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.
On August 10, 2011, the FASB approved a pending exposure draft, "Testing Goodwill for Impairment.” The revision to the accounting standards codification adds an optional qualitative assessment (referred to by some as the “Step Zero” test) to the annual goodwill impairment testing process. If, on the basis of an assessment of various qualitative factors, the reporting entity determines that it is more likely than not (i.e., a greater than 50% likelihood) that the fair value of a reporting unit exceeds its carrying value, the fair value of the reporting unit need not be measured. In other words, Step 1 of the goodwill impairment test will no longer be required if a reporting unit passes the qualitative Step Zero assessment.
The paragraphs added to Topic 350 (350-20-35-3A through 350-20-35-3G) include examples of events and circumstances that should be evaluated in preparing the qualitative assessment. The examples cited encompass macroeconomic, industry, market, and firm-specific factors.
A few things to keep in mind regarding this new addition to the codification:
The fair value reporting terrain continues to be rugged and uncertain. We are here to help. If you would like to discuss in confidence how the Step Zero test might apply to your company, please give one our experienced professionals a call.
Companies often use contingent consideration when structuring M&A transactions to bridge differing perceptions of value between a buyer and seller, to share risk related to uncertainty of future events, to create an incentive for sellers who will remain active in the business post-acquisition, and other reasons. Starting when SFAS 141R (now ASC 805) became effective in 2009, acquiring entities are now required to record the fair value of earn-outs and other contingent payments as part of the total purchase price at the acquisition date. This rule came into effect in the aftermath of the financial crisis when M&A activity slowed to a stand-still. Given the recent experience and continued expectation of increases in M&A activity, a refresher on the new rules may be helpful for CFOs and controllers of companies contemplating acquisitions in 2011.
ASC 805, the section of the FASB codification that addresses business combinations, requires that:
In the case of contingent consideration, fair value represents the amount the reporting entity would have to pay a hypothetical counter-party to transfer responsibility for paying the contingent liability. This amount is basically the present value of the probability-weighted expected amount of the future payment.
The complexity of the procedures necessary to estimate the future payment ultimately depends on the structure of the earn-out.
For earn-out structures including milestone payments or tiered schedules, the fair value of the contingent payment is generally most sensitive to the estimate of the probability-weighted expected payment (rather than other inputs such as duration of contingency or discount rate). Developing reasonable estimates of the probability of future events is inherently difficult, but the use of decomposition and cross-checks will help improve the quality of these estimates. Decomposition is the process of breaking down a big event (such as commercialization of a development-stage product) into a series of smaller, more familiar pieces to make the probability estimate process easier. Cross-checks using aggregate industry information (such as the average length of time to receive regulatory approval from the FDA) can be helpful to validate assumptions that by nature rely on judgment. Industry expertise can be extremely valuable when selecting a valuation specialist to help with estimating the fair value of contingent consideration. An expert will be able to decompose common pathways into a series of managable steps to estimate, will have familiarity with available industry data that can be used to help support assumptions, and will be able to effectively explain and defend the assumptions.
In most cases, you or someone else in your company will likely be the individual most knowledgeable of the potential outcomes. The role of the valuation specialist is to integrate this information into the appropriate valuation model, test it for reasonableness, and to articulate the nuances of the inputs and valuation model in such a way that is clear for auditors and other third-party reviewers to understand. For simple situations it may not be necessary to bring in the outside help of a valuation specialist. For more complicated situations requiring multiple scenarios or Monte Carlo analysis, however, outside support may be necessary. If you have any questions regarding the valuation of contingent consideration or the impact of particular structures on financial reporting procedures, feel free to contact us in confidence.
In December 2010, the FASB issued ASU 2010-28, which updated rules pertaining to the appropriate measure of reporting unit carrying value. Historically, the carrying value of a reporting unit could be measured on an equity or total capital basis, as long as it was compared to the corresponding measure of value for the Step 1 goodwill impairment test. ASU 2010-28 mandates that reporting unit carrying value can only be measured on an equity basis. Under the Step 1 impairment test which compares reporting unit carrying value to fair value, any reporting unit with a zero or negative equity carrying value automatically passes the test (because the fair value of an equity stake generally cannot be less than zero).
To address this issue, ASU 2010-28 introduces the new requirement that any reporting unit with zero or negative carrying value must automatically perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. The update provides a list of qualitative factors that should be considered in making this "more likely than not" determination, examples of which include:
For public entities, the update is effective for fiscal years beginning after December 15, 2010. For non-public entities, the update is effective for fiscal years beginning after December 15, 2011, but early adoption is permitted.
The Public Company Accounting Oversight Board (PCAOB) recently released the Report on Observations of PCAOB Inspectors Related to Audit Risk Areas Affected by the Economic Crisis which identified instances where auditors failed to comply with PCAOB standards. The document specifically references a number of fair value-related items including goodwill impairment, intangible assets, contingencies, complex or illiquid financial assets, and other fair value measurements.
Here are some tips for reporting entities to keep in mind through 2011 and 2012:
At Mercer Capital, our goal is to minimize the hassle and disruption of the fair value measurement and review process for all parties involved, including company management, the audit team, and the auditor’s valuation review team.
When it comes to portfolio company fair value measurement and reporting, 2011 lacked the drama of 2008 and 2009. New procedures and policies spawned by SFAS 157 (now Topic 820) have hardened into established routines, the FASB did not offer any new crisis-related guidance, and (with the exception on a rather petulant August) financial markets were reasonably well-behaved. Nonetheless, private equity fund managers – and their limited partners – cannot take fair value measurement for granted. To help ensure that the upcoming year-end portfolio fair value measurement process is as uneventful as it should be, we have created the following checklist to help fund managers measure the fair value of portfolio company investments.
Mercer Capital provides a range of fair value measurement services to investment fund managers. We are always happy to discuss your valuation issues in confidence as you plan for the year-end fair value measurement cycle. Give us a call today.
The FASB issued an exposure draft regarding a broad range of proposed amendments to Topic 820 on June 29, 2010, with a comment period extending through September 7, 2010. The exposure draft is part of the ongoing convergence project and is intended to more closely align fair value measurements under U.S. GAAP and IFRS. For the sake of our busy friends and colleagues who may not have reviewed the exposure draft yet, we offer a quick overview of some of the more significant proposed changes.
The pace of change at the FASB and IASB shows no signs of slackening. At Mercer Capital, we continue to monitor these developments so we can help make fair value measurement as painless as possible for our clients and their auditors. Our financial statement reporting professionals are always eager to discuss your fair value reporting issues in confidence. Give us a call today.
Reprinted from Mercer Capital’s Financial Reporting Valuation Flash, originally published August 30, 2010.
Every valuation assignment begins with a determination of the appropriate definition, or standard, of value. The standard of value provides guidance about how value is determined and from what perspective. The appropriate standard of value for most financial reporting valuation assignments, including impairment testing, is fair value, as defined in ASC 820.
Note that fair value is different than other standards of value such as fair market value or the legally-defined statutory fair value.
Fair value is defined in the glossary of ASC 820 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value assumes a hypothetical transaction for the subject asset or liability at the measurement date. ASC 820 provides additional clarification related to the nature of this hypothetical transaction, which we summarize below.
ASC 820 explicitly states that fair value assumes exposure to the relevant market for a sufficient period of time for normal marketing activities. The hypothetical transaction is not a forced liquidation or distressed sale. However, it does reflect prevailing market conditions.
Fair value is measured from the perspective of the owner of the asset. In other words, it is measured as the price that would be received to sell an asset (exit price) rather than the price that would be paid to acquire an asset (entry price). In the context of measuring the fair value of a reporting unit, exit and entry prices are often indistinguishable.
According to ASC 820, the hypothetical transaction occurs in the “principal market” for the asset, or if there is no principal market for the asset, the hypothetical transaction occurs in the “most advantageous market” for the asset. The principal market is defined as “the market in which the reporting entity would sell the asset… with the greatest volume and level of activity….” In the context of ASC 350, there is generally no principal market for reporting units (or intangible assets); unlike securities, reporting units are not homogenous assets with active markets. So what is the most advantageous market?
The most advantageous market is defined as “the market in which the reporting entity would sell the asset… with the price that maximizes the amount that would be received for the asset… considering transaction costs in the respective markets.” Depending on the circumstances surrounding a particular situation, the most advantageous market for a reporting unit could be the market made up of strategic buyers or the market made up of financial buyers. In any case, the most advantageous market is ultimately defined by the relevant market participants, as we will discuss later.
While transaction costs should be included in the consideration of the most advantageous market for the given asset, these costs must be excluded from the fair value measurement itself. Transactions are an attribute of a market rather than the subject asset itself, and as such, they are not a component of the “price that would be received”.
Fair value is defined from the perspective of market participants rather than a specific party, such as the reporting entity. A market participant is defined as 1) an unrelated party, 2) knowledgeable of the subject asset, 3) able to transact, and 4) motivated but not compelled to transact. In the context of the most advantageous market, potential market participants could be existing industry players, companies looking to enter the industry, private equity investors, or other parties.
ASC 820 clarifies that it is not necessary to identify specific market participants, but rather the characteristics that distinguish market participants in the given situation should be identified. For example, private equity investors generally rely on different funding sources than large operating companies; this is a distinguishing characteristic that would be relevant in the context of fair value.
Fair value is determined with reference to the assumptions market participants would use in valuing the subject asset or liability; assumptions used by the reporting entity may not be consistent with those made by market participants.
Fair value also assumes that an asset will be employed in its highest and best use by market participants. Highest and best use is defined in ASC 820 as the use that would maximize the value of the asset or group of assets within which the subject asset would be used. Fair value should be determined based on the hypothetical transaction price assuming the asset would be used within the “highest and best use” asset group, and that the other assets in that group would be available to market participants. If an asset is most valuable outside the context of any other assets, the fair value should be measured based on a hypothetical transaction of the asset on a stand-alone basis.
For reporting units, the use of an “in-use” or “in-exchange” valuation premise is not often controversial. The delineation of the likely market participants is often more significant in determining the degree to which synergies with potentially complementary businesses ought to be reflected in the fair value measurement.
Having discussed the definition of value pertinent to goodwill impairment testing, we will introduce some foundational valuation concepts in the following sections.
Generally accepted valuation theory (as well as ASC 820) recognizes three general approaches to valuation. , Within each approach, a variety of valuation methods (or techniques) can be applied to fair value measurement in a given situation. ASC 820 states that valuation techniques consistent with these approaches should be used to measure fair value.
In the context of measuring the fair value of a reporting unit for purposes of the Step 1 goodwill impairment test, valuation techniques under the market and income approaches are generally most appropriate. Business valuation techniques under the cost approach frequently do not capture the value of goodwill and certain other intangible assets; in such cases, the resulting valuation indications would not be consistent with the objective of measuring fair value.
Inputs to the various valuation techniques may be either observable or unobservable. ASC 820 contains a hierarchy which prioritizes inputs into three broad levels:
Fair value measurements should rely on the highest level inputs available. ASC 820 notes that the availability of inputs can impact the selection of valuation techniques, but clarifies that the hierarchy prioritizes valuation inputs, not techniques.
Fair value measurements for impairment testing tend to rely heavily on Level 3 inputs, but can also include Level 2 inputs. Common inputs include:
By their nature, unobservable inputs cannot be derived from external market information. Accordingly, unobservable inputs should reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.
Reprinted from Mercer Capital’s Value Added (TM), Vol. 22, No. 1, May 2010
For privately held companies (particularly those sponsored by private equity and venture capital funds), getting the valuation process right the first time for equity compensation grant compliance is always the least expensive route in terms of both direct and indirect cost.
In general, it is safe to expect the level of scrutiny over equity compensation-related valuation to increase with the size of the equity compensation grant – both the absolute magnitude (in terms of dollars) and relative magnitude (as a percentage of total revenue or enterprise value). While complexity of the equity compensation grant or capital structure does not inherently increase scrutiny, it does make it more challenging to demonstrate clear compliance with tax and financial reporting regulations. With appropriate awareness, management can minimize total compliance cost by selecting valuation procedures appropriate to the situation and getting it right the first time.
Reprinted from Mercer Capital’s Financial Reporting Valuation Flash, April 2010.
With many acquirers spending 2009 on the sidelines, the new accounting treatment for contingent consideration arrangements under SFAS 141R remains largely untested. When markets thaw, however, we expect that acquirers will be anxious to make up for lost time, and a resumption of deal activity will spark new conversations with auditors regarding the appropriate treatment of earnouts and other forms of contingent consideration.
As an expression of our faith in the future of the economy, we offer a few cautionary notes regarding the accounting for contingent consideration.
Reprinted from Mercer Capital's Financial Reporting Flash, published November 6, 2009.
Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.
Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.
While every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:
A purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:
The purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.
Discussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.
The intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.
After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).
The historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.
This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).
Transaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.
The report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.
Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.
At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”
A purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.
Reprinted from Mercer Capital’s Value Matters (TM) 2007-10, October 2007.
Reprinted from Mercer Capital’s E-Law Newsletter 00-03 & 2000-04, March 13, 2000.
On February 15, 2000, the Weinberg case was filed in U.S. Tax Court. [Estate of Etta H. Weinberg, et al, v. Commissioner, T.C. Memo. 2000-51.]
Since we had just reported in this year’s first E-LAW that we were unaware of any published opinions in which the QMDM was discussed, I was rather excited to read the case. I received a copy on February 19th and pages 20 and 28 were flagged for my attention. I quickly turned to page 20 and read:
“Dr. Kursh [who was the IRS’ expert] then applied a marketability discount. In order to determine the amount of this discount, he used the Quantitative Marketability Discount Model (QMDM) that is described in a book written by Mr. Z. Christopher Mercer entitled Quantifying Marketability Discounts (1997).”
I then turned to page 28 where I read:
“. . . we did not find the QMDM helpful in this case.”
Wow! My first reactions were irritation, worry, and anxiety, not necessarily in that order. This was the first reported case to my knowledge in which the QMDM has been addressed and things didn’t look so good.
But, like every case, Weinberg is based on a particular set of facts and circumstances. We need to review the case, the treatments of the valuation issues by the two experts and the Court in order to place Judge Whalen’s comments about the QMDM into proper perspective.
Let me say that after reviewing the case, I believe the Court DID find the QMDM helpful, as is proven by the results of the case. In fact, Weinberg is not a case about the marketability discount but about the minority interest discoun.
The conclusions of the experts and the Court are summarized in Table 1 so readers can see where we are headed at the outset.
The experts in the case were:
This E-LAW is based on the facts as presented in the Court’s opinion. We supplemented our review of the opinion by obtaining a copy of Dr. Kursh’s valuation report and talking briefly with him about his report. We have not yet been able to obtain a copy of Mr. Siwicki’s report. We chose to take time for a complete analysis of the case rather than responding quickly. Thanks to all of our readers who have called to let us know about the case or to inquire about our response. Here it is.
Etta H. Weinberg, the decedent, died on December 15, 1992, the valuation date in this case. On the date of her death, the decedent possessed a general power of appointment over the principal of a marital deduction trust that had been created under her late husband’s will referred to as Trust A. Trust A owned a 25.235% interest in Hill House Limited Partnership (“Hill House” or “the FLP”). Hill House owned and operated an 11-story, single building apartment complex that contained 188 apartments, an office suite, an underground parking garage, and a swimming pool. The complex had been built in 1964. Occupancy exceeded 98% as of the valuation date. [Dr. Kursh visited the property in connection his appraisal. He commented that the location of the property resulted in extremely low vacancy rates. He further stated that the property was visually in excellent condition, and that, according to management, there were no significant deferred maintenance issues.]
The apartment had a mortgage with four remaining monthly installments of principal and interest of $18,406. [Other things remaining the same, the FLP’s annual cash flow was going to increase by $220,872 ($18,406 x 12 months) within four months.] The parties stipulated that the fair market value of the apartment complex was $10,050,000. [This was the average value of two real estate appraisals prepared in this matter ($9,600,000 and $10,500,000)]
The Hill House Limited Partnership Agreement provided the general partner “sole discretion to determine when distributions are made” and that “such distributions shall be made pro rata to the Partners in accordance with their respective Percentage Interests.” There was a restriction on transfer in the Agreement giving all the other partners a right of first refusal for any interests any partner hoped to sell on the same terms and conditions offered by a third party. And the agreement provided that the general partner had sole discretion to consent to or to deny the substitution of a limited partner, unless the purchaser of an interest was already a partner. Trust A’s 25.235% interest was the largest limited partnership interest. There were three interests of 14% to 15% each, three more interests on the order of 9%, and a final 3% interest in the FLP. The decedent’s son was the sole general partner with a 1% interest.
The financial statements summarized in the Court’s opinion provided the information found in Table 2 which is supplemented by relevant calculations.
During the period reviewed, Hill House experienced growth in net income and maintained a strong cash position while making substantial distributions of its earnings. Average distributions for the 1990-1992 period totaled $683,333, or 82% of net income.
A market value balance sheet providing a stipulated net asset value is reproduced in Table 3.
The sole issue for the Court’s consideration was the fair market value of the subject 25.235% interest in Hill House Limited Partnership. While the Court summarized the valuations of the experts based on the subject interest, we will discuss the value of the partnership in its entirety in order to maintain visible relationships to net asset value and to distributions as we proceed.
The Court concluded that the fair market value of the subject interest was $1,309,651. Although there is a specific valuation rationale for the Court’s conclusion, we note that the conclusion is approximately a splitting of the difference between the two appraisals presented to the Court.
Mr. Siwicki’s valuation (on behalf of the taxpayer) is summarized in Table 4.
Mr. Siwicki used two methods in arriving at his conclusion, the capitalization of income method, and a “net asset value method.” In reality, we will see that he effectively used a single method. Beginning with Partnership Profiles, Inc.’s May/June 1992 publication (covering 1991 transactions), “The Perspective,” Siwicki narrowed his search from all 85 publicly registered partnerships to seven that invested in residential property, had little or no debt, and made cash distributions to limited partners. In the final analysis, he relied on a single company, IDS/Balcor Income Properties, as the basis for his capitalization rate of 11.0%, and discount to net asset value (NAV) of 51%.
Siwicki capitalized the three-year average distributions of $683,333 using a capitalization rate of 11.0% to reach an indication of value of $6.2 million. Note that Siwicki is capitalizing a measure of distributions expected to be available to the limited partners and not the cash flow of the enterprise.
He did not capitalize the higher level of 1992 distributions ($800,000), nor did he consider that potential annual distributions could soon exceed $1.0 million as result of the mortgage expected pay-off in four months. In other words, it appears that Siwicki capitalized far less cash flow than the cash flow that was currently being distributed or that might reasonably be expected to be distributed in the near future.
Siwicki then applied the discount to NAV from the single comparable of 51% to the net asset value of $10.3 million to reach a “net asset value” of $5.9 million. Note, however, that the discount of 51% to NAV for the comparable was created because the yield on its NAV was not sufficient to induce a buyer to come forth at a higher price. For example, assume that the dividend of IDS/Balcor Income Properties was $1.00 per unit. If that dollar was priced to yield 11.0%, it was priced at $9.09 per unit (i.e., $1.00 / 11%). Correspondingly, the $9.09 per unit price represented a 51% discount to IDS/Balcor’s NAV, so its NAV is $18.55 per unit (i.e., solving for X when $9.09 = (1 – .51X)).
There is no new information in the NAV calculation. It is simply a proxy for a capitalization of income, and not, strictly speaking, a net asset value method. The reason that his capitalized income figure yields a higher indicated value results from Hill House’s higher payout percentage relative to the selected comparable. [Dr. Kursh indicated that he tried to explain this issue during his testimony. Unfortunately, the Court either did not understand or did not agree with his explanation. The fact is, Kursh’s interpretation is correct.]
Siwicki used weights of 75% on his capitalization of income method and 25% on his net asset value method, yielding an indication of value prior to the application of his marketability discount of $5.9 million, or a 43% minority interest discount to net asset value of Hill House of $10.3 million. Note that the yield at this indication of value is 11.5% based on the 3-year average distributions, and 13.5% based on 1992 distributions, before the application of a marketability discount.
At this point, Siwicki “reviewed various market studies on illiquid securities” to arrive at a 35% marketability discount. In particular, he relied upon the 1971 SEC restricted stock study. After applying his 35% marketability discount, Siwicki concluded that the fair market value of the limited partnership was $3.9 million, or 37% of net asset value of $10.3 million (i.e., a 63% discount from NAV).. The value of the subject interest of 25.235% was therefore $972 thousand. The yields implied by his conclusion are 17.7% based on three-year average distributions and 20.8% based on 1992 distributions.
Dr. Kursh’s valuation is summarized in Table 5 and commented on below.
Dr. Kursh used only one method, a capitalization of income method, in valuing the subject interest. He used this method to determine an effective minority interest discount from NAV.
Beginning with the May/June 1993 issue of “The Perspective” published by Partnership Profiles, Inc. (covering 1992 transactions) Kursh selected partnerships that owned residential and/or commercial real estate. These partnerships also had low debt or leverage, had cash flows greater than their distributions and capital expenditures, and had assets that were valued by independent appraisers. Yields on the selected partnerships ranged from 9.3% to 11.6%, and Kursh selected a base rate of return of 10.45% (the median). He adjusted this yield for: a) the lack of diversity of the subject (+0.50%); b) commonality of interests (-1.00%, because the general partner was also a limited partner; and, c) distressed sales in the Partnership Profiles data base (-0.25%). His resulting yield applied for capitalization was 9.7%.
Kursh recognized that the mortgage would soon be paid off and that there would be a substantial increase in cash flow thereafter. He used distributions of $800,476 (after adjusting for his rounding) for 1992 as the “minimum level that a potential buyer would anticipate.” [His reasons for this assumption included the long history of paying dividends, the known increase in cash flow in four months, the excellent condition of the property and the fact that the general partner had substantial interests (direct and indirect) in the distributions to the limited partners.] His resulting marketable minority indication of value was $8.3 million, or a 20% minority interest discount to net asset value of $10.3 million.
Kursh used the QMDM to arrive at a marketability discount of 15%. Now some jaded readers are likely to think that he used a lower than “normal” marketability discount because his client was the IRS. In fact, Kursh used a lower than “normal” marketability discount because a low discount was warranted by the facts! And the Court agreed.
There are five key assumptions to the QMDM. The Court noted four of them used by Kursh.
The expected growth rate of value was estimated at 3% to 4%, based on expected inflation. Note that this is consistent with recent growth in earnings shown above. We will use 3.5% in this analysis. Kursh assumed that the expected growth rate in dividends would be in the same 3% to 4% range. We will use 3.5% in our analysis. [This assumption regarding the expected growth of distributions is clear from Kursh’s report, although not noted by the Court.]
His expected distribution yield was 10% ($800 thousand / $8.3 million, rounded).
He assumed a required holding period return of 16.4%. He used a build-up method beginning with Treasury yields and added a total of 9.2% for a combined large and small stock premium. To his resulting base equity discount rate of 14.4% he added a 1% premium for holding period uncertainty and another 1% premium for lack of diversification. He then bracketed this discount rate and assumed a relevant range of required returns of 16% to 18% in his analysis.
And Kursh assumed that the expected holding period would be between 10 and 15 years.
Kursh presented QMDM tables that, under his assumptions, yielded a marketability discount of 15%. His conclusion of 15% is highlighted for visual reference. The Court’s conclusion of 20% is also shown to be well within the range of judgment indicated by Dr. Kursh’s assumptions! (see Table 6)
A detailed QMDM analysis summarizing Dr. Kursh’s assumptions, and showing his conclusion regarding the marketability discount, that of the Court, and the investment indicated by the Court’s variation on Kursh’s assumptions is provided as Table 7.
Applying the 15% marketability discount to a capitalized income indication of $8.3 million yielded a value of $7.0 million for the FLP, and $1,770,103 for the subject interest. The yield at this conclusion is 9.7% based on 3-year average distributions, and 11.4% based on 1992 distributions.
[It should be clear by now that I believe that Dr. Kursh’s analysis is closer to cosmic truth than Mr. Siwicki’s. Consider another possibility. The limited partners of Hill House do not have to wait for an ultimate sale for substantial liquidity. The general partner could elect to re-mortgage the property and make a special distribution in the near future, which mortgage could be repaid by lowering or eliminating current partnership distributions. There are obviously tax implications to such a strategy, but it is illustrative of the flexibility that existed with Hill House.]
The Court took elements from each of the appraisers in arriving at a value, before marketability discount, of $6.5 million as can be seen in Table 8. Note that this represents an effective minority interest discount of 37%. We will put this aspect of the Court’s analysis into perspective below.
The Court’s conclusion of fair market value of Hill House was $5.2 million, or 50% of NAV. The fair market value of the 25.235% subject interest was therefore $1,309,651. The implied yields based 3-year average distributions and 1992 distributions were 13.2% and 15.4%, respectively.
Mr. Siwicki and the Court (following Siwicki) used Partnership Profiles transaction data to determine a minority interest discount. In doing so, I believe they overstated the effective minority interest discount. Dr. Kursh could be criticized for making the same mistake but to a much lesser degree (because he did not combine his yield capitalization with a “net asset value method”). However, his use of the QMDM allowed him to derive a reasonable conclusion nonetheless.
We need some background regarding Partnership Profiles data to put these comments into perspective. They will assist in understanding the differences between Mr.Siwicki’s 43% minority interest discount, the Court’s 37% minority interest discount, and the 20% minority interest discount applied by Dr. Kursh.
It is generally recognized that, while there is a limited market for the publicly owned limited partnerships, the market is not considered to be overly active or efficient.
Publicly traded limited partnership interests are thinly traded in the secondary market compared to the activity of stocks in the primary markets, such as the New York Stock Exchange (NYSE). When an investor sells shares of a company traded on the NYSE, he or she can receive the cash proceeds in three days. However, it typically takes 60 to 180 days for an investor in publicly traded limited partnership units to complete the transaction and receive the cash proceeds primarily because of the required paperwork with the general partner. Even with this delay, a public limited partnership interest is generally more liquid than a private limited partnership interest, causing the private interest to normally be worth less than a comparable publicly traded interest. [Fishman, Pratt, et al, GUIDE TO BUSINESS VALUATIONS (Fort Worth: Practitioners Publishing Company, 1999), p. 14-18].
In a recent presentation by Charles Elliott, ASA, of Howard, Frazier, Barker and Elliott, several aspects of the secondary market for limited partnership interests were discussed. The paper was presented at the 1998 Annual Business Valuation Conference of the AICPA [Elliott, “An Outline of Valuation Considerations Related to Limited Partnerships,” which is available through SHANNON PRATT’S BUSINESS VALUATION UPDATE website (http://www.bvupdate.com). After subscriber login, click on Whitepapers and search for “Family Limited Partnerships, AICPA 1998 Conference”].
Elliott’s analysis of the secondary market is consistent with theimplications of the QMDM. We highlight certain sections and comment on their relationship to the QMDM factors noted above (these sections are found in Elliott’s paper under the “Valuation’sky hooks’/valuation reference points” heading).
4. Based upon input from the Secondary Market and from Partnership Profiles, Inc., the following conclusions are drawn regarding the basis upon which pricing of limited partnership units in the Secondary Market is determined.
4a. Cash distributions and therefore yield are most important; this is clearly the driver of pricing of partnerships in the Secondary Market. [Therefore, the QMDM’s focus on expected distribution yields and distribution growth.]
4d. Underlying cash flow coverage of yearly distributions made to partners. [This goes to the riskiness of the expected earnings stream and would be considered in the development of the required holding period return of the QMDM.]
4f. Whether or not the assets of the partnership are well diversified. [Again, the mix and diversification of a partnership relate to its riskiness as well as general attractiveness.]
4h3. The time period until liquidation. [A critical focus of the QMDM is in making a realistic estimate of the expected holding period until an opportunity for liquidity may arise. Note that we can almost never know with certainty what the expected holding period will be. However, it is important to make a reasonable estimate based on the facts and circumstances of each case. There is an implicit holding period assumption (or range of assumptions) in every concluded marketability discount. The QMDM asks the appraiser to make reasoned and reasonable judgments regarding this factor and to make those judgments (and the rationales therefore) explicit.]
4h4. The universe of interested buyers. [In the QMDM, we consider the return requirements of relevant universe of buyers of particular interests in the development of the required holding period return. If the universe of buyers is very limited, well-heeled, and sophisticated, the required returns can be substantial (and therefore, the derived marketability discounts may be substantial, depending on the other relevant factors).]
4h6. The presence of rights of first refusal. [Rights of first refusal limit marketability and add to the riskiness of investments in illiquid minority interests. In addition, they can increase the expected holding period for an investment. Both of these aspects are considered in the QMDM.]
We could examine all of Elliott’s observations and discuss each of them in the context of the QMDM. What Elliott is saying, however, is that the secondary market prices limited partnership interests on a rational basis that considers the economics and riskiness of ownership. That is what the QMDM attempts to do.
Now, Elliott goes on further to discuss the secondary market, indicating a flaw with Mr. Siwicki’s analysis regarding the marketability discount.
Because our valuation reference source is the Secondary market, it is inappropriate to utilize traditional lack of marketability discounts in the 30-50 percent range. The reason is that the Secondary market is a “thin market.” As a consequence, there is an element of illiquidity already expressed in the pricing of units in the Secondary Market.
Various sources in the Secondary Market have suggested that additional yield of about 200 basis points may be required than otherwise because of the impaired liquidity of the Secondary Market. This translates into a range of lack of marketability discounts of 15-25%, to be applied to the value of a non- controlling interest in a real estate [distributing] FLP.
Siwicki considered the “illiquidity already expressed” mentioned by Elliott in his capitalization of distributions. He then further discounted by weighting a price/NAV method. Finally, he discounted further by applying a “traditional lack of marketability discount” of 35%. The compounding of discounts resulted in a low value with a very high implied yield on expected distributions. This yield represented a premium to his 11% secondary market pricing base of about 1000 basis points, or far greater than Elliott’s suggestion. The Court achieved a more reasonable result by applying a lower than “traditional” marketability discount.
By using market returns from Partnership Profiles applied to the expected distributions of Hill House, Dr. Kursh developed a value indication reflecting approximately a 20% minority interest discount from NAV. His minority interest discount may be overstated somewhat due to the thinness of the secondary market. However, by basing his expected yield on this value, the QMDM mitigated any overstatement of the marketability discount. Unfortunately, these relationships are not necessarily intuitive and are somewhat difficult to explain. [The calculations referenced in the “Alternative Calculations” section below provide support for this observation.]
The Court “did not find the QMDM helpful in this case” because certain assumptions made by Dr. Kursh were “not based on hard data.” So let’s look at Dr. Kursh’s QMDM assumptions and see where they came from [based on information reported in the decision and the Kursh report].
Referring back to the discussion from Fishman above, shortly following the passage cited, Fishman indicates:
“Understanding how publicly traded limited partnership are priced is essential to determining the fair market value of FLP interests. The total expected return for publicly traded limited partnerships generally ranges from 16% to 22%.”
Examining Dr. Kursh’s assumptions in this light, we see he has assumed a total rate of return in the range of 19% (16% lower range return plus 3% inflation) to 22% (18% higher range of return plus 4% inflation). While we sometimes see total returns somewhat higher than this, Dr. Kursh’s results seem clearly within the range of known market data (and the same market data relied upon by the Court).
Based on our review of the case and Dr. Kursh’s report, it appears that Dr. Kursh used information that was factually based and within the range of reasonable comparisons with market data in his application of the QMDM. It is unfortunate, but the Court was apparently not convinced of the reasonableness of Dr. Kursh’s assumptions and their consistency with “hard data” that was in his report and otherwise readily available.
Dr. Kursh used an effective 20% minority interest discount, with Mr. Siwicki and the Court advancing even higher minority interest discounts of 43% and 37%, respectively. I’ve suggested that the higher minority interest discounts are too high. In fact, many appraisers reference studies of closed-end funds and other market data to suggest minority discounts on the order of 10% to 15%. We developed a series of alternative calculations using this lower range of assumptions to show how the QMDM interrelates with differing minority interest discounts to develop appropriate marketability discounts. These calculations are in the context of the assumptions used in the case regarding distributions (either that a 3-year average was appropriate or that the 1992 level was appropriate).
They are further made in the context of Dr. Kursh’s QMDM assumptions. While in an independent analysis, we might have made somewhat different assumptions, Kursh’s assumptions appear generally reasonable and supported by the facts and circumstances of the case. See Table 9.
Since the relevant distribution yield in the QMDM is the yield at the marketable minority level, we might have used somewhat different distribution yields than Dr. Kursh. [We suggest performing a more detailed distribution analysis to convert the yield to a C Corporation equivalent yield.] So the distribution yields vary based on the indicated distributions (3-year and 1992) and minority interest discounts (10% and 15%), relative to the higher minority interest discounts and lower marketable minority indications used by the appraisers in WEINBERG.
We can now make several observations regarding the alternative calculations.
This is not surprising. Hypothetical and real investors pay a price for an investment in the hope of achieving a target expected return. They do not care what the minority interest or marketability discounts might be. These discounts are tools used by appraisers to simulate the thinking of investors. As mentioned previously, all three calculations value the same expected cash flows and should yield similar results. In this regard, the QMDM is a forgiving tool. Mis-estimates in the minority interest discount tend to be offset by yield adjustments relative to the concluded marketable minority indications (for high distribution entities in particular).
Recall that I believe the Court, following Siwicki’s methodology, overstated the minority interest discount. Because the Court’s effective 37% minority interest discount includes significant elements of a marketability discount (see the Fishman and Elliott discussions above), the application of a 20% marketability discount (larger than Kursh’s calculated discount of 15%) overstates the effective marketability discount relative to the alternate calculations with similar assumptions (and yields a lower conclusion).
[Readers should not infer that I am faulting the Court’s conclusion. Judge Whalen relied on economic evidence that was presented by one expert (Siwicki). Dr. Kursh’s report did not address the logical problems and theoretical issues with the use of Partnership Profiles data raised above by way of rebuttal. He did attempt to explain the problem in Court. However, as is seen by this E-LAW, whose length exceeds that of the Court’s entire decision or Dr. Kursh’s report, there is room for confusion. I do hope this E-LAW will help clarify the issues. We encourage all readers to review the cited sections of Fishman, Pratt and to access Elliott’s analysis.]
I do believe that Dr. Kursh’s analysis using the QMDM was helpful to the Court. It kept a clear focus on the impact of distribution yield on value. It allowed the Court for the first time (at least in a published decision) to focus on all the critical QMDM factors. It also gave the Court a basis to reach a conclusion of fair market value that was far more reasonable than that advanced by the taxpayer’s expert. As should be clear from the analysis above, it appears that Dr. Kursh “won” the battle over the appropriate marketability discount. He “lost” the battle over the appropriate minority interest discount. It is unfortunate that the Court’s comments seem critical of the QMDM, because the Court’s conclusion is entirely consistent with its application by Dr. Kursh.
Two final notes. First, I approach case reviews with caution and considerable trepidation. As an appraiser and a writer, I know that I am subject to review and analysis by other appraisers and courts. I always try to treat the work of other appraisers with respect and hope to receive similar treatment.
Second, it is possible that a case review of mine could be interpreted as critical of a Court or a particular trier of fact.
Again, I approach each case review with the utmost respect for the Court. In valuation cases, the trier of fact has a difficult job. He or she must deal with complex valuation issues, often presented in multiple valuation reports of varying quality, listen to and make judgments about expert testimony and factual issues, as well as deal with other relevant aspects of each case – and the judge has to write a decision that will be reviewed by multiple parties. I hope all readers of these case reviews will consider them in the context they are offered – as constructive and, hopefully, objective analyses to offer valuation insights to our readers.
Reprinted from Mercer Capital’s E-Law Newsletter 2000-03 & 2000-04, March 13, 2000.
In Davis v. Commissioner (Estate of Artemus D. Davis v. Commissioner, 110 T.C. 35 (1998)), the Tax Court ruled favorably for an economic consideration of the embedded capital gains tax inside an asset holding company for the first time since the repeal of The General Utilities doctrine in 1986.
In November 1992, Taxpayer made two minority gifts of approximately 26% each of an asset holding company, the primary asset of which was a 1.3% interest in Winn-Dixie, a large, publicly traded grocery chain. The market value of the interest was some $70 million, which approximated the embedded capital gain. The blocks of shares represented founders’ shares, and were subject to restrictions under Rule 144 of the SEC Act of 1934.
The Tax Court heard from two experts for the taxpayer and one for the IRS. All three were experienced business appraisers who held senior member designations (ASA or FASA) from the American Society of Appraisers. All three experts submitted appraisal reports to the Court.
Upon review of the appraisal reports and the testimony of the experts, and of a stipulation of the net asset value of the holding entity (before consideration of embedded capital gains), the Court dealt with four issues.
Based on a review of the case, it appears that the Court was presented with an array of valuation evidence that it considered, in the main, to be credible. There is nothing unusual about the Court’s treatment of the minority interest discount, or the marketability discount (excluding the embedded gains issue). The restricted stock/blockage issue was unusual in that no discount was allowed.
Davis v. Commissioner will be remembered as an embedded capital gains tax liability case because it is the first post-1986 Tax Court case that has allowed explicit consideration of this liability.
Neither of the experts advancing the “incremental marketability discount” treatment of the embedded gains liability offered any evidence or rationale for their selected increment. The Court provided no further insight. Appraisers relying on the “Davis methodology” are likely to find themselves using unreliable evidence, absent a compelling rationale or explanation of their own.
The Court should have allowed a deduction from net asset value for the entire amount of the embedded capital gains tax liability. The rationale for this conclusion is developed in a forthcoming article that will appear in the November/December 1998 issue of Valuation Strategies. The article’s working title is “Embedded Capital Gains in Post-1986 C Corporation Asset Holding Companies.” The arguments and analyses presented in this article can help solve the problem of the “Not So Good News” noted above.
The article also comments on the Second Circuit Court of Appeals decision {Eisenberg v. Commissioner [1998 WL 480814] (2nd Cir.)} regarding Eisenberg v. Commissioner [T.C.M. 1997-483, October 27, 1997], which effectively eliminates (at least from our valuation-oriented reading) the ability of the IRS to cite pre-1986 cases to support an argument for not considering embedded capital gains liabilities in a post-General Utilities world.
Embedded capital gains tax liabilities are now recognized as real liabilities by the Tax Court. Appraisers must begin to provide economic arguments to support their positions regarding economic consideration.
Reprinted from Mercer Capital’s E-Law Newsletter 98-02, October 29, 1998.
Reprinted from Mercer Capital’s E-Law Newsletter 98-01, October 23, 1998.
It was interesting to read Estate of Pauline Welch (T.C.M. 1998-167), which was issued in May 1998. Pauline Welch died on March 18, 1993. At the time of her death, Mrs. Welch was a minority shareholder holding voting and nonvoting shares of two privately owned companies, Electric Services, Inc. (ESI) and Industrial Sales, Inc. (ISC). According to the Court’s opinion (with numbered items noted to facilitate further discussion):
The sole issue before the Court was whether a 34% built-in capital gain on real estate held by ESI and ISC should be allowed. In filing the Form 706, the estate took values provided by Mercer Capital for each of the companies (which, as noted above, excluded the value of the real estate and, further, adjusted the earnings of the businesses for rental income on the excluded real estate), added estimated values for the real estate, and then deducted a 34% capital gains allowance on the value of the real estate (not just on the gains), and took a 50% minority interest discount to yield the value of the estate’s minority interest in each of ESI and ISC. At this point, we can address the numbered items in the quotation from the Court’s opinion above:
(1) The Court indicated that the appraisals were prepared on a net asset value method. This is not technically correct. Both companies were operating companies with significant non-operating assets in the form of investment securities. Earnings values were prepared for each of the companies after adjusting for both the rent on the real estate which was excluded and the earnings from the non-operating assets. In each case, indications of value from both a capitalized earnings method and a net asset value method were employed, with the net asset value method being weighted most heavily in the final correlations of value. 100% of the equity of each company, adjusted to exclude the value of real estate, was valued at modest discounts to net asset value.
(2) Mercer Capital WAS NOT EMPLOYED BY THE ESTATE. We were not aware that there was an estate tax issue at the time of the appraisal. Our report was prepared as of June 30, 1993, with a report date of September 7, 1993. Quoting from the first paragraph of the ESI report (in the “Assignment Definition” section, which received parallel treatment in the ISI report):
“Mercer Capital Management, Inc. (“Mercer Capital”) has been retained by Electric Service, Inc. (“the Company” or “Electric Service”), Nashville, Tennessee, to provide valuation services. This report represents an appraisal of the fair market value of the 570 issued and outstanding shares of common stock of Electric Service as of June 30, 1993. The appraisal is prepared on a controlling interest basis. It is our understanding that this report will be used by our client for the purpose of evaluating a possible exchange of shares between the controlling shareholders or a possible sale to a third party.” The court and the estate clearly relied upon the Mercer Capital report for a purpose for which it explicitly was not intended. No representative of Mercer Capital was asked to testify regarding the reports. Our first knowledge of the tax litigation came as the result of a friend calling and asking about our position on built-in capital gains. We were employed to provide valuations of 100% of the stock of each of the companies for purposes of possible transactions between the companies or the parties. We were NOT EMPLOYED to provide valuations of the minority interest blocks of shares of the companies, which included appreciated real estate assets, for estate tax purposes. (The shareholder lists we were provided did not include the estate as a shareholder.)
(3) We did not consider either ESI or ISC to be in liquidation because neither company was in liquidation, nor was liquidation mentioned as a possible outcome for either business.
(4) Mercer Capital DID exclude the book value (and market values) of the underlying real estate. SUCH EXCLUSION WAS REQUIRED BY OUR ASSIGNMENTS. The objective of our appraisals was to determine the value of the companies ON A CONTROLLING INTEREST BASIS WITHOUT THE REAL ESTATE, because the parties knew that those values would be determined in the near future in the anticipated eminent domain proceedings.
(5) The second paragraph of each valuation report reads as follows:
“The Company’s land and buildings are expected to be acquired by the City of Nashville within the foreseeable future via either a negotiated sale or eminent domain proceedings. As of the date of this appraisal, no price for the fixed assets has been discussed. This appraisal was prepared excluding the value of the Company’s real estate assets.”
We were told that the properties had been “targeted for potential sale to the City of Nashville.” And, parenthetically, they were sold to the City.
(6) Since Mercer Capital excluded the real properties from its appraisals, as indicated above, there was no reason to consider the built-in capital gains taxes on the properties.
(7) The estate, the IRS and the Court accepted Mercer Capital’s values of 100% of the common stocks of ESI and ISC without adjustment. Note that this valuation base was at the controlling interest basis. All parties accepted the estate’s suggested 50% minority interest discount (note that Mercer Capital was not consulted by the estate regarding the magnitude of appropriate minority interest discounts or marketability discounts applicable to the estate’s minority interests in the two companies). The sole issue before the Court regarded the applicability of the estate’s suggested 34% capital gains tax on the appreciated real estate in each business. All the arguments were apparently made by counsel for the estate and for the IRS. The record mentions no expert testimony on the issue. For a fact, no representative of Mercer Capital was called upon to testify.
This communication has been written to make several points:
Reprinted from Mercer Capital’s E-Law Newsletter 98-01, October 23, 1998.