Valuation of PE portfolio investments for financial reporting can be challenging for many reasons. PE investments are, by nature, illiquid. Portfolio companies are not publicly traded, and holding periods are generally long. PE investments often employ complex capital structures that include several tranches of equity, debt or hybrid securities with differing rights to intermediate and exit proceeds. In addition, derivative instruments are also popularly used in incenting management teams.
Market participants are increasingly sensitive to (the appearance of) conflicts of interest in PE valuations. In the absence of public, transparent information, investors have to rely on valuation marks provided by PE managers to assess performance, review allocations, determine compensation and fulfill their own reporting requirements. Regulatory agencies, including the SEC, are increasingly scrutinizing valuation practices within PE and other alternative investment managers.
In the absence of public price discovery, analysts must rely on or devise models to conduct valuations of portfolio companies and investments. At the same time, accounting principles prescribe maximizing the use of publicly observable inputs in the valuation models. A defensible valuation opinion needs to consider, conduct, and document a number of procedures including historical financial review, independent analysis of public guideline or comparable companies and private transactions, evaluation of acceptable and relevant income methods (capitalization or discounted cash flow), and tests for internal consistency.
Mercer Capital has years of experience in providing third-party valuation opinions on illiquid investments to PE clients’ and other stakeholders’ satisfaction. Our recent presentation, “Best Practices for Fair Value Measurement,” available at http://mer.cr/pe-val-ppt, throws some light upon a number of valuation issues specific to PE portfolios.
It is vital that analysts exercise impartiality in conducting portfolio valuations. Larger PE funds increasingly rely on valuations prepared by third-party specialists to ensure objective reporting of portfolio investments. Investor-facing groups including the Institutional Limited Partner Association, European Private Equity and Venture Capital Association, and the Alternative Investment Management Association acknowledge and recommend the use of independent third-party valuation specialists.
Contact a Mercer Capital professional to discuss your needs for independent valuation and consulting services.
In this article, we provide a broad overview of business value and why understanding basic valuation concepts is critical for business owners. Why is this valuation knowledge important? Because businesses change hands much more frequently than one might think. In fact, every business changes hands at least every generation, even if control is maintained by a single family unit.
According to statistics about business size from the U.S. Census Bureau, there are about six million businesses with payrolls (meaning these businesses employ people) in the United States.[1] A little more than three and a half million U.S. businesses have sales of less than $500 thousand. Without any disrespect, these businesses are often referred to as “mom and pop” operations because their basic function is to provide jobs for the owner(s) and sometimes a few other people.
About two million businesses have annual sales between $500 thousand and $10 million.[2] This segment of the business community is generally given credit for the majority of job growth. Only about 200 thousand businesses have annual sales exceeding $10 million.[3]
At the top of the business pyramid are public companies. Of these, as of 2012, only about four thousand have active public markets for their shares with regular stock pricing and volume information available.[4] Because of their size and visibility, this relatively small group of public companies gets the lion’s share of coverage in the business press. As a result, most of the popular business press coverage of valuation issues relates to public companies.
But most of the businesses in corporate America are closely held, or private corporations. This means that most of the business owners in corporate America are not in public companies, but in generally smaller entities owned by a single, or a small number of shareholders. Therefore, it’s important for these business owners and their advisors to have an understanding of the nature of value in these businesses.
Most business owners, and, quite often, their advisors, have inaccurate conceptions of the value of their businesses. This is not surprising, because there is no such thing as “the value” of any business. Value changes, often rapidly, over time. Yet it is important for business owners to have current and reasonable estimates of the values of their businesses for numerous reasons, including ownership transfer.
There are many reasons for ownership transfer, including:
If you don’t believe that businesses change hands, examine the Business Transfer Matrix in Figure 1.
When a business changes hands, there will be either a partial transfer of ownership (in the form of gifts, sales to employees, going public, etc.) or a total transfer of ownership (through outright sale or death).
The Business Transfer Matrix also indicates that ownership transfers are either voluntarily or involuntary because we do not always control the timing or circumstances of sale.
Unfortunately, most business owners don’t plan for the eventual transfer of their business. In our experience, most business sale or transfer decisions are made fairly quickly. In many cases, business owners never seriously contemplate the sale of their businesses until the occurrence of some precipitating event, and shortly thereafter, a transfer takes place.
The logical inference is that many, if not most, business sales occur under less than optimal circumstances.
The only way business owners can benefit is to constantly do the right things to build and preserve value in their businesses, whether or not they have ever entertained a single thought about eventual sale.
In other words, owners should operate their businesses under the presumption that it may someday (maybe tomorrow) be necessary or appropriate to sell. When the day comes, business owners will be ready – not starting to get ready and already behind the eight ball.
It is a hard truth for many business owners to learn that what they think regarding the value of their business doesn’t matter. The value of any business is ultimately a function of what someone else with capacity (i.e., the ability to buy) thinks of its future earning power or cash generation ability.
For other transactions with gift or estate tax implications or with legal implications for minority shareholders, what a business owner thinks still doesn’t matter. What then becomes important is the value a qualified, independent business appraiser or the court concludes it is worth. In so doing, the appraiser or the court will simulate the arms’ length negotiation process of hypothetical willing buyers and sellers through the application of selected valuation methodologies.
Theoretically, the value of a business today is the present value of all its future earnings or cash flows discounted to the present at an appropriate discount rate. To determine a business’s worth, determine two things: 1) What someone else (with capacity) thinks the company’s earnings really are; and 2) what multiple they will pay. Simplistically, we are saying:
Hypothetical (or real) buyers of capacity will make reasonably appropriate adjustments to the company’s earnings stream in their earning power assessments. In addition, they will incorporate their expectations of future growth in earning power into their selected multiples (price/earnings ratios). Or they will make a specific forecast of earnings into the future and discount the future cash flows to the present.
Now let’s talk a bit about the value of companies from a conceptual viewpoint by beginning with a familiar term and its definition: Fair Market Value.
A hypothetical willing buyer and a hypothetical willing seller, both of whom are fully or at least reasonably informed about the investment, neither of whom are acting under any compulsion, and both having the financial capacity to engage in a transaction engage in a hypothetical transaction
That may not sound like the real world, but it is the way that appraisers attempt to simulate what might happen in the real world in actual transactions in their appraisals.
And it is the way that business owners state in agreements – quite often in buy-sell agreements, put agreements, and other contractual relationships – that value will be determined.
Just so everything is crystal clear, this concept of fair market value can be considered on several levels.
The basic value equation is also known as the Gordon Model:
A company’s price/sales ratio is a function of the margin, say pre-tax earnings, and the appropriate multiple. If companies in the industry tend to sell in the range of 50 cents per dollar of revenue, that might be because the typical pre-tax margin is around 10% and the pre-tax multiple is about 5x.
The multiples of sales that people talk about obviously come from somewhere. Now we know where they come from.
If Value = Earning x Multiple, what about Earnings?
At the margin, if a business increases its costs at a slightly slower rate than its revenues increase, its margins will increase and there will be a multiplicative impact on earnings growth.
If a company’s margins aren’t where they need to be, a business owner should begin a conscious effort each period to hold cost increases to something under revenue increases. If this is done, single digit revenue growth can be turned into double digit earnings growth – at least until margins normalize. We call this “margin magic.” In the process, the business owner will have begun to optimize the value of the business.
Therefore, the multiple can be characterized as:
Along the road to building the value of a business it is necessary, and indeed, appropriate, to look at the business in a variety of ways. Each provides unique perspective and insight into how a business owner is proceeding along the path to being ready for sale.
So, how does a business owner look at their business? And how can advisers to owners help owners look at their businesses? There are at least six ways and they are important, regardless of the size of the business.
Why is it important to look at a company in these ways? Together, these six ways of looking at a company provide a unique way for business owners and key managers to continuously reassess and adjust their performance to achieve optimal results.
At Mercer Capital, we have provided over 8,000 valuation opinions for companies throughout the nation. Many of our client companies (which have ranged from a few hundred thousand dollars to multiple billions of dollars in value) are enormously successful enterprises.
Our successful client companies have one thing in common – they achieved their success by conscientiously working to build value over time. Success rarely comes instantly. For most companies, it comes slowly, and then only in spurts.
Successful companies manage to grow through their spurts, and then to hang on until internal and external circumstances are ripe for another spurt. In this pattern, they slowly build enterprises of substantial value.
We noted earlier that value is, theoretically, equal to the product of a company’s believable earning power and a realistic multiple applied to that earning power. Business owners need to focus on both earnings and the multiple to maximize value. They also need to understand that it can take a long time to build businesses of substantial value. However, having done so, even modest growth rates bring substantial dollar growth in value.
If you have questions about the value of your business or would like to discuss opportunities for ownership transition, please contact us.
ENDNOTES
[1] Statistics about Business Size (including Small Business) from the U.S. Census Bureau 2007. About three quarters of all U.S. business firms have no payroll. Most are self-employed persons operating unincorporated businesses, and may or may not be the owner’s principal source of income. Because nonemployers account for only about 3.4 percent of business receipts, they are not included in most business statistics, for example, most reports from the Economic Census.
[2] Ibid.
[3] Ibid.
[4] “Investors face a shrinking stock supply,” Matt Krantz, Karl Gelles and Sam Ward, USA TODAY.
For a hypothetical example to accompany this article, please see “Community Bank Stress Testing: A Hypothetical Example.”
While community banks may be insulated from certain more onerous stress testing and capital expectations placed upon larger financial institutions, recent regulatory guidance suggests that community banks should be developing and implementing some form of stress testing and/or scenario analyses. The OCC’s supervisory guidance in October 2012 stated “community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions.”1 Further, the OCC’s guidance considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.”2 A stress test can be defined as “the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making with the bank.”3
The hallmark of community banking has historically been the diversity across institutions and the guidance from the OCC suggests that community banks should keep this in mind when adopting appropriate stress testing methods by taking into account each bank’s attributes, including the unique business strategy, size, products, sophistication, and overall risk profile. While not prescriptive in regards to the particular stress testing methods, the guidance suggests a wide range of effective methods depending on the Bank’s complexity and portfolio risk. However, the guidance does note that stress testing can be applied at various levels of the organization including:
Transaction Level Stress Testing: This method is a “bottom up” analysis that looks at key loan relationships individually, assesses the potential impact of adverse economic conditions on those borrowers, and estimates loan losses for each loan.
Portfolio Level Stress Testing: This method involves the determination of the potential financial impact on earnings and capital following the identification of key portfolio concentration issues and assessment of the impact of adverse events or economic conditions on credit quality. This method can be applied either “bottom up,” by assessing the results of individual transaction level stress tests and then aggregating the results, or “top down,” by estimating stress loss rates under different adverse scenarios on pools of loans with common characteristics.
Enterprise-Wide Level Stress Testing: This method attempts to take risk management out of the silo and consider the enterprise-wide impact of a stress scenario by analyzing “multiple types of risk and their interrelated effects on the overall financial impact.”4 The risks might include credit risk, counter-party credit risk, interest rate risk, and liquidity risk. In its simplest form, enterprise-wide stress testing can entail aggregating the transaction and/or portfolio level stress testing results to consider related impacts across the firm from the stressed scenario previously considered.
Further, stress tests can be applied in “reverse” whereby a specific adverse outcome is assumed that is sufficient to breach the bank’s capital ratios (often referred to as a “break the bank” scenario). Management then considers what types of events could lead to such outcomes. Once identified, management can then consider how likely those conditions are and what contingency plans or additional steps should be made to mitigate this risk.
Regardless of the stress testing method, determining the appropriate stress event to consider is an important element of the process. Little guidance was provided although the OCC’s guidance did note that the scenarios should include a base case and a more adverse scenario based on macro and local economic data. Examples of adverse economic scenarios that might be considered include a severe recession, downturn in the local economy, loss of a major client, or economic weakness across a particular industry for which the bank has a concentration issue.
The simplest method described in the OCC guidance as a starting point for stress testing was the “top-down” portfolio level stress test. The “Hypothetical Stress Testing Example” that follows provides an illustrative example of a portfolio level stress test based largely on the guidance and the example provided from the OCC.
The answer to this question will likely depend on the bank’s specific situation. For example, let’s assume that your bank is relatively strong in terms of capital, asset quality, and recent earnings performance and has taken a proactive approach to stress testing. A well-reasoned and documented stress test could serve to provide regulators, directors, and management with the knowledge to consider the bank’s capital levels more than adequate and develop and approve the deployment of that excess capital through a shareholder buyback plan, elevated dividend, capital raise, merger, or strategic acquisition. Alternatively, let’s consider the situation of a distressed bank, which is in a relatively weaker position and facing heightened regulatory scrutiny in the form of elevated capital requirements. In this case, the stress test may be more reactive as regulators and directors are requesting a more robust stress test be performed. In this case, the results may provide key insight that leads to developing an action plan around filling the capital shortfall (if one is determined) or demonstrating to regulators and directors that the distressed bank’s existing capital is adequate. The results of the stress test should enhance the bank’s decision-making process and be incorporated into other areas of the bank’s management of risk, asset/liability strategies, capital and strategic planning.
Having successfully completed thousands of community bank engagements over the last 30 years, Mercer Capital has the experience to solve complex financial issues impacting community banks. Mercer Capital can help scale and improve your bank’s stress testing by assisting your bank in a variety of ways, ranging from providing advice and support for assumptions within your Bank’s pre-existing stress test to developing a unique, custom stress test that incorporates your bank’s desired level of complexity and adequately captures the unique risks facing your bank. Regardless of the approach, the desired outcome is a stress test that can be utilized by managers, directors, and regulators to monitor capital adequacy, manage risk, enhance the bank’s performance, and improve strategic decisions. Feel free to call Mercer Capital to discuss your bank’s unique situation in confidence.
Endnotes
1OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.
2Ibid.
3“Stress Testing for Community Banks” presentation by Robert C. Aaron, Arnold & Porter LLP, November 11, 2011.
4OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.
The Quantitative Marketability Discount Model is a shareholder-level discounted cash flow model designed to help valuation experts derive and explain a reasonable and transparent conclusion based upon the facts and circumstances of each case.
For information on the model, download the QMDM Fact Sheet.
One critical part of the valuation process is the management interview or, as it is sometimes called, the due diligence visit. The management interview provides the business appraiser with an opportunity to integrate many sources of information about a business into a logical and consistent whole. The interview also helps to complete an overall understanding of how a particular business operates. The process of preparing for and conducting a management interview requires the appraiser to develop a command of the facts and circumstances of this particular valuation case.
The specific objectives of the management interview include:
The management interview, if properly conducted, will enable the appraiser gain a more complete perspective of a business than is possible from reviewing documents alone. Ultimately appraisers have the task of understanding the risk profile of the business as a whole and the facets that compose it and of assessing the opportunity profile of business. Risk and growth assessment are both over arching (the forest) as well as the core (the trees) of the appraiser’s valuation development and reporting processes.
Appraisers are often asked why they need to pose certain questions or to collect certain data (sometimes owners and managers chafe at questions in the why and what-if categories). In fact, a good management interview likely involves a few tense moments. Einstein may have said it best when he commented, “not everything that can be counted counts, and not everything that counts can be counted.”
Most valuation firms make it policy that first-time engagements with a client company require an on-site interview. Subsequent valuations of the same business enterprise need not require a visit unless there has been a material change in the key personnel, facilities, financial performance, an extended time since the prior visit, or some other factor that, in the determination of the appraiser and/or the client, suggests something more than a teleconference and exchange of information. Special circumstances limiting the need and/or relevance of on-site visitation might include the valuation of investment vehicle entities, such as family limited partnerships or other entities that hold and manage assets that can be thoroughly studied from afar.
There are additional factors that influence the nature of the due diligence process. These may include the client’s need to address questions about the engagement, the client’s concern for engagement timing and expense, the nature of the valuation opinion, and the involvement and needs of other advisors, particularly fiduciaries.
Good interviewing, whether on-site or by other means, starts with thorough preparation. Assuming information collection is largely complete; the materials should be reviewed and organized in a fashion that facilitates productive inquiry by the appraiser and responsiveness from the interviewee. Historical financial information should be recast in a manner that allows for the examination of trend over time (say, five years) and that promotes the ability of client and appraiser to highlight potential financial adjustments. Also, the appraiser should have reviewed documents related to the business’s history, ownership, and current organizational structure. Economic data for the city, county, and region should be obtained from independent sources, as well as from the business, when available and reviewed. Also, the subject company’s marketing and web-based materials can provide a useful context for assessing the success of the report in presenting the company as it exists in the eyes of those who own and operate it. Industry vocabulary and news items can also prove helpful in assessing the company’s position within its industry and among its competitors.
Most valuation practitioners use some form of questionnaire or checklist that is structured in such a fashion as to promote coverage of the subject matter that could be reasonably expected to influence the valuation. A well-crafted valuation report will provide the reader with a thorough narrative description of the subject business enterprise and the ownership interests therein.
Identifying who should be interviewed and where interviews should be conducted is important to gaining appropriate perspective about the subject company. The nature, size, and complexity of the business enterprise generally guide the appraiser’s design of the interview process. Small businesses with concentrated operations usually do not require the appraiser to meet with more than a few select individuals or at more than a single location. Large diverse businesses with complicated operations and highly delineated senior job responsibilities may require the appraiser to meet with numerous individuals and at differing locations.
The valuation of most small, closely held businesses generally involves the interviewing of a senior, big-picture executive (president, CEO, COO) and a financial officer. In many cases additional interviews or follow-up might be conducted with an external accountant or legal advisor.
The following bullet points provide an outline of a typical management interview. For perspective, assume the subject company is a manufacturing business with $50 million in annual revenue and a single facility harboring both production and administrative departments. The budgeted time is approximately five hours, effectively a day-long interview session when coupled with the travel burden normal to most due diligence.
Experience has taught us that the overriding goal for interviewing and face-to-face meetings is to get the big picture in the words of and from the perspective of company managers and owners that know more about their industry and their operation than the appraiser ever will.
The management interview is an important part of the valuation process. Users of valuation reports should inquire into the level of due diligence used by an appraiser to ensure that confidence in the results is warranted. Some appraisers do not visit the business in the normal course of preparing appraisals. In many cases, these appraisers provide fee quotes that are considerably less expensive than other appraisers who follow due diligence procedures similar to those outlined in this article. In the case of valuations, however, as in many other areas of life, cheaper is not always better. Caveat emptor.
Mercer Capital is a national business valuation and financial advisory firm. We bring analytical resources and over 30 years of experience working with private and public operating companies, financial institutions, asset holding companies, high-net worth families, and private equity/hedge funds. Contact us to discuss a valuation issue in confidence.
Article adapted from A Reviewer’s Handbook to Business Valuation: Practical Guidance to the Use and Abuse of a Business Appraisal by Timothy R. Lee and L. Paul Hood (John Wiley & Sons, 2011)
We have preached for several years here at Mercer Capital that all businesses with more than one shareholder should have a current, well-written buy-sell agreement.
Business appraisers retained pursuant to the operation of buy-sell agreements are normally bound to prepare their valuations in accordance with the kind of value described or defined within the agreements. For clients with valuation processes as part of their agreements, it is imperative for estate planners to understand the six defining valuation elements of a valuation process agreement (as outlined in the book Buy-Sell Agreements for Closely Held and Family Business Owners).
This article deals with one of those defining elements – the level of value. Keep in mind that there is no such thing as “the value” of a closely held business. Confusion over an appraiser’s basis of value, either by appraisers or by users of appraisal reports, can lead to the placing of inappropriately high or low values for a buy-sell agreement transaction. Therefore, it is essential that business appraisers and the parties using appraisals are aware of the correct basis (level) of value. Properly specifying the intended level of value provides a platform for appropriate and consistent valuation methodologies in deriving the conclusion of value.
The levels of value chart is an economic and financial model used by appraisers to describe the underlying financial behavior of individual owners and businesses in the process of buying and selling businesses and business interests. It summarizes a hierarchy of detailed facts and circumstances that characterize transactions involving particular business interests in specific situations. The model generally describes and organizes the valuation relationships that emerge from observing many thousands of individual transactions.
Understandably, business owners are often confused by or are totally unaware of the various levels of value. Business owners tend to think of value in terms of an “enterprise” basis or perhaps a “sale” basis. Valuation professionals look more at terminology like “controlling interest” basis or “minority interest.”
The levels of value chart has been an established model since the early 1990s. The original chart showed three levels, as indicated in Figure 1.
Figure 1: Traditional Levels of Value
In current thinking, there are four conceptual levels of value as shown in Figure 2.
Many business appraisers believe that the marketable minority and the financial control levels of value are, if not synonymous, essentially the same.
One way of describing the financial control value is that buyers are willing to pay for the expected cash flows of enterprises and will pay no more than the marketable minority value. However, they may believe they can run a company better and if the competitive bidding situation requires that they share a portion of potential improvements with the seller, these two levels can diverge somewhat.
Figure 2: Updated Levels of Value
Recently, with the large influx of capital into private equity groups and hedge funds, competitive pressure for deals has caused some financial buyers to compete with strategic buyers. To do so, they must lower their expected rates of return, since strategic or synergistic cash flow benefits are not generally available to them.
Business appraisers look in part to the transaction markets for pricing guidelines when developing valuations at the strategic and financial control levels of value.
Minority investors in actively traded public companies cannot exercise control over companies. However, they can exercise control over whether they hold shares or sell them. In selling, they obtain the current share price, which is their pro rata share of the public market’s pricing of the companies.
Business appraisers look to similar publicly traded companies, in part, to develop valuations at the marketable minority level of value.
The selection of the level of value, in conjunction with the standard of value, begins to specify a valuation or appraisal assignment of a particular business or business interest. Without looking at any numbers, it is clear that the strategic control level of value is higher (more valuable on a per-share or pro rata basis) than is the nonmarketable minority level of value.
In any multiple appraiser valuation process, if one appraiser believes that the appropriate level of value is strategic control and the other believes that the nonmarketable minority level of value is appropriate, the disparity in their conclusions will be wide. That is why business owners have to agree on these two important elements that help to specify the appraisals that will be performed based on their buy-sell agreements.
Where there is a lack of understanding about valuation concepts, confusion will reign. Recall the old expression: “A picture is worth a thousand words.” Here’s a word picture and then a visual picture.
Assume that a buy-sell agreement was triggered and the company was required to acquire a shareholder’s shares per its terms. Unfortunately, the agreement had vague and confusing language regarding the level of value.
The company retained a well-qualified business appraiser, as did the shareholder. Under the terms of the agreement, each was required to provide a valuation.
The conclusions of value at each level of value are shown in Figure 3. Note that there is exact agreement on value at the financial control/marketable minority level.
Figure 3: Levels of Value in Action
Note the dramatic difference in concluded values after reaching their respective final values – $60 per share versus $140 per share.
The parties now have two appraisals. They are quite similar in many respects, but widely different in their respective conclusions of value. The visual picture raises several questions for consideration:
So, what level of value should be indicated in your client’s buy-sell agreement? There can be many reasons to select from any of the available levels of value, though we do observe that the financial control/marketable minority level of value should work as the most “fair” solution in many situations.
While the specific level of value decision will depend on specific circumstances, it is imperative for the owners of businesses drafting a buy-sell agreement to reach agreement on which level of value is desired. After coming to such agreement, the document should specifically refer to the appropriate level of value to eliminate any questions that appraisers, who are be retained at future trigger events, might have. It would be even more helpful to include a diagram of a levels of value chart in the agreement along with this reference.
If you follow this advice, the parties to the buy-sell agreement should get the kind of valuation they and their fellow owners agreed on and minimize the potential for disagreements after the buy-sell agreement gets triggered.
Mercer Capital is the leading provider of buy-sell agreement valuation services in the nation.
We bring analytical resources and over 30 years of experience working with private and public companies to the business valuation issues surrounding buy-sell agreements. We act as the named appraiser in numerous buy-sell agreements, provide annual or recurring valuations, provide expert witness services when a buy-sell agreement dispute arises, and review buy-sell agreements to identify any areas of confusion concerning valuation provisions.
Contact us to discuss a buy-sell agreement issue in confidence.
Non-compete covenants are a staple in most purchase agreements. These agreements are usually designed to protect the buyer in the event that one of the selling shareholders/managers decides to pocket their deal proceeds and start a competing venture across the street.
From an accounting perspective, the value of a non-compete agreement usually doesn’t come up except in business combinations, or perhaps in litigation. In business combinations, non-compete agreements are identifiable intangible assets (per ASC 805) and may require a fair value measurement along with other intangible assets like tradenames, patents, technology, and customer relationships.
The value of a non-compete agreement can vary considerably by industry, business size, and factors specific to the individuals covered under the agreement. However, the valuation methodologies are similar whether the agreement is being valued for GAAP or tax compliance.
Matt Crow, ASA, CFA, President of Mercer Capital, spoke on the topic of valuing non-compete agreements at the 2012 ASA Advanced Business Valuation Conference in Phoenix, Arizona. The presentation covers background on non-competes, reviews key accounting guidance and tax court cases, and provides detailed valuation examples.
Download the recent presentation by Jeff K. Davis, Managing Director of Financial Institutions, and Andrew K. Gibbs, Leader of Mercer Capital’s Depository Institutions Team from the 2013 Acquire or Be Acquired Conference sponsored by Bank Director magazine on the topic of Bank Capital Management: Alternatives and Uncertainties
Mercer Capital had the opportunity to attend the AICPA conference on banks and thrifts held September 10th to 12th in Washington, DC. Between sessions focusing on technical accounting issues, several presenters offered observations pointing to the direction of banking industry. We thought Mr. Rodgin Cohen offered the most trenchant observations regarding the state of the banking industry and the complex range of issues affecting it.
Mr. Cohen is the senior chairman of the law firm Sullivan & Cromwell based in New York. Many of the books written on the financial crisis reference Mr. Cohen’s role in providing legal counsel in a number of the failures, recapitalizations, and mergers that marked the height of the financial crisis. While Mr. Cohen’s practice focuses on the largest financial institutions, we believe his comments are instructive for all banks. In a speech lasting less than one hour, Mr. Cohen managed to complete that most difficult of tasks for a speaker or writer – communicating profoundly with an economy of words. At the risk of understating the subtlety of his comments, we provide the following synopsis of Mr. Cohen’s speech. Where noted, we also elaborate on Mr. Cohen’ comments, suggesting the impact of his large bank centric comments on community banks.
In Mr. Cohen’s forty year career advising financial institutions, the current period represents the most difficult regulatory environment for the following reasons:
These themes are laced throughout the remainder of Mr. Cohen’s comments. To place the preceding themes in context, Mr. Cohen decomposes the current regulatory environment into four components: legislative, regulatory, supervisory, and enforcement.
With respect to legislation, Mr. Cohen accepts that Dodd/Frank represented the most significant thrust from a legislative standpoint. However, he also believes that most of the Dodd/Frank rules would have been implemented via regulation in the absence of Dodd/Frank, as they were sensible responses to shortcomings in the pre-crisis regulatory architecture. Importantly, Mr. Cohen would make exceptions for certain elements of Dodd/Frank that were more punitive in nature, such as the Durbin amendment affecting interchange income.
From a supervisory standpoint, Mr. Cohen notes tightening standards on capital, liquidity, and other matters while, at the same time, regulatory agencies have become more apt to intervene in banks’ decision making. In short, the current model has become one of regulation by supervision. Unlike proposed regulations, new or modified supervisory standards are not subject to a formal rulemaking process that provides interested parties an opportunity to comment.
To illustrate his perspective on the supervisory environment, Mr. Cohen uses the large bank stress testing process undertaken by the regulatory agencies as indicative of the centrality of regulators in creating the new banking regime – one that is quite apart from any legislative requirements. The stress test regime represents a novel set of capital requirements that is largely a mystery to the banks, as the Federal Reserve’s models are secret. Effectively, the regulators can create new capital requirements for banks simply by changing the (largely unknown) assumptions underlying or the inner workings of the stress test model. From the bank’s perspective, this exercise in uncertainty makes long-term planning nearly impossible.
Mr. Cohen notes that recent enforcement actions are damaging the reputation of the banking industry. Previously, actions by banks that would have merited informal sanctions have resulted in fines measuring in the billions and potentially more adverse CAMELS scores. Several intertwined issues relating to the enforcement environment exist:
As another example, Mr. Cohen references Barclays’ settlement over LIBOR reporting. In this matter, Barclays reported its concerns regarding LIBOR fixings to its regulators. Barclays faced a dilemma as to how to proceed – report higher LIBOR fixings when weaker banks were reporting lower LIBOR fixings (thereby creating the risk of a run on Barclays) or report lower LIBOR fixings more in line with other banks. Ultimately, Barclays faced a severe penalty despite its efforts to bring the LIBOR matter to the attention of its regulators.1
For many bankers, one of Mr. Cohen’s most surprising observations may have been his comment that the best and brightest individuals at the bank should be assigned to compliance activities, given the risk of compliance failures.
From Mercer Capital’s vantage point, there may be a tendency in the community banking industry to view these enforcement matters as the province of the largest banks. Schadenfreude may be a natural response, but the risk exists that the large banks’ current $400 million fine for a previously accepted practice could be a community bank’s fine of $400 thousand next year for a similarly accepted practice.
It seems common today among commentators to accept that increased regulation will lead to greater consolidation activity. Mr. Cohen offered an alternative thesis, that enhanced regulation is a hindrance to consolidation activity. He supports the observation as follows:
Certain of the preceding comments are more applicable to the larger banks. However, for community banks Mr. Cohen’s comments are instructive as to matters that acquirers should consider. First, capital levels are of the utmost importance to regulators. Second, compliance issues should not be overlooked in due diligence reviews.
This article represents Mercer Capital’s summary of Mr. Cohen’s comments. Any shortcomings in the description of Mr. Cohen’s views, in relation to his actual intent, are attributable to the author of this article.
Endnotes
1Mr. Cohen would distinguish between actions of traders, as captured in emails, that were unauthorized by management and actions that resulted from Barclays’ corporate policies and discussions with regulatory agencies. Mr. Cohen would agree that the former would require significant punishment.
The final aspect of many merger/sale transactions is the fairness opinion. A fairness opinion is provided by an independent financial advisor to the board of directors of selling companies in many transactions today, especially those with a significant number of minority shareholders. In cases where the transaction is considered to be “material” for the acquiring company, a fairness opinion from another financial advisor is sometimes retained on its behalf.
A fairness opinion involves a total review of a transaction from a financial point of view. The financial advisor must look at pricing, terms and consideration received in the context of the market for similar companies. The advisor then opines that the transaction is fair, from a financial point of view and from the perspective of minority shareholders.
Why is a fairness opinion important? While there are no specific guidelines as to when to obtain a fairness opinion, it is important to recognize that the board of directors is endeavoring to demonstrate that it is acting in the best interest of all the shareholders by seeking outside assurance that its actions are prudent.
The facts of any particular transaction can lead reasonable (or unreasonable) people to conclude that a number of perhaps preferable alternatives are present. A fairness opinion from a qualified financial advisor can minimize the risks of disagreement among shareholders and misunderstandings about a deal, as well as litigation than can kill transactions.
Although the following is not a complete list, consideration should be given to obtaining a fairness opinion if one or more of these situations are present:
Directors have a fiduciary responsibility to the shareholders known as the business judgment rule. In general, directors and management are given broad discretion in directing the affairs of a business. Directors are expected to act in good faith based upon the care that an ordinary person would take in supervising the affairs of the business. Inherent in this rule is the requirement that the board of directors be informed about the basis for major decisions prior to reaching a conclusion. In essence, there is an expectation that reasonable decisions will be made in a proper way.
In the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985), the Delaware Supreme Court expanded the concept of the business judgment rule to encompass a requirement for informed decisions. The process by which a board goes about reaching a decision can be just as important as the decision itself. While the Delaware court decision is applicable only to Delaware, the wide influence of Delaware law on business law in general makes the case very important. There have, of course, been other cases relating to fairness opinions since Smith v. Van Gorkom, but a case review is beyond our scope in this short article.
The fairness opinion is a short document, typically a letter. The supporting work behind the fairness opinion letter is substantial, however. A well-developed fairness opinion will be based upon at least the following five considerations:
Due diligence work is crucial to the development of the fairness opinion. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling for stock). We believe that it is prudent to visit the selling company, conduct extensive reviews of documentation, and interview management.
A similar process should be performed with respect to the buying company, especially if the consideration is its stock. If the purchaser is a public company, it is imperative that all recent public financial disclosure documents be reviewed. It is also helpful to talk with financial analysts who routinely follow the purchasing company in the public markets.
Fairness opinions are often memorialized in the form of fairness memoranda. A fairness memorandum examines the major factors of the fairness opinion in some detail, and summarize the considerations of each factor for discussion by the board of directors. In many cases, the financial advisor will participate in these discussions and answer questions addressed by the board.
Reprinted from Mercer Capital’s Bizval.com – Vol. 9, No. 1, 1997.
Business appraisers provide support to attorneys working on cases involving valuation and business damages. When a business valuation is called for in a valuation-related dispute, we provide necessary opinions. If the case involves corporate damages, we provide the necessary opinions regarding alleged damages. These services are fairly obvious uses of business appraisal expertise.
The focus of this article, however, is on some not-so-obvious services that business valuation professionals can provide in the context of business-oriented litigation.
In litigation involving business valuation or economic damages issues, business valuation professionals are capable of providing a surprisingly broad assortment of litigation support services. These services can begin before a decision is made to file a litigation, and can continue throughout the discovery, deposition, trial preparation and trial processes. Attorneys are increasingly learning that the effectiveness of business valuation and damages-related litigation support services is enhanced by retaining experts as early in the process as possible.
In litigated matters, business valuation professionals are often assigned to:
These assignments are customary not only to business valuation professionals, but also to litigators handling matters which involve issues of business valuation or economic damages. However, the toolbox of business valuators includes a number of not so customary litigation services, or additional services that are only beginning to be considered by litigators, including:
Some attorneys request these services at the outset of engagements. Others could potentially make their jobs easier and leverage their legal expertise by engaging competent business valuation litigation support services earlier in the litigation process.
The work product of a business valuation or corporate damages professional can be the basis of a dispute. In other cases, existing business appraisals may provide important information to support a lawsuit in disagreements regarding valuation. Consider two real-life examples.
In both cases, the minority shareholders engage attorneys to represent them in discussions with the respective companies. In both cases, the attorneys and their clients could benefit from discussing the matters with a business valuation professional. In cases like these two examples, the business appraiser who is consulted early can review the reports prepared by the other experts, and, in the process, can identify potential shortcomings of the subject valuation, or affirm their reasonableness.
The purpose of this early review is to assist counsel in assessing not only the probability of successfully trying the case, but also the potential valuation differential (the potential payoff). Keep in mind, however, that any perspective offered by a business valuation professional at this stage in an engagement is preliminary and potentially subject to significant changes. Let’s tell the rest of the story from the first example above:
The minority shareholders of Company A retained counsel. The attorney obtained the appraisals prepared by the industry broker and sent them to us, asking that we conduct an informal review of both of them and the implied exchange rate.
The companies were of similar size and earnings, but Company A was valued materially lower than Company B. We concluded, based on our preliminary, informal review, that the exchange rate was substantially dilutive to the minority shareholders of Company A. Based on this analysis, the attorney advised the shareholders of Company A to dissent to the transaction under the state’s dissenting shareholder statutes. They did so, demanding the fair value of their shares according to their statutory rights.
An appraisal process was initiated, and we provided our opinions of the fair value of Company A and Company B, and the fair value of the exchange ratio. The appraisals bore out the initial calculations. There were depositions of the experts in the matter. When Mr. X realized that his expert would be unable to sustain his valuations, he offered to buy out the shares of Company A owned by the minority shareholders at our appraised price, thus ending the litigation and avoiding the expense, publicity, and angst of a trial.
The determination of economic damages often involves a complex analysis with many variables. While it is not possible to provide an opinion of alleged damages without a thorough review of the facts and circumstances of a case, it is sometimes possible for business valuators to develop a reasonable range within which a conclusion is likely to lie. We are also able to help attorneys develop initial damages theories prior to the filing of damages litigations.
By contacting a business appraisal expert before filing litigation, attorneys and their clients have a sounding board for developing their approach to the matter and are likely to better articulate their claim. Before taking legal action, attorneys and their clients should perform a thorough cost-benefit analysis of a damages litigation to ensure the reasonableness of moving forward with their claim. Discussing the facts of the matter with a business valuation professional can enhance an attorney’s understanding of both sides of a cost-benefit analysis: the potential cost of preparing and defending an opinion of damages and the potential amount of awarded damages. For example:
We received a call from an attorney regarding a potential business damages matter. His client was a manufacturer who had entered into a joint selling venture with another company. After introducing the joint venture partner to its customer base, the partner hired a key employee of the manufacturer who used company records to establish new customer relationships for the joint venture partner.
The attorney’s client was incensed, and had suggested to the attorney that damages were in the range of $15 million or more. They had been wronged and they knew it and they wanted to extract maximum punishment from their former partner.
We were then provided with some basic documentation regarding the joint venture and the company itself. It was almost immediately apparent that the client’s expectation of $15 million in alleged damages was unreasonable and would be unsupportable. A lawsuit was filed asking for damages in the range of $4 million.
The expectations of the client and the attorney were much more realistic as result of our early work. The case settled following a round of depositions, including those of the experts.
Every damages case is unique, and typically a relatively brief conversation with a business valuation professional can go a long way toward helping counsel understand the merit of a potential damages claim.
In some matters, formal litigation, and its significant costs, may be avoided altogether by engaging a business valuation professional to be an independent voice of reason, jointly retained by the two sides of a dispute. In this context, the business valuation professional reviews the relevant documents, conducts research, holds discussions with representatives of one or both sides of the matter, and ultimately offers a reasonable and independent estimate of value or damages.
From the outset, the two sides may agree to make the business valuation professional’s opinion binding or non-binding. Further, the business valuation professional may be asked to prepare a full appraisal or economic damages report, including a detailed narrative and financial analysis, or the work-product may instead be limited to calculations (lacking a detailed narrative) and/or a presentation with descriptive slides.
As an example, we were engaged in a dispute between a company and a departing shareholder, whose interest was to be purchased by the company pursuant to a buy-sell agreement.
- The governing agreement called for an appraisal by a particular business valuation firm, which had already produced a report and provided an opinion of value before we were engaged.
- The purchase price was to be paid in the form of (1) an initial cash payment and (2) an amortizing note with annual payments over three years.
- The company (represented by its remaining shareholders) claimed the departing shareholder’s interest was overvalued.
- The buyout would force the company to take on a relatively large amount debt, which could ultimately jeopardize the company’s ongoing operations.
Before litigation was filed, we were given the opportunity to conduct an on-site management interview and review a number of relevant documents (such as the shareholders’ agreement and the appraisal which established the purchase price). Within the existing appraisal, we identified arithmetic errors and internal inconsistencies which contributed to an overvaluation of the subject interest. We also prepared our own valuation, including a leveraged buyout analysis that evaluated the feasibility of taking on significant debt to fund the purchase of the departing shareholder’s interest.
Our analysis, in tandem with our critique of the original appraisal, led to a relatively swift settlement and saved both sides from the costs and risks of battling in court. While our work ultimately led to a reduced price, favoring the company, the departing shareholder understood that the initial appraisal was based on mathematical and other errors. Further, by agreeing to a reasonable purchase price which did not require the company to overextend its capital structure, the departing shareholder and soon-to-be creditor of the company could be confident in the company’s ability to satisfy the note issued in conjunction with the buyout.
There are few pieces of information about a given company and its economic context that a business valuation professional would not like to review before issuing an opinion of value with respect to such company. In the same vein, there is a good deal of information about a given company and its economic context that a business valuation professional must consider before an unqualified opinion of value can be issued.
In order to comply with prevailing professional standards, business valuation professionals are required to perform adequate due diligence. In a litigation context, making the most of the discovery process is essential to satisfying due diligence requirements and delivering credible expert testimony and supporting work products.
Even seasoned litigators are unlikely to request all of the documents a business valuation professional will need to prepare an appraisal or economic damages report. It is important to engage a business valuation professional early in the discovery process, if not before it begins, to ensure that he or she will have a chance to request necessary documents.
In the discovery process, we typically cast a wide net from the outset, review the documents produced in response, and then issue crucial follow-up requests. Without pre-existing familiarity with the subject business, it is virtually impossible to cover all important information needs in a single request. That is one of the reasons it is important to engage a business valuation professional early in the process and keep him or her up to date with respect to the key dates of the discovery process schedule.
We once worked in a damage litigation involving a hospital. The period of damages was historical, and ownership of the hospital had changed. During the damages period, the hospital had been a subsidiary of a publicly traded hospital management company. Discovery had not yielded important financial and operational information regarding the hospital over a several year period. The plaintiffs (the former corporate owner of the hospital) claimed that they did not exist.
We told counsel that, based on our experience with other hospitals and management companies, the monthly reports had to exist. Substantial public companies do not run subsidiaries without adequate and regular financial and operational reporting. The only possible explanation for their lack of existence would have been that they were destroyed.
Armed with this information, counsel was able to once again request the missing information. We obtained the information and were able to use it successfully in our analysis on behalf of the defendant.
Business valuation professionals are well-positioned to help attorneys prepare questions for the deposition of opposing business valuation experts and certain types of fact witnesses.
Attorneys deservedly take pride in their ability to ask questions and to extract information from witnesses. However, even expert questioners can use a little help when taking on expert witnesses. Expert witnesses in the field of business valuation speak the language of business valuation, have a keen eye for spotting and honing in on work product weaknesses, and are able to distill an analysis to a handful of key assumptions which drive an expert’s opinions. These attributes make business valuation professionals well-equipped to aid counsel in the questioning of other business valuation professionals. Attendance at the deposition of opposing experts can also be helpful at times. The attending expert has an opportunity to see the opposing expert in action and can, if circumstances permit, provide additional lines of questions for counsel based on responses heard.
Another reason for hiring experts early in the litigation process is for assistance in deposing management fact witnesses. Too often, attorneys go through the deposition process before hiring their experts. Then, when the expert needs certain questions asked, the witnesses are no longer available.
In some cases, we have been denied direct access to the management of the subject company in litigation. In this context, the deposition of the subject company’s management team members (i.e., fact witnesses) is an imperfect, but nonetheless invaluable forum for enhancing our perspective of the company and delivering more credible expert opinions.
Experienced litigation support professionals will not only provide a list of questions for the witness. Many questions have one or more likely answers, each of which naturally leads to follow-on questions. If an attorney is armed with good questions and multiple options for follow-up on key issues, the usefulness of depositions can be enhanced. By having conditional lists of questions, the deposing attorney will be in a stronger position to deal with witnesses who attempt to sidestep questions or are generally uncooperative.
The potential benefits of these not-so-customary services referenced, include:
For more information about Mercer Capital’s litigation support services, visit our website at www.mercercapital.com. To discuss a valuation or litigation-related issue in confidence, contact us at 901.685.2120.
On Sunday, October 3, 2010, Mercer Capital’s Tim Lee presented “Demystifying Distributorship Valuation: Translating and Understanding Your Valuation in an Evolving Market” at the National Beer Wholesaler’s Association 73rd Annual Convention in Chicago, Illinois. Lee’s presentation led attendees through a typical valuation report, identifying the elements of a thorough valuation and exploring how distributor valuations differ based on methodology and intended purpose.
Estate planners work with business appraisers every day. Experience suggests that there are numerous aspects of business valuation that when known to estate planners greatly benefit the proposal and execution processes. We have compiled a “top 10” list of things every estate planner should know about business valuation. While a few of the items might seem obvious, to many they are not.
In order for the appraiser to plan the assignment, estimate the fee, and understand the client’s specific needs, the estate planner needs to provide some basic benchmark information, such as: a description of the specific ownership interest to be appraised (number of shares, units, bonds); a clearly stated understanding of the “level of value” for the interest being appraised; a specific valuation date, which may just be current, or may be a specific historical date, and a description of the purpose of the appraisal (inform the appraiser why your client needs an appraisal and how the report will be used).
There are different standards of value for appraisals under certain circumstances and in different jurisdictions. Corporate and owner-level tax compliance appraisals are based on “fair market value,” certain jurisdictions require “fair value” in dissenters’ rights cases; and “liquidation value” may be appropriate in certain cases. Most appraisals are developed using a premise that the subject entity of the appraisal is a “going concern” in which business assets are used to conduct business versus being liquidated in a piece meal sale of assets.
Even in straightforward buy-sell agreements, family limited partnerships, or corporate reorganizations, it is usually helpful to seek the advice of the appraiser before the deal is finalized to see if there are key elements of the contract document that could be modified to provide a more meaningful appraisal to your client.
Many of the corporate entities appraised either own or rent the real estate where the business is operated. For a successful operating business, the most meaningful valuation is typically based on some measure of income, rather than the value of the underlying real estate. However, one should recognize that the value of some businesses, due to the nature of the subject business model, is better characterized by the value of underlying assets, and less so by the ongoing income. This is true for asset holding entities, and for some older family businesses with marginal earnings but with appreciated real estate on the books. Many business appraisers are not asset appraisers, and therefore, may need to consider a qualified real estate appraisal in the business valuation process.
Each client’s business appraisal is a custom piece of work. Clients rarely have available all the information requested at the outset of a business valuation assignment. Typically, a valuation project takes several weeks to complete once the engagement is authorization to proceed. Timing can be accelerated to meet special needs, but it is usually a good idea to avoid rushing the production of a complex appraisal project.
Each business appraisal is unique and experience counts. Most business valuation firms are generalists rather than industry specialists. However, the experience gained in discussing operating results and industry constraints with a broad client base helps an appraisal firm understand each client’s special situation. While credentials are no guarantee of performance, they do indicate a level of professionalism for having achieved and maintained them.
Business valuation is an art as well as a science and appraisers utilize various valuation methods and treatments as required to appropriately address the unique considerations of each assignment. Key methods typically include: transactions method (focuses on actual transactions in the security being appraised); underlying net asset value method (considers estimates of fair market value of the entity’s net assets, on a tax-adjusted basis); capitalization of earnings method (based on estimates of underlying earning power times a derived capitalization factor); guideline company method (similar to the capitalized earnings method, but uses comparable, or guideline companies to derive the appropriate capitalization factor) or discounted cash flow (derives the present value of future cash flows, based on a combination of projected future cash flow and a derived discount rate appropriate to the situation). Other valuation methods may be appropriate to certain companies in specific industries where particular comparable transaction data may be available.
A well-reasoned and documented appraisal report serves as an indication of the seriousness and professionalism with which you address a client’s needs. Having an independent valuation in a transaction situation provides a level playing field for negotiations in good faith on both sides. For tax-compliance cases, the appraisal serves notice to the other side that they need to be equally prepared to support a contrary opinion of value.
The business appraiser cannot serve as advocate for your client, but it is always helpful to have an experienced business appraiser available for expert opinion testimony. In addition to providing a well-reasoned and documented report, the appraiser must be able to articulate the reasonableness of valuation and investment conclusions to the court and be able to deal with intensive cross examination.
In most cases, the fee for appraisal services is nominal compared to the dollars at risk and the marginal cost of getting the best is negligible. You can help your appraiser do the best job possible by ensuring full disclosure and expecting an independent opinion of value. The best appraisers have the experience and credentials described above, but recognize the delicate balance between art and science that enables them to interpret the qualitative responses to due-diligence interviews and put them in a stylized format that quantifies the results.
When talking with business owners about transacting their business, an issue that almost always arises relates to the appropriate deal and financial expertise of the transaction advisor.
The basic question is: Should we hire an industry expert for this transaction or a deal expert with experience in completing hundreds of transactions and engagements in a myriad of industries?
There are thousands of industry categories and subcategories; therefore, there are more industry categories than there are corresponding industry specialists.
Conversely, if an industry is large, it can have too many industry experts.
No matter the size of the industry, industry expertise is helpful. However, deal expertise is vital.
Therefore, if you hire an industry expert to value and sell your or your client’s business, be sure that the industry expert also has deal expertise. Lessons learned by way of engagements across multiple industry sectors are too valuable to lose when your deal needs negotiating.
Deal expertise is attained from years of hands-on experience and knowledge of financial markets. Deal and valuation expertise includes a working knowledge of complex financial theory. This enables deal experts to learn new industries quickly.
For example, at Mercer Capital, we have provided transaction advisory services and/or valuation services in more than 500 industry categories and subcategories. Along the way, we have developed specific expertise in a number of industries, including financial institutions, insurance agencies, manufacturing-related companies, distribution-related companies, construction-related companies, as well as asset management companies.
If you are confused about whether to choose an industry expert or a deal expert for a proposed transaction, consider the following:
In our opinion, based on decades of experience, deal expertise combined with a broad base of industry experience is preferable to industry expertise alone. If you or your client can obtain both sets of qualifications in one firm; so much the better.
The transaction advisor you employ to guide your transaction should be a deal expert, as well as have knowledge of a broad base of industries. If you are considering an industry expert versus a deal expert, you owe it to yourself to achieve the added value deal expertise can earn for you.
If you are contemplating any type of transaction, contact Nick Heinz at 901.685.2120 or email him at heinzn@mercercapital.com. Confidentiality is ensured.
Mercer Capital leverages its historical valuation and investment banking experience to help clients navigate a critical transaction, providing timely, accurate, and reliable results. We have significant experience advising boards of directors, management, trustees, and other fiduciaries of middle-market public and private companies in a wide range of industries. Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction, and we are well-versed in the new industry standards.
This handbook addresses an important omission in the current financial environment: the lack of a broader, strategic understanding of the possible roles of Employee Stock Ownership Plans, or ESOPs, as a tool for managing a variety of issues facing banks.
Banks proportionately make more use of ESOPs than any other industrial classification in the U.S.
While an ESOP is not suitable in all circumstances, an ESOP may provide assistance in resolving the following issues, either by itself or in conjunction with other elements of a well-rounded strategic plan:
Written by Corporate Capital Resources, LLC and Mercer Capital, this handbook describes the function of ESOPs in the real world of banks and bank holding companies.
Bank directors and managers can use the information in this handbook to make solid, initial decisions regarding the potential merits of an ESOP.
Before embarking on a particular strategy to deal with the various challenges facing small- to mid-size banks, the decision makers in profitable institutions may wish to consider how an ESOP can assist in addressing issues such as shareholder liquidity, employee ownership and compensation, and capital management.
Valuing Financial Institutions is the first book written specifically to meet the needs of professional appraisers of financial institutions, executives in financial institutions, and the accountants, attorneys, and other professionals who serve the industry. Mercer’s Valuing Financial Institutions is a ground-breaking resource that focuses on the special issues of financial institution appraisal.
Unlike any other guide to business valuation, this book provides the facts about bank valuation principles, methodologies relating to minority interest and controlling interest values, Employee Stock Ownership Plans (ESOPs), and the impact of regulation on valuation. In addition, Mercer discusses critical merger/sale/purchase considerations, fairness opinions, core deport intangible asset and branch valuation issues, and litigation support related to valuation issues.
Valuing Financial Institutions is an essential addition to the library of every banker and business appraiser, as well as the attorneys, accountants, and other professionals who support banks and need to understand bank analysis, operations, and valuation issues.
This book is an indispensable reference for anyone involved with the valuation of a bank, bank holding company, thrift institution, thrift holding company, or other financial institution. It is the first and only comprehensive, how-to-treatise on the valuation of financial institutions written in the mainstream of business valuation theory and practice.
Virtually every bank and thrift in the national will have specific valuation requirements over the next three to five years. Valuing Financial Institutions, and essential guide for every banker, supporting bank professional, and business appraiser, shows you how to measure performance, compile data for valuation purposes, and use the knowledge gained from the valuation process to increase the value of banking institutions. Focusing on the issues which differentiate financial institutions from other types of companies, this book gives you useful checklists, tables, exhibits, and appendixes that will increase understanding and save time when the principles are applied to unique valuation situations.
With step-by-step guidance on what to do for those performing bank appraisal, or what to expect for those who must rely on them, Valuing Financial Institutions takes you from assignment definitions to the final report and includes:
When was the last time you read Revenue Ruling 59-60? Do you understand how business appraisers utilize the Ruling in income and estate & gift tax valuation engagements? Would you like an easy resource that explains how the Ruling is applied in the real world?
Revenue Ruling 59-60 is over 50 years old and it continues to be a foundational document for estate planning and business valuation professionals. This book is a non-technical resource. It clearly explains how business appraisers attempt to translate the guidance found in the Ruling into actual valuation engagements.
Inside:
Clear, concise, and to the point, this book should be a part of every estate planner’s library.
Valuation issues intersect with a bank’s affairs more often than you may imagine, and they are likely to arise during your tenure as a director or manager. These valuation issues might include merger and acquisition activity, an employee stock ownership plan, capital planning, litigation, or financial planning, among others. Mercer Capital has been working with financial institutions for over 30 years and has provided valuation and other financial consulting services to thousands of clients. We find that most of our clients have the same basic questions about these important valuation issues. This handbook is written to address many of these questions and to provide useful information for bank directors and managers when valuation needs emerge. It is unique in that it focuses specifically on valuation-related issues, and is designed to be a ready resource rather than an academic treatise.
This handbook is written specifically for bank directors and managers. It provides basic information and insight into those circumstances that involve valuation and other financial consulting. Each chapter addresses a valuation issue that might surface at your financial institution. Meant to stand alone, the chapters summarize the key issues on which you should focus and provide insight and a vocabulary to assist you in asking the right questions of your professional advisors.
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.