impairments to liquidity may apply to any given block of securities. For example, the marketability of a block of registered shares may be impaired by the presence of a lockup agreement or other contractual restriction as well as large size relative to recent trading volume. By the same token, a block of stock for which volume blockage or contractual restrictions are not present may not be freely tradable in the public market due to lack of registration under Rule 144.
Guidance on valuing unregistered or restricted securities of public companies for Federal tax purposes is provided in Revenue Ruling 77-287. A valuation under this pronouncement (essentially the determination of the appropriate discount from the quoted market price) requires consideration of the various limitations and enhanced rights attaching to the subject block and the financial condition of the issuer. The marketability discount is quantified by reference to the discounts documented in various published restricted stock studies which analyze the pricing of sales of restricted stock relative to the market prices of otherwise identical freely tradable shares in historical, publicly reported transactions.
An alternative methodology for quantifying the discount relative to the market price of the subject security is the use of an option pricing model to estimate the cost of hedging the price of the security during the period of illiquidity implied by Rule 144, or by any contract or during the period required to conduct an orderly liquidation in the case of volume blockage.
In addition to impaired marketability, a subject holding of securities issued by a public company may carry with it features which further distinguish it from the issuer’s registered securities. Common and preferred shares may lack voting rights. Debt securities and preferred stock may lack the protective covenants or priority of claims attaching to their registered counterparts. Conversion rights and redemption provisions may differ. When valuing nonregistered securities, it is important to consider all characteristics of the subject security which may differ from the issuer’s publicly traded stocks and bonds and reflect those differences in the valuation of the subject security. In these cases it may be necessary to go beyond merely applying a marketability discount to the quoted exchange price of a stock. For example, if the issuer’s public debt is better secured or has better call protection, pricing a minority issued note to yield a rate representative of an incremental return for lack of marketability plus the market yield on the issuer’s publicly traded debt securities of similar maturity may overstate the note’s fair market value.
Clarity regarding the fair market value of privately issued securities of public companies is essential in the following situations:
The presence of a block of such securities in an estate and a transfer of same may entail an overpayment of taxes if the quoted market price is applied without consideration of impaired marketability or of other differences relative to the issuer’s public securities.
If the securities issued by the purchaser to the seller do not qualify for a capital gains rollover and a capital gains tax liability is realized at the closing of the transaction, an excessive capital gains tax liability may be calculated if the quoted market price is applied without consideration of impaired marketability or of other differences relative to the issuer’s public securities.
In addition, comparisons of offers by competing bidders or comparisons with the pricing of other transactions may be misleading if quoted market prices are applied to securities offered as purchase consideration without considering impaired marketability or other differences relative to the issuer’s public securities. Similar valuation issues may also arise in a variety of other situations, including corporate reorganization transactions, marital dissolutions, bankruptcies and transactions involving trusts.
Simply applying the market price of an issuer’s publicly traded securities to the shares or bonds in a given block may provide a deceptive indication of value leading to faulty tax and investment decisions. Mercer Capital has substantial experience in valuing the unregistered shares, restricted stock and other privately issued securities of public companies and in determining block size discounts. Please call us if you have a question in this area.
Reprinted from Mercer Capital’s Value AddedTM – Vol. 10, No. 3, 1998.
The world of fair market value is not the real world. It is a special world in which the participants are expected (defined) to act in specific and predictable ways. It is a world of hypothetical willing buyers and sellers and of hypothetical transactions. The real world is populated by real people, whose actions are unpredictable, and not subject to consistent definition, who engage in actual transactions with unpredictable results. It should come as no surprise that these two worlds, the hypothetical world of fair market value and the real world, are sometimes in conflict over the question of the value of businesses and business interests.
We begin this article with a review of the definition of fair market value. The second part of the article offers a partial interpretation of the meaning of fair market value from a valuation perspective and looks into the hypothetical world of fair market value.
The definition of fair market value is known as a “willing buyer and willing seller” concept. The Department of Labor’s “Proposed Regulation Relating to the Definition of Adequate Consideration”, which to our knowledge has not been finalized, but is still generally relied upon by appraisers as the authoritative guideline for EOSP valuations, defines “adequate consideration” as the “fair market value” of the asset as determined in good faith by the Trustee or named fiduciary. This definition essentially reflects the well established meaning of fair market value as presented in Revenue Ruling 59-60.
Revenue Ruling 59-60 provides a working definition of fair market value:
2.2 Section 20.2031-1(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax Regulations 105) and section 25.2512-1 of the Gift Tax Regulations (section 86.19 of Gift Tax Regulations 108) define fair market value, in effect, as [1] the price at which the property would change hands [2] between a willing buyer [3] and a willing seller [4] when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, [5] both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that [6] the hypothetical buyer and seller are assumed to be able, [7] as well as willing, to trade and [8] to be well informed about the property and [9] concerning the market for such property. [parentheticals added]
This definition provides a bare-bones description of the hypothetical world of fair market value. The parentheticals indicate nine elements in the definition of fair market value for consideration. They will be discussed below. However, it is almost impossible to cite the definition of fair market value without also noting the eight factors enumerated in RR 59-60 for consideration in a fair market value determination. They are so commonly cited in business appraisal reports that Mercer Capital refers to them as the Basic Eight factors (from Section 4.01):
The Basic Eight factors of RR 59-60 are required to be examined in the context of what we call the Critical Three factors of common sense, informed judgment, and reasonableness (from Section 3.01), which “must enter into the process of weighing those factors and determining their aggregate significance.”
The nine [parenthetical] elements of the definition of fair market value are the focus of this article, rather than the Basic Eight factors. However, these nine definitional elements are necessarily interpreted in the broad analytical context provided by the Basic Eight and under the general umbrella of the Critical Three factors of common sense, informed judgment and reasonableness.
We now focus on the nine elements noted parenthetically in the definition of RR 59-60 above. Recall, as was noted above, that the world of fair market value is not the real world. It is a specific definable world in which hypothetical buyers and sellers react in predictable ways.
As can be seen in the definition above, there are several qualifying characteristics that define “the price at which the property would change hands.” Note that the definition references the price, and not the proceeds, of the sale of a property.
Elsewhere in RR 59-60, we find that the fair market value price is paid in terms of money or money’s worth, so the fair market value price is a cash-equivalent concept. It is paid in terms of dollars today or the present value of consideration to be received in the future. Note also that property changes hands. A transaction is presumed in the definition of fair market value.
Appraisers sometimes consider discounts for controlling interests of companies relating to the transactions costs incurred while selling those entities. While transactions costs are undoubtedly real in actual transactions, such costs are deductible to sellers and therefore reduce proceeds, not price. Other costs, such as those related to deferred hirings or maintenance, for example, may well lower value, and thus, price. Appraisers should therefore distinguish between costs that influence price (value) and proceeds (value less transactions costs).
If fair market value is a cash-equivalent concept, how meaningful are stock-for-stock acquisition transactions in consolidating industries (like banking and auto dealerships, to name two) as a basis for determining the fair market value of an entity on a controlling interest basis for estate tax purposes? It is fairly well documented that stock-for-stock deals generally occur at higher dollar-denominated prices than cash deals. If fair market value is a cash-equivalent price, and if the stock-for-stock value indications exceed the price that could be obtained if an entity were sold in a cash deal, business appraisers attempting to determine the fair market value price should probably take this factor into account.
The hypothetical buyer of fair market value fame is a willing buyer and is interested in engaging in a transaction to acquire the subject interest and is inclined to do so “if the price is right.” Hypothetical buyers make their determinations of price based upon rational financial and economic principles applied in relation to a subject interest. In other words, the hypothetical willing buyer is a rational buyer.
The hypothetical seller of fair market value fame is a willing seller. Specific sellers are not always interested in selling, particularly if market conditions are perceived as poor. Yet, they can sometimes be convinced to sell an asset “if the price is right,” to obtain liquidity, or to invest in a higher yielding alternative investment. But note that for a seller, the timing must also be right. If the definition of fair market value is to hold up, the contemplated class of willing sellers must be comprised of a group of potential sellers for whom the timing for a (hypothetical) transaction is favorable.
If a hypothetical seller does not sell, he or she has become, in effect, a buyer who acquires (by retaining) a subject interest. So every hypothetical seller is evaluating the same economic and financial factors under consideration by the relevant group of hypothetical buyers. So the hypothetical willing seller, like the hypothetical willing buyer, is a rational investor. A discussion containing many of the same concepts is found in a recent article in the Business Valuation Review.
The definition of fair market value assumes willing buyers and willing sellers. Some might argue that because someone would not buy a particular interest, it therefore must be next to worthless. Others sometimes suggest that because a holder of an interest would not sell, it should be valued dearly. Both positions may at times be correct, but neither represents fair market value.
The lack of willingness to engage in a transaction by any particular party should not enter into a determination of the fair market value of the subject interest, else the behavioral requirements of the definition are not met. Finding that a seller would not sell because the price is “too low” or that a buyer would not buy because the price is “too high” implies analysis of the motivation of specific sellers or buyers, ignores the need to consider hypothetical sellers and hypothetical buyers, and introduces elements of speculation and subjectivity not contemplated by the definition of fair market value.
Appraisers sometimes use the terms typical buyers and typical sellers as representatives of hypothetical willing investors. These are important concepts. A specific buyer will likely consider the intrinsic worth of an investment to him or to her. A specific seller will also consider the worth of an investment from his or her unique perspective. Such considerations do not constitute a market. A group of typical buyers, on the other hand, collectively represents one side of a market and a group of typical sellers represents the other side. Together they create the hypothetical market of fair market value.
Neither party is assumed to be under any compulsion to engage in a transaction, nor to be under any duress. This point suggests that although willing to engage in a transaction, the parties are under no pressure to do so. Compulsion to engage in a transaction by a party to a transaction usually works adverse to that party’s interests. A “motivated buyer” is likely to pay more than a rational price to acquire an asset. On the other hand, a “motivated seller” is likely to sell for less than he or she would otherwise accept for the sale of an asset. Hypothetical buyers and sellers in the fair market value world, being equally uncompelled, can negotiate the price and terms of their deals based on their rational financial and economic consequences.
Recall that we suggested above that attempting to ascertain why specific persons did not engage in a transaction is speculative and subjective. Analyzing actual transactions to attempt to ascertain or estimate the motivations of market participants is a far more objective process and can often add value to the process of determining fair market value.
A specific buyer for a subject interest with strategic or synergistic motivations may pay a price that is unaffordable to a typical buyer who lacks synergistic opportunities or strategic motivation to enter a market. So fair market value will likely not reflect the highest price that might be obtained. It more probably should reflect the consensus rational pricing that might be discerned by a group of buyers with typical motivations to achieve reasonable returns based on the expected cash flows of an investment.
This logic also suggests that a transaction in a company’s stock may not be indicative of fair market value, even if that transaction occurred between independent parties. The mere fact that the parties were independent of each other says nothing about the motivations of either party. In many, if not most cases, we may never know or understand the actual motivation of the parties. But we can analyze the economics of actual transactions and assess whether they occurred under rational conditions that reflect the elements of fair market value. If a transaction in a subject company or a guideline transaction involving another company cannot be explained rationally, chances are neither is a candidate for inference regarding the fair market value of a particular subject interest.
Both parties are assumed to have reasonable knowledge about the relevant facts. This is an important assumption, because knowledge about certain companies, interests in companies, or other investments is not generally available to everyone. For example, there is one universe of investors making investments in the public securities markets, and a substantially different universe investing in large, private placements of debt or equity. A small investor in the public securities markets may, for instance, lack the wherewithal, interest or ability to understand a complex private placement document.
The term fully informed is often used to describe the state of reasonable knowledge of relevant facts. In real life, we know that buyers and sellers of equity interests are seldom fully informed. Why is it that the surprises that happen after acquisitions are invariably adverse to buyers? From a seller’s viewpoint, the refrain that “nothing will change after the merger” is so often wrong as to be laughable. And some of the issues that come to light after transactions are quite knowable beforehand, based on reasonable analysis or investigation. They are, however, frequently ignored or overlooked by participants in real life transactions who might be motivated, compelled, or not quite fully informed.
Reasonable knowledge and the future. Real life transactions are based on facts and circumstances known up to the minute of their closings, and consider reasonable outlooks for the future. Reasonably, or fully informed does not mean having a crystal ball that eliminates uncertainties by forecasting the future with precision.
After-the-fact valuations should not abuse the standard of reasonable knowledge based on facts that clarified themselves shortly or long after an historical valuation date. Attorneys representing the side in a dispute benefited by knowledge of post-valuation date events may want to believe that the certainty of those events was reasonably knowable at the valuation date. Independent appraisers do not have this luxury in the context of a fair market value determination.
In some instances, the fact that an event might occur in the future is known at the time of a transaction or at a valuation date. What is not generally known is when or with what probability the event might occur. Appraisers must assess those probabilities and incorporate the risks or potential benefits appropriately in their appraisals – the way that reasonably informed hypothetical willing investors might, based on information available as of a valuation date.
This brief discussion of the reasonable knowledge component of the definition of fair market value should illustrate that following its implied guidance requires the exercise of common sense, informed judgment and reasonableness.
The hypothetical willing buyer and seller are assumed to be able to engage in a transaction. The implication is that each of the parties must have the financial capacity to engage in the subject transaction.
Consider the following specific example: the subject interest has no market, is worth about $500 thousand, and provides a market yield for similar assets. In the context of such a cash flowing investment, the universe of hypothetical buyers would include individual investors who, in the context of diversified portfolios of investments, would have the ability to purchase an investment in this value range. Such investors would likely be fully taxable individuals or corporations paying taxes at the maximum statutory rate.
If we assume that most rational investors would not place more than 10% or so of their portfolios in any single investment (about the minimum number of investments to achieve reasonable diversification if all the individual investments are publicly traded securities), then we are discussing a group of investors with liquid financial capacity on the order of $5 million or more.
Yet consider that investors are usually willing to place smaller portions of their wealth in specific illiquid assets. The universe of hypothetical investors for our $500 thousand asset might, in reality, be those with a net worth of $10 million or more who might be willing to place only about 5% of their assets into any single, illiquid security. This universe of investors will likely have different return requirements and investment expectations than the broader group of investors who invest in the public securities markets.
So, the universe of hypothetical investors should be considered in making their determinations of fair market value. Specifically, appraisers should consider the impact of the investment requirements of the relevant universe of hypothetical investors on the fair market value of particular interests. Attorneys and other users of appraisal reports should have the expectation that such considerations are made, either explicitly or implicitly, in appraisal reports.
Both parties must be willing to make the trade. It should be clear that hypothetical investors are rational investors. They engage in transactions and approach the issue of price from a rational economic and financial perspective.
Both parties are assumed to be well-informed about the property that is the subject of the appraisal. In other words, the parties must have the knowledge and the ability to investigate the potential investment. This aspect of the definition carries the point of being reasonably informed in a general sense to being well-informed in a specific sense.
Gaining such knowledge about a specific property or transaction can be time-consuming and expensive, so it is an important characteristic to consider in an appraisal. Further, the hypothetical investors are negotiating over the economic and financial value of the property itself, and not on the synergies, strategic impetus, or psychological benefit it might provide to a particular buyer.
The last element of the definition of fair market value carries the concept of reasonably informed one step further. Both parties are assumed to be knowledgeable, not only about the specific property, but also about the market for the relevant property. This fact adds a layer of time and expense or experience to the process of investigation by hypothetical buyers. Knowledge about the market for a property assumes an understanding of industry conditions as well as local, regional and/or national economic conditions.
The markets in which properties trade in the fair market value world are rational markets and they are consistent markets. This can create occasional disjoints between actual market pricing and fair market value. In speculative markets, publicly traded shares of companies may trade at values significantly greater than the value of the entire company if it were sold. This can occur as a result of general speculation as with Amazon.com, which currently trades at a minority interest value per share that no rational analysis can justify. It can also occur in the shares of publicly traded companies in consolidating industries. Appraisers sometimes have to rationalize market guideline company evidence before it can be applied in a determination of fair market value.
As mentioned earlier, ESOP participants, appraisers, and attorneys should have more than a superficial understanding of the valuation implications of the standard of value known as fair market value. Fair market value is not the real world. Appraisers, attorneys and other users of business valuation reports who operate every day in the real world need to continue to develop a better understanding of that other world, the hypothetical market in which fair market value transactions occur. As noted in the IRS Coursebook:
. . . the consideration of any valuation case would ensure that both sides, including their respective appraisers, if any, are employing the correct definition and criteria for determining fair market value. No case is stronger than its weakest link and if the wrong valuation standard is applied, the conclusion will be defective.
It is important for appraisers to focus specifically on the definitional elements of fair market value while describing valuation opinions in their reports. And attorneys and other users of valuation reports should expect this in their reviews of valuation reports.
Certain appraisers rely upon academic research in their determination of the magnitude of the marketability discount to a marketable minority interest of value. We thought it appropriate to review one such piece of academic research to determine its content and applicability to the ongoing debate.
In 1993 a paper was published entitled “Market Discounts and Shareholder Gains for Placing Private Equity” by Michael Hertzel and Richard L. Smith.1 It has drawn attention (and been quoted) for its observations about discounts observed in private placements.
The objective of the Hertzel/Smith study was to determine the underlying reasons for discounts observed in the pricing of securities in private placements and the positive abnormal returns associated with the announcement. While illiquidity associated with unregistered stock seemed to provide a partial explanation, “it is not clear why investors require, and firms are willing to accept, such sizable discounts.”2
The authors used a sample of private placement announcements from January 1, 1980 through May 31, 1987 . The information was derived from a variety of public sources. The study identified 106 transactions (of which 18 were for unregistered shares) with some two-thirds of the observations occurring in the second half of the study. Mean and median discounts were 20.14% and 13.25%, respectively. The authors also found an additional discount of 13.5% for placements of restricted shares.3 The range of discounts for the 106 observations is not explicitly stated. However, the data seems to suggest lower discounts (less than 10%) for the larger companies in the study (market value greater than $75 million) to the higher levels (approximately 35%) for companies with less than $25 million in market value.
In summary, the total discounts observed seem consistent with a number of other private placement/restricted stock studies. Hertzel and Smith attempt to analyze private placement discounts to determine what factors may influence the size of the discount, rather than simply saying it was a marketability discount due to illiquidity.
Hertzel and Smith concluded that the private placement discounts were influenced by:
The size of the private placement discount tended to increase as the:
The authors further concluded that a private placement was evidence that management believed that the subject company was undervalued in the marketplace. In essence, the private placement was cheaper in that management believed that the existing shareholders would retain a higher proportion of ownership with a private placement than with a new public issue of stock.
Hertzel and Smith concluded the additional discount of 13.5% for private placement of restricted shares was consistent with the belief that restricting resale of the shares was costly for the selling firm (and presumably more risky for the purchasing shareholder). Nevertheless, the authors expressed some skepticism that the restrictions on resale would result in a discount so high. They note that restrictions on resale would not be important to many investors in private placements, as they are long term investors. The following comment is found in a footnote of the paper: “…given the substantial resources of institutions that do not value liquidity such as life insurance companies and pension funds, it is not obvious that investors would require substantial liquidity discounts just for committing not to resell quickly.”5
The authors do not explain why they believe that insurance companies or pension funds do not value liquidity. However, that is not important to the essential point. The fact that the reason for the discount is not obvious does not render the existence of the illiquidity discount untrue. The reality seems to be that their study isolates a substantial discount for the inability to dispose of a stock quickly (illiquidity). Secondly, the investment attitudes of long-term investors do not serve to reduce the aggregate discounts in their sample. The total discount exists whether they value liquidity in its purest sense or not.
The authors believe that informational effects are critical in understanding the magnitude of the discounts. In essence, a private placement resolves the informational asymmetry in the marketplace. As the difficulty in measuring and assessing value rises, the discount was also observed to rise thus compensating the investor for the costs associated with assessing the firm value. Given that small firms were more likely to be the most difficult to assess, it is not surprising that the higher discounts were associated with this group. To the extent that the investment appeared to be in an “opportunity” as compared to a more developed business, the discount would be higher, once there is a linkage to smaller size as a proxy for higher risk.
Another example of higher risk requiring a discount was the observed increase in the discount of 9% when the firm was evidencing financial distress. Once again, higher risk translated into a higher discount. Does this mean that higher financial risk means that an additional 9% is automatically added to the computation of the discount? Of course not. It only proves that the discount is likely higher (with this one factor isolated from the others) and that a higher return for risk must be explicitly considered. The impact of risk on the final conclusion of the discount must be taken in context with all of the other factors.
The authors also consider a broader definition of the “costs” of a public offering as compared to a private placement as a further means of understanding the discount. They suggest that a private placement “avoids the negative public issues announcement effect, the underwriter spread, residual underpricing, and other costs not reflected in the spread.”6 The authors immediately caution the reader that “simple cost comparisons can be misleading.”7 For example, Hertzel and Smith suggest that the shares of companies which used a public offering to raise funds exhibited adverse share price movements, effectively raising the cost of the offering. Nevertheless, the differentials in cost do not appear to fully explain the discount according to the authors. This concept of cost can be very meaningful given the propensity of some appraisers and the courts to consider only the direct underwriting as a cost of raising funds in the public market.
The study also examines the impact of the ownership changes on the observed discount. Seventy of the 106 transactions reported sufficient data to be analyzed. Lower discounts were often observed when there was a change of control or an infusion of cash by investors who previously owned a significant portion of the outstanding stock. Changes of control were described as events, which could influence corporate governance. Single buyers were more likely to cause a visible change in influence than passive investors were. The authors ultimately concluded; however, that change of ownership concentration was not a variable with a high potential for explaining discounts in their sample.
What can business appraisers draw from this paper?
The work of Hertzel and Smith and other academics studies noted in the paper should likely prompt us, as business appraisers, to look more carefully at our vocabulary. The existence of discounts in private placements is undeniable, yet only a portion is likely due to pure illiquidity. The key factors of (1) risk, (2) expected growth in value, and (3) the holding period are all clearly present. It is incumbent on any business appraiser to identify these key factors and measure them as best as possible given the situation.
It is also important to recognize that the existence of uncertainty in the analysis does not render it invalid. Investors in privately placed securities accept key elements of uncertainty as an inherent part of the transaction. The business appraiser simulates these factors in a careful and detailed analysis of the entity being valued in order to determine the discount to the marketable minority value. The current appraisal vernacular may call it a marketability discount, but it really encompasses all of the elements which reduce value from the freely traded minority interest.
Endnotes
1 Hertzel, Michael and Smith, Richard L., “Market Discounts and Shareholder Gains for Placing Private Equity,” The Journal of Finance, Volume 48, Issue 2 (June 1993), pp. 459-485.
2 Ibid, p. 459.
3 Ibid, p. 480.
4 Ibid, p. 465.
5 Ibid, p. 480.
6 Ibid, p. 469.
7 Ibid, p. 469.
Reprinted from Mercer Capital’s E-Law Newsletter 2003-02, June 5, 2003.
A new form of business organization, the limited liability company (LLC), could present new planning opportunities for business owners. Basically, the LLC has the pass-through tax attributes of a partnership, but can provide the shareholder-liability protection of a corporation. The LLC is neither fish nor fowl. It is a kind of corporation-partnership hybrid that is a creature of the state law under which the company is organized. Most states now have LLC statutes. There are some state-by-state quirks, but there are also some common threads that characterize the LLC.
Following is a sampling of new terms in the LLC lexicon:
One of the principal advantages of organizing as an LLC is the federal tax benefit of partnership treatment; i.e., having just one level of tax on profits and passing through tax losses and credits to help shelter earnings from other sources. In order to qualify for partnership tax status, LLCs cannot have more than two of the following corporate characteristics:
Limited Liability. By definition, an LLC automatically has this corporate characteristic. Practically speaking, an LLC can therefore possess just one of the other three characteristics.
Under U.S. Treasury Regulations, centralization of management means that a person, entity or narrow group (either from within or without the overall membership) has continuing, exclusive and unilateral authority to make management decisions. A member-managed LLC generally will not have this characteristic, and a manager-managed LLC generally will. When member-managers behave more like general partners of a partnership than like shareholders of a corporation, management tends to become less centralized. This is a flexible and prickly issue. Sometimes it can be difficult to distinguish between centralized and non-centralized management, so facts and circumstances tests might come into play.
To transfer a membership interest means to completely confer upon the transferee all attributes of ownership, including rights to vote, act on behalf of the LLC, share in the profits, etc. Restricted transferability of LLC membership is a corollary to a general feature of partnership interests. Somewhat like partners, LLC members cannot transfer their ownership and compel their co-owners to be in business with someone they consider to be undesirable. LLC statutes usually ensure that member interests are not freely transferable by requiring that at least a majority of the non-transferring members consent to the transfer. States vary by the degree to which consent of co-owners must be obtained. Some require unanimous consent and some require majority consent. It is important to note that the concept of free transferability contemplates all of the rights and privileges of ownership, so an assignment to a transferee of an economic interest in the profits and distributions of an LLC is not necessarily the same as a transfer of the membership interest itself. Freedom to transfer economic interests does not constitute free transferability of interests.
Under federal tax regulations, a business organization lacks continuity of life if it is required to dissolve upon the death, insanity, bankruptcy, retirement, resignation, expulsion or other event of withdrawal of an equity owner. This kind of language is generally written into LLC statutes as an organizational requirement. However, mechanisms can be put in place to grant non-withdrawing members an option to continue the business of the LLC upon an event of dissolution. If properly written, the business continuation option will not impart continuity of life to the LLC.
Some business owners will view these features of an LLC as advantages:
There could also be some disadvantages:
There might be more questions than answers in the LLC valuation arena because facts and circumstances can be so varied. An LLC membership interest can have blended features of a stock, a general partnership interest and a limited partnership interest. Valuation of a specific interest can be tricky when the features are specially tailored to the needs of the company and its owners. In addition, certain partnership tax rules can affect LLCs, either adding or detracting from value, depending on the circumstances and specific agreements among the members. Some of the issues affecting LLC valuation include:
We are expecting to see increased interest in LLCs and a rise in LLC formations. They should be useful tools for managing family business wealth, transferring ownership from one generation to the next, streamlining ownership of cumbersome portfolios and pursuing new business growth opportunities. At the same time, they will limit liability for their owners and provide flexibility in structuring ownership features.
Competent legal and tax counsel should be obtained to establish an LLC. Please call if you have any questions or if we can help you in any way.
Reprinted from Mercer Capital’s Bizval.com – Vol. 6, No. 4, 1994.
Usually when there is talk of a limited partnership structure in an estate plan, the individual or family is seeking to simplify an otherwise cumbersome process of gifting hard-to-value or hard-to-divide assets such as real estate, marketable securities, closely held businesses, or perhaps, even assets of a more peculiar nature. Of course, another benefit of this “simplification” can be a reduced estate and/or gift tax.
The typical valuation begins with a top-down analysis of the inventory of assets and liabilities inside the partnership. Underlying asset values are individually appraised by qualified experts or asset values are observed in the markets in which they trade. This part of the analysis establishes the aggregate net asset value of the limited partnership. Moving from this point to the conclusion requires a careful processing of what can be a large amount of additional information:
Answers to these and similar questions help us to interpret the economics of the limited partnership interest and can help lead to a reasonable quantification of what are commonly referred to as minority and marketability “discounts”. The most important part of the limited partnership valuation analysis is quantifying appropriate discount adjustments. Discounts deserve careful support, which can be obtained from a variety of sources:
Valuing a limited partnership interest can be complicated and time consuming. Whatever the level of complexity, careful documentation of the valuation process will benefit users of limited partnerships. There is a sound and reasonable framework for valuation, but there is no standard formula. Please call for more information or to discuss a valuation issue in confidence.
Reprinted from Mercer Capital’s Value AddedTM – Vol. 7, No. 4, 1995.
Since family limited partnerships (or FLPs) became popular in 1994, we have valued hundreds such asset holding entities. Family limited partnerships are useful because one generation, owning a general partnership interest, can control the cash flow from gifted assets. FLPs can simplify estate planning, allowing for gifting of fractional interests, and helping consolidate family assets. Another advantage of FLPs is that they are often designed to protect family assets from failed marriages, “unworthy” heirs, creditors, and other family disputes.
The valuation of FLPs generally begins with an estimate of net asset value. Appraisers then consider the application of appropriate minority interest and marketability discounts based on the facts and circumstances of each case. The cumulative amount of discounting in FLP appraisals is important because, given a net asset value, it determines the fair market value at which interests are gifted, and thus the taxes which must be paid on the value of the gift.
Because the use of FLPs is relatively new to many attorneys and clients, we are often asked to answer questions about how we value them. Many attorneys have asked the following (or a similarly worded) question. Since we are dealing with limited partnership interests, and since what can be transferred in most instances is only an assignee interest, shouldn’t there be a further discount applicable to the assignee interest? Good question.
To answer it, we need some further background. It is helpful to think of ownership in a limited partnership as consisting of two components: 1) the economic interest, and 2) the rights attached to the interest. We believe it is important not to confuse the two.
The economic interest is the pro rata ownership of or claim to distributions and assets. In almost all cases, an ownership interest of, say, 1%, has a pro rata 1% claim on all distributions (whether interim or at dissolution), as well as indirect ownership of 1% of the assets underlying the Partnership. Thus, in almost all cases, if a distribution of, say, $100 thousand is declared, then a 1% general partnership interest receives $1,000, as does a 1% limited partnership interest, as does a 1% assignee/transferee interest.
The rights attached are the second component of value, and the differences in rights attached can be significant. General partners might collectively own only 1% to 10% of total interests in a given partnership, but typically have exclusive authority to manage the partnership, including its investment policy, distribution policy, and other aspects of management. Limited partners and assignees/transferees typically have no real aspects of control over the partnership, despite the fact that they might own a majority in interest of the outstanding partnership units. This relationship is achieved by the covenant that is the partnership agreement, and is akin to the difference between voting and non-voting stock in a corporation, with some differences. Assignee interests are in essence limited partnership interests with economic participation equal to that of limited partnership interests but typically without the same rights.
The difference in rights attached to limited partnership interests versus that of assignee or transferee interests can be significant. In most FLPs, limited partners typically have the right to call meetings of the partners, to vote on certain matters such as dissolution and successor general partners, to inspect the books of the partnership, to transfer their interests to other partners or to third parties (sometimes subject to restrictions), and other similar rights. Assignee or transferee interests, on the other hand, typically do not garner the right to vote, inspect the books of the partnership, or transfer their interests.
The problem in attaching specific value to the rights relating to a limited partnership interest versus that of an assignee/transferee interest (or, conversely, discounting an assignee interest from the value of a limited partnership interest), is that the rights attached to a limited partnership interest are typically not transferable. If a limited partner wants to assign, gift, or sell his or her interest to another person, the interest that is received by the acquirer is generally an assignee interest, not a limited partnership interest. The rights of a limited partner are not usually transferable, only the economic benefit. Typically, only after the acquirer has received or has purchased the economic interest in the partnership do the partners vote to admit or refuse the assignee as a limited partner.
There is good reason for this. Partnerships are contracts between persons designed for their mutual benefit. One protection that limited partners receive is that they cannot easily be forced to accept someone with whom they did not originally covenant as their partner. Thus, the assignee interest is a sort of in-between phase in which the acquirer of an economic interest in the partnership petitions to become a partner. In some cases, only the general partner must approve. In other cases, the process of becoming a full limited partner is more onerous.
Nonetheless, if the only value transferable is the economic benefit (and not the limited partner rights attached to it), then is not every (or nearly every) valuation of a limited partnership interest actually the valuation of an assignee interest? Again, it is important to remember that the heir, acquirer, or purchaser of a limited partnership interest actually receives an assignee interest, not a limited partnership interest. The Quantitative Marketability Discount Model used by Mercer Capital is designed to value the economic aspects attributes of a limited partnership interest, i.e., the assignee interest. Our reasoning is consistent with a recent ruling of the United States Court of appeals (Fifth Circuit) [See McLendon v. Commissioner, KTC 1995-624 (5th Cir. 1995), case no. 94-40584.], in which the Court agreed that limited partner interests should be valued as assignee interests.
In a United States Tax Court case, the Court saw no economic distinction between valuing a disputed gift as a limited partnership interest versus that of an assignee interest (but ultimately valued it as an LP interest) [See Kerr v. Commissioner, United States Tax Court 113 T.C. No. 30, docket no. 14449-98.]. Unfortunately, a third ruling, also by the United States Tax Court, clouds the issue by agreeing that certain limited partnership interests should be valued as assignees for transfer tax purposes (so far so good). In this case, however, the Court then valued certain general partnership interests as general partner interests rather than as assignee interests because they were received by an existing general partner, contrary to the valuation standard of “hypothetical” buyers and sellers [See Nowell v. Commissioner, United States Tax Court T.C. Memo 1999-15., docket no. 19056-96.].
At this time, we have determined no compelling reasons to value gifts of assignee interests at a lower level than limited partnership interests. If, under appropriate circumstances, we were to assign value to limited partner rights above and beyond that of their economic interest, the impact of this adjustment would likely not be large. Market evidence of the differential between voting and nonvoting common stock interests suggests a minor impact if translated to the relationship between assignee interests (nonvoting) and limited partnership interests (voting), perhaps on the order of five percent, plus or minus a bit. However, in the context of a fair market value appraisal, a rational acquirer of an assignee interest would likely attribute little (if any) value to “the vote” since there is a positive probability that they might never be obtained.
If you have questions about the valuation of family limited partnerships or other similar concerns, please contact us. We would be glad to help.
Reprinted from Mercer Capital’s Value AddedTM – Vol. 12, No. 1, 2000.
Asset-holding entities are typically partnerships or limited liability companies with assets that include some combination of real estate, marketable securities, and/or closely held securities. As part of the appraisal due diligence process, information is obtained from general partners and/or managing members as well as from a variety of other sources (generally attorneys, real estate appraisers, accountants, securities brokers, and industry contacts). Such information provides a basis for the appraiser to understand the composition, operations, strategy, and governance of the entity. This article focuses on the importance of analyzing, from a valuation perspective, the reasonableness of this information.
When information fails to reconcile with industry or circumstantial norms, or appears unreasonable or lacking in common sense, appraisers may need to make “normalizing” adjustments. These adjustments attempt to modify reported facts and circumstances to conform to the standard of fair market value. Under the standard of fair market value, the financial characteristics of the valuation subject must make sense and be reasonably representative of the considerations of hypothetical investors.
A hypothetical asset-holding entity can illustrate the concepts. At issue in the example are the reasonableness of the general partner’s compensation and the reasonableness of rental income paid to a limited partnership.
The hypothetical asset-holding entity is a limited partnership with assets consisting primarily of a fractional interest in a commercial building. The property houses a chain retailer in potentially serious financial difficulty as of the valuation date. The property was appraised and the appraisal took into account the partnership’s fractional interest by applying a 25% fractional interest discount.
Approximately 60% of the partnership’s current total income (mostly rent) is being paid as compensation to the general partner. In addition to overseeing the management of the partnership, the general partner essentially acted as a property manager. According to our research, industry rates for property management fees generally range from approximately 6% to 11% of collected rents, which is much lower than the 60% the hypothetical general partner is receiving in this scenario. Is this level of compensation reasonable? The answer requires further clarification regarding the amount of the partnership’s rental income.
An analysis of the partnership’s reported asset values and revenue implies a 20% capitalization rate on annual rental income. Typically, capitalization rates on properties of this nature range from 11% to 15%. Either the rental income is unusually high or the appraisal is potentially flawed by understating the value of the property.
Ultimately, the income and expense profile related to this property affects our analysis of a limited partner’s expected liquidity resulting from distributions. This, in turn, affects the magnitude of the marketability discount. As appraisers, we have to reconcile the facts from the perspective of a reasonable investor’s long-term expectation. The questions we must address are: (1) what is a reasonable and sustainable level of future rental income? and (2) what is a reasonable level of compensation for the general partner?
After conversations with several real estate appraisers, a capitalization rate of 11% was applied to the appraised market value of the subject property (pro rata, exclusive of the fractional interest discount). This provides us with a reasonable and sustainable level of rental income on the property. Correspondingly, we believe that a rational investor would anticipate a lower level of general partner compensation. Such compensation should likely be based on traditional property management rates.
Using the normalized rental income described above, we believe that the general partner should be compensated at approximately 10% of collected rents. Such compensation also reflects the general partner’s administration of the entity’s overall business.
In Table 1, note that the adjustments applied in this case result in a difference of nearly 11% of asset value. The resulting cash flow would make a potentially significant difference in the growth of the partnership’s assets or to the funds available for distribution. Both of these aspects are crucial to the development of an appropriate marketability discount for the valuation of a limited partner interest.
A limited partner has virtually no control over such things as the management, distribution of cash flows, and investment strategy of the partnership. However, fair market value is defined as the price at which a hypothetical willing buyer and a hypothetical willing seller, both of whom are fully informed, neither of whom is under any compulsion, and both of whom have the capacity to engage in a transaction. Any hypothetical investor would anticipate a “normalized” level of income and a corresponding level of general partner compensation based on some industry norm.
Normalizing adjustments reveal the true investment characteristics that are the source of “potential value” to buyers of minority interests. When minority interests are purchased, investment judgments are made based upon how and when this potential value might ultimately be realized. Based on the timing and the amount of expected returns on illiquid minority interests, appraisers develop marketability discounts that are sufficient enough to consummate the hypothetical transaction.
It can be argued that because limited partners (or other similar minority investors) lack control to change things like general partner compensation or to negotiate property leases, normalizing adjustments should not be made. However, keep in mind that minority shareholders of public companies lack this discretionary ability as well. If unusual activity is occurring on the income statement, minority shareholders of the public company will find alternative investments and the price of the public company’s stock will eventually reflect this.
Information should not be taken at face value. It must be examined and reconciled to a standard of reasonableness, common sense, and informed judgment. Our hypothetical partnership illustrates the importance of understanding the numbers and the necessity of normalizing adjustments.
Reprinted from Mercer Capital’s Value AddedTM – Vol. 12, No. 3, 2000.
As of December 3, 2008, the major stock indexes were down on the order of 40% for the year. In addition, the long-suspected recession has been officially declared. While the depth and length of the current recession is laden with uncertainty, what is certain is that virtually no investment sector has remained unscathed. For those dealing with an estate tax issue from within the last year, consideration of the alternate valuation date is almost certain to provide vital information for the estate tax filing process.
As part of the Economic Growth and Tax Relief Reconciliation Act of 2001, Section 2032 of the IRS Tax Code was designed to provide some measure of relief to those taxpayers negatively affected by fluctuating markets. The alternate valuation date provides taxpayers the option to choose to use a date six months subsequent to the date of death to value an estate. In order to choose this option, the following conditions and processes must apply:
Although the alternate valuation date appears to generally be an attractive option in the current economic climate, one must consider the singular drawback that, if the alternate date provides a lower value, then it also results in a lower step up in basis for those inheriting the estate’s interests. Therefore, any gains on assets sold at a later date will be larger than would be the case with a higher step up in basis at the date of death.
It should also be noted that not all states conform to the federal alternate valuation date, but rather require the use of date of death, which could cause the taxpayer to have a different basis for state and federal tax purposes.
Despite the lower step up in basis consideration, the alternate valuation date warrants serious consideration at any time, but particularly in the current economic environment for estates with a date of death within the last year. With no end in sight for the declining markets, tax savings may well be very significant.
In 2008, we described the “perfect storm” of conditions existing at the time that increased the likelihood of success for a grantor retained annuity trust (“GRAT”). Although much has changed since 2008, most of the circumstances promoting the consideration of a GRAT still prevail. The “perfect storm” will likely be stilled if the Senate passes a pending bill. The legislation, called the Small Business and Infrastructure Jobs Tax Act of 2010 (HR 4849), was passed by the House of Representatives on March 24, 2010.
Lawmakers designed the bill to provide incentives for small business and infrastructure job creation, but such incentives require “Revenue Provisions” necessary to offset spending and tax cuts. Section 307 of the bill acts as one of those revenue generators by expanding the rules on GRATs, which in turn increases the transfer tax income to the federal government. The Congress Joint Committee on Taxation estimates that $4.45 billion in revenue will be generated over ten years by this provision.
Under certain conditions, a GRAT can result in the transfer of wealth to family members without gift tax. First, a quick overview of how GRATs work. The grantor transfers assets into an irrevocable trust, which is established for a set term, and an annuity is paid back to the grantor during each year of that term. For gift tax assessment, the IRS assumes an expected level of asset appreciation, called the Section 7520 rate. The amount of the taxable gift is the fair market value of the property when it is transferred to the trust less the present value of the grantor’s annuity interest, using the Section 7520 rate as the discount rate. This difference is often referred to as the remainder interest.
Figure One shows a five-year GRAT with the annuity set up such that the remainder interest equals zero, assuming $10 million of assets are placed into the trust with a Section 7520 rate of 3.4%.
In order for the strategy to be successful, a portion of the assets transferred must remain in the trust after the satisfaction of the annuity. For this to occur, the return on the assets must exceed the section 7520 rate and the grantor must survive the term of the trust. If the return on assets does not exceed the 7520 rate, the assets will return to the grantor. If the grantor dies prior to expiration of the term, all assets remaining in the GRAT become a part of his or her estate. Therefore, current law limits downside risk of GRATs to wasted legal and administrative fees.
Figure Two displays the potential cumulative transfer of assets through the five year GRAT from Figure One, assuming the $10 million of assets grow at an annual rate of 10.0% after the formation of the GRAT.
At year five, approximately $3 million dollars of appreciated assets remain in the trust. If the grantor survives the five year term, that portion of wealth passes to the beneficiary free of transfer tax. In this example, 18.1% of the assets placed into the GRAT are transferred to the beneficiary free of tax.
The portion of assets shifted to the beneficiary depends on the spread between the actual return on the asset contributed to the trust and the 7520 rate. If these rates are equal, no assets are transferred through the GRAT to the beneficiary. If we assume that the assets will grow at 15.0% in the previous example, 28.8% of wealth is transferred through the trust. In short, this strategy can benefit those planning to gift appreciating assets.
As mentioned earlier, the current law may have a short life. Section 307 of the pending legislation imposes two major additional requirements on GRATs: (1) the term must be no less than ten years and (2) the remainder interest must have a value greater than zero at the time of the transfer. Thus, as the new bill is currently written, the “mortality risk” of the grantor increases and the taxable gift must be greater than zero. The Senate Committee on Finance may suggest a minimum remainder interest such that a minimum taxable gift amount must be transferred, increasing the downside risk of the strategy. If such an amendment is added and the assets in a GRAT fail to appreciate at a rate greater than the 7520 rate, then the grantor will have paid unnecessary taxes in addition to administrative fees. If the bill remains unchanged from its current form, the positive taxable gift requirement is open to interpretation: could the gift value be $0.01?
In 2008, we discussed three conditions that provided a “perfect storm” for GRATs: (1) a low section 7520 rate, (2) depressed asset values in most markets, and (3) the uncertainty of GRAT restricting legislation.
If the GRAT strategy meets a potential grantor’s objectives, now may be the time to take swift action.
GRATs are frequently formed using shares or interests in closely-held corporations, or family limited partnerships, and it is necessary to obtain an appraisal of these shares or interests to set the initial fair market value transferred to the GRAT. If the pending legislation is seen as the beginning of an era of increased scrutiny, grantors and beneficiaries will benefit from hiring experienced valuation firms they can trust to appraise the assets placed into their GRATs. As one of the country’s premier business valuation firms, Mercer Capital has vast experience valuing corporations and partnerships. In addition, we can also value GRATs and provide other GRAT valuation consulting. Feel free to give us a call today at 901.685.2120 if we can help you or your client.
Reprinted from Mercer Capital’s Value Added(TM), Vol. 22, No. 1, May 2010
A confluence of three factors make 2020 an ideal time for estate planning transactions for owners of private companies
As a result of these factors, many business owners are currently contemplating whether to engage in significant ownership transfers. For many high net worth individuals and family offices, complex ownership structures have evolved over time, typically involving multi-tiered entity organizations and businesses with complicated ownership structures and governance.
Mercer Capital has been performing complicated tax engagements for decades. In this article, we describe the processes that lead to credible and timely valuation reports. These processes contribute to smoother engagements and better outcomes for clients.
Defining the valuation project is an important step in every engagement process, but when multiple or tiered entities are involved it becomes critical. It is insufficient to define a complicated engagement by referring only to the top tier entity in a multi-tiered organizational structure. The engagement scope should clearly identify all the direct and indirect ownership interests that will need to be valued. This allows the appraiser to plan the underlying due diligence and analytical framework and to design the deliverable work product.
For example, will the appraiser need to perform a separate appraisal at each level of a tiered structure? Or, can certain entities or underlying assets be valued using a consolidated analytical framework? Planning well on the front end of an engagement leads to more straightforward analyses that are easier to defend.
During the initial discussion of the engagement the appraiser will usually request certain descriptive and financial information (such as governing documents, recent audits, compilations and/or tax returns) to determine the scope of analysis needed to render a credible appraisal for the master, top-tier entity and the underlying entities and assets.
Upon being retained, one of the first things an appraiser will do is to prepare a more comprehensive information request list designed to solicit all the documentation necessary to render a valuation opinion. Full and complete disclosure of all requested information, as well as other information believed pertinent to the appraisal, will aid the appraiser in preventing double-counting or otherwise missing assets all together.
Requested information for complex multi-tiered entity valuations typically falls into three broad categories:
The ultimate efficiency of the project often hinges on timely receipt of all requested information. Disorganized information or data that requires a lot of handling or interpretation on the part of the appraiser adds to project cost, and more importantly, can make it harder to defend valuation conclusions that are later subject to scrutiny.
In short, providing high quality information in response to the appraiser’s request promotes a more predicable outcome with the IRS and with other stakeholders.
Upon completing research, due diligence interviews with appropriate parties, and valuation analysis, the appraiser should provide a draft appraisal report for review. The steps discussed thus far – careful planning and timely information collection – are not substitutes for careful review of the draft appraisal report. The complexity of many multi-tiered structures increases the need for relevant parties to review the draft appraisal for completeness and factual accuracy. Reviewers should read the draft report with numerous questions in mind:
Engagements involving complicated entity and operational structures are not easily shoehorned into typical appraisal reporting formats and presentation. Unique entity and asset attributes may require creative valuation techniques and heighten the need for clear and concise reporting of appraisal results. Regardless of the complexity of the underlying structure and valuation techniques, the appraisal report should still be easy to read and understand.
Mercer Capital has been providing reliable appraisals for gift and estate planning efforts for nearly four decades. Over that time, we have completed many large valuation engagements for complex, multi-tiered entities.
We pride ourselves in differentiating our services and approach through careful pre-engagement planning, which allows us to meet client deadlines and avoid costly do-overs. We are committed to doing our part to improve the planning and decision-making processes of our clients and their advisors. To discuss in confidence any engagement requiring Mercer Capital’s customized valuation solutions, please contact any of our senior valuation professionals.
On April 5, 2012, the Jumpstart Our Business Startups Act (“JOBS Act”) was signed into law in an attempt to reduce regulatory burdens on small businesses. The Act relaxes limits regarding the number of shareholders a company may have before it must register its securities with the Securities & Exchange Commission. For privately-held companies approaching the shareholder limit, the additional reporting requirements related to SEC registration can be particularly burdensome, without the benefits of access to capital markets and stock liquidity that being publicly traded offer. As a result, privately-held companies were compelled to undertake transactions such as reverse stock splits or share reclassifications to avoid triggering registration.
Since the JOBS Act became law, deregistration activity has been rising. According to a May 29, 2012 article on SNL Financial, approximately 60 banks had made the necessary filings to deregister their securities with additional filings expected. Most of these banks were relatively small, generally having total assets below $1 billion.
The JOBS Act increases the threshold for the number of shareholders that would require SEC registration from 500 to 2,000. Additionally, companies may terminate their existing registration by reducing the number of shareholders to fewer than 1,200 shareholders, relative to the former requirement of 300 shareholders. These rules offer opportunities for small, privately-held businesses, particularly for community banks which often have a relatively large base of local shareholders and demand for their stock within the local community.
The opportunity can present itself to community banks through two general scenarios:
For members of bank management contemplating taking action, several financial considerations unique to each scenario are discussed below. A number of legal considerations would arise as well, which are beyond the scope of this discussion.
While the opportunity to eliminate the drawbacks associated with SEC registration is compelling, bank management should carefully consider all options and the associated consequences. Oftentimes, this will require a firm understanding of the bank’s financial strength, growth prospects, and stock price, under both the contemplated transaction and the status quo. Mercer Capital has wide ranging experience in assisting management with stock valuation for capital raises and redemptions, as well as performing pro forma analyses under varying scenarios. If you think we can be of assistance regarding these matters, we would welcome your inquiry.
Reprinted from Mercer Capital’s Bank Watch, June 2012
Despite an anticipated surge of transactions within the banking industry, bank merger and acquisition activity declined in 2011 compared to the prior year, hindered by a weak economic recovery, mounting regulatory pressures, and, according to some analysts, excessive seller expectations. Deal volume excluding government assisted transactions decreased 15.8% in 2011 from 2010 levels and approximated 2008 levels. It appears deal volumes bottomed out in 2009 at a total of 104 for the year. Unfortunately, the number of transactions not reporting a deal value has increased in recent periods (from 39 in 2009 to 51 in 2011), making a comparison of trends in deal values difficult. The number of deals presented is exclusive of FDIC-assisted transactions, which decreased to 92 in 2011 from 157 during 2010.
Deal value (for those transactions which reported it) totaled $6.8 billion in 2011 versus $11.7 billion in the prior year. Total deal value included PNC’s $3.5 billion acquisition of RBC Bank, which was announced in the second quarter of 2011, completed in the first quarter of 2012, and represented 51% of total reported deal value in 2011. Comerica’s $1.0 billion acquisition of Sterling Bancshares (announced in the first quarter and completed in the third quarter) accounted for 15% of total deal value during the year.
Notably, total deal value for transactions in 2010 included several sizeable acquisitions, such as BMO’s purchase of Marshall & Ilsley Corporation ($5.8 billion), Hancock Holding Company’s purchase of Whitney Holding Corporation ($1.8 billion), and First Niagara Financial Group’s purchase of NewAlliance Bancshares, Inc. ($1.5 billion). The following table provides additional perspective with regard to transaction activity in the banking industry since 2006.
As in 2010, the majority of acquisitions involved sellers with assets less than $500 million. As shown below, for deals for which pricing multiples and deal value were available (a total of 72 transactions), 56 transactions, or more than 75%, involved targets with assets less than $500 million.
Twenty-one of the 72 transactions for which pricing information was available were all-cash transactions, 35 deals involved some mixture of cash and other consideration (generally common stock), and 10 transactions involved common stock as currency. The remaining deals were unclassified or not reported.
Regional economic viability again affected transaction volume during the year. Deal volume was highest in the Midwest and West regions1, which reported 24 and 19, respectively, of the 72 total transactions with pricing multiples. The Atlantic Coast and Northeast regions followed with 11 deals each in 2011. Seven transactions occurred in the Southeast region. For comparison, FDIC-assisted transactions, which totaled 92 in 2011 compared to 157 in 2010, continued to be concentrated in states with severely depressed real estate markets, such as Florida and Georgia (both in the Southeast region), which had 13 and 23 bank failures, respectively, during 2011. Illinois and Colorado followed with nine and five failures, respectively, and all remaining states reported less than five failures each during the year.
Through March of 2012, a total of 16 bank failures were reported with eight attributable to the Southeast region. Florida and Tennessee each reported two failures, while Georgia reported four, and Illinois reported three failures. For comparison, through March of 2012, transaction volume was higher with 56 total deals reported (compared to 47 in the first quarter of 2011). Total reported deal value through the first quarter of 2012 was also higher at $3.0 billion (compared to $1.5 billion in the first quarter of 2011) and included Mitsubishi UFJ Financial Group’s $1.5 billion acquisition of Pacific Capital Bancorp as well as Prosperity Bancshares’ $529 million acquisition of American State Financial Corp. Deal volume in the first quarter of 2012 was weakest in the Northeast, where four transactions occurred, while deal volume was higher in the Midwest and Southeast, which reported 25 and 13 transactions, respectively.
Some analysts have attributed the heightened transaction activity in the first quarter of 2012 to the improved economy and an increased confidence among buyers, and, in particular, confidence with regard to loan portfolio assessment. Transaction activity going forward is expected to remain concentrated among smaller institutions in light of revenue and regulatory challenges. However, uncertainty concerning regulatory changes and the resulting burdens placed on institutions (smaller ones in particular), coupled with market volatility and the heated political climate, still looms, threatening any impending, potential surge of transaction activity.
Furthermore, capital raising remains difficult, and lackluster market activity caused many institutions to look to private equity firms as a source of capital in 2011. Preferred stock issuances were successful for several firms during the year, and some analysts expect more buyers to utilize such issuances to finance acquisitions when consolidation activity resumes.
Endnote
1 The regions include the following states:
Originally published in Mercer Capital’s Bank Watch, May 2012.
Mercer Capital works extensively with both the management of an acquirer and their loan review personnel (both internal and external) to obtain an in-depth understanding of loans being acquired. We provide a detailed valuation model along with extensive documentation to support our analysis of the fair value of the subject loans, reflective of the credit risk embedded therein.
Our clients find these analyses helpful both when assessing a target initially and when accounting for the acquired loans at the transaction closing date. Here are three ways that a loan portfolio analysis is helpful to your bank when considering an acquisition.
In addition to loan portfolio valuation services, we 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. We are always happy to discuss your valuation issues in confidence as you plan for a potential acquisition. Give us a call today.
Bank stocks ended a particularly volatile month in August 2011 on something of a good note, which masked the intra-month volatility. Looking forward, does this greater stock price volatility represent a “new normal,” as banks face an environment marked by greater macroeconomic risk?
Three bank stock indices we track performed as follows in August, relative to the S&P 500:
While the deterioration in market values evident in the table above is substantial, the declines are even more significant when measured at points earlier in the month. Table 2 indicates the compression in market values between July 29, 2011 and the lowest point observed for each index in August1:
For example, the aggregate SNL Bank Index declined by 22% between July 29, 2011 and its August 22nd low, although subsequent gains cut this loss to 10% by month-end. Chart 1 provides daily observations for the four indices during August 2011.
The volatile performance appeared to be driven by various factors:
While these general factors affected most stocks in August, we attempted to isolate which factors most affected the performance of publicly traded banks in August. The following table shows the performance of banks in August stratified by asset size.
At August 31, 2011, no banks with assets exceeding $5 billion reported a higher stock price than at July 29, 2011, and larger banks generally reported weaker performance than smaller banks. This reflects several factors:
We also examined the relationship between August 2011 stock market performance and return on tangible common equity. As indicated in the following table, banks with stronger profitability generally performed better, as measured by the median change in their respective stock prices, providing some evidence that investors were more apt to avoid banks with lower profitability, since such banks may have less wherewithal to manage more distressed economic conditions.
Given the depths to which some bank stocks fell in August, we thought it interesting to compare the price/tangible book value multiples, measured based on each bank’s lowest stock price during the month, to the price/tangible book value multiples observed as of December 31, 2008, which represents a proxy for the timing of most distressed period of the financial crisis. This analysis indicates the following:
For perspective, the chart below plots the changes in the price/tangible book value multiples reported by the publicly traded banks between December 31, 2008 and their respective August 2011 lows.
Endnotes
1 These low points occurred on August 8th for the S&P 500; August 19th for the SNL Bank Index comprised of banks with between $1 and $5 billion of assets; August 22nd for the aggregate SNL Bank Index; and August 25th for the SNL Bank Index comprised of banks with between $500 million and $1 billion of assets.
Originally published in Mercer Capital’s Bank Watch 2011-09, released September 15, 2011
Earlier this year, we presented a review of community banks’ 2010 financial performance, which reflected a mixed bag – some metrics improved, while others deteriorated. With the mid-year filing cycle complete for banks’ Call Reports, we updated this analysis to assess whether the trends noted in 2010 have persisted. In general, we conclude that trends continue to improve, although the pace of improvement appears to be slowing for some metrics.
The analysis relies on a data set comprised of approximately 3,800 commercial banks with assets between $100 million and $5 billion. Additionally, we excluded banks owned by non-U.S. domiciled bank holding companies, subsidiaries of holding companies with more than $5 billion of assets, and banks with unusual levels of non-interest income or consumer lending. As a result, the data set does not have the bias evident in some analyses of aggregate banking industry data, which are weighted in favor of the largest domestic banks.
Reflecting community banks’ steady profitability improvement, 597 banks reported a loss in the first half of 2011, down from 739 in the first half of 2010 and 857 in fiscal 2010. However, the gradual nature of the improvement in performance is evident in the industry’s return on assets – the median bank’s return on assets improved from 0.62% in the first half of 2010 only to 0.68% in the first half of 2011, which remains well below the pre-crisis level that exceeded 1.00%. The improvement realized relative to the first half of 2010 is driven largely by lower loan loss provisions.
Figure One
The following matrix groups community banks based on their net income into four categories including (a) positive net income in both the first half of 2010 and the first half of 2011, (b) net losses in both the first half of 2010 and 2011, or © positive net income in one period and a net loss in the other period. As indicated in the matrix, 76% of banks reported positive net income in both periods, while 11% reported net losses in both periods.
Figure Two
Net interest margin enhancement contributed to many community banks’ improving performance. For example, in fiscal 2010, net interest margin expansion benefited about 60% of the banks in the analysis. However, data from 2011 suggest that the trend of rising net interest margins is weakening. For the first half of 2011, approximately one-half of the banks in the sample reported higher net interest margins than in the first half of 2010.
After declining for the last two quarters, the median net interest margin widened in the second quarter of 2011, suggesting that community banks continue to benefit from deposit rate reductions.
Figure Three
For a majority of the community banks in the analysis, loan growth has not yet resumed. As of June 30, 2011, 62% of community banks reported lower balances of non-agricultural loans, as compared to December 31, 2010 – a trend consistent with the 58% of banks that reported lower loan balances at year-end 2010 than at year-end 2009. The aggregate loans outstanding held by community banks declined by 0.79% between year-end 2010 and June 30, 2011. However, the contraction was not spread evenly throughout loan portfolios. Instead, construction and development loans continue to shrink, offsetting growth in commercial real estate (both owner and non-owner occupied) and commercial and industrial loans.
Figure Four
Liquidity continues to accumulate within the community banking industry, albeit at a somewhat slower pace than in recent years, as indicated in the following table showing the median ratio of liquid assets to total earning assets. Offsetting this increase, the median ratio of loans to earning assets declined from 74% at June 30, 2010 and December 31, 2010 to 71% at June 30, 2011.
Figure Five
One notable trend in fiscal 2010 among community banks was the steady quarterly increase in non-performing assets, despite a gradually recovering economy. After reaching 3.78% in the first quarter of 2011, the median ratio of non-performing assets to loans and other real estate owned decreased by four basis points in the second quarter of 2011, marking the first decline in this ratio since the second quarter of 2006.
Figure Six
As further evidence of the gradual improvement in asset quality, new additions to non-accrual assets dropped below $8 billion (in aggregate for the 3,800 banks) in both the first and second quarters of 2011 – a level below any quarter in 2010. In addition, loans past-due 30-89 days, representing potential future non-accrual loans, fell to $10.9 billion at June 30, 2011, the lowest level since at least the first quarter of 2010.
Figure Seven
Similar to the trend reported by larger banks in their mid-year earnings releases, community banks continue to see reductions in loan loss provisions. The aggregate loan loss provision reported by the 3,800 banks in the data set declined by 32% in the first half of 2011, versus the same period in 2010. For the median bank, the annualized loan loss provision dropped to 0.45% of loans in the first half of 2011, as compared to 0.59% in the first half of 2010. To some degree, though, credit costs have shifted within the income statement from loan loss provisions to losses and other costs related to other real estate owned. In the first half of 2011, losses on sale of other real estate owned increased by 40% versus the first half of 2010.
Figure Eight
Figure Nine
For the second half of 2011, trends to monitor include:
Originally published in Mercer Capital’s Bank Watch, released August 15, 2011.
For several years now, industry experts have been predicting a wave of bank consolidation. The initial reasoning was that weaker banks would be absorbed by stronger banks, many against their will when faced with the choice of merger or failure. As time passed the industry realized that even the healthiest institutions were either unwilling or unable (sometimes both) to take on the debt, shareholder dilution, and asset quality problems that come along with an acquisition.
At present, the presumed M&A driver for the near-term is regulatory changes, which will place a substantial burden on institutions. The smaller the institution, the theory goes, the more onerous the burden and the more diminished the ability to absorb the associated costs. The only solution, many argue, is to grow organically (not easily done in the current environment) or find strategic combinations that will create a bank large enough to support the additional operating expense.
Is this wave of predicted merger activity finally coming to fruition? One might think so, based on the uptick in announced bank deals in 2010. According to SNL Financial, LLC there were 205 announced deals in 2010, compared to 175 announced in 2009. This does not include the 157 FDIC-assisted transactions which occurred during the year. Additionally, deal value was substantially higher in 2010, at $11.8 billion, compared to $2.0 billion in 2009. The increase in total deal value was supported by a few larger acquisitions, including BMO’s purchase of Marshall & Ilsley Corporation ($5.8 billion), Hancock Holding Company’s purchase of Whitney Holding Corporation ($1.8 billion), and First Niagara Financial Group’s purchase of NewAlliance Bancshares, Inc. ($1.5 billion).
However, the M&A story in 2010 lies within the realm of the community bank. As shown below, for deals in which pricing multiples and deal value are available (a total of 111 transactions), 84 transactions, or more than 75%, involved a seller with assets less than $500 million.
What is notable in the table above is that the size of the seller appears to be negatively correlated with the pricing multiples received, particularly on a book value basis.
The smallest banks were the only group which reported a median purchase price at a premium to book value, both reported and tangible. Of course, it is worth noting that the larger groups contain a fewer number of transactions, and perhaps reflect a more dire situation on the part of the seller, who presumably has little incentive to sell in the current pricing environment.
Cash remained king in 2010 as the most common form of transaction funding. Forty of the 111 transactions reporting multiples were all-cash acquisitions, followed closely by 38 which were some mixture of cash and other consideration (generally common stock). Capital contributions accounted for eighteen of the transactions and common stock was used as currency in six of the transactions. The remainder were unclassified or not reported.
The banking industry has always exhibited a proclivity to finance acquisitions using cash on hand. However, it is no surprise that buyers, who likely are facing their own problems with low stock valuations, are reluctant to dilute shareholders by using what many consider to be an undervalued asset to fund purchases. After all, pricing multiples in the public marketplace remain well off the highs of 2006 and 2007, when bank stocks commonly traded at price-to-earnings multiples approaching twenty times and book value multiples as high as three times. Additionally, with the universe of transactions focused on smaller institutions, many do not have publicly traded equity, and sellers often frown on accepting illiquid stock as transaction currency.
In terms of geography, there was a distinct relationship between the economic health of various regions and the volume of transaction activity. During 2010 the concentration of FDIC-assisted transactions (i.e., bank failures) centered around states with severely disrupted real estate markets, such as Florida (29 failures), Georgia (21 failures), Illinois (16 failures), California (12 failures), and Washington (11 failures). Perhaps not surprisingly, non-assisted transaction activity was highest in regions without a high level of bank failures, as shown in the table below (includes only those deals reporting pricing multiples).1
The next logical question is what will 2011 hold for bank M&A activity? While we do not have a perfectly clear crystal ball, here are a few things to consider:
Will 2011 be the year of the bank merger? Signs remain mixed, but it appears conditions are favorable at the very least for an increase in merger activity. Then again, we have definitely heard that before.
ENDNOTES
1 The regions include the following states:
Originally published in Mercer Capital’s Bank Watch 2011-03, released March 2011.
After completing an FDIC-assisted transaction, the acquirer faces the task of accounting for the transaction in accordance with FASB ASC 805, Business Combinations (formerly SFAS141R). ASC 805 requires the acquirer to record purchased loans at their fair value, or the amount that would be received upon the sale of the subject loans in a transaction between market participants. Given the credit deterioration evident in the loan portfolios of most failed banks, the book values and fair values of acquired loans may diverge to a material degree.
Deposit assumption transactions generally present no complex accounting or valuation issues. Demand and savings accounts are recorded at their book values, which equal fair value. The acquired time deposit portfolio may require a determination of fair value. Unlike a non-assisted transaction, however, acquirers in assisted transactions have the right to adjust the rates on time deposit accounts immediately upon the acquisition. These rate adjustments, along with any attendant deposit run-off, may require consideration in the fair value analysis. Lastly, although not recorded in some transactions, the acquirer may recognize a core deposit intangible asset. While the acquirer may agree upon a deposit premium with the FDIC (or agree that a premium is not appropriate), this premium may not be determinative of fair value, as the intent of fair value is to determine a price in an “orderly” transaction. An FDIC-assisted transaction may not meet the definition of an “orderly” transaction for purposes of determining fair value.
Assisted transactions whereby the acquirer obtains the failed bank’s assets, including its loans, along with a loss-sharing agreement present a much more complicated series of valuation and accounting issues. The valuation and accounting issues can be grouped in two primary categories:
Mercer Capital reviewed SEC filings of banks participating in loss-share transactions. From this review, there appears to be some diversity of practice as to the accounting for loss-share transactions. The following discussion, therefore, is general in nature. Banks participating in loss-share transactions are advised to seek guidance from their accounting firms as to the valuation and accounting issues raised by the transactions.
At the acquisition date, an acquirer would need to determine the fair value of the following assets:
Based on the preceding determinations of fair value, the acquirer would then calculate the amount of goodwill or negative goodwill. While goodwill is recorded as an asset on the balance sheet, negative goodwill results in a gain to the acquirer in the period surrounding the acquisition (included in non-interest income).
To demonstrate the preceding accounting and valuation issues, consider the following hypothetical transaction:
Based on the preceding, Figure One amortizes the acquired loans:
After determining the expected cash flows from the portfolio, the acquirer can then determine the fair value of the acquired loans. Because credit spreads have widened since origination of the loans, and to reflect the risk of adverse deterioration in default rates, the acquirer estimates that an 8% discount rate is appropriate.
Figure Two then illustrates the determination of fair value of the acquired loan portfolio:
The acquirer would thus record the acquired loan portfolio at its fair value of $773. Next, the acquirer would determine the fair value of the loss-share agreement, based on the projected loan losses and the loss coverage percentage agreed upon with the FDIC. The valuation of the loss-share agreement generally assumes a lower discount rate than the determination of fair value of the loan portfolio, given the relative assurance of collection of amounts due under the loss-share agreement from the FDIC.
Figure Three shows this calculation.
Based on the preceding determinations of fair value, and assuming the fair value of the liabilities equals book value, Figure Four indicates the assets and liabilities acquired in the transaction.
In the transaction, the acquirer received $1,068 of assets at fair value and assumed $1,000 of liabilities. To balance its books, therefore, the acquirer would need to need to record “negative goodwill” of $68; however, negative goodwill is not recorded as a “negative” asset. Instead, ASC 805 indicates that the acquirer should record a gain equal to the amount of negative goodwill.
In many instances, due to the volume of problem assets, the magnitude of the fair value adjustments to the loan portfolio, and the need to track the loss-share asset, the post-acquisition accounting for the acquired loans is more complicated than the acquisition-date accounting. The primary ongoing accounting issues faced by the acquiring bank include the following:
Figure Five rolls the loan portfolio balance forward from the acquisition date starting with the beginning fair value of the portfolio ($773).
In each period, the bank collects principal and interest payments on the portfolio, per the amortization of the portfolio in Figure One. In addition, the bank determined the fair value of the portfolio based on the return required by market participants at the valuation date (8%), which exceeded the stated note rate on the portfolio (5%). This disparity results in an additional loan discount accretion.
For example, in year 1, at an 8% interest rate, the portfolio would yield income of $62 ($773 x 8%). However, the bank collects interest of only $45 from borrowers. The $17 difference between the market yield and the note rate is accreted into income by the acquiring bank. The ending portfolio balance therefore equals the beginning portfolio balance ($773), minus principal collections ($285), plus the discount accretion ($17). Figure Six shows the roll-forward of the loss-share asset.
As indicated in Figure Six, the loss-share asset declines as the FDIC remits payments against covered losses. In addition, the fair value of the loss-share agreement was determined based upon an assumed 3% discount rate. As for the loans, this 3% return is accreted into income. Figure Seven summarizes the interest collected and accreted on the loan portfolio and loss-share asset.
In sum, the acquiring bank’s interest income from the acquired loans would consist of three sources – the interest paid by the borrowers, the discount accretion on the loans, and the accretion of interest on the loss-share agreement. Overall, the acquiring bank would earn an effective yield of approximately 7.25% to 7.50% on the assets acquired, versus the actual note rate of 5%.
The preceding analysis, while still complex, is greatly simplified from real world practice. In reality, acquirers are faced with many challenging issues, such as:
Reprinted from Mercer Capital’s Value Added (TM) Vol. 22, No. 1, May 2010