The world of fair market value is not the real world. It is a special world in which the participants are expected (defined) to act in specific and predictable ways. It is a world of hypothetical willing buyers and sellers and of hypothetical transactions. The real world is populated by real people, whose actions are unpredictable, and not subject to consistent definition, who engage in actual transactions with unpredictable results. It should come as no surprise that these two worlds, the hypothetical world of fair market value and the real world, are sometimes in conflict over the question of the value of businesses and business interests.
We begin this article with a review of the definition of fair market value. The second part of the article offers a partial interpretation of the meaning of fair market value from a valuation perspective and looks into the hypothetical world of fair market value.
The definition of fair market value is known as a “willing buyer and willing seller” concept. The Department of Labor’s “Proposed Regulation Relating to the Definition of Adequate Consideration”, which to our knowledge has not been finalized, but is still generally relied upon by appraisers as the authoritative guideline for EOSP valuations, defines “adequate consideration” as the “fair market value” of the asset as determined in good faith by the Trustee or named fiduciary. This definition essentially reflects the well established meaning of fair market value as presented in Revenue Ruling 59-60.
Revenue Ruling 59-60 provides a working definition of fair market value:
2.2 Section 20.2031-1(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax Regulations 105) and section 25.2512-1 of the Gift Tax Regulations (section 86.19 of Gift Tax Regulations 108) define fair market value, in effect, as [1] the price at which the property would change hands [2] between a willing buyer [3] and a willing seller [4] when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, [5] both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that [6] the hypothetical buyer and seller are assumed to be able, [7] as well as willing, to trade and [8] to be well informed about the property and [9] concerning the market for such property. [parentheticals added]
This definition provides a bare-bones description of the hypothetical world of fair market value. The parentheticals indicate nine elements in the definition of fair market value for consideration. They will be discussed below. However, it is almost impossible to cite the definition of fair market value without also noting the eight factors enumerated in RR 59-60 for consideration in a fair market value determination. They are so commonly cited in business appraisal reports that Mercer Capital refers to them as the Basic Eight factors (from Section 4.01):
The Basic Eight factors of RR 59-60 are required to be examined in the context of what we call the Critical Three factors of common sense, informed judgment, and reasonableness (from Section 3.01), which “must enter into the process of weighing those factors and determining their aggregate significance.”
The nine [parenthetical] elements of the definition of fair market value are the focus of this article, rather than the Basic Eight factors. However, these nine definitional elements are necessarily interpreted in the broad analytical context provided by the Basic Eight and under the general umbrella of the Critical Three factors of common sense, informed judgment and reasonableness.
We now focus on the nine elements noted parenthetically in the definition of RR 59-60 above. Recall, as was noted above, that the world of fair market value is not the real world. It is a specific definable world in which hypothetical buyers and sellers react in predictable ways.
As can be seen in the definition above, there are several qualifying characteristics that define “the price at which the property would change hands.” Note that the definition references the price, and not the proceeds, of the sale of a property.
Elsewhere in RR 59-60, we find that the fair market value price is paid in terms of money or money’s worth, so the fair market value price is a cash-equivalent concept. It is paid in terms of dollars today or the present value of consideration to be received in the future. Note also that property changes hands. A transaction is presumed in the definition of fair market value.
Appraisers sometimes consider discounts for controlling interests of companies relating to the transactions costs incurred while selling those entities. While transactions costs are undoubtedly real in actual transactions, such costs are deductible to sellers and therefore reduce proceeds, not price. Other costs, such as those related to deferred hirings or maintenance, for example, may well lower value, and thus, price. Appraisers should therefore distinguish between costs that influence price (value) and proceeds (value less transactions costs).
If fair market value is a cash-equivalent concept, how meaningful are stock-for-stock acquisition transactions in consolidating industries (like banking and auto dealerships, to name two) as a basis for determining the fair market value of an entity on a controlling interest basis for estate tax purposes? It is fairly well documented that stock-for-stock deals generally occur at higher dollar-denominated prices than cash deals. If fair market value is a cash-equivalent price, and if the stock-for-stock value indications exceed the price that could be obtained if an entity were sold in a cash deal, business appraisers attempting to determine the fair market value price should probably take this factor into account.
The hypothetical buyer of fair market value fame is a willing buyer and is interested in engaging in a transaction to acquire the subject interest and is inclined to do so “if the price is right.” Hypothetical buyers make their determinations of price based upon rational financial and economic principles applied in relation to a subject interest. In other words, the hypothetical willing buyer is a rational buyer.
The hypothetical seller of fair market value fame is a willing seller. Specific sellers are not always interested in selling, particularly if market conditions are perceived as poor. Yet, they can sometimes be convinced to sell an asset “if the price is right,” to obtain liquidity, or to invest in a higher yielding alternative investment. But note that for a seller, the timing must also be right. If the definition of fair market value is to hold up, the contemplated class of willing sellers must be comprised of a group of potential sellers for whom the timing for a (hypothetical) transaction is favorable.
If a hypothetical seller does not sell, he or she has become, in effect, a buyer who acquires (by retaining) a subject interest. So every hypothetical seller is evaluating the same economic and financial factors under consideration by the relevant group of hypothetical buyers. So the hypothetical willing seller, like the hypothetical willing buyer, is a rational investor. A discussion containing many of the same concepts is found in a recent article in the Business Valuation Review.
The definition of fair market value assumes willing buyers and willing sellers. Some might argue that because someone would not buy a particular interest, it therefore must be next to worthless. Others sometimes suggest that because a holder of an interest would not sell, it should be valued dearly. Both positions may at times be correct, but neither represents fair market value.
The lack of willingness to engage in a transaction by any particular party should not enter into a determination of the fair market value of the subject interest, else the behavioral requirements of the definition are not met. Finding that a seller would not sell because the price is “too low” or that a buyer would not buy because the price is “too high” implies analysis of the motivation of specific sellers or buyers, ignores the need to consider hypothetical sellers and hypothetical buyers, and introduces elements of speculation and subjectivity not contemplated by the definition of fair market value.
Appraisers sometimes use the terms typical buyers and typical sellers as representatives of hypothetical willing investors. These are important concepts. A specific buyer will likely consider the intrinsic worth of an investment to him or to her. A specific seller will also consider the worth of an investment from his or her unique perspective. Such considerations do not constitute a market. A group of typical buyers, on the other hand, collectively represents one side of a market and a group of typical sellers represents the other side. Together they create the hypothetical market of fair market value.
Neither party is assumed to be under any compulsion to engage in a transaction, nor to be under any duress. This point suggests that although willing to engage in a transaction, the parties are under no pressure to do so. Compulsion to engage in a transaction by a party to a transaction usually works adverse to that party’s interests. A “motivated buyer” is likely to pay more than a rational price to acquire an asset. On the other hand, a “motivated seller” is likely to sell for less than he or she would otherwise accept for the sale of an asset. Hypothetical buyers and sellers in the fair market value world, being equally uncompelled, can negotiate the price and terms of their deals based on their rational financial and economic consequences.
Recall that we suggested above that attempting to ascertain why specific persons did not engage in a transaction is speculative and subjective. Analyzing actual transactions to attempt to ascertain or estimate the motivations of market participants is a far more objective process and can often add value to the process of determining fair market value.
A specific buyer for a subject interest with strategic or synergistic motivations may pay a price that is unaffordable to a typical buyer who lacks synergistic opportunities or strategic motivation to enter a market. So fair market value will likely not reflect the highest price that might be obtained. It more probably should reflect the consensus rational pricing that might be discerned by a group of buyers with typical motivations to achieve reasonable returns based on the expected cash flows of an investment.
This logic also suggests that a transaction in a company’s stock may not be indicative of fair market value, even if that transaction occurred between independent parties. The mere fact that the parties were independent of each other says nothing about the motivations of either party. In many, if not most cases, we may never know or understand the actual motivation of the parties. But we can analyze the economics of actual transactions and assess whether they occurred under rational conditions that reflect the elements of fair market value. If a transaction in a subject company or a guideline transaction involving another company cannot be explained rationally, chances are neither is a candidate for inference regarding the fair market value of a particular subject interest.
Both parties are assumed to have reasonable knowledge about the relevant facts. This is an important assumption, because knowledge about certain companies, interests in companies, or other investments is not generally available to everyone. For example, there is one universe of investors making investments in the public securities markets, and a substantially different universe investing in large, private placements of debt or equity. A small investor in the public securities markets may, for instance, lack the wherewithal, interest or ability to understand a complex private placement document.
The term fully informed is often used to describe the state of reasonable knowledge of relevant facts. In real life, we know that buyers and sellers of equity interests are seldom fully informed. Why is it that the surprises that happen after acquisitions are invariably adverse to buyers? From a seller’s viewpoint, the refrain that “nothing will change after the merger” is so often wrong as to be laughable. And some of the issues that come to light after transactions are quite knowable beforehand, based on reasonable analysis or investigation. They are, however, frequently ignored or overlooked by participants in real life transactions who might be motivated, compelled, or not quite fully informed.
Reasonable knowledge and the future. Real life transactions are based on facts and circumstances known up to the minute of their closings, and consider reasonable outlooks for the future. Reasonably, or fully informed does not mean having a crystal ball that eliminates uncertainties by forecasting the future with precision.
After-the-fact valuations should not abuse the standard of reasonable knowledge based on facts that clarified themselves shortly or long after an historical valuation date. Attorneys representing the side in a dispute benefited by knowledge of post-valuation date events may want to believe that the certainty of those events was reasonably knowable at the valuation date. Independent appraisers do not have this luxury in the context of a fair market value determination.
In some instances, the fact that an event might occur in the future is known at the time of a transaction or at a valuation date. What is not generally known is when or with what probability the event might occur. Appraisers must assess those probabilities and incorporate the risks or potential benefits appropriately in their appraisals – the way that reasonably informed hypothetical willing investors might, based on information available as of a valuation date.
This brief discussion of the reasonable knowledge component of the definition of fair market value should illustrate that following its implied guidance requires the exercise of common sense, informed judgment and reasonableness.
The hypothetical willing buyer and seller are assumed to be able to engage in a transaction. The implication is that each of the parties must have the financial capacity to engage in the subject transaction.
Consider the following specific example: the subject interest has no market, is worth about $500 thousand, and provides a market yield for similar assets. In the context of such a cash flowing investment, the universe of hypothetical buyers would include individual investors who, in the context of diversified portfolios of investments, would have the ability to purchase an investment in this value range. Such investors would likely be fully taxable individuals or corporations paying taxes at the maximum statutory rate.
If we assume that most rational investors would not place more than 10% or so of their portfolios in any single investment (about the minimum number of investments to achieve reasonable diversification if all the individual investments are publicly traded securities), then we are discussing a group of investors with liquid financial capacity on the order of $5 million or more.
Yet consider that investors are usually willing to place smaller portions of their wealth in specific illiquid assets. The universe of hypothetical investors for our $500 thousand asset might, in reality, be those with a net worth of $10 million or more who might be willing to place only about 5% of their assets into any single, illiquid security. This universe of investors will likely have different return requirements and investment expectations than the broader group of investors who invest in the public securities markets.
So, the universe of hypothetical investors should be considered in making their determinations of fair market value. Specifically, appraisers should consider the impact of the investment requirements of the relevant universe of hypothetical investors on the fair market value of particular interests. Attorneys and other users of appraisal reports should have the expectation that such considerations are made, either explicitly or implicitly, in appraisal reports.
Both parties must be willing to make the trade. It should be clear that hypothetical investors are rational investors. They engage in transactions and approach the issue of price from a rational economic and financial perspective.
Both parties are assumed to be well-informed about the property that is the subject of the appraisal. In other words, the parties must have the knowledge and the ability to investigate the potential investment. This aspect of the definition carries the point of being reasonably informed in a general sense to being well-informed in a specific sense.
Gaining such knowledge about a specific property or transaction can be time-consuming and expensive, so it is an important characteristic to consider in an appraisal. Further, the hypothetical investors are negotiating over the economic and financial value of the property itself, and not on the synergies, strategic impetus, or psychological benefit it might provide to a particular buyer.
The last element of the definition of fair market value carries the concept of reasonably informed one step further. Both parties are assumed to be knowledgeable, not only about the specific property, but also about the market for the relevant property. This fact adds a layer of time and expense or experience to the process of investigation by hypothetical buyers. Knowledge about the market for a property assumes an understanding of industry conditions as well as local, regional and/or national economic conditions.
The markets in which properties trade in the fair market value world are rational markets and they are consistent markets. This can create occasional disjoints between actual market pricing and fair market value. In speculative markets, publicly traded shares of companies may trade at values significantly greater than the value of the entire company if it were sold. This can occur as a result of general speculation as with Amazon.com, which currently trades at a minority interest value per share that no rational analysis can justify. It can also occur in the shares of publicly traded companies in consolidating industries. Appraisers sometimes have to rationalize market guideline company evidence before it can be applied in a determination of fair market value.
As mentioned earlier, ESOP participants, appraisers, and attorneys should have more than a superficial understanding of the valuation implications of the standard of value known as fair market value. Fair market value is not the real world. Appraisers, attorneys and other users of business valuation reports who operate every day in the real world need to continue to develop a better understanding of that other world, the hypothetical market in which fair market value transactions occur. As noted in the IRS Coursebook:
. . . the consideration of any valuation case would ensure that both sides, including their respective appraisers, if any, are employing the correct definition and criteria for determining fair market value. No case is stronger than its weakest link and if the wrong valuation standard is applied, the conclusion will be defective.
It is important for appraisers to focus specifically on the definitional elements of fair market value while describing valuation opinions in their reports. And attorneys and other users of valuation reports should expect this in their reviews of valuation reports.
Certain appraisers rely upon academic research in their determination of the magnitude of the marketability discount to a marketable minority interest of value. We thought it appropriate to review one such piece of academic research to determine its content and applicability to the ongoing debate.
In 1993 a paper was published entitled “Market Discounts and Shareholder Gains for Placing Private Equity” by Michael Hertzel and Richard L. Smith.1 It has drawn attention (and been quoted) for its observations about discounts observed in private placements.
The objective of the Hertzel/Smith study was to determine the underlying reasons for discounts observed in the pricing of securities in private placements and the positive abnormal returns associated with the announcement. While illiquidity associated with unregistered stock seemed to provide a partial explanation, “it is not clear why investors require, and firms are willing to accept, such sizable discounts.”2
The authors used a sample of private placement announcements from January 1, 1980 through May 31, 1987 . The information was derived from a variety of public sources. The study identified 106 transactions (of which 18 were for unregistered shares) with some two-thirds of the observations occurring in the second half of the study. Mean and median discounts were 20.14% and 13.25%, respectively. The authors also found an additional discount of 13.5% for placements of restricted shares.3 The range of discounts for the 106 observations is not explicitly stated. However, the data seems to suggest lower discounts (less than 10%) for the larger companies in the study (market value greater than $75 million) to the higher levels (approximately 35%) for companies with less than $25 million in market value.
In summary, the total discounts observed seem consistent with a number of other private placement/restricted stock studies. Hertzel and Smith attempt to analyze private placement discounts to determine what factors may influence the size of the discount, rather than simply saying it was a marketability discount due to illiquidity.
Hertzel and Smith concluded that the private placement discounts were influenced by:
The size of the private placement discount tended to increase as the:
The authors further concluded that a private placement was evidence that management believed that the subject company was undervalued in the marketplace. In essence, the private placement was cheaper in that management believed that the existing shareholders would retain a higher proportion of ownership with a private placement than with a new public issue of stock.
Hertzel and Smith concluded the additional discount of 13.5% for private placement of restricted shares was consistent with the belief that restricting resale of the shares was costly for the selling firm (and presumably more risky for the purchasing shareholder). Nevertheless, the authors expressed some skepticism that the restrictions on resale would result in a discount so high. They note that restrictions on resale would not be important to many investors in private placements, as they are long term investors. The following comment is found in a footnote of the paper: “…given the substantial resources of institutions that do not value liquidity such as life insurance companies and pension funds, it is not obvious that investors would require substantial liquidity discounts just for committing not to resell quickly.”5
The authors do not explain why they believe that insurance companies or pension funds do not value liquidity. However, that is not important to the essential point. The fact that the reason for the discount is not obvious does not render the existence of the illiquidity discount untrue. The reality seems to be that their study isolates a substantial discount for the inability to dispose of a stock quickly (illiquidity). Secondly, the investment attitudes of long-term investors do not serve to reduce the aggregate discounts in their sample. The total discount exists whether they value liquidity in its purest sense or not.
The authors believe that informational effects are critical in understanding the magnitude of the discounts. In essence, a private placement resolves the informational asymmetry in the marketplace. As the difficulty in measuring and assessing value rises, the discount was also observed to rise thus compensating the investor for the costs associated with assessing the firm value. Given that small firms were more likely to be the most difficult to assess, it is not surprising that the higher discounts were associated with this group. To the extent that the investment appeared to be in an “opportunity” as compared to a more developed business, the discount would be higher, once there is a linkage to smaller size as a proxy for higher risk.
Another example of higher risk requiring a discount was the observed increase in the discount of 9% when the firm was evidencing financial distress. Once again, higher risk translated into a higher discount. Does this mean that higher financial risk means that an additional 9% is automatically added to the computation of the discount? Of course not. It only proves that the discount is likely higher (with this one factor isolated from the others) and that a higher return for risk must be explicitly considered. The impact of risk on the final conclusion of the discount must be taken in context with all of the other factors.
The authors also consider a broader definition of the “costs” of a public offering as compared to a private placement as a further means of understanding the discount. They suggest that a private placement “avoids the negative public issues announcement effect, the underwriter spread, residual underpricing, and other costs not reflected in the spread.”6 The authors immediately caution the reader that “simple cost comparisons can be misleading.”7 For example, Hertzel and Smith suggest that the shares of companies which used a public offering to raise funds exhibited adverse share price movements, effectively raising the cost of the offering. Nevertheless, the differentials in cost do not appear to fully explain the discount according to the authors. This concept of cost can be very meaningful given the propensity of some appraisers and the courts to consider only the direct underwriting as a cost of raising funds in the public market.
The study also examines the impact of the ownership changes on the observed discount. Seventy of the 106 transactions reported sufficient data to be analyzed. Lower discounts were often observed when there was a change of control or an infusion of cash by investors who previously owned a significant portion of the outstanding stock. Changes of control were described as events, which could influence corporate governance. Single buyers were more likely to cause a visible change in influence than passive investors were. The authors ultimately concluded; however, that change of ownership concentration was not a variable with a high potential for explaining discounts in their sample.
What can business appraisers draw from this paper?
The work of Hertzel and Smith and other academics studies noted in the paper should likely prompt us, as business appraisers, to look more carefully at our vocabulary. The existence of discounts in private placements is undeniable, yet only a portion is likely due to pure illiquidity. The key factors of (1) risk, (2) expected growth in value, and (3) the holding period are all clearly present. It is incumbent on any business appraiser to identify these key factors and measure them as best as possible given the situation.
It is also important to recognize that the existence of uncertainty in the analysis does not render it invalid. Investors in privately placed securities accept key elements of uncertainty as an inherent part of the transaction. The business appraiser simulates these factors in a careful and detailed analysis of the entity being valued in order to determine the discount to the marketable minority value. The current appraisal vernacular may call it a marketability discount, but it really encompasses all of the elements which reduce value from the freely traded minority interest.
Endnotes
1 Hertzel, Michael and Smith, Richard L., “Market Discounts and Shareholder Gains for Placing Private Equity,” The Journal of Finance, Volume 48, Issue 2 (June 1993), pp. 459-485.
2 Ibid, p. 459.
3 Ibid, p. 480.
4 Ibid, p. 465.
5 Ibid, p. 480.
6 Ibid, p. 469.
7 Ibid, p. 469.
Reprinted from Mercer Capital’s E-Law Newsletter 2003-02, June 5, 2003.
A new form of business organization, the limited liability company (LLC), could present new planning opportunities for business owners. Basically, the LLC has the pass-through tax attributes of a partnership, but can provide the shareholder-liability protection of a corporation. The LLC is neither fish nor fowl. It is a kind of corporation-partnership hybrid that is a creature of the state law under which the company is organized. Most states now have LLC statutes. There are some state-by-state quirks, but there are also some common threads that characterize the LLC.
Following is a sampling of new terms in the LLC lexicon:
One of the principal advantages of organizing as an LLC is the federal tax benefit of partnership treatment; i.e., having just one level of tax on profits and passing through tax losses and credits to help shelter earnings from other sources. In order to qualify for partnership tax status, LLCs cannot have more than two of the following corporate characteristics:
Limited Liability. By definition, an LLC automatically has this corporate characteristic. Practically speaking, an LLC can therefore possess just one of the other three characteristics.
Under U.S. Treasury Regulations, centralization of management means that a person, entity or narrow group (either from within or without the overall membership) has continuing, exclusive and unilateral authority to make management decisions. A member-managed LLC generally will not have this characteristic, and a manager-managed LLC generally will. When member-managers behave more like general partners of a partnership than like shareholders of a corporation, management tends to become less centralized. This is a flexible and prickly issue. Sometimes it can be difficult to distinguish between centralized and non-centralized management, so facts and circumstances tests might come into play.
To transfer a membership interest means to completely confer upon the transferee all attributes of ownership, including rights to vote, act on behalf of the LLC, share in the profits, etc. Restricted transferability of LLC membership is a corollary to a general feature of partnership interests. Somewhat like partners, LLC members cannot transfer their ownership and compel their co-owners to be in business with someone they consider to be undesirable. LLC statutes usually ensure that member interests are not freely transferable by requiring that at least a majority of the non-transferring members consent to the transfer. States vary by the degree to which consent of co-owners must be obtained. Some require unanimous consent and some require majority consent. It is important to note that the concept of free transferability contemplates all of the rights and privileges of ownership, so an assignment to a transferee of an economic interest in the profits and distributions of an LLC is not necessarily the same as a transfer of the membership interest itself. Freedom to transfer economic interests does not constitute free transferability of interests.
Under federal tax regulations, a business organization lacks continuity of life if it is required to dissolve upon the death, insanity, bankruptcy, retirement, resignation, expulsion or other event of withdrawal of an equity owner. This kind of language is generally written into LLC statutes as an organizational requirement. However, mechanisms can be put in place to grant non-withdrawing members an option to continue the business of the LLC upon an event of dissolution. If properly written, the business continuation option will not impart continuity of life to the LLC.
Some business owners will view these features of an LLC as advantages:
There could also be some disadvantages:
There might be more questions than answers in the LLC valuation arena because facts and circumstances can be so varied. An LLC membership interest can have blended features of a stock, a general partnership interest and a limited partnership interest. Valuation of a specific interest can be tricky when the features are specially tailored to the needs of the company and its owners. In addition, certain partnership tax rules can affect LLCs, either adding or detracting from value, depending on the circumstances and specific agreements among the members. Some of the issues affecting LLC valuation include:
We are expecting to see increased interest in LLCs and a rise in LLC formations. They should be useful tools for managing family business wealth, transferring ownership from one generation to the next, streamlining ownership of cumbersome portfolios and pursuing new business growth opportunities. At the same time, they will limit liability for their owners and provide flexibility in structuring ownership features.
Competent legal and tax counsel should be obtained to establish an LLC. Please call if you have any questions or if we can help you in any way.
Reprinted from Mercer Capital’s Bizval.com – Vol. 6, No. 4, 1994.
Usually when there is talk of a limited partnership structure in an estate plan, the individual or family is seeking to simplify an otherwise cumbersome process of gifting hard-to-value or hard-to-divide assets such as real estate, marketable securities, closely held businesses, or perhaps, even assets of a more peculiar nature. Of course, another benefit of this “simplification” can be a reduced estate and/or gift tax.
The typical valuation begins with a top-down analysis of the inventory of assets and liabilities inside the partnership. Underlying asset values are individually appraised by qualified experts or asset values are observed in the markets in which they trade. This part of the analysis establishes the aggregate net asset value of the limited partnership. Moving from this point to the conclusion requires a careful processing of what can be a large amount of additional information:
Answers to these and similar questions help us to interpret the economics of the limited partnership interest and can help lead to a reasonable quantification of what are commonly referred to as minority and marketability “discounts”. The most important part of the limited partnership valuation analysis is quantifying appropriate discount adjustments. Discounts deserve careful support, which can be obtained from a variety of sources:
Valuing a limited partnership interest can be complicated and time consuming. Whatever the level of complexity, careful documentation of the valuation process will benefit users of limited partnerships. There is a sound and reasonable framework for valuation, but there is no standard formula. Please call for more information or to discuss a valuation issue in confidence.
Reprinted from Mercer Capital’s Value AddedTM – Vol. 7, No. 4, 1995.
Since family limited partnerships (or FLPs) became popular in 1994, we have valued hundreds such asset holding entities. Family limited partnerships are useful because one generation, owning a general partnership interest, can control the cash flow from gifted assets. FLPs can simplify estate planning, allowing for gifting of fractional interests, and helping consolidate family assets. Another advantage of FLPs is that they are often designed to protect family assets from failed marriages, “unworthy” heirs, creditors, and other family disputes.
The valuation of FLPs generally begins with an estimate of net asset value. Appraisers then consider the application of appropriate minority interest and marketability discounts based on the facts and circumstances of each case. The cumulative amount of discounting in FLP appraisals is important because, given a net asset value, it determines the fair market value at which interests are gifted, and thus the taxes which must be paid on the value of the gift.
Because the use of FLPs is relatively new to many attorneys and clients, we are often asked to answer questions about how we value them. Many attorneys have asked the following (or a similarly worded) question. Since we are dealing with limited partnership interests, and since what can be transferred in most instances is only an assignee interest, shouldn’t there be a further discount applicable to the assignee interest? Good question.
To answer it, we need some further background. It is helpful to think of ownership in a limited partnership as consisting of two components: 1) the economic interest, and 2) the rights attached to the interest. We believe it is important not to confuse the two.
The economic interest is the pro rata ownership of or claim to distributions and assets. In almost all cases, an ownership interest of, say, 1%, has a pro rata 1% claim on all distributions (whether interim or at dissolution), as well as indirect ownership of 1% of the assets underlying the Partnership. Thus, in almost all cases, if a distribution of, say, $100 thousand is declared, then a 1% general partnership interest receives $1,000, as does a 1% limited partnership interest, as does a 1% assignee/transferee interest.
The rights attached are the second component of value, and the differences in rights attached can be significant. General partners might collectively own only 1% to 10% of total interests in a given partnership, but typically have exclusive authority to manage the partnership, including its investment policy, distribution policy, and other aspects of management. Limited partners and assignees/transferees typically have no real aspects of control over the partnership, despite the fact that they might own a majority in interest of the outstanding partnership units. This relationship is achieved by the covenant that is the partnership agreement, and is akin to the difference between voting and non-voting stock in a corporation, with some differences. Assignee interests are in essence limited partnership interests with economic participation equal to that of limited partnership interests but typically without the same rights.
The difference in rights attached to limited partnership interests versus that of assignee or transferee interests can be significant. In most FLPs, limited partners typically have the right to call meetings of the partners, to vote on certain matters such as dissolution and successor general partners, to inspect the books of the partnership, to transfer their interests to other partners or to third parties (sometimes subject to restrictions), and other similar rights. Assignee or transferee interests, on the other hand, typically do not garner the right to vote, inspect the books of the partnership, or transfer their interests.
The problem in attaching specific value to the rights relating to a limited partnership interest versus that of an assignee/transferee interest (or, conversely, discounting an assignee interest from the value of a limited partnership interest), is that the rights attached to a limited partnership interest are typically not transferable. If a limited partner wants to assign, gift, or sell his or her interest to another person, the interest that is received by the acquirer is generally an assignee interest, not a limited partnership interest. The rights of a limited partner are not usually transferable, only the economic benefit. Typically, only after the acquirer has received or has purchased the economic interest in the partnership do the partners vote to admit or refuse the assignee as a limited partner.
There is good reason for this. Partnerships are contracts between persons designed for their mutual benefit. One protection that limited partners receive is that they cannot easily be forced to accept someone with whom they did not originally covenant as their partner. Thus, the assignee interest is a sort of in-between phase in which the acquirer of an economic interest in the partnership petitions to become a partner. In some cases, only the general partner must approve. In other cases, the process of becoming a full limited partner is more onerous.
Nonetheless, if the only value transferable is the economic benefit (and not the limited partner rights attached to it), then is not every (or nearly every) valuation of a limited partnership interest actually the valuation of an assignee interest? Again, it is important to remember that the heir, acquirer, or purchaser of a limited partnership interest actually receives an assignee interest, not a limited partnership interest. The Quantitative Marketability Discount Model used by Mercer Capital is designed to value the economic aspects attributes of a limited partnership interest, i.e., the assignee interest. Our reasoning is consistent with a recent ruling of the United States Court of appeals (Fifth Circuit) [See McLendon v. Commissioner, KTC 1995-624 (5th Cir. 1995), case no. 94-40584.], in which the Court agreed that limited partner interests should be valued as assignee interests.
In a United States Tax Court case, the Court saw no economic distinction between valuing a disputed gift as a limited partnership interest versus that of an assignee interest (but ultimately valued it as an LP interest) [See Kerr v. Commissioner, United States Tax Court 113 T.C. No. 30, docket no. 14449-98.]. Unfortunately, a third ruling, also by the United States Tax Court, clouds the issue by agreeing that certain limited partnership interests should be valued as assignees for transfer tax purposes (so far so good). In this case, however, the Court then valued certain general partnership interests as general partner interests rather than as assignee interests because they were received by an existing general partner, contrary to the valuation standard of “hypothetical” buyers and sellers [See Nowell v. Commissioner, United States Tax Court T.C. Memo 1999-15., docket no. 19056-96.].
At this time, we have determined no compelling reasons to value gifts of assignee interests at a lower level than limited partnership interests. If, under appropriate circumstances, we were to assign value to limited partner rights above and beyond that of their economic interest, the impact of this adjustment would likely not be large. Market evidence of the differential between voting and nonvoting common stock interests suggests a minor impact if translated to the relationship between assignee interests (nonvoting) and limited partnership interests (voting), perhaps on the order of five percent, plus or minus a bit. However, in the context of a fair market value appraisal, a rational acquirer of an assignee interest would likely attribute little (if any) value to “the vote” since there is a positive probability that they might never be obtained.
If you have questions about the valuation of family limited partnerships or other similar concerns, please contact us. We would be glad to help.
Reprinted from Mercer Capital’s Value AddedTM – Vol. 12, No. 1, 2000.
Asset-holding entities are typically partnerships or limited liability companies with assets that include some combination of real estate, marketable securities, and/or closely held securities. As part of the appraisal due diligence process, information is obtained from general partners and/or managing members as well as from a variety of other sources (generally attorneys, real estate appraisers, accountants, securities brokers, and industry contacts). Such information provides a basis for the appraiser to understand the composition, operations, strategy, and governance of the entity. This article focuses on the importance of analyzing, from a valuation perspective, the reasonableness of this information.
When information fails to reconcile with industry or circumstantial norms, or appears unreasonable or lacking in common sense, appraisers may need to make “normalizing” adjustments. These adjustments attempt to modify reported facts and circumstances to conform to the standard of fair market value. Under the standard of fair market value, the financial characteristics of the valuation subject must make sense and be reasonably representative of the considerations of hypothetical investors.
A hypothetical asset-holding entity can illustrate the concepts. At issue in the example are the reasonableness of the general partner’s compensation and the reasonableness of rental income paid to a limited partnership.
The hypothetical asset-holding entity is a limited partnership with assets consisting primarily of a fractional interest in a commercial building. The property houses a chain retailer in potentially serious financial difficulty as of the valuation date. The property was appraised and the appraisal took into account the partnership’s fractional interest by applying a 25% fractional interest discount.
Approximately 60% of the partnership’s current total income (mostly rent) is being paid as compensation to the general partner. In addition to overseeing the management of the partnership, the general partner essentially acted as a property manager. According to our research, industry rates for property management fees generally range from approximately 6% to 11% of collected rents, which is much lower than the 60% the hypothetical general partner is receiving in this scenario. Is this level of compensation reasonable? The answer requires further clarification regarding the amount of the partnership’s rental income.
An analysis of the partnership’s reported asset values and revenue implies a 20% capitalization rate on annual rental income. Typically, capitalization rates on properties of this nature range from 11% to 15%. Either the rental income is unusually high or the appraisal is potentially flawed by understating the value of the property.
Ultimately, the income and expense profile related to this property affects our analysis of a limited partner’s expected liquidity resulting from distributions. This, in turn, affects the magnitude of the marketability discount. As appraisers, we have to reconcile the facts from the perspective of a reasonable investor’s long-term expectation. The questions we must address are: (1) what is a reasonable and sustainable level of future rental income? and (2) what is a reasonable level of compensation for the general partner?
After conversations with several real estate appraisers, a capitalization rate of 11% was applied to the appraised market value of the subject property (pro rata, exclusive of the fractional interest discount). This provides us with a reasonable and sustainable level of rental income on the property. Correspondingly, we believe that a rational investor would anticipate a lower level of general partner compensation. Such compensation should likely be based on traditional property management rates.
Using the normalized rental income described above, we believe that the general partner should be compensated at approximately 10% of collected rents. Such compensation also reflects the general partner’s administration of the entity’s overall business.
In Table 1, note that the adjustments applied in this case result in a difference of nearly 11% of asset value. The resulting cash flow would make a potentially significant difference in the growth of the partnership’s assets or to the funds available for distribution. Both of these aspects are crucial to the development of an appropriate marketability discount for the valuation of a limited partner interest.
A limited partner has virtually no control over such things as the management, distribution of cash flows, and investment strategy of the partnership. However, fair market value is defined as the price at which a hypothetical willing buyer and a hypothetical willing seller, both of whom are fully informed, neither of whom is under any compulsion, and both of whom have the capacity to engage in a transaction. Any hypothetical investor would anticipate a “normalized” level of income and a corresponding level of general partner compensation based on some industry norm.
Normalizing adjustments reveal the true investment characteristics that are the source of “potential value” to buyers of minority interests. When minority interests are purchased, investment judgments are made based upon how and when this potential value might ultimately be realized. Based on the timing and the amount of expected returns on illiquid minority interests, appraisers develop marketability discounts that are sufficient enough to consummate the hypothetical transaction.
It can be argued that because limited partners (or other similar minority investors) lack control to change things like general partner compensation or to negotiate property leases, normalizing adjustments should not be made. However, keep in mind that minority shareholders of public companies lack this discretionary ability as well. If unusual activity is occurring on the income statement, minority shareholders of the public company will find alternative investments and the price of the public company’s stock will eventually reflect this.
Information should not be taken at face value. It must be examined and reconciled to a standard of reasonableness, common sense, and informed judgment. Our hypothetical partnership illustrates the importance of understanding the numbers and the necessity of normalizing adjustments.
Reprinted from Mercer Capital’s Value AddedTM – Vol. 12, No. 3, 2000.
As of December 3, 2008, the major stock indexes were down on the order of 40% for the year. In addition, the long-suspected recession has been officially declared. While the depth and length of the current recession is laden with uncertainty, what is certain is that virtually no investment sector has remained unscathed. For those dealing with an estate tax issue from within the last year, consideration of the alternate valuation date is almost certain to provide vital information for the estate tax filing process.
As part of the Economic Growth and Tax Relief Reconciliation Act of 2001, Section 2032 of the IRS Tax Code was designed to provide some measure of relief to those taxpayers negatively affected by fluctuating markets. The alternate valuation date provides taxpayers the option to choose to use a date six months subsequent to the date of death to value an estate. In order to choose this option, the following conditions and processes must apply:
Although the alternate valuation date appears to generally be an attractive option in the current economic climate, one must consider the singular drawback that, if the alternate date provides a lower value, then it also results in a lower step up in basis for those inheriting the estate’s interests. Therefore, any gains on assets sold at a later date will be larger than would be the case with a higher step up in basis at the date of death.
It should also be noted that not all states conform to the federal alternate valuation date, but rather require the use of date of death, which could cause the taxpayer to have a different basis for state and federal tax purposes.
Despite the lower step up in basis consideration, the alternate valuation date warrants serious consideration at any time, but particularly in the current economic environment for estates with a date of death within the last year. With no end in sight for the declining markets, tax savings may well be very significant.
In 2008, we described the “perfect storm” of conditions existing at the time that increased the likelihood of success for a grantor retained annuity trust (“GRAT”). Although much has changed since 2008, most of the circumstances promoting the consideration of a GRAT still prevail. The “perfect storm” will likely be stilled if the Senate passes a pending bill. The legislation, called the Small Business and Infrastructure Jobs Tax Act of 2010 (HR 4849), was passed by the House of Representatives on March 24, 2010.
Lawmakers designed the bill to provide incentives for small business and infrastructure job creation, but such incentives require “Revenue Provisions” necessary to offset spending and tax cuts. Section 307 of the bill acts as one of those revenue generators by expanding the rules on GRATs, which in turn increases the transfer tax income to the federal government. The Congress Joint Committee on Taxation estimates that $4.45 billion in revenue will be generated over ten years by this provision.
Under certain conditions, a GRAT can result in the transfer of wealth to family members without gift tax. First, a quick overview of how GRATs work. The grantor transfers assets into an irrevocable trust, which is established for a set term, and an annuity is paid back to the grantor during each year of that term. For gift tax assessment, the IRS assumes an expected level of asset appreciation, called the Section 7520 rate. The amount of the taxable gift is the fair market value of the property when it is transferred to the trust less the present value of the grantor’s annuity interest, using the Section 7520 rate as the discount rate. This difference is often referred to as the remainder interest.
Figure One shows a five-year GRAT with the annuity set up such that the remainder interest equals zero, assuming $10 million of assets are placed into the trust with a Section 7520 rate of 3.4%.
In order for the strategy to be successful, a portion of the assets transferred must remain in the trust after the satisfaction of the annuity. For this to occur, the return on the assets must exceed the section 7520 rate and the grantor must survive the term of the trust. If the return on assets does not exceed the 7520 rate, the assets will return to the grantor. If the grantor dies prior to expiration of the term, all assets remaining in the GRAT become a part of his or her estate. Therefore, current law limits downside risk of GRATs to wasted legal and administrative fees.
Figure Two displays the potential cumulative transfer of assets through the five year GRAT from Figure One, assuming the $10 million of assets grow at an annual rate of 10.0% after the formation of the GRAT.
At year five, approximately $3 million dollars of appreciated assets remain in the trust. If the grantor survives the five year term, that portion of wealth passes to the beneficiary free of transfer tax. In this example, 18.1% of the assets placed into the GRAT are transferred to the beneficiary free of tax.
The portion of assets shifted to the beneficiary depends on the spread between the actual return on the asset contributed to the trust and the 7520 rate. If these rates are equal, no assets are transferred through the GRAT to the beneficiary. If we assume that the assets will grow at 15.0% in the previous example, 28.8% of wealth is transferred through the trust. In short, this strategy can benefit those planning to gift appreciating assets.
As mentioned earlier, the current law may have a short life. Section 307 of the pending legislation imposes two major additional requirements on GRATs: (1) the term must be no less than ten years and (2) the remainder interest must have a value greater than zero at the time of the transfer. Thus, as the new bill is currently written, the “mortality risk” of the grantor increases and the taxable gift must be greater than zero. The Senate Committee on Finance may suggest a minimum remainder interest such that a minimum taxable gift amount must be transferred, increasing the downside risk of the strategy. If such an amendment is added and the assets in a GRAT fail to appreciate at a rate greater than the 7520 rate, then the grantor will have paid unnecessary taxes in addition to administrative fees. If the bill remains unchanged from its current form, the positive taxable gift requirement is open to interpretation: could the gift value be $0.01?
In 2008, we discussed three conditions that provided a “perfect storm” for GRATs: (1) a low section 7520 rate, (2) depressed asset values in most markets, and (3) the uncertainty of GRAT restricting legislation.
If the GRAT strategy meets a potential grantor’s objectives, now may be the time to take swift action.
GRATs are frequently formed using shares or interests in closely-held corporations, or family limited partnerships, and it is necessary to obtain an appraisal of these shares or interests to set the initial fair market value transferred to the GRAT. If the pending legislation is seen as the beginning of an era of increased scrutiny, grantors and beneficiaries will benefit from hiring experienced valuation firms they can trust to appraise the assets placed into their GRATs. As one of the country’s premier business valuation firms, Mercer Capital has vast experience valuing corporations and partnerships. In addition, we can also value GRATs and provide other GRAT valuation consulting. Feel free to give us a call today at 901.685.2120 if we can help you or your client.
Reprinted from Mercer Capital’s Value Added(TM), Vol. 22, No. 1, May 2010
A confluence of three factors make 2020 an ideal time for estate planning transactions for owners of private companies
As a result of these factors, many business owners are currently contemplating whether to engage in significant ownership transfers. For many high net worth individuals and family offices, complex ownership structures have evolved over time, typically involving multi-tiered entity organizations and businesses with complicated ownership structures and governance.
Mercer Capital has been performing complicated tax engagements for decades. In this article, we describe the processes that lead to credible and timely valuation reports. These processes contribute to smoother engagements and better outcomes for clients.
Defining the valuation project is an important step in every engagement process, but when multiple or tiered entities are involved it becomes critical. It is insufficient to define a complicated engagement by referring only to the top tier entity in a multi-tiered organizational structure. The engagement scope should clearly identify all the direct and indirect ownership interests that will need to be valued. This allows the appraiser to plan the underlying due diligence and analytical framework and to design the deliverable work product.
For example, will the appraiser need to perform a separate appraisal at each level of a tiered structure? Or, can certain entities or underlying assets be valued using a consolidated analytical framework? Planning well on the front end of an engagement leads to more straightforward analyses that are easier to defend.
During the initial discussion of the engagement the appraiser will usually request certain descriptive and financial information (such as governing documents, recent audits, compilations and/or tax returns) to determine the scope of analysis needed to render a credible appraisal for the master, top-tier entity and the underlying entities and assets.
Upon being retained, one of the first things an appraiser will do is to prepare a more comprehensive information request list designed to solicit all the documentation necessary to render a valuation opinion. Full and complete disclosure of all requested information, as well as other information believed pertinent to the appraisal, will aid the appraiser in preventing double-counting or otherwise missing assets all together.
Requested information for complex multi-tiered entity valuations typically falls into three broad categories:
The ultimate efficiency of the project often hinges on timely receipt of all requested information. Disorganized information or data that requires a lot of handling or interpretation on the part of the appraiser adds to project cost, and more importantly, can make it harder to defend valuation conclusions that are later subject to scrutiny.
In short, providing high quality information in response to the appraiser’s request promotes a more predicable outcome with the IRS and with other stakeholders.
Upon completing research, due diligence interviews with appropriate parties, and valuation analysis, the appraiser should provide a draft appraisal report for review. The steps discussed thus far – careful planning and timely information collection – are not substitutes for careful review of the draft appraisal report. The complexity of many multi-tiered structures increases the need for relevant parties to review the draft appraisal for completeness and factual accuracy. Reviewers should read the draft report with numerous questions in mind:
Engagements involving complicated entity and operational structures are not easily shoehorned into typical appraisal reporting formats and presentation. Unique entity and asset attributes may require creative valuation techniques and heighten the need for clear and concise reporting of appraisal results. Regardless of the complexity of the underlying structure and valuation techniques, the appraisal report should still be easy to read and understand.
Mercer Capital has been providing reliable appraisals for gift and estate planning efforts for nearly four decades. Over that time, we have completed many large valuation engagements for complex, multi-tiered entities.
We pride ourselves in differentiating our services and approach through careful pre-engagement planning, which allows us to meet client deadlines and avoid costly do-overs. We are committed to doing our part to improve the planning and decision-making processes of our clients and their advisors. To discuss in confidence any engagement requiring Mercer Capital’s customized valuation solutions, please contact any of our senior valuation professionals.
On April 5, 2012, the Jumpstart Our Business Startups Act (“JOBS Act”) was signed into law in an attempt to reduce regulatory burdens on small businesses. The Act relaxes limits regarding the number of shareholders a company may have before it must register its securities with the Securities & Exchange Commission. For privately-held companies approaching the shareholder limit, the additional reporting requirements related to SEC registration can be particularly burdensome, without the benefits of access to capital markets and stock liquidity that being publicly traded offer. As a result, privately-held companies were compelled to undertake transactions such as reverse stock splits or share reclassifications to avoid triggering registration.
Since the JOBS Act became law, deregistration activity has been rising. According to a May 29, 2012 article on SNL Financial, approximately 60 banks had made the necessary filings to deregister their securities with additional filings expected. Most of these banks were relatively small, generally having total assets below $1 billion.
The JOBS Act increases the threshold for the number of shareholders that would require SEC registration from 500 to 2,000. Additionally, companies may terminate their existing registration by reducing the number of shareholders to fewer than 1,200 shareholders, relative to the former requirement of 300 shareholders. These rules offer opportunities for small, privately-held businesses, particularly for community banks which often have a relatively large base of local shareholders and demand for their stock within the local community.
The opportunity can present itself to community banks through two general scenarios:
For members of bank management contemplating taking action, several financial considerations unique to each scenario are discussed below. A number of legal considerations would arise as well, which are beyond the scope of this discussion.
While the opportunity to eliminate the drawbacks associated with SEC registration is compelling, bank management should carefully consider all options and the associated consequences. Oftentimes, this will require a firm understanding of the bank’s financial strength, growth prospects, and stock price, under both the contemplated transaction and the status quo. Mercer Capital has wide ranging experience in assisting management with stock valuation for capital raises and redemptions, as well as performing pro forma analyses under varying scenarios. If you think we can be of assistance regarding these matters, we would welcome your inquiry.
Reprinted from Mercer Capital’s Bank Watch, June 2012
Despite an anticipated surge of transactions within the banking industry, bank merger and acquisition activity declined in 2011 compared to the prior year, hindered by a weak economic recovery, mounting regulatory pressures, and, according to some analysts, excessive seller expectations. Deal volume excluding government assisted transactions decreased 15.8% in 2011 from 2010 levels and approximated 2008 levels. It appears deal volumes bottomed out in 2009 at a total of 104 for the year. Unfortunately, the number of transactions not reporting a deal value has increased in recent periods (from 39 in 2009 to 51 in 2011), making a comparison of trends in deal values difficult. The number of deals presented is exclusive of FDIC-assisted transactions, which decreased to 92 in 2011 from 157 during 2010.
Deal value (for those transactions which reported it) totaled $6.8 billion in 2011 versus $11.7 billion in the prior year. Total deal value included PNC’s $3.5 billion acquisition of RBC Bank, which was announced in the second quarter of 2011, completed in the first quarter of 2012, and represented 51% of total reported deal value in 2011. Comerica’s $1.0 billion acquisition of Sterling Bancshares (announced in the first quarter and completed in the third quarter) accounted for 15% of total deal value during the year.
Notably, total deal value for transactions in 2010 included several sizeable acquisitions, such as BMO’s purchase of Marshall & Ilsley Corporation ($5.8 billion), Hancock Holding Company’s purchase of Whitney Holding Corporation ($1.8 billion), and First Niagara Financial Group’s purchase of NewAlliance Bancshares, Inc. ($1.5 billion). The following table provides additional perspective with regard to transaction activity in the banking industry since 2006.
As in 2010, the majority of acquisitions involved sellers with assets less than $500 million. As shown below, for deals for which pricing multiples and deal value were available (a total of 72 transactions), 56 transactions, or more than 75%, involved targets with assets less than $500 million.
Twenty-one of the 72 transactions for which pricing information was available were all-cash transactions, 35 deals involved some mixture of cash and other consideration (generally common stock), and 10 transactions involved common stock as currency. The remaining deals were unclassified or not reported.
Regional economic viability again affected transaction volume during the year. Deal volume was highest in the Midwest and West regions1, which reported 24 and 19, respectively, of the 72 total transactions with pricing multiples. The Atlantic Coast and Northeast regions followed with 11 deals each in 2011. Seven transactions occurred in the Southeast region. For comparison, FDIC-assisted transactions, which totaled 92 in 2011 compared to 157 in 2010, continued to be concentrated in states with severely depressed real estate markets, such as Florida and Georgia (both in the Southeast region), which had 13 and 23 bank failures, respectively, during 2011. Illinois and Colorado followed with nine and five failures, respectively, and all remaining states reported less than five failures each during the year.
Through March of 2012, a total of 16 bank failures were reported with eight attributable to the Southeast region. Florida and Tennessee each reported two failures, while Georgia reported four, and Illinois reported three failures. For comparison, through March of 2012, transaction volume was higher with 56 total deals reported (compared to 47 in the first quarter of 2011). Total reported deal value through the first quarter of 2012 was also higher at $3.0 billion (compared to $1.5 billion in the first quarter of 2011) and included Mitsubishi UFJ Financial Group’s $1.5 billion acquisition of Pacific Capital Bancorp as well as Prosperity Bancshares’ $529 million acquisition of American State Financial Corp. Deal volume in the first quarter of 2012 was weakest in the Northeast, where four transactions occurred, while deal volume was higher in the Midwest and Southeast, which reported 25 and 13 transactions, respectively.
Some analysts have attributed the heightened transaction activity in the first quarter of 2012 to the improved economy and an increased confidence among buyers, and, in particular, confidence with regard to loan portfolio assessment. Transaction activity going forward is expected to remain concentrated among smaller institutions in light of revenue and regulatory challenges. However, uncertainty concerning regulatory changes and the resulting burdens placed on institutions (smaller ones in particular), coupled with market volatility and the heated political climate, still looms, threatening any impending, potential surge of transaction activity.
Furthermore, capital raising remains difficult, and lackluster market activity caused many institutions to look to private equity firms as a source of capital in 2011. Preferred stock issuances were successful for several firms during the year, and some analysts expect more buyers to utilize such issuances to finance acquisitions when consolidation activity resumes.
Endnote
1 The regions include the following states:
Originally published in Mercer Capital’s Bank Watch, May 2012.
Mercer Capital works extensively with both the management of an acquirer and their loan review personnel (both internal and external) to obtain an in-depth understanding of loans being acquired. We provide a detailed valuation model along with extensive documentation to support our analysis of the fair value of the subject loans, reflective of the credit risk embedded therein.
Our clients find these analyses helpful both when assessing a target initially and when accounting for the acquired loans at the transaction closing date. Here are three ways that a loan portfolio analysis is helpful to your bank when considering an acquisition.
In addition to loan portfolio valuation services, we provide acquirers with valuations of other financial assets and liabilities acquired in a bank transaction, including depositor intangible assets, time deposits, and trust preferred securities. We are always happy to discuss your valuation issues in confidence as you plan for a potential acquisition. Give us a call today.
Bank stocks ended a particularly volatile month in August 2011 on something of a good note, which masked the intra-month volatility. Looking forward, does this greater stock price volatility represent a “new normal,” as banks face an environment marked by greater macroeconomic risk?
Three bank stock indices we track performed as follows in August, relative to the S&P 500:
While the deterioration in market values evident in the table above is substantial, the declines are even more significant when measured at points earlier in the month. Table 2 indicates the compression in market values between July 29, 2011 and the lowest point observed for each index in August1:
For example, the aggregate SNL Bank Index declined by 22% between July 29, 2011 and its August 22nd low, although subsequent gains cut this loss to 10% by month-end. Chart 1 provides daily observations for the four indices during August 2011.
The volatile performance appeared to be driven by various factors:
While these general factors affected most stocks in August, we attempted to isolate which factors most affected the performance of publicly traded banks in August. The following table shows the performance of banks in August stratified by asset size.
At August 31, 2011, no banks with assets exceeding $5 billion reported a higher stock price than at July 29, 2011, and larger banks generally reported weaker performance than smaller banks. This reflects several factors:
We also examined the relationship between August 2011 stock market performance and return on tangible common equity. As indicated in the following table, banks with stronger profitability generally performed better, as measured by the median change in their respective stock prices, providing some evidence that investors were more apt to avoid banks with lower profitability, since such banks may have less wherewithal to manage more distressed economic conditions.
Given the depths to which some bank stocks fell in August, we thought it interesting to compare the price/tangible book value multiples, measured based on each bank’s lowest stock price during the month, to the price/tangible book value multiples observed as of December 31, 2008, which represents a proxy for the timing of most distressed period of the financial crisis. This analysis indicates the following:
For perspective, the chart below plots the changes in the price/tangible book value multiples reported by the publicly traded banks between December 31, 2008 and their respective August 2011 lows.
Endnotes
1 These low points occurred on August 8th for the S&P 500; August 19th for the SNL Bank Index comprised of banks with between $1 and $5 billion of assets; August 22nd for the aggregate SNL Bank Index; and August 25th for the SNL Bank Index comprised of banks with between $500 million and $1 billion of assets.
Originally published in Mercer Capital’s Bank Watch 2011-09, released September 15, 2011
Earlier this year, we presented a review of community banks’ 2010 financial performance, which reflected a mixed bag – some metrics improved, while others deteriorated. With the mid-year filing cycle complete for banks’ Call Reports, we updated this analysis to assess whether the trends noted in 2010 have persisted. In general, we conclude that trends continue to improve, although the pace of improvement appears to be slowing for some metrics.
The analysis relies on a data set comprised of approximately 3,800 commercial banks with assets between $100 million and $5 billion. Additionally, we excluded banks owned by non-U.S. domiciled bank holding companies, subsidiaries of holding companies with more than $5 billion of assets, and banks with unusual levels of non-interest income or consumer lending. As a result, the data set does not have the bias evident in some analyses of aggregate banking industry data, which are weighted in favor of the largest domestic banks.
Reflecting community banks’ steady profitability improvement, 597 banks reported a loss in the first half of 2011, down from 739 in the first half of 2010 and 857 in fiscal 2010. However, the gradual nature of the improvement in performance is evident in the industry’s return on assets – the median bank’s return on assets improved from 0.62% in the first half of 2010 only to 0.68% in the first half of 2011, which remains well below the pre-crisis level that exceeded 1.00%. The improvement realized relative to the first half of 2010 is driven largely by lower loan loss provisions.
Figure One
The following matrix groups community banks based on their net income into four categories including (a) positive net income in both the first half of 2010 and the first half of 2011, (b) net losses in both the first half of 2010 and 2011, or © positive net income in one period and a net loss in the other period. As indicated in the matrix, 76% of banks reported positive net income in both periods, while 11% reported net losses in both periods.
Figure Two
Net interest margin enhancement contributed to many community banks’ improving performance. For example, in fiscal 2010, net interest margin expansion benefited about 60% of the banks in the analysis. However, data from 2011 suggest that the trend of rising net interest margins is weakening. For the first half of 2011, approximately one-half of the banks in the sample reported higher net interest margins than in the first half of 2010.
After declining for the last two quarters, the median net interest margin widened in the second quarter of 2011, suggesting that community banks continue to benefit from deposit rate reductions.
Figure Three
For a majority of the community banks in the analysis, loan growth has not yet resumed. As of June 30, 2011, 62% of community banks reported lower balances of non-agricultural loans, as compared to December 31, 2010 – a trend consistent with the 58% of banks that reported lower loan balances at year-end 2010 than at year-end 2009. The aggregate loans outstanding held by community banks declined by 0.79% between year-end 2010 and June 30, 2011. However, the contraction was not spread evenly throughout loan portfolios. Instead, construction and development loans continue to shrink, offsetting growth in commercial real estate (both owner and non-owner occupied) and commercial and industrial loans.
Figure Four
Liquidity continues to accumulate within the community banking industry, albeit at a somewhat slower pace than in recent years, as indicated in the following table showing the median ratio of liquid assets to total earning assets. Offsetting this increase, the median ratio of loans to earning assets declined from 74% at June 30, 2010 and December 31, 2010 to 71% at June 30, 2011.
Figure Five
One notable trend in fiscal 2010 among community banks was the steady quarterly increase in non-performing assets, despite a gradually recovering economy. After reaching 3.78% in the first quarter of 2011, the median ratio of non-performing assets to loans and other real estate owned decreased by four basis points in the second quarter of 2011, marking the first decline in this ratio since the second quarter of 2006.
Figure Six
As further evidence of the gradual improvement in asset quality, new additions to non-accrual assets dropped below $8 billion (in aggregate for the 3,800 banks) in both the first and second quarters of 2011 – a level below any quarter in 2010. In addition, loans past-due 30-89 days, representing potential future non-accrual loans, fell to $10.9 billion at June 30, 2011, the lowest level since at least the first quarter of 2010.
Figure Seven
Similar to the trend reported by larger banks in their mid-year earnings releases, community banks continue to see reductions in loan loss provisions. The aggregate loan loss provision reported by the 3,800 banks in the data set declined by 32% in the first half of 2011, versus the same period in 2010. For the median bank, the annualized loan loss provision dropped to 0.45% of loans in the first half of 2011, as compared to 0.59% in the first half of 2010. To some degree, though, credit costs have shifted within the income statement from loan loss provisions to losses and other costs related to other real estate owned. In the first half of 2011, losses on sale of other real estate owned increased by 40% versus the first half of 2010.
Figure Eight
Figure Nine
For the second half of 2011, trends to monitor include:
Originally published in Mercer Capital’s Bank Watch, released August 15, 2011.
For several years now, industry experts have been predicting a wave of bank consolidation. The initial reasoning was that weaker banks would be absorbed by stronger banks, many against their will when faced with the choice of merger or failure. As time passed the industry realized that even the healthiest institutions were either unwilling or unable (sometimes both) to take on the debt, shareholder dilution, and asset quality problems that come along with an acquisition.
At present, the presumed M&A driver for the near-term is regulatory changes, which will place a substantial burden on institutions. The smaller the institution, the theory goes, the more onerous the burden and the more diminished the ability to absorb the associated costs. The only solution, many argue, is to grow organically (not easily done in the current environment) or find strategic combinations that will create a bank large enough to support the additional operating expense.
Is this wave of predicted merger activity finally coming to fruition? One might think so, based on the uptick in announced bank deals in 2010. According to SNL Financial, LLC there were 205 announced deals in 2010, compared to 175 announced in 2009. This does not include the 157 FDIC-assisted transactions which occurred during the year. Additionally, deal value was substantially higher in 2010, at $11.8 billion, compared to $2.0 billion in 2009. The increase in total deal value was supported by a few larger acquisitions, including BMO’s purchase of Marshall & Ilsley Corporation ($5.8 billion), Hancock Holding Company’s purchase of Whitney Holding Corporation ($1.8 billion), and First Niagara Financial Group’s purchase of NewAlliance Bancshares, Inc. ($1.5 billion).
However, the M&A story in 2010 lies within the realm of the community bank. As shown below, for deals in which pricing multiples and deal value are available (a total of 111 transactions), 84 transactions, or more than 75%, involved a seller with assets less than $500 million.
What is notable in the table above is that the size of the seller appears to be negatively correlated with the pricing multiples received, particularly on a book value basis.
The smallest banks were the only group which reported a median purchase price at a premium to book value, both reported and tangible. Of course, it is worth noting that the larger groups contain a fewer number of transactions, and perhaps reflect a more dire situation on the part of the seller, who presumably has little incentive to sell in the current pricing environment.
Cash remained king in 2010 as the most common form of transaction funding. Forty of the 111 transactions reporting multiples were all-cash acquisitions, followed closely by 38 which were some mixture of cash and other consideration (generally common stock). Capital contributions accounted for eighteen of the transactions and common stock was used as currency in six of the transactions. The remainder were unclassified or not reported.
The banking industry has always exhibited a proclivity to finance acquisitions using cash on hand. However, it is no surprise that buyers, who likely are facing their own problems with low stock valuations, are reluctant to dilute shareholders by using what many consider to be an undervalued asset to fund purchases. After all, pricing multiples in the public marketplace remain well off the highs of 2006 and 2007, when bank stocks commonly traded at price-to-earnings multiples approaching twenty times and book value multiples as high as three times. Additionally, with the universe of transactions focused on smaller institutions, many do not have publicly traded equity, and sellers often frown on accepting illiquid stock as transaction currency.
In terms of geography, there was a distinct relationship between the economic health of various regions and the volume of transaction activity. During 2010 the concentration of FDIC-assisted transactions (i.e., bank failures) centered around states with severely disrupted real estate markets, such as Florida (29 failures), Georgia (21 failures), Illinois (16 failures), California (12 failures), and Washington (11 failures). Perhaps not surprisingly, non-assisted transaction activity was highest in regions without a high level of bank failures, as shown in the table below (includes only those deals reporting pricing multiples).1
The next logical question is what will 2011 hold for bank M&A activity? While we do not have a perfectly clear crystal ball, here are a few things to consider:
Will 2011 be the year of the bank merger? Signs remain mixed, but it appears conditions are favorable at the very least for an increase in merger activity. Then again, we have definitely heard that before.
ENDNOTES
1 The regions include the following states:
Originally published in Mercer Capital’s Bank Watch 2011-03, released March 2011.
After completing an FDIC-assisted transaction, the acquirer faces the task of accounting for the transaction in accordance with FASB ASC 805, Business Combinations (formerly SFAS141R). ASC 805 requires the acquirer to record purchased loans at their fair value, or the amount that would be received upon the sale of the subject loans in a transaction between market participants. Given the credit deterioration evident in the loan portfolios of most failed banks, the book values and fair values of acquired loans may diverge to a material degree.
Deposit assumption transactions generally present no complex accounting or valuation issues. Demand and savings accounts are recorded at their book values, which equal fair value. The acquired time deposit portfolio may require a determination of fair value. Unlike a non-assisted transaction, however, acquirers in assisted transactions have the right to adjust the rates on time deposit accounts immediately upon the acquisition. These rate adjustments, along with any attendant deposit run-off, may require consideration in the fair value analysis. Lastly, although not recorded in some transactions, the acquirer may recognize a core deposit intangible asset. While the acquirer may agree upon a deposit premium with the FDIC (or agree that a premium is not appropriate), this premium may not be determinative of fair value, as the intent of fair value is to determine a price in an “orderly” transaction. An FDIC-assisted transaction may not meet the definition of an “orderly” transaction for purposes of determining fair value.
Assisted transactions whereby the acquirer obtains the failed bank’s assets, including its loans, along with a loss-sharing agreement present a much more complicated series of valuation and accounting issues. The valuation and accounting issues can be grouped in two primary categories:
Mercer Capital reviewed SEC filings of banks participating in loss-share transactions. From this review, there appears to be some diversity of practice as to the accounting for loss-share transactions. The following discussion, therefore, is general in nature. Banks participating in loss-share transactions are advised to seek guidance from their accounting firms as to the valuation and accounting issues raised by the transactions.
At the acquisition date, an acquirer would need to determine the fair value of the following assets:
Based on the preceding determinations of fair value, the acquirer would then calculate the amount of goodwill or negative goodwill. While goodwill is recorded as an asset on the balance sheet, negative goodwill results in a gain to the acquirer in the period surrounding the acquisition (included in non-interest income).
To demonstrate the preceding accounting and valuation issues, consider the following hypothetical transaction:
Based on the preceding, Figure One amortizes the acquired loans:
After determining the expected cash flows from the portfolio, the acquirer can then determine the fair value of the acquired loans. Because credit spreads have widened since origination of the loans, and to reflect the risk of adverse deterioration in default rates, the acquirer estimates that an 8% discount rate is appropriate.
Figure Two then illustrates the determination of fair value of the acquired loan portfolio:
The acquirer would thus record the acquired loan portfolio at its fair value of $773. Next, the acquirer would determine the fair value of the loss-share agreement, based on the projected loan losses and the loss coverage percentage agreed upon with the FDIC. The valuation of the loss-share agreement generally assumes a lower discount rate than the determination of fair value of the loan portfolio, given the relative assurance of collection of amounts due under the loss-share agreement from the FDIC.
Figure Three shows this calculation.
Based on the preceding determinations of fair value, and assuming the fair value of the liabilities equals book value, Figure Four indicates the assets and liabilities acquired in the transaction.
In the transaction, the acquirer received $1,068 of assets at fair value and assumed $1,000 of liabilities. To balance its books, therefore, the acquirer would need to need to record “negative goodwill” of $68; however, negative goodwill is not recorded as a “negative” asset. Instead, ASC 805 indicates that the acquirer should record a gain equal to the amount of negative goodwill.
In many instances, due to the volume of problem assets, the magnitude of the fair value adjustments to the loan portfolio, and the need to track the loss-share asset, the post-acquisition accounting for the acquired loans is more complicated than the acquisition-date accounting. The primary ongoing accounting issues faced by the acquiring bank include the following:
Figure Five rolls the loan portfolio balance forward from the acquisition date starting with the beginning fair value of the portfolio ($773).
In each period, the bank collects principal and interest payments on the portfolio, per the amortization of the portfolio in Figure One. In addition, the bank determined the fair value of the portfolio based on the return required by market participants at the valuation date (8%), which exceeded the stated note rate on the portfolio (5%). This disparity results in an additional loan discount accretion.
For example, in year 1, at an 8% interest rate, the portfolio would yield income of $62 ($773 x 8%). However, the bank collects interest of only $45 from borrowers. The $17 difference between the market yield and the note rate is accreted into income by the acquiring bank. The ending portfolio balance therefore equals the beginning portfolio balance ($773), minus principal collections ($285), plus the discount accretion ($17). Figure Six shows the roll-forward of the loss-share asset.
As indicated in Figure Six, the loss-share asset declines as the FDIC remits payments against covered losses. In addition, the fair value of the loss-share agreement was determined based upon an assumed 3% discount rate. As for the loans, this 3% return is accreted into income. Figure Seven summarizes the interest collected and accreted on the loan portfolio and loss-share asset.
In sum, the acquiring bank’s interest income from the acquired loans would consist of three sources – the interest paid by the borrowers, the discount accretion on the loans, and the accretion of interest on the loss-share agreement. Overall, the acquiring bank would earn an effective yield of approximately 7.25% to 7.50% on the assets acquired, versus the actual note rate of 5%.
The preceding analysis, while still complex, is greatly simplified from real world practice. In reality, acquirers are faced with many challenging issues, such as:
Reprinted from Mercer Capital’s Value Added (TM) Vol. 22, No. 1, May 2010
As the world hoped to return to normalcy after a turbulent 2007, 2008 proved to be a worse year for bankers. A credit crunch and housing collapse maintained the downward pressure on stock prices that began in 2007. 2008 saw the closure of 25 banks nationwide, and the overall banking industry has struggled with deteriorating asset quality and liquidity concerns. In order to gauge the impact of the 2008 financial institution market trends on smaller institutions, Mercer Capital conducted a study of two asset size based bank indices: banks with assets between $500 million and $1 billion (referred to hereafter as the “Small Community Bank Group”) and banks with assets between $1 billion and $5 billion (the “Large Community Bank Group”).
The banking industry made headlines throughout the second half of 2008. The struggles of Freddie Mac and Fannie Mae necessitated nationalization of the two government-sponsored enterprises, and the failures of IndyMac Bank and Washington Mutual Bank fueled the erosion of confidence in the banking industry. Furthermore, the acquisitions of Merrill Lynch by Bank of America and Wachovia by Wells Fargo signaled consolidation in the banking industry in order to survive the economic uncertainty.
In an attempt to provide assistance to the banking industry, the government developed several programs to improve banks’ asset quality and capital positions. Under the Emergency Economic Stimulus Act of 2008, the Troubled Asset Relief Program (“TARP”) was developed with the intention of cleaning up the balance sheets of banks by removing troubled assets from the books. Because pricing the troubled assets was difficult given economic uncertainty, the initial structure of the TARP was abandoned shortly after the program was established. Instead, the Capital Purchase Program under the TARP attempted to provide stability for financial institutions by providing capital injections.
Figure One depicts market pricing trends of financial institutions during 2008. As shown, the Large Community Bank Group saw a price decline of 19.5%, outperforming the overall market, as measured by the performance of the S&P 500, as well as the banking industry, as measured by the SNL Bank Index. For comparison purposes, the SNL Bank Index saw a 45.6% decline in price due primarily to the decline in value of a number of large institutions, and the S&P 500 saw a 38.5% decline in 2008. The Small Community Bank Group observed a decline of 37.8%, reflecting their poorest performance in the last decade.
In order to attempt to isolate the driving trends behind the market performance of these institutions in 2008, we stratified the banks in each group based on TARP participation, asset quality metrics, loan portfolio concentrations, and location. Banks with unavailable financial data were excluded from our stratification, and the resulting analysis included 160 banks in the Large Community Bank Group and 84 banks in the Small Community Bank Group. The following discussion summarizes our findings.
Given market volatility and uncertainty about the effects of new regulations and government support, investors have limited confidence in the overall market. The government is continually amending the TARP regulations and has begun performing stress tests on some of the largest financial institutions to examine banks’ ability to cope with various changes in the economy and try to improve capital positions. As the events of 2009 unfold in accordance with government programs and regulations as well as continued consolidation, the banking industry hopes for improved performance in the second half of 2009.
Reprinted from Mercer Capital’s Bank Watch, Special Edition, May 19, 2009.
While most banks and their directors are generally aware of the tax benefits of an S election, there are some potential disadvantages. One disadvantage is the potential for S elections to encounter additional volatility to the equity account and lower capital ratios relative to C corporations when losses are incurred (all else equal).
When banks are profitable, the impact of the tax election on equity for S and C corporation banks is relatively muted as both pay out a portion of earnings to cover taxes either in the form of a direct payment of the federal tax liability as a C corporation or in the form of a cash distribution to shareholders to cover their portion of the tax liability as an S corporation. However, S corporations are typically limited relative to C corporations in their ability to recognize certain tax benefits when losses occur. The equity accounts of most C corporations benefit from the ability to recognize tax loss carrybacks and deferred tax assets following the occurrence of losses, which serve to soften the direct impact of the loss on capital. S corporations are generally precluded from any tax benefit after the recognition of losses and the resulting loss is directly deducted from equity. A few nasty quirks of book and tax income can make the situation even worse for shareholders and the S corporation bank.
To help illustrate the point further, consider the following example which details how losses realized as an S corporation can flow directly through to equity without the tax benefit recognized by a C corporation. As detailed below, the capital account of the S corporation was impacted more adversely following the recognition of losses than the C corporation (all else equal).
In a recent survey of bank transaction activity nationwide conducted by Mercer Capital, we noticed some evidence of this disadvantage surfacing among S corporation banks. Of transactions (whole bank sales) involving target banks with assets between $100 million and $1 billion announced since June 30, 2008, the majority of S corporation banks sold were distressed, defined as either having non-performing assets as a percentage of assets greater than 3.0% (three out of four transactions involving S corporation targets) or reporting a loss in the most recent year-to-date period (two out of four transactions involving S corporation targets). This trend is illustrated more fully in the chart below and is notable especially when compared to transaction activity of C corporations over this period.
We found some additional evidence that S corporation banks may be experiencing the detrimental impact of additional capital volatility in a review of bank failures. Of 8 total S corporation bank failures since 1998, five have occurred since January 1, 2008, with three occurring since December 1, 2008.
While it is too early to tell whether this evidence of increased transaction activity and failures among distressed S corporations is purely a coincidence or early indications of an emerging trend of capital volatility for S corporation banks, this analysis prompted a number of questions:
If your bank is dealing with any of these issues, feel free to give us a call to discuss the situation confidentially.
An S “election” represents a change in a bank’s tax status. When a bank “elects” S corporation status, it opts to become taxed under Subchapter S of the U.S. Tax Code, instead of Subchapter C of the Code. When taxed as a C corporation, the bank pays federal income taxes on its taxable income. By making the S election, the bank no longer pays federal income tax itself. The tax liability does not disappear altogether, though. Instead, the tax liability “passes through” to the shareholders. This means that the bank’s tax liability becomes the obligation of the bank’s shareholders. While no guarantees generally exist, the bank will ordinarily intend to distribute enough cash to the shareholders to enable them to satisfy the tax liability.
The following table shows what happens when a bank makes an S election. In the table, the bank no longer incurs any federal tax liability following the S election. However, the $350 tax obligation simply “passes through” to the shareholders.
In the preceding table, the bank’s pre-tax income generated a $350 tax obligation, regardless of whether the bank was taxed as a C or S corporation. In the C corporation scenario, the bank directly paid the tax obligation to the government; in the S corporation alternative, the shareholders paid the taxes due on the bank’s earnings. Since the taxes due remain constant at $350 regardless of whether the bank elects
S corporation status or not, what incentive exists for banks to elect S corporation status?
The S election creates two primary tax advantages relative to C corporations:
The best way to illustrate tax advantage #1 is with an example.
In the C corporation scenario, the bank pays $200 of dividends to shareholders. After the shareholders pay taxes on these dividends (at a 15% tax rate on dividends), the shareholders will have after-tax cash flow of $170 from their investment. Assume, instead, that the bank elects S corporation status. In this case, the shareholders owe taxes of $350 (35% of the bank’s $1,000 pre-tax income), but the bank makes distributions of $550. This leaves the shareholders with $200 of after-tax cash flow. No further taxes are owed on the $200. In fact, for any amount of distributions between zero and $1,000 (the bank’s pre-tax earnings), the shareholders will generally face tax liability of $350. By electing S corporation status, therefore, shareholders increase their after-tax cash flow from $170 to $200, an 18% increase.
Given the aforementioned tax benefits, why would every bank not elect S corporation status? Several potential disadvantages of the election exist:
To minimize these risks, the board of directors and management may adopt a more conservative management style for the S corporation bank than the C corporation bank. For instance, higher capital ratios may be desirable. In addition, the bank may adopt more strict underwriting requirements or maintain a lower loan/deposit ratio to reduce the risk of losses.
S corporation elections may be an attractive alternative for banks, but a careful examination of the advantages and disadvantages is necessary. Banks with relatively low balance sheet growth and high profitability often make the best candidates for S elections, because these banks have the capacity to distribute a large portion of their earnings. On the other hand, an S election would be less beneficial for other types of banks. For instance, banks that intend to pursue acquisitions or that have potentially volatile earnings may be better served by remaining C corporations.
If your bank does elect to make an S election, it is typically more complicated than simply “checking a box” on a tax filing. Instead, a number of professionals may need to be involved to ensure the bank’s goals are achieved:
Reprinted from Mercer Capital’s Value Matters™ 2008-08, published August 31, 2008
Capital raising efforts among financial institutions began in earnest in late 2007, primarily among money center banks and investment banks suffering under the weight of mark-to-market adjustments on various asset types. Banks with fewer assets marked to fair value through the income statement largely maintained sufficient capital to manage the initial wave of industry problems. However, the capital pressures intensified in 2008 as past-due levels and losses increased across a spectrum of loans tied to real estate, causing a number of banks to reassess their capital positions and, in some cases, to capitulate under the weight of the external environment and seek out additional capital.
This article provides a summary of capital raising transactions that have occurred in 2008 and offers insight into the financial considerations present in evaluating each capital alternative. These considerations are relevant whether a bank is in the position of raising capital to buttress the balance sheet or, alternatively, has an opportunity to make an investment in another bank facing a capital shortfall.
The surest way to shore-up capital ratios is through the issuance of common stock, which places no pressure on the company’s cash flow if no dividends are declared. The primary disadvantage of common stock offerings is the dilution that current shareholders may experience to their ownership positions and future earnings per share.
Figure One indicates recent common stock offerings. Most of the issuances have occurred at discounts to the issuer’s stock price prior to the transaction. In one-half of the issuances, the offering price for the common stock was less than pro forma tangible book value per share (existing tangible book value, plus the equity raised in the offering). One recent article noted that investors were potentially willing to purchase stock at tangible book value per share, as adjusted to reflect the investors’ estimate of expected losses in the loan portfolio.
In considering a common stock issuance, important questions for community banks to consider include:
Depending on its structure, preferred stock can bear a resemblance to either long-term debt or equity. In its simplest form, “straight” preferred stock economically resembles long-term debt with either fixed or floating rate payments. Convertible preferred stock is a hybrid instrument that combines elements of both debt and equity. Generally, convertible preferred stock has a lower dividend rate than straight preferred stock, but a higher yield than common stock. To compensate investors for accepting the lower current return, the investors receive the right to participate in the appreciation of the common stock. Further, preferred stock dividends can be either cumulative (meaning that dividends are accrued in the intent of paying such dividends later) or noncumulative.
From a bank’s perspective the advantages of preferred stock include:
Potential disadvantages from a bank’s perspective include:
From an investor’s perspective, preferred stock can be an attractive alternative to common stock. For convertible preferred stock, the investor may receive a dividend in excess of the common stock’s dividend, plus the right to enjoy appreciation in the underlying common stock. Thus, the higher dividend protects the investor’s downside (to the extent the issuer actually pays the dividend). Further, if the investor is a corporation, the tax deduction for dividends received may be available.
Preferred stocks have been a popular capital raising tool in the present environment, owing to their flexibility and the downside protection afforded to investors. Figure Two indicates issuances announced during 2008.
When structuring a preferred stock issuance, important considerations include:
From an issuer’s perspective, the most unattractive terms include a high dividend rate and a low conversion premium. As an example, consider South Financial Group’s May offering of 10% preferred stock with a 0.3% conversion premium.
Trust preferred securities are a hybrid instrument, combining the tax treatment of debt and the Tier 1 capital treatment of equity. From a bank’s perspective, the favorable after-tax cost of capital represents one of the primary advantages. Prior to late 2007, another significant advantage of trust preferred securities was that community banks could easily access the capital markets by participating in one of the pooled offerings underwritten by investment banks. As conditions in the credit markets deteriorated, this advantage disappeared, as the pooled offerings have largely vanished from the marketplace, although they may eventually return if investor demand improves.
Figure Three indicates data on trust preferred securities offerings announced in 2008 by publicly traded banks. While pooled offerings have not occurred in 2008, several smaller publicly traded banks have placed trust preferred securities with institutional investors. The pricing in these offerings has increased since the last pooled offerings, which often contained spreads in the range of 150 basis points over LIBOR. The variable rate offerings indicated in the table contain spreads in the range of 350 basis points over LIBOR.
While the availability of trust preferred securities through pooled offerings is currently uncertain, other investors may exist. Alternatively, banks can consider issuing trust preferred securities to local investors or shareholders. Although this type of offering may require more time and professional fees than a pooled offering, the bank will still enjoy the significant tax and capital benefits of trust preferred securities. Questions to consider for banks include:
In the event that the bank needs to raise Tier 2 capital, instead of Tier 1 capital, subordinated debentures may be desirable. Subordinated debentures may be included in Tier 2 capital, subject to a limitation equal to 50% of Tier 1 capital. Like trust preferred securities, interest payments on subordinated debentures are tax deductible. Subordinated debentures can be issued at the subsidiary bank level, which may decrease their credit risk for investors, relative to instruments that require the holding company to maintain sufficient liquidity from bank dividends or other sources of funds.
Figure Four indicates the pricing of subordinated debenture offerings in 2008. While few community banks are included in this group of offerings, subordinated debentures may remain an attractive alternative to curing a Tier 2 capital need. Transactions announced in April and May have occurred at interest rates ranging from 8.75% to 9.50%. All of the issuances have involved either ten or thirty year terms.
For community banks where subordinated debentures may solve a problem, the following questions should be considered:
For community banks needing capital, the alternatives possess substantially different impacts on existing shareholders and the bank’s future returns, not to mention divergent capital treatments. For potential investors in community banks, downside protection is important in the present environment. As a result, recent capital raises have included common stock issued at discounts to the issuer’s market price and convertible preferred stock issuances with relatively high dividend rates and low conversion premiums.
Mercer Capital can assist community banks and investors with considering the advantages and disadvantages of the spectrum of capital instruments available to a particular bank, focusing on their effects on existing shareholders and future shareholder returns, as well as evaluating the pro forma capital impact of different instruments and offering amounts. We can also assist banks and investors in determining an appropriate stock price or interest rate in offerings sold to local investors, analyzing, from an investor’s standpoint, the advantages and disadvantages of different proposed investment structures, and providing fairness opinions that the capital offering is fair to a specified group of shareholders.
Reprinted from Mercer Capital’s Bank Watch 2008-05, published May 28, 2008.
The majority of respondents to a recent survey presented in the January 2008 edition of Mercer Capital’s Bank Watch are expecting a difficult, if not dismal, 2008. Nearly 83% of respondents believe that the American economy will be in a recession at some point during 2008. In keeping with this theme, virtually all of the respondents believe that interest rates will decline in 2008, and none expect them to increase, with approximately two-thirds of respondents expecting a decline of more than 50 basis points. Given the actions taken by the Fed after this survey, this is not surprising. Despite the current industry focus on credit quality, 40% of respondents listed margin performance and the interest rate environment as their primary concern going into 2008.
Opinions were rather mixed concerning when the industry’s earnings will bottom out, with approximately one-third of respondents indicating the first half of 2008, the majority (43%) indicating the second half of 2008, and the remainder stating that it will be 2009 or beyond before earnings recover. One lone dissenter believes earnings reached bottom in 2007.
However, with the credit crisis still in full force and the dominant topic in the industry for months now, the focus of concern continues to be the quality of the loan portfolio, with 66% of respondents listing that as their primary concern for 2008. Responses were mixed, however, with regard to the types of loans that will present the most problems in 2008.
We’d like to thank everyone who took the time to respond to the survey. We hope that you find the results informative.
Reprinted from Mercer Capital’s Bank Watch, February 26, 2008.
As the world celebrated the closing of another year on December 31, many bankers hoped to soon forget one of the worst periods for bank stock performance in recent history. Credit quality concerns, margin pressure, slowing earnings growth, and a declining housing market took a toll on the market for shares of publicly traded banks, which generally underperformed broader market indices such as the S&P 500 for the year. Seemingly, no public bank was left untouched by the effects of the subprime market collapse and subsequent credit market disruptions; Bank of America and Citigroup, the two largest banking institutions in the U.S., saw price declines of 22.7% and 47.2%, respectively, from year-end 2006 to year-end 2007.
But how has the market affected community banks? Mercer Capital observed two asset size-based bank indices – banks with assets between $1 billion and $5 billion, and banks with assets between $500 million and $1 billion – to gauge the impact of the 2007 financial institution market trends on smaller institutions.
As shown in Figure One, the larger group of banks with assets greater than $1 billion and less than $5 billion felt a more severe impact than the banking industry overall (as measured by the performance of the SNL Bank index) with a year-over-year price decline of 28.9%, reflecting the worst performance observed over the past ten years. For comparison purposes, the SNL Bank index exhibited a decline of 25.2%, while the S&P 500 saw a slight increase of 3.5% for the same period. The unfavorable performance of the larger index was fairly widespread, with 97% (158 out of 163) of the banks reporting price declines in 2007. More than half of the group experienced larger declines than the SNL Bank index overall. Of the five banks with an increase in stock price from 2006 to 2007, four were either targets in a merger or acquisition or the subject of strong takeover speculation.
Public banks with assets between $500 million and $1 billion fared somewhat better, with an overall decline of 21.7%; however, the price decline observed for these banks also reflected the most unfavorable performance in the last decade. Of the 102 banks included in the group, 84% saw declining prices in 2007, with 42% reporting price declines greater than that observed for the SNL Bank index.
Figure Two reflects the historical trend in market performance for the two size-based indices with the 2007 performance notably weaker than 1999, the weakest previous year since 1997. One dollar invested in the larger bank index at the beginning of 1997 would have been worth $3.80 at year-end 2006 but declined to $2.97 at year-end 2007.
In order to attempt to isolate the driving trends behind the market performance of these institutions in 2007, we stratified the banks in each group based on location, loan portfolio concentrations, and asset quality metrics. Tables One and Two and subsequent discussion summarize our findings.
For the larger index, 42 banks were located in higher-risk markets where home price appreciation skyrocketed during the housing boom and are now experiencing the most rapid real estate market declines (Florida, California, Nevada, Georgia, or Colorado) or markets with a struggling local economy (Michigan). Of these banks, 100% reported price declines with a median decrease of 44%. Results for banks in the smaller index located in the same markets were similar, with 95% of the 21 banks reporting a price decline and a median decrease of 37% for the entire group.
Twelve of the larger public banks reported construction & development loans accounting for more than 40% of their loan portfolio at September 30, 2007; all of which saw price declines from 2006 and eleven of which underperformed the SNL Bank index. The median price decline for the larger banks with high concentrations of construction and development loans was 48%, substantially above the median for the $1 billion to $5 billion group overall. The remaining banks in the index reporting construction and development credits at less than 40% of total loans experienced a median price decline of 26%.
For the smaller bank index, each of the nine banks reporting C&D loan levels higher than 40% of loans at September 30, 2007 experienced price declines greater than the SNL Bank index and saw a median price decline of 43% for 2007. The median price decline for the remaining banks in the index was 20%.
Of the 163 banks in the larger index, nine reported commercial real estate loans comprising more than 50% of their entire portfolio at September 30, 2007. Of these banks, eight reported price declines more severe than the overall bank index, with price declines ranging from 21% to 62%. The median price decline for the group was 50%. For comparison purposes, the remaining banks in the index with CRE concentrations less than 50% reported a median price decline of 26%.
CRE concentration observations were less conclusive for the smaller bank index, as the median price decline was less than that observed for the banks with low CRE levels. The pricing disparity may reflect the small number of banks in the index with higher CRE levels, three of which reported price increases apparently reflecting other factors, such as strong asset quality and lower concentrations of riskier construction loans.
24 of the banks with assets between $1 billion and $5 billion reported non-performing assets measuring greater than 2.00% of loans plus OREO at third quarter-end. Of these banks, 22 (92%) underperformed the SNL Bank index; the median price decline for the group was 52%. The remaining banks with non-performing asset ratios less than 2.00% experienced a median price decline of 23%, with less than half underperforming the SNL Bank index. Eight banks in the smaller index reported non-performing assets greater than 2.00%, seven of which saw a price decline greater than the SNL Bank index. The median price decline for these banks was 36%, as compared to 20% for the remaining banks in the index with stronger asset quality metrics.
The above observations regarding smaller publicly traded banks are consistent with the performance of many community banks throughout the U.S. Those with a significant portion of loans in areas with a rapidly declining housing market, high levels of construction and development or CRE credits, or unfavorable trends in asset quality have been viewed more negatively in public markets than those without such characteristics. Banks in this situation may be more likely to encounter earnings obstacles in the near future as the real estate market and credit issues are resolved.
At the time of publication, most of the banks observed in these studies had not yet released financial data for the fourth quarter. As such information is released, our observations of the stock market performance and financial characteristics of the banks discussed above will be updated and further examined in a future issue of Bank Watch.
Reprinted from Mercer Capital’s Bank Watch, January 2008.
On March 31, 2010, Diamond Foods, Inc. completed its acquisition of Kettle Foods, a premium potato chip manufacturer. Diamond paid approximately $616 million for Kettle Foods and $235 million, or nearly 40%, of the purchase price was allocated to “brand intangibles”.1 Such a high value leads to the question: How are such valuations determined and what are the drivers?
Whether it’s the name of an entire business or a single product, trade names can represent substantial value in business transactions and are recognized as a marketing-related intangible asset under ASC 805. ASC 805 states:
“Trademarks are words, names, symbols, or other devices used in trade to indicate the source of a product and to distinguish it from the products of others.”2
Generally the relief from royalty method is used to determine the fair value of a trademark or trade name. The relief from royalty method seeks to measure the incremental net profitability generated by the owner of the subject intangible asset through the avoidance of royalty payments that would otherwise be required to enjoy the benefits of ownership of this asset.
Applying the relief from royalty method requires several steps:
So what might the valuation of a trademark like Kettle Foods look like?
The professionals at Mercer Capital are experienced in valuing trademarks and trade names in numerous industries. Please contact us to find out how we can help you measure the fair value of acquired intangibles.
Endnotes
1 Diamond Foods, Inc. Form 10-Q, October 31, 2010.
2 ASC 805-20-55, paragraph 16.
The AICPA released a draft accounting and valuation guide for “Assets Acquired to Be Used in Research and Development Activities” in November 2011. The guide replaces the 2001 practice aid “Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices & Pharmaceutical Products.” The draft guide focuses on the treatment of acquired intangible assets that will be used in research and development efforts subsequent to the transaction (“In-Process R&D” or “IPR&D” assets). IPR&D assets also include assets expected to be used defensively to protect assets related to ongoing R&D projects. Here are five takeaways from the draft guide:
Mercer Capital provides a range of fair value measurement services to financial managers. Please contact us to explore how we can help you measure and document the fair value of IPR&D assets.