Insights

Proprietary insight, expert analysis, and a forward-looking views for valuation decisions that matter.

January 2026 SAAR

January 2026 SAAR declined to 14.9 million units, reflecting seasonal weakness, weather disruption, and lingering effects from Q4 tariff and EV credit dynamics. While transaction prices and consumer spending remain firm, brand-level inventory divergence and affordability pressures are shaping margin outlooks for dealers.

Internal vs. External Valuations for RIAs

Internal and external RIA transactions often reflect different economics beneath the headline multiples. While external buyers may justify higher prices through synergies and lower cost of capital, internal transitions can strengthen succession, reduce key person risk, and enhance long-term value.

What a Sushi Chain Can Teach Family Businesses About Shareholder Surveys

What if boards took a more disciplined approach to listening?

Harkins to Co-present at the 2025 NADC Annual Member Conference

David W. R. Harkins, CFA, ABV is co-presenting at the 2025 NADC Annual Member Conference on May 6, 2025, in Naples, Florida.He will be presenting alongside David Blum, JD of Akerman LLP, and John Davis, CPA and Mike Toth, CFA of Haig Partners. Their presentation is titled "2026 Estate Tax Cliff – Why Auto Dealers Need to Revisit their Estate Plan"David Harkins is a Vice President at Mercer Capital. He has been involved with hundreds of valuation and litigation support engagements in a diverse range of industries on local, national, and international levels. As the leader of the firm’s Auto Dealership Industry team, David publishes research on valuation issues in the newsletter Value Focus: Auto Dealer Industry. He also contributes regularly to Mercer Capital’s Auto Dealer Valuation Insights Blog. As a member of Mercer Capital’s Litigation team, he provides both valuation and lifestyle analyses in addition to preparing attorneys and clients for various aspects of the marital dissolution process.

Who Should Value Your RIA?

Valuation Expertise and Industry Experience Aren’t Mutually Exclusive

Most RIA valuations are routine and uncontroversial, which can make different experts seem interchangeable. But when a tax filing is challenged, a buy-sell agreement is triggered, or a court or regulator scrutinizes the work, valuation stops being an opinion and becomes evidence. In those moments, the question is no longer just the number—it’s whether the professional behind it is qualified to defend it.

What Buy-Sell Agreements Reveal About Shareholder Priorities

Buy-sell agreements in family businesses do more than govern ownership transitions. They reflect shareholder priorities around liquidity, control, and fairness, often based on assumptions that may no longer apply. When those priorities change but the agreement does not, even ordinary events can create friction. For directors, revisiting these agreements is a matter of alignment, not flaw-finding.

Natural Gas Outlook: Producers Face A Familiar Disconnect In 2026

Despite volatile prices and cautious sentiment, U.S. natural gas fundamentals are tightening as disciplined supply and structural demand reshape 2026.

Understanding Seasonality in the Auto Industry

Auto retail has always been cyclical. While headlines often focus on the why (e.g. interest rates, inventory levels, or near-term economic uncertainty), seasonality remains one of the most consistent forces shaping monthly auto sales performance. Over the past decade, even amid supply chain disruptions and changing consumer behavior, the industry’s calendar-driven rhythm has remained remarkably durable.

What a Cold Snap Teaches Us About Cycles in RIA M&A

Seasonal Market Metaphors

While frigid temperatures disrupted travel and infrastructure across the country, the RIA M&A market has remained anything but frozen. Deal activity continues at historically strong levels, reminding firms that favorable conditions are best used to prepare for the inevitable shifts that come with market cycles.

Bank Watch: January 2026

Some “Slop” About 2025 Bank Stock Performance

Small-cap bank stocks delivered a so so 2025. Despite solid earnings growth, small-cap bank valuation multiples remain below long-term averages, reflecting a gap between bank performance metrics and investor sentiment. Large-cap banks continued to outperform small-caps, as well as the broader market, due to strong capital markets activity.

Value Matters^® January 2026

Making Buy-Sell Agreements Work: Valuation Mechanisms and Drafting Pitfalls

Executive SummaryBuy-sell agreements are a cornerstone of planning for closely held businesses and family enterprises. Advisors spend significant time addressing ownership transitions, funding mechanisms, and tax considerations. Yet despite their importance, valuation provisions in buy-sell agreements are often treated as secondary drafting issues. Too often, they are boilerplate clauses that receive far less scrutiny than they deserve. When buy-sell agreements fail, valuation provisions are often the root cause.This article is the first in a two-part series examining how buy-sell agreements function in practice and why so many fall short of their intended purpose. Part I focuses on the valuation mechanisms commonly used in buy-sell agreements – fixed price, formula pricing, and appraisal-based processes – and explains the structural weaknesses that often undermine them. Drawing on our extensive valuation experience, we offer a practical framework for designing valuation provisions that are more likely to produce fair, predictable, and workable outcomes when a triggering event occurs.Part II will address what is required for buy-sell agreement pricing to be used to fix the value for gift and estate tax matters, including the requirements of Internal Revenue Code §2703 and guidance from key court cases such as Estate of Huffman and Connelly. Together, these articles are intended to help estate planners move beyond theoretical drafting and toward buy-sell agreements that withstand both real-world and IRS scrutiny.Common Buy-Sell Valuation MechanismsMost buy-sell agreements fall into one of four categories based on how price is determined:Fixed priceFormula pricingMultiple appraiser processSingle appraiser processEach approach has perceived advantages, but each also carries structural weaknesses that estate planners should carefully evaluate.Fixed-Price AgreementsFixed-price buy-sell agreements establish a specific dollar value for the business or ownership interests based on the owners’ agreement at a point in time. Their appeal lies in simplicity. The price is clear, easily understood, and inexpensive to administer. In theory, fixed-price agreements encourage owners to revisit and reaffirm value periodically.In practice, however, fixed prices are rarely updated with sufficient frequency. As the business evolves, the fixed price may become materially understated, overstated, or – by coincidence – approximately correct. The fundamental problem is not the use of a fixed price, but the absence of a reliable and consistently followed process for updating it. When the price becomes stale, incentives become misaligned. An unrealistically low price benefits the remaining owners, while an inflated price benefits the exiting owner. These distortions undermine fairness and often surface only after a triggering event, when renegotiation is least likely to succeed.Formula Price AgreementsFormula pricing agreements determine value by applying a predefined calculation, often based on financial statement metrics such as EBITDA multiples, book value, or shareholders’ equity. These agreements are frequently viewed as more objective than fixed prices and are attractive because they appear to adjust automatically as financial results change.The perceived precision of formulas is often illusory. Over time, changes in the business model, capital structure, accounting practices, or industry conditions can render a once-reasonable formula obsolete. Even when formulas are recalculated mechanically, they may fail to reflect economic reality (book value as a formula is a prime example of this). More importantly, most formula agreements lack guidance on when or how the formula itself should be revisited. Without periodic reassessment, formula pricing can embed significant inequities into the agreement while giving shareholders a false sense of certainty of fairness. Formula price agreements also fail to account for any non-operating assets that may have accumulated on the balance sheet. Valuation Process AgreementsValuation process agreements defer the determination of price until a triggering event occurs and rely on professional appraisers to establish value at that time. These agreements generally fall into two categories: multiple appraiser processes and single appraiser processes.Multiple Appraiser ProcessUnder a multiple appraiser process, each side appoints its own appraiser to value the business following a triggering event. If the resulting valuations differ beyond a specified threshold, the agreement typically calls for the appointment of a third appraiser to resolve the difference or render a binding conclusion.While this approach is intended to ensure fairness through balanced input, it often introduces uncertainty, delay, and cost. The final price, timing, and expense of the process are unknown at the outset. In addition, even well-intentioned appraisers may be perceived as advocates for the parties who selected them, complicating negotiations and eroding confidence in the outcome. For family-owned businesses in particular, the multiple appraiser process can unintentionally escalate conflict at a sensitive moment.Single Appraiser ProcessUnder a single appraiser process, one valuation firm is designated, either in advance or at the time of a triggering event, to perform a valuation. This approach is generally more efficient and cost-effective and avoids dueling opinions. When valuations are performed periodically, it can also make outcomes more predictable well before a triggering event occurs. Its effectiveness, however, depends entirely on careful advance planning and drafting.A More Effective Framework: “Single Appraiser: Select Now, Value Now and Annually (or Periodically) Thereafter”Given the shortcomings of traditional valuation mechanisms, is it possible to design a buy-sell valuation process that reliably produces reasonable outcomes? We believe it is.Based on extensive buy-sell agreement related valuation experience, we recommend a framework built on three principles: selecting the appraiser in advance, exercising the valuation process before a triggering event, and careful drafting of the valuation language in the agreement. 1. Retain an Appraiser NowEstate planners and other attorneys who draft buy-sell agreements should encourage clients to retain a qualified business appraiser at the outset, rather than waiting for a triggering event. Conducting an initial valuation transforms abstract agreement language into a concrete report that shareholders can review, understand, and question. This process reveals ambiguities in the agreement, clarifies expectations, and allows revisions to be made when no party knows whether they will ultimately be a buyer or a seller.This “Single Appraiser: Select Now, Value Now and Annually (or Periodically) Thereafter” approach offers several advantages:The valuation process is known and observed in advanceThe appraiser’s independence is established before any economic conflict arisesValuation methodologies and assumptions are understood by all partiesThe initial valuation becomes the operative price until updated or conditions changeAmbiguities in valuation language are identified and corrected earlyFuture valuations are more efficient, consistent, and less contentious2. Update the Valuation Annually or PeriodicallyStatic valuation mechanisms do not work in a dynamic business environment. Annual or periodic valuation updates help align expectations and reduce the likelihood of surprise or dissatisfaction when a triggering event occurs. In practice, disputes are more often driven by unmet expectations than by the absolute level of value. Regular valuations promote transparency and reduce friction.3. Draft Precise Valuation LanguageEven the best valuation process can fail if the agreement lacks clarity. Attorneys drafting buy-sell agreements should ensure that the agreements address, at a minimum:Standard of value (e.g., fair market value vs. fair value)Level of value (enterprise vs. interest level; treatment of discounts)Valuation date (“as of” date)Funding mechanismAppraiser qualifications (making certain to use business appraiser qualifications. For example, a “certified appraiser” refers to a real estate appraiser, rather than a business valuation expert.) Applicable appraisal standardsAmbiguity on any of these points materially increases the risk of divergent interpretations and unsuccessful outcomes.ConclusionBuy-sell agreements fail not because valuation is inherently subjective, but because valuation provisions are often left ambiguous, untested, or static. Estate planners and other attorneys who draft buy-sell agreements play a critical role in preventing these failures. By selecting appraisers in advance, exercising valuation processes periodically, and carefully drafting valuation language, advisors can dramatically improve the likelihood that a buy-sell agreement will function as intended.When valuation mechanisms are designed with the same rigor as tax and estate plans, buy-sell agreements can become durable planning tools capable of delivering predictability, fairness, and continuity when they are needed most. And the buy-sell agreement pricing may even be able to be used to fix the value for gift and estate tax filings. We will discuss this in Part II.For advisors who want to delve deeper into valuation concepts, planning strategies, and practical applications in estate and business succession planning, we recommend Buy-Sell Agreements: Valuation Handbook for Attorneys by Z. Christopher Mercer, FASA, CFA, ABAR (American Bar Association), written by our firm’s founder and Chairman. This book offers a thorough treatment of valuation issues and provides example language for consideration by attorneys when drafting buy-sell agreements that contain language important to the valuation process.

Middle Market Transaction Update Winter 2025

Middle market M&A activity rebounded in the third quarter of 2025, although year-to-date activity remains depressed compared to prior-year levels.

Being Ready for an Unsolicited Offer

Preparedness is often mistaken for “getting ready to sell.” In reality, it is a governance discipline, one that gives families clarity about what the business means to them, how decisions will be made under pressure, and whether opportunities will be evaluated thoughtfully rather than reactively.

RIA M&A Update: Q4 2025

M&A activity in the RIA industry remained elevated through the end of 2025, capping a year defined by historically strong deal volume. While monthly deal counts in the fourth quarter moderated from the record-setting pace observed earlier in the year, overall activity remained well ahead of prior-year levels.

The Third Appraiser Isn’t There to Split the Difference

For many family businesses, valuation is treated as a one-time event rather than an ongoing tool. When viewed only at moments of necessity, valuation can create surprises, tension, and misalignment. Directors who treat valuation as a continuous process, however, use it to support better governance, promoting clear communication and more informed decision-making over time.

Defying the Cycle: Haynesville Production Strength in a Shifting Gas Market

Haynesville shale production defied broader market softness in 2025, leading major U.S. basins with double-digit year-over-year growth despite heightened volatility and sub-cycle drilling activity. Efficiency gains, DUC drawdowns, and Gulf Coast demand dynamics allowed operators to sustain output even as natural gas prices fluctuated sharply.

The State of Wealth Management Entering 2026

The wealth management industry delivered another year of growth in 2025, supported by favorable equity market performance amid periods of market volatility. Within the publicly traded RIA universe, outcomes varied across investment manager models and asset exposures.

Digital Assets and Divorce

The rapid rise of digital assets over the last several years has introduced new considerations and investigative needs for forensic accountants and family law practitioners. Once considered a niche investment vehicle, digital assets have become an increasingly common component of marital estates. Today, we must consider a broad range of digital assets, including cryptocurrencies, non-fungible tokens (“NFTs”), assets held in digital wallets, decentralized finance (“DeFi”) accounts, token-based compensation, and other blockchain-based holdings.

Valuation Is a Process, Not an Event

December 2025 SAAR

The U.S. auto industry closed 2025 with modest sequential improvement, surpassing 16 million units for the first time since 2019. While volumes stabilized late in the year, continued year-over-year declines, rising incentives, and uneven inventory levels across brands highlight a market that is normalizing rather than accelerating. As the industry moves into 2026, disciplined inventory management and margin preservation will be critical drivers of dealer performance and franchise value.

Haynesville Shale M&A Update: 2025 in Review

Key TakeawaysHaynesville remains a strategic LNG-linked basin. 2025 transactions emphasized long-duration natural gas exposure and proximity to Gulf Coast export infrastructure, reinforcing the basin’s importance in meeting global LNG demand.International utilities drove much of the activity. Japanese power and gas companies pursued direct upstream ownership, signaling a shift from traditional offtake agreements toward greater control over U.S. gas supply.M&A was selective but meaningful in scale and intent. While overall deal volume was limited, announced transactions and reported negotiations reflected deliberate, long-term positioning rather than opportunistic shale consolidation.OverviewM&A activity in the Haynesville Shale during 2025 was marked by strategic, LNG-linked transactions and renewed international investor interest in U.S. natural gas assets. While investors remained selective relative to prior shale upcycles, transactions that did occur reflected a clear pattern: buyers focused on long-duration gas exposure, scale, and proximity to Gulf Coast export markets rather than short-term development upside.Producers and capital providers increasingly refocused efforts on the Haynesville basin during the year, including raising capital to acquire both operating assets and mineral positions. This renewed attention followed a period of subdued transaction activity and underscored the basin’s continued relevance within global natural gas portfolios.Although the Haynesville did not experience the breadth of consolidation seen in some oil-weighted plays, the size, counterparties, and strategic motivations behind 2025 transactions reinforced the basin’s role as a long-term supply source for LNG-linked demand.Announced Upstream TransactionsTokyo Gas (TG Natural Resources) / ChevronIn April 2025, Tokyo Gas Co., through its U.S. joint venture TG Natural Resources, entered into an agreement to acquire a 70% interest in Chevron’s East Texas natural gas assets for $525 million. The assets include significant Haynesville exposure and were acquired through a combination of cash consideration and capital commitments.The transaction was characterized as part of Tokyo Gas’s broader strategy to secure long-term U.S. natural gas supply and expand its upstream footprint. The deal reflects a growing trend among international utilities to obtain direct exposure to U.S. shale gas through ownership interests rather than relying solely on long-term offtake contracts or third-party supply arrangements.From an M&A perspective, the transaction highlights continued willingness among major operators to monetize non-core or minority positions while retaining operational involvement, and it underscores the Haynesville’s attractiveness to buyers with a long-term, strategic view of gas demand.JERA / Williams & GEP Haynesville IIIn October 2025, JERA Co., Japan’s largest power generator, announced an agreement to acquire Haynesville shale gas production assets from Williams Companies and GEP Haynesville II, a joint venture between GeoSouthern Energy and Blackstone. The transaction was valued at approximately $1.5 billion.This acquisition marked JERA’s first direct investment in U.S. shale gas production, representing a notable expansion of the company’s upstream exposure and reinforcing JERA’s interest in securing supply from regions with strong connectivity to U.S. LNG export infrastructure.This transaction further illustrates the appeal of the Haynesville to international buyers seeking stable, scalable gas assets and highlights the role of upstream M&A as a tool for portfolio diversification among global utilities and energy companies.Reported Negotiations (Not Announced)Mitsubishi / Aethon Energy ManagementIn June 2025, Reuters reported that Mitsubishi Corp. was in discussions to acquire Aethon Energy Management, a privately held operator with substantial Haynesville production and midstream assets. The potential transaction was reported to be valued at approximately $8 billion, though Reuters emphasized that talks were ongoing and that no deal had been finalized at the time.While the transaction was not announced during 2025, the reported discussions were notable for both their scale and the identity of the potential buyer. Aethon has long been viewed as one of the largest private platforms in the Haynesville, and any transaction involving the company would represent a significant consolidation event within the basin.The reported talks underscored the depth of international interest in Haynesville-oriented platforms and highlighted the potential for large-scale transactions even in an otherwise measured M&A environment.ConclusionWhile overall deal volume remained selective, the transactions and reported negotiations in 2025 reflected sustained global interest in U.S. natural gas assets with long-term relevance. Collectively, the transactions and negotiations discussed above point to a Haynesville M&A landscape driven less by opportunistic consolidation and more by deliberate, long-term positioning. As global energy portfolios continue to evolve, the Haynesville basin remains a focal point for strategic investment, particularly for buyers seeking exposure tied to U.S. natural gas supply and LNG export linkages.

RIA Market Update: Q4 2025

Alternative asset managers faced a more challenging quarter, with declining prices and valuation compression driven by investor preference for traditional strategies in a higher-for-longer rate environment. Despite near-term headwinds, scale, recurring revenue models, and long-term growth fundamentals continued to underpin investor interest across the sector. We explore these trends further in our Q4 2025 Market Update.

What Are You Prioritizing in 2026?

As the new year begins, family business boards have an opportunity to reflect on the often-unspoken priorities that shape their strategic finance decisions. This post explores four key “matched pairs” of priorities—optionality vs. conviction, growth vs. resilience, reinvestment vs. liquidity, and concentration vs. diversification—where misalignment can create tension and confusion. Entering 2026 with clarity and open dialogue about these tradeoffs can be one of a family business’s most valuable strategic assets.

Bank Watch: December 2025

Bank M&A in 2026 May Have a 1990s Vibe

Bank M&A activity in 2025 returned to a more normal pace, with announced deals rising to 176 and disclosed deal value jumping to $49 billion, supported by improved pricing, stronger bank valuations, and faster regulatory approvals. Large regional bank transactions, including Fifth Third–Comerica and Huntington’s acquisitions, signaled a more favorable and permissive environment that could resemble the consolidation wave of the late 1990s. Looking ahead to 2026, stable economic conditions, healthier bank profitability, and supportive equity markets suggest M&A activity could remain strong, though outcomes will depend on market performance and pricing discipline.

Medtech and Device Industry Newsletter - Q4 2025

Feature Article | Year in Review: Across MedTech, Discipline Is a Recurring Theme

Top 12 Family Business Director Blog Posts of 2025

2025 Year in Review

2025 – what a year it has been! Our Mercer Capital Family Law Valuation and Forensic Insights Newsletter now reaches almost 6,000 readers. We seek to provide you and your teams with useful information focusing on various complex financial issues in a manner which is understandable and helpful to our readers.

PODCAST | Beyond the Lot: Understanding Dealership Valuations

with Kevin Timson and David Harkins

Mercer Capital Vice President David Harkins was recently featured on the podcast Beyond the Lot: Understanding Dealership Valuations, hosted by Kevin Timson, for a wide-ranging conversation on the factors that truly drive value in automotive dealerships. Drawing from his experience advising auto dealers nationwide, David discusses how elements such as brand strength, real estate, fixed operations, and local market dynamics influence dealership valuations.

Top 10 Oil & Gas Blog Posts of 2025

Year-end 2025 is quickly approaching so that means it’s time to take a look back at the year. Here are the top ten posts for the year measured by readership.

‘Twas the Blog Before Christmas

The Ghost of Trust

Each year, we close our blog with a holiday poem inspired by Clement Clarke Moore’s A Visit from St. Nicholas. This season, with markets at record highs but public trust in institutions on shakier ground, it seemed fitting to summon the ghost of J. P. Morgan himself. In “The Ghost of Trust,” Morgan visits on a December night in New York to remind us that even in an age of algorithms, skyscrapers, and artificial intelligence, the most important capital a firm can hold is integrity.

Compensation Questions: Staying True to Your “True North” in an Era of Volatility

Macro-economic volatility has put pressure on compensation programs that depend on accurate goal-setting and stable growth, affecting executive morale and jeopardizing talent retention. Ultimately, the family-owned companies that best weather this uncertainty consider pay adjustments within the broader context of family shareholder and business needs.

Trust Capabilities and the RIA Move Up-Market

A growing number of RIAs are positioning themselves up-market, targeting larger households, multi-generational families, and clients whose needs extend well beyond investment management. Ultra-high-net-worth clients often rely on trusts not just for estate planning but as central vehicles for governance, control, tax efficiency, and multi-generational wealth transfer. These structures must be administered accurately and consistently for years — often decades — after they are created.

Themes from Q3 2025 Earnings Calls

Third-quarter commentary from E&P and oilfield service companies highlighted a cautious near-term outlook paired with growing confidence in long-term demand. While operators remain in “maintenance mode,” structural growth themes—LNG, data centers, offshore development, and water midstream—continue to shape strategy. Despite softer activity, companies emphasized free cash flow, efficiency, and positioning for stronger demand later in the decade.

Making it Through December

As each year draws to a close, family business directors naturally assess how the business performed and the firm’s profitability over the course of the year. For some, profitability was assured months ago. For others, it remains uncertain whether they will make it through December without incurring a loss for the year.

Fair Value of Contingent Consideration (Earn-Outs) in M&A

Financial Reporting Flash: Issue 3, 2025

Contingent consideration, often structured as earn-outs, helps buyers and sellers in M&A transactions navigate differing views on price. Under accounting rules, these arrangements must be measured at fair value on the acquisition date, with potential remeasurements in future periods. Analytical approaches vary depending on the payout structure, underlying metrics, and risk characteristics. Careful attention to structure, modeling approach, and documentation of key assumptions is essential for financial reporting.

New Resource Available: Business Valuation 101

In our newest booklet, Mercer Capital provides a framework of business valuation. Valuation is both an art and a science requiring technical knowledge and experience, informed judgment, and a clear understanding of the context in which an opinion of value will be applied. Whether for marital dissolution, shareholder dispute, estate planning, or transaction advisory, the valuation of a privately held business or business interest demands careful consideration of purpose, standard of value, premise of value, and facts and circumstances unique to the engagement and other factors.

November 2025 SAAR

The November 2025 SAAR improved to 15.6M, yet industry volumes posted a second month of year-over-year declines amid tariff impacts and expiring EV incentives. After September’s tax-credit rush, BEV market share has fallen by more than half, signaling a sharp reset in EV sales momentum. Finally, despite likely topping 16M units for 2025, per-unit profitability is slipping, and dealer performance is increasingly dependent on brand-specific inventory discipline.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of December 4, 2025

Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.

Five Ways RIAs Can Turn Good Years Into Lasting Momentum

How to Convert a Great Year Into Durable Success

Momentum for RIAs isn’t about riding strong markets, it’s about building systems that hold up when conditions tighten. As firms look toward 2025-26, the advantage will go to those that understand the true drivers of their growth, reinforce margins, and modernize ownership to support long-term strategy.

Bank Watch: November 2025

Top Three Questions for Potential Bank Acquirers

Community bank M&A accelerated in 2025, with deal volume, values, and pricing all rising amid a more favorable regulatory climate and continued economic expansion. If these trends continue, 2026 could offer attractive opportunities for banks exploring strategic options. Against this backdrop, acquirers should focus on strategic fit, realistic valuation, and the pro forma impact of any potential transaction.

100 Pounds of Popcorn and the Lessons of Family Enterprise

To be frank, we find most “business books” to be boring, earnest attempts to render the blindingly obvious as unique insight and the banal as profound. So, when asked about our favorite business books, we don’t hesitate to recommend Hazel Krantz’s 100 Pounds of Popcorn, a children’s book published in 1961 and now, sadly, out of print. Three siblings stumble upon a mysterious 100-pound bag of popcorn in the road. What starts as a curiosity quickly becomes an adventure in decision-making, cooperation, and the sometimes-messy economics of running a tiny enterprise.

Valuing a Business for Estate Planning Purposes During a Transaction Whitepaper

Whitepaper | Valuing a Business for Estate Planning Purposes During a Transaction

This whitepaper discusses several items we consider when appraising a business for estate planning purposes while a transaction process is underway.

The Long Run: Gratitude, Trust, and Legacy in Family Business

As we head into Thanksgiving, I encourage family business leaders to take a moment and reflect on who makes your success possible; recognize those contributions in tangible ways; reinvest in the community that supports you; and reaffirm the shared values that unite your family and your enterprise.

Leftovers: RIA Themes from 2025 That Will Carry Into 2026

As firms sort through the “leftovers” of 2025, several themes are poised to carry meaningful weight into 2026. Margin discipline, improved client engagement, and rising operational maturity have strengthened the industry’s foundation. Strategic dealmaking, evolving succession plans, and measured progress with AI adoption continue to shape valuations and competitive dynamics. These lingering trends aren’t remnants—they’re the building blocks of a resilient, opportunity-rich year ahead for RIAs.

Earnouts That Actually Pay in RIA M&A

Earnouts can bridge valuation gaps in RIA M&A by tying part of the purchase price to post-close performance. This article explains the differences between retention and growth earnouts, key metric choices, and structural considerations that help create clear, predictable, and effective earnout frameworks for both buyers and sellers.

Just Released: Q3 2025 Oil & Gas Industry Newsletter

Region Focus: Appalachia

Overall, the Appalachian basin enters late-2025 on firmer footing than a year ago, characterized by stable production, recovering equity performance, and improving infrastructure fundamentals. Continued progress on export capacity and incremental LNG demand should provide a constructive backdrop for basin economics heading into 2026.

Dividends as Dialogue

Using Policy to Communicate & Align Across Generations

Dividends communicate more than cash flow. In family businesses, dividend policy is not merely a financial decision.

A Decade in Motion: How COVID Reshaped Valuations in the Transportation Industry

The last several years have been nothing short of transformative for the transportation and logistics industry. Shifts in global trade patterns, consumer behavior, capital markets, and cost structures have left an indelible mark on both the operating performance and valuation metrics of transportation companies. A review of enterprise value to EBITDA (EV/ EBITDA) multiples across key subsectors, truckload, less-than-truckload (LTL), air, marine, rail, and logistics, reveals three distinct eras: the calm before the storm (pre-COVID), the whiplash of the pandemic years, and the normalization that followed.

Transportation & Logistics Newsletter

Third Quarter 2025

How RIAs Should Use Their Excess Horsepower

Making Productive Use of Earnings

Investment management firms generate more earnings than they need. The real challenge isn’t making money—it’s deciding, intentionally and strategically, how best to use it.

Beyond the SAAR: What Really Drives Auto Dealership Value

Because the federal government has just reopened, the official data for the monthly light-vehicle SAAR (Seasonally Adjusted Annual Rate) is not yet available. In the meantime, we invite you to download and review our whitepaper, “Understand the Value of Your Auto Dealership.”

Oil vs. Gas: Diverging Valuations in the Energy Patch Persist

U.S. Upstream Producers Are Closing 2025 with Sharply Different Stories Depending on the Molecules They Sell

2025 continues some of the same valuation trends that I have written about earlier this year. As U.S. oil producers battle with middling prices, emerging breakeven cost issues, and shrinking Tier 1 acreage, gas investors are foreseeing growth and future profitability. Investors are rewarding future demand visibility over near-term cash generation, a rare reversal in a sector long dominated by oil.

Capital Budgeting in 5 Minutes

In this video, Travis Harms provides a concise overview of the key elements of the capital budgeting cycle, highlighting some common missteps along the way.

Medtech and Device Industry Newsletter - Q3 2025

Feature Article | Caris Life Sciences: Precision Medicine Meets AI

What to Look for in an Acquisition Target for Your RIA

This week we’re flipping the script on last week’s post, "What to Look for in a Buyer for Your RIA," to analyze transactions from the buy-side perspective. This post focuses on the key attributes that RIA acquirers should look for in a target that should make the transaction successful, value-accretive, and enduring.

The Evolving Economics of Oilfield Water

From Breakevens to Data Centers

The oilfield water sector continues to mature as one of the more strategically significant and rapidly changing segments of the energy value chain. At the recent 7th Annual Oilfield Water Industry Update, executives and analysts from across the industry discussed how water management is no longer a secondary operational consideration but a primary driver of production economics, infrastructure planning, and even cross-industry innovation.

Insights from Brown Brothers Harriman’s 2025 Private Business Owner Survey

Succession Planning Is a Persistent Challenge: While a majority of family business owners recognize the importance of succession, only 23% have a fully implemented plan.

November 2025 | Lessons from Estate of Rowland

Value Matters^® November 2025

Documenting Fair Market Value: Lessons from Estate of Rowland v. Commissioner

A Guide for Estate PlannersExecutive SummaryBusiness valuations that are well-documented with support for the methodology used and how the concluded value was arrived at are at the core of effective estate tax planning. The recent decision in Estate of Rowland v. Commissioner (T.C. Memo. 2025-76) reinforces that truth by showing how incomplete valuation documentation within Form 706 can jeopardize an otherwise straightforward portability election.While Rowland involved a filing delay, the Court’s opinion makes clear that a deficient or poorly documented valuation can be just as damaging as a missed deadline. For estates holding closely held business interests, which are often significant and complex assets, the importance of thoroughly documenting the process of reaching fair market value cannot be overstated.Background: The Portability Election and Form 706Under Internal Revenue Code § 2010(c)(5)(A), a surviving spouse may use any portion of the deceased spouse’s unused estate tax exclusion (the deceased spousal unused exclusion, or “DSUE”) if the first spouse’s executor properly elects portability.That election must be made through a timely filed and complete Form 706. Even when an estate owes no estate tax, the return must contain detailed and supportable valuations of every asset, including business interests. Omitting or estimating values exposes the election to IRS challenge and potential invalidation.Facts of the CaseFay Rowland died in 2016, leaving an estate approximately $3.7 million below the filing threshold. Her executor obtained a six-month extension but filed Form 706 nearly six months after the extended deadline.The return also lacked key valuation detail: 1) schedules reflected only estimated totals, not fair market values for individual assets; and 2) the executor claimed the “relaxed reporting” exception for assets passing to a surviving spouse, yet a portion of the estate passed to grandchildren’s trusts, making the exception inapplicable.When the surviving spouse’s estate (Billy Rowland) later claimed Fay’s DSUE, the IRS denied the election, arguing the filing was neither timely nor properly prepared. The Tax Court agreed, which lead to Billy’s Estate paying approximately $1.5 million in additional taxes.The Court’s ReasoningTimeliness Was Not EnoughThe Court held the return untimely, but even if it had met the filing window, it failed the requirement of being “complete and properly prepared.” Completeness, the Court emphasized, includes providing valuation information sufficient for the IRS to verify reported amounts and compute the DSUE accurately.Valuation Documentation Is Integral to CompletenessTreas. Reg. § 20.2010-2(a)(7) requires a Form 706 filed solely to elect portability to include the same detail as a taxable return, except for assets passing entirely to a spouse or charity. The Rowland estate’s generalized estimates prevented the IRS from evaluating the DSUE computation.The Court rejected arguments of substantial compliance and equitable relief, holding that valuation documentation is not simply a procedural technicality, but rather a statutory prerequisite.Why Business Valuations MatterFor many families, closely held business interests comprise a large share of estate value. These assets require specialized valuation under Revenue Ruling 59-60. A well-supported valuation not only establishes compliance but also enhances the credibility of the entire filing.A defensible business valuation requires:Identifying the rights and benefits of the interest being valued (control, transfer restrictions, etc.).Using relevant market evidence, including public comparables and transaction data.Applying sound financial analysis that addresses expected cash flows, risk, and growth prospects.Reporting clearly and effectively to the IRS and other readers.Documentation: The Bridge Between Valuation and ComplianceThe Rowland decision underscores that a valuation unsupported by documentation is no valuation at all. A properly prepared Form 706 should therefore include:Narrative descriptions of each business interest, outlining ownership, structure, and rights.Detailed valuation schedules explaining how conclusions were reached.Supporting exhibits, such as financial statements and methodology summaries.Explicit reference to appraisal standards that demonstrate compliance with USPAP and Treasury requirements.Without these elements, a return fails the “complete and properly prepared” standard which is exactly what happened in Rowland.Practical Guidance for Estate PlannersEngage Qualified Appraisers Early. Business interests should be appraised by professionals experienced in federal transfer tax matters and IRS examinations.Coordinate Across Disciplines. Attorneys, accountants, and appraisers should align on ownership structures and entity specifics to ensure consistent reporting.Avoid Estimates or Prior-Year Values. Fair market value is determined as of the date of death; using approximations risks inconsistency with IRS standards.Explain Discounts and Assumptions. Clearly document the rationale for any discount for lack of control or marketability.Maintain Comprehensive Records. Preserve valuation reports, source data, and correspondence to support the filing if later reviewed or aud.ConclusionThe Estate of Rowland v. Commissioner decision delivers a clear message: Form 706 filings must contain credible, well-documented fair market value determinations for all assets, particularly business interests, or risk invalidation. Portability hinges not only on timeliness but on the completeness and substantiation of reported values. The strength of the filing lies in the quality of its appraisals and the documentation supporting them.At Mercer Capital, we integrate these principles into every estate and gift tax engagement, ensuring our valuation opinions are technically sound, clearly presented, and defensible which positions clients for successful outcomes under IRS scrutiny.Valuations are a critical element of successful tax planning strategies and objective third-party valuation opinions are vital. Since 1982, Mercer Capital has provided objective valuations for estate, gift, and income tax matters across virtually every industry sector. To discuss your valuation needs in confidence, please contact one of our professionals .

2025 Year in Review: Across MedTech, Discipline Is a Recurring Theme

Last month, the medtech team at Mercer Capital attended the 2025 Musculoskeletal New Ventures Conference, where discussions among founders, venture investors, strategic acquirers, and advisors converged on a consistent message: activity in the industry is increasingly shaped by discipline around clinical differentiation, capital efficiency, and strategic coherence. Innovation continues across the ecosystem, though expectations around execution, funding, and exit visibility have tightened. For early-stage companies, investors described an environment that supports new ventures, albeit with a greater emphasis on efficient capital deployment. Successful companies are pursuing leaner development strategies with earlier clinical or regulatory wins, rather than broad, capital-intensive pipelines. Incremental innovation, particularly in mature segments such as orthopedics, has been attractive when paired with platform scalability or data-enabled (AI) differentiation. Management quality and adaptability remain critical at this stage. In contrast, as other observers have also noted, venture capital has favored select growth-stage and later-stage deals. Investments flowed into companies able to articulate coherent clinical and commercial strategies aligned with the priorities of large, strategic buyers. Clear narratives around end-market adoption, strategic fit, and integration potential have tended to lead to higher valuations across observed transactions. Among large, established medtech companies, portfolio optimization was an ongoing effort. For public companies, exposure to higher-growth segments has increasingly supported better valuation multiples and relative equity performance. In response, strategic acquirers such as Stryker, Boston Scientific, Medtronic, and Johnson & Johnson have tuned their portfolios through targeted acquisitions, divestitures, and capital redeployment. For example, Stryker’s acquisition of Inari Medical reflects the appeal of the high-growth interventional markets with strong clinical differentiation, while its divestment of the spine business demonstrates an effort to exit slower-growth or less strategically differentiated segments. Similarly, Johnson & Johnson’s acquisitions of Shockwave Medical and V-Wave in 2024 augmented a cardiovascular platform focused on markets with long-term growth potential, while the announced separation of its DePuy Synthes orthopedics business signals a broader effort to simplify and sharpen strategic focus within its portfolio. Overall healthcare IPO activity in 2025 was broadly in line with 2024 levels, with issuance concentrated among higher-quality medtech and life sciences companies rather than reflecting a broad-based market reopening. Offerings such as Caris Life Sciences, which combined scale, revenue growth, and a differentiated data-driven platform, were relatively well received, suggesting that the IPO window remains available but is selective. Across various company stages and transactions, 2025 activity in medtech reflected a consistent emphasis on disciplined, capital-efficient growth. Whether among early-stage investments prioritizing focused development, later-stage companies articulating clear strategic fit, or large strategics actively reshaping portfolios, the common thread has been the pursuit of durable clinical differentiation and well-defined paths to scale or exit.

What to Look for in a Buyer for Your RIA

For many RIA founders, the decision to sell is one of the most significant milestones in their professional lives. A sale represents not only the opportunity to unlock financial value but also the responsibility to ensure that clients, employees, and the firm’s legacy are well cared for in the next chapter. The growing number of active acquirers in the RIA space means that founders have choices—but more options can also make the decision more complex.

Now Available: Mercer Capital’s 2025 Energy Purchase Price Allocation Study

The 2025 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that reported their purchase allocation data in calendar year 2024 and not reported in previous annual filings.

STUDY | Mercer Capital’s Energy Purchase Price Allocation Study

This study researches and observes publicly available purchase price allocation data from companies primarily contained in one of the four sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; (iii) midstream; and (iv) downstream. This study is unlike any other in terms of energy industry specificity and depth.The Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that reported their purchase allocation data in calendar year 2024 and not reported in previous annual filings.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity. It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions. The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.

Capital Budgeting in 30 Minutes

A Guide for Family Business Directors and Shareholders

This latest guide continues our mission to help family business directors navigate complex financial concepts with clarity and confidence. Capital budgeting decisions—those that determine which projects a company should invest in—are among the most consequential choices a board can make. “Do-overs” are expensive, and understanding how to evaluate potential investments is critical to preserving and enhancing shareholder value.

The Discount for Lack of Marketability in Divorce: Real World Examples and Considerations – Part 2

In Part 1 of this post, we defined valuation discounts such as the discount for lack of control and discount for lack of marketability. We discussed the difference between fair value and fair market value, illustrated the importance of the prevailing state statute, and gave arguments for and against employing valuation discounts in a divorce context. Now we will discuss common drivers of marketability discounts and contextualize them with common provisions in partnership agreements and go through a case study.

Whitepaper: How to Value Your Exploration and Production Company

For this week’s post, we’re highlighting our whitepaper, How to Value Your Exploration and Production Company. The piece provides a comprehensive overview of the key factors that drive value in the upstream oil and gas sector, offering readers a clear framework for understanding how operational performance, reserve economics, and commodity pricing influence company worth. It also explores core energy valuation methodologies—including cash flow analysis, reserve-based approaches, and market benchmarking—to help executives, investors, and advisors navigate the complexities of assessing value in a constantly evolving energy market.

Understanding Reinsurance for Auto Dealers (Part II)

Valuation and Planning Considerations

In this post, we discuss the valuation implications of reinsurance on auto group corporate planning and ownership estate planning options, and contrast them to core dealership operations as well as the real estate owned by the auto group.

Schwab's SAN Shift Demands RIA Organic Growth and Dashboard Vigilance

From Autobahn to Blind Curve

Schwab’s announcement that they’re halving client referrals to RIAs through the SAN program threatens an industry that was already struggling with organic growth. Dependable, sustainable growth requires building a marketing strategy that isn’t dependent on outside factors like ambitious custodians, and a tracking system to know how that marketing strategy is performing. Keeping an eye on your metrics will help keep you on the road to lasting value.

When Family Mission Meets Family Business

Aligning Purpose and Prosperity

Mission statements articulate why the family exists. Understanding the economic meaning of the business clarifies how the enterprise sustains that mission.

Appalachian Basin Finds Its Footing

The economics of oil and gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Haynesville, and Appalachian plays. The cost of producing oil and gas depends on the geological makeup of the reserve, the depth of the reserve, and the cost to transport production to market. These factors drive meaningful differences in costs across regions. This quarter, we take a closer look at the Appalachian.

RIA M&A Update: Q3 2025

RIA M&A activity rebounded sharply in 2025, with record deal volume in the first half of the year. Through September, 209 transactions were completed—up from 156 in 2024—driven by private equity involvement, lower borrowing costs, and ongoing consolidation trends. While total transacted AUM declined, serial acquirers and aggregators continued to dominate deal flow. For RIAs, shifting rate dynamics, valuation trends, and evolving buyer profiles highlight the importance of strategic planning—whether pursuing growth, transitioning ownership, or exploring a sale.

5 Things to Know About Selling Your Business to Private Equity

We recently read a fantastic post on the Altair Advisers' blog, "Words on Wealth," by Jason M. Laurie, Managing Director and Chief Investment Officer. The post addresses five things that founders wish someone had told them before selling their businesses to private equity firms. We thank Jason for allowing us to share the post with our readers.

Alternative Asset Managers Stumble in 2025 Following Half a Decade of Outperformance

After several years of industry-leading performance, alternative asset managers have begun to lose momentum in 2025. Despite strong fundamentals, these firms have underperformed broader markets amid higher-for-longer interest rates and shifting investor preferences toward liquidity. While short-term valuations have softened, the long-term case for alternatives remains intact, supported by their structural advantages and ability to navigate volatility.

Appalachian Basin M&A Update: October 2024 to September 2025

A Quiet Consolidation Phase

Over the October 2024 through September 2025 timeframe, merger and acquisition activity in the Appalachian Basin (Marcellus / Utica / associated plays) has been relatively muted, reflecting constrained upstream deal flow across the U.S. At the same time, selective bolt-ons, midstream consolidations, and creative capital structures have surfaced where synergies and niche value remain. In this post, we examine the notable transactions and thematic drivers emerging from this period.

Navigating the Sale of Your Family Business

Lessons from the Auction Block

Selling a family business is a deeply personal and strategic endeavor, much like auctioning a rare and storied object.

Third-Party Fairness Opinions in Continuation Funds: Lessons from Deep NAV Discounts

The Paramount Deal: A Reality Check on ValuationsOn September 17, 2025, alternative asset manager Rith Capital Corp. (NYSE:RITM) agreed to acquire office REIT Paramount Group, Inc. (NYSE:PGRE) for $1.5 billion cash, or $6.60 per share. Paramount is an integrated REIT that manages and owns 13.1 million square feet of Class A offices (86% occupancy rate) in New York and San Francisco.Word of the deal, but not the price, leaked because the shares rose 4% on September 16 to $7.39 per share on volume that was 5x above average. Relative to the pre-leak closing price on September 15, the deal price represented a 7% discount and equated to 48% of book value and 10.2x funds from operations (“FFO”).By way of comparison, RITM’s shares as of year-end 2019 closed at $13.92 per share, which equated to 82% of book value and 14.5x LTM FFO. And for those who can time the market, the shares traded just below $4.00 per share immediately after “Liberation Day” and thereby provided a great five-month return.When Book Value Isn’t Market ValueParamount was not a high-flyer. The dividend was suspended in September 2024 after having been cut in June 2023 and December 2020. The stock traded below book value for years. The public market and change-of-control transactions imply the carrying value of the assets was too high though the 2024 10-K notes that real estate assets carried at cost less accumulated depreciation are individually reviewed for any impairment.Aside from an impairment issue, GAAP did not dictate that the $8.3 billion land, buildings and improvements be marked-to-market so that book value could be directly equated with net asset value (“NAV”). Nonetheless, investors did so daily yet still over-estimated NAV that a competitive process revealed it to be in a change-of-control transaction.Secondary Pricing as % of NAV (by weighted average volume)The Broader Challenge: Overstated NAVs in Private MarketsParamount illustrates what some think is a pervasive issue in private equity and to a lesser extent private credit whereby fair value marks and therefore NAVs are too high. An unwillingness to recognize reality may be one reason PE exits are too low relative to investment. Assets are held in the hope that next year conditions will be better – the M&A market improves, the company’s earnings will be higher, etc.Continuation Funds and Valuation GapsContinuation vehicles (“CV”) with five year lives that acquire assets from PE funds are a bridge to a potentially better tomorrow, but valuation gaps today based upon what the CV asset marketing process reveals vis-И-vis the current mark can be material though the data is nuanced. Evercore in its mid-year 2025 update estimates that 87% of GP-led secondaries transacted at less than NAV. Lazard estimates that 90% of single-asset and 70% of multi-asset GP-led secondaries transacted at 90% of NAV or higher in 2024. However, the data does not distinguish between cash paid at closing and contingent earn-out payments; so, the effective transaction price vs NAV may be wider. LP-led secondaries offer additional perspective—albeit for a portfolio interest vs one or more ~plum assets—with discounts to NAV on the order of 10% for buyout interests vs 25% for venture and real estate assets. One could argue the LP discount or some portion of it reflects an illiquidity discount vs appropriateness of the NAV mark forthe portfolio.Governance Under Pressure: The Business Judgment RuleDirectors of corporations operate under the long-held concept of the Business Judgment Rule (“BJR”) where courts generally will not second guess decisions as long as directors do not violate the fiduciary triad of care (informed decision making), loyalty (interests aligned with shareholders, conflicts fully disclosed), and good faith. Application of the BJR to GPs varies by state and will be viewed through the lens of the partnership agreement when disputes arise.BJR murkiness notwithstanding, GP-led secondary transactions are problematic from a governance perspective because GPs are both seller and buyer, and the GP has a financial incentive to extend the period on which management fees and carry are earned. Secondary Market Transaction Volume Over Time ($bn)The Role of Fairness OpinionsThe institutionalization of GP-led continuation funds has led to the development of a fair dealing process to address the loyalty question—at least outwardly—in which a third-party financial advisor markets the subject asset(s) to investors who would capitalize a CV. The proposal with the combination of the best price and terms with confirmed access to capital will be selected to transact subject to a conflict of interest waiver from the LP advisory committee (“LPAC”).Third-party fairness opinions emerge as indispensable here for the LPAC, bridging process and price vis-И-vis the historical fair value marks. Unlike binary “fair/unfair” verdicts, these assessments—rooted in rigorous due diligence—evaluate the marketing process, transaction terms from a financial point of view, dissecting NAV assumptions, cap rates, and exit multiples against market comps.Best Practices and Industry GuidanceFor continuation funds, the stakes are higher: GPs must demonstrate that discounts reflect arm’s-length negotiations, not convenient happenstance. The CFA Institute research on ethics in private markets emphasizes competitive bidding processes to mitigate manager incentives—strong financial additions like promoted interests in the new fund can skew outcomes toward overvaluation. ILPA’s 2023 guidance amplifies this, urging 30-45 day timelines for LP re-underwriting, full disclosures on advisor conflicts, and LPAC pre-approvals to safeguard alignment.Beyond a Checkbox: Upholding Fiduciary IntegrityUltimately, fairness opinions are not mere check boxes; they are part of the governance protocol to address the care and loyalty duties that are the cornerstone of the BJR.About Mercer CapitalMercer Capital is an independent valuation and financial advisory firm founded in 1982, specializing in business valuation, corporate transactions, and financial opinions. With offices in Dallas, Houston, Memphis, Nashville, and Winter Park, we serve private equity sponsors, portfolio companies, and institutional investors in valuing complex, illiquid equity, credit, mezzanine and other such securities. Our fairness opinion practice, a cornerstone of our expertise, provides objective assessments for conflicted transactions such as GP-led secondaries and continuation funds. Drawing on deep market insights and rigorous due diligence, we help clients navigate governance challenges, ensure regulatory compliance, and maximize stakeholder alignment. For more, visit mercercapital.com.Originally featured in Mercer Capital's Portfolio Valuation Newsletter: Fall 2025

Upstream Valuation Through a Lender’s Lens

What Credit Analysts See

Credit analysis offers a different lens on upstream performance—one centered on sustainability rather than growth alone. Scale and production mix drive efficiency and resilience, while cost structure and netbacks expose the true quality of assets. Reserve life and replacement efficiency underpin long-term viability, and strong liquidity, hedging, and leverage discipline ultimately determine access to capital and enterprise value.

Understanding Reinsurance for Auto Dealers (Part I)

What It Is and Why It Matters

In the first post of this series, we introduce the basics of reinsurance in the context of auto dealerships and explore both the pros and cons of establishing a reinsurance company.

RIA Market Update: Q3 2025

RIAs delivered mixed results in Q3 2025, with larger asset managers leading the sector at an 11% quarterly gain, outpacing the S&P 500’s 8% return. Smaller managers rose modestly, while alternative managers continued to lag after a stretch of strong growth in 2023 and early 2024.

October 2025 | The New Frontier of Consumer Credit: Banks vs. Fintechs

Bank Watch: October 2025

Evaluating the Buyer’s Shares and The New Frontier of Consumer Credit: Banks vs. Fintechs

Bank M&A activity has surged in 2025, with roughly 175 transactions expected by year-end. For selling shareholders, deal consideration often includes the buyer’s stock—raising important questions about the investment merits of those shares. Understanding liquidity, profitability, valuation, and capital management is critical, yet often overlooked. Mercer Capital outlines key factors boards should consider when evaluating a buyer’s shares and highlights why “value” deserves as much attention as “price.”

October 2025 | Webinar: Valuing a Business Amid a Potential Sale

Value Matters^® October 2025

In Case You Missed the Webinar: Valuing a Business Amid a Potential Sale—What Estate Planners Must Know

Executive SummaryEstate planning for business owners is rarely straightforward, and it becomes significantly more complex when a potential sale of the business in question enters the picture. Timing matters and so does understanding how valuation interacts with both estate planning goals and the expectations of the IRS.In Mercer Capital’s new 75-minute webinar, Valuing a Business Amid a Potential Sale: What Estate Planners Must Know, Nicholas J. Heinz, ASA and Thomas C. Insalaco, CFA, ASA, explain how to navigate valuation in such an uncertain environment.When Estate Planning and M&A OverlapA liquidity event can be transformative for a family, but it raises complex valuation questions. How do you determine fair market value for gift or estate tax purposes when an M&A process is underway but incomplete? This webinar offers insight into what valuation analysts must consider when a company is “in play.” Heinz and Insalaco explain how to evaluate indications of value that emerge from deal discussions, what constitutes relevant market evidence, and how to apply weights to preliminary offers that may or may not close.What the IRS ExpectsThe presenters outline IRS guidance that provides insight into how appraisers should document assumptions and support their conclusions when a sale may occur soon after the transfer date. Estate planners will gain perspective on what information should be shared with valuation professionals and what documentation supports defensibility.Practical Scenarios and TakeawaysUsing examples drawn from real-world engagements, the webinar examines several practical scenarios:A business exploring a sale but not yet under letter of intentA transaction announced but not yet closedA sale that falls through after gift transfers are madeIn each case, Heinz and Insalaco discuss the influence of timing, negotiation progress, and third-party interest. They also highlight coordination points between the estate planner, client, and valuation expert to avoid costly missteps.Watch the RecordingThis session is designed for estate planning attorneys, tax advisors, and wealth professionals who advise business-owning families. Even if no sale is imminent, understanding how valuation shifts during an M&A process prepares planners to identify risk, manage client expectations, and anticipate IRS scrutiny. The recording is available on Mercer Capital’s YouTube channel: Watch the webinar here.For additional reading, the August 2025 issue of Value Matters® explores these same issues and offers complementary analysis.Together, these resources seek to equip estate planners with practical guidance for advising clients whose estate planning and exit planning timelines may overlap—a scenario that is increasingly common in today’s dynamic M&A environment.

Beyond the Balance Sheet: Four Strategic Questions for Family Business Directors

Understanding your family business’s asset base is more than a financial exercise; it is a strategic responsibility. By asking the right questions about cash, working capital, capital investments, and what truly drives value, directors can shift the conversation from what the business owns to why it owns it.

The Family Business Director To-Do List: Shareholder Liquidity

For this week’s post, we put together a to-do list that includes important tasks for family business directors to complete whether planning for a one-time share redemption or establishing a family shareholder liquidity program.

The UHNW Institute’s "Wealthesaurus"

The post introduces The UHNW Institute’s Wealthesaurus—a glossary of terms central to family wealth and enterprise conversations. For investment managers, this resource provides a valuable framework for understanding how families think about sustainability, reporting, liquidity, and governance, all of which influence investment decisions.

Hart Energy’s A&D Strategies and Opportunities Conference Recap

At Hart Energy’s 2025 A&D Strategies and Opportunities Conference in Dallas, two central themes emerged: the maturation of Tier 1 U.S. shale inventory and diverging dynamics between private and public players in dealmaking. The conference highlighted the evolving dynamics of the U.S. upstream oil and gas market. With Tier 1 shale assets maturing, private and public participants are behaving differently, and deal strategies have become more selective.

Private Equity’s Growing Influence on RIA Dealmaking and Valuation Multiples

Examining the trends fueling PE’s dominance, the valuation multiples shaping transactions, and strategic considerations for RIA owners navigating this transformative landscape

A Valuable New Resource: The UHNW Institute’s “Wealthesaurus”

Without common definitions, conversations can quickly veer off track. That’s why we were intrigued to discover a new resource from the UHNW Institute: the Wealthesaurus.

August 2025 SAAR

In August 2025, the U.S. auto industry slowed as the SAAR of 16.1 million units represented a 2.9% decrease from the prior month. However, the trend of year-over-year increases continued, as eleven of the past twelve months have beat the prior year, with a 6.2% increase from August 2024. The August 2025 performance is particularly impressive given the inflated baseline from the previous year's CDK software outage that shifted sales into July and August 2024.

The One Big Beautiful Bill Act: Implications for U.S. Oil & Gas Valuations

The OBBB represents a significant shift in the U.S. oil and gas industry and is a key component of the Trump Administration’s agenda for U.S. energy dominance. The BBB represents a significant shift in how public lands are managed and how our government supports energy development.

Is There a Scarcity Value for Independent Trust Companies?

Supply/Demand Dynamics in Trust Company M&A

The scarcity of independent trust companies in today’s market underscores a compelling opportunity for RIAs seeking to enhance their service offerings and secure long-term growth and for trust companies that are considering an external sale.

An Overview of Senior Care / Long-Term Care as of Q2 2025

While the senior care industry faces a variety of challenges, including staffing shortages, regulatory pressures, and rising costs, there are also numerous opportunities for growth.

Dental Service Organizations

By 2028, an estimated 16% of specialized practices will be affiliated with DSOs. These specialized practices have even higher margins than general practices and have been receiving more referrals each year, making them particularly attractive to PE firms.

ESOPs: The Basics and the Benefits

An ESOP is an employee benefit plan designed with enough flexibility to be used to motivate employees through equity ownership.

Ambulatory Surgery Centers

The popularity of ASCs among patients and insurers has propelled the value of the ASC market in the United States. Currently, the market is valued at $46 billion and is expected to reach $66 billion by 2033.

Navigating Buy-Sell Agreements Part II

Three Examples Where Independent Appraisers Make the Difference

In this post, we examine three compelling reasons why engaging an independent appraiser is essential in these scenarios, with practical examples tailored to the dynamics of private family businesses.

Ten Takes from Ten Years of RIA Valuation Insights

After 500 Blog Posts, We Still Have More to Say

In the late spring of 2015, we started talking about creating a blog to explore what we were seeing regarding valuation and advisory projects in the RIA space. The big question was not whether we could start it, but whether we could keep it going. When we got back from lunch, I pulled up a Word doc and Brooks and I started brainstorming topics. In a few minutes, we had several dozen ideas, so it was pretty clear we had enough to say. Ten years later, we still haven’t run out of ideas.

Navigating Private Company Valuations

When and Why to Use an Independent Appraiser

An independent appraisal, also known as a business valuation, provides an unbiased assessment of a private company’s fair market value, conducted by a skilled and impartial expert or firm. This process generates an objective valuation by drawing on financial information, market trends, and other relevant factors in order to effectively eliminate the distortions that can arise from in-house valuations. For private business owners and directors, this independence can provide peace of mind when making key financial and strategic decisions.

Bank Watch: September 2025

2025 Core Deposit Intangibles Update

Core deposit intangible (CDI) values have remained relatively stable in 2025. As deposit mix, rate outlook, and funding pressures continue to evolve, understanding the unique drivers of your institution’s deposit base is critical. In our latest analysis, Mercer Capital examines recent trends in CDI values, deposit premiums, and what they may signal for banks moving forward.

The Discount for Lack of Marketability in Divorce: When Should It Apply? – Part 1

During divorce proceedings, one of the most complex financial issues may be “what is the value of a business interest?”

Themes from Q2 2025 Earnings Calls

In this week's post, we cover what auto retailer executives had to say during the Q2 2025 earnings calls. We noted three major themes from last quarter’s calls: tariffs, acquisitions, and fixed operations.

The Growing Appeal of Independent Trust Companies

Within the broader investment management industry, independent trust companies are carving out a significant niche, capturing the attention of high-net-worth clients and investment management professionals alike.

Rollover Equity in Private Equity Transactions

Rollover equity has become a defining feature of U.S. middle-market private equity transactions, offering sellers a blend of immediate liquidity and future upside while helping buyers bridge financing gaps and align incentives. As its use continues to rise, careful attention to valuation, capital structure, and exit dynamics is critical to understanding the true economic impact of a “second bite of the apple.”

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of August 26, 2025

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of June 11, 2025

Middle Market Transaction Update Fall 2025

Middle market M&A activity rebounded in the second quarter of 2025, although year-to-date activity remains depressed compared to prior-year levels.

Navigating Buy-Sell Agreements: Part 1

Buy-sell agreements aren’t set-it-and-forget-it documents; they evolve with your business and family.

Themes from Q2 2025 Earnings Calls

Disciplined Capital Allocation Meets International Opportunity Amid Domestic Uncertainty

The second quarter of 2025 brought no shortage of talking points across both oilfield services (“OFS”) providers and exploration and production (“E&P”) companies. Management teams faced questions on market softness, capital discipline, and whether the long-awaited offshore and international upcycle has truly taken hold. Some leaned into shareholder returns and consolidation, others stressed patience in a choppy pricing environment, and nearly all pointed to selective opportunities abroad as a counterweight to domestic headwinds.

Building Valuable RIAs

Navigating Margins, Compensation, and Long-Term Growth

When assessing your firm’s margins, it’s important to consider the context of the firm’s ownership and compensation structure and also the tradeoffs associated with margins that are too high or too low.

Video: Dividend Policy in 5 Minutes

Travis Harms explains how to go about the decision-making process regarding distribution and why considering various shareholder characteristics and business attributes matters.

July 2025 SAAR

The July 2025 SAAR came in at 16.4 million units, up 7.1% from last month and up 3.7% from July 2024. It is important to note that this modest year-over-year gain requires a bit more context due to irregularly high sales this time last year. The June 2024 CDK software outage shifted sales into July and August 2024, making July 2025’s year-over-year performance even more impressive.

Why E&P Companies Need a Quality of Earnings Analysis

The purpose of a QofE analysis is to translate historical reported (GAAP) earnings into a relevant picture of earnings and cash flow that is useful in developing credible forward-looking estimates.

Enhancing RIA Value Through Family Office Services

Being Ambitious Without Becoming Delusional

In the ever-evolving wealth management sector, we see RIAs exploring ways to bolster their competitive edge, long-term sustainability, margin, and valuation. An increasingly common strategy involves integrating family office services.

Stock Buybacks at Record Highs

What’s the Lesson for Family Businesses?

Family businesses face unique challenges in executing share redemptions.

Change in Republicans’ Thinking Shifts Policy Support in Renewables

While the battle continues for the hearts and minds of Americans over the debate between fossil fuels and renewables, the current Trump administration appears to be responsive to this shift by setting priorities for the development of fossil fuels.

Just Released: Q2 2025 Oil & Gas Industry Newsletter

Regional Focus: Permian Despite a late-period decline in rig counts, Permian production continued upward over the latest year. However, geopolitical forces and international trade matters pushed oil prices lower, resulting in the Permian producer stock prices being battered since June 2024, particularly in the first quarter and early second quarter of 2025.

You Can’t Spell RIA Without AI

The Impact of Artificial Intelligence on the RIA Industry

This post explores the multifaceted impact of AI on the RIA industry, drawing on trends observed in Q2 2025 and beyond, while providing actionable insights for firms looking to adapt.

Dividend Policy in 30 Minutes

A Guide for Family Business Directors and Shareholders

The purpose of this booklet is to help family business directors formulate and communicate a dividend policy that contributes to family shareholder wealth and satisfaction. We hope this provides a helpful resource for you and your fellow directors and shareholders.

RIA M&A Isn’t the Only Way

Internal Transactions Still Work

Internal transactions don’t generate headlines, and prospective buyers (next-gen management) likely aren’t beating your door down to close a deal. While they may be less conspicuous, internal transactions are a viable avenue for succession planning and one that many RIAs accomplish successfully.

BankWatch: August 2025

2025 Mid-Year Market Update

Bank stocks have staged a strong recovery in 2025, with the Nasdaq Bank Index up 16.2% year-to-date and larger banks leading gains amid a “flight to quality.” Net interest margins continue to improve for most institutions, supported by a stable rate environment and expectations of further Fed cuts. M&A activity is also on the rise, with deal volume already surpassing 2024 levels by mid-year. In this month's Bank Watch newsletter, we discuss these market trends, net interest margin expansion, and what shifting interest rates could mean for bank performance and M&A activity going forward.

Understanding the Company Specific Risk Premium – A Component of the Discount Rate

When valuing a business using the income approach, one of the most significant inputs is the discount rate, which is used to discount future cash flows to present value. In this piece, we focus on one of the components of the discount rate: the company specific risk premium (“CSRP”).

Value Matters^® August 2025

Navigating Business Valuations During Active M&A Processes

Critical Considerations for Estate PlannersExecutive SummaryThis article summarizes Mercer Capital’s newest whitepaper, Valuing a Business for Estate Planning Purposes During a Transaction, which addresses the complex intersection of business valuations and estate planning when M&A processes are underway.Estate planning for business owners becomes much more complicated when a merger or acquisition process is underway. IRS guidance suggests requirements that business valuations for transfer tax purposes must consider all knowable facts as of the valuation date—including pending transaction processes. This creates both opportunities and risks for estate planners working with clients who own businesses actively engaged in sale discussions.The challenge lies in determining how much weight to assign to potential deal proceeds versus traditional standalone valuations at different stages of the M&A process. While early-stage processes may warrant minimal consideration of transaction value, later stages with formal offers require greater weighting of expected proceeds. Understanding the nuances of an engagement of this type is essential for avoiding costly mistakes and ensuring credible valuations that optimize estate planning outcomes.The intersection of business transactions and estate planning presents one of the most complex challenges in wealth transfer strategies. When business owners—whose enterprises often represent the majority of their wealth—simultaneously pursue exit opportunities and engage in estate planning, the valuation considerations become particularly intricate and consequential.IRS Chief Counsel Advice 202152018In Chief Counsel Advice 202152018 (“CCA 202152018”), the IRS addressed two issues in the context of a business owner who funded a GRAT during an active sale process. First, it considered whether hypothetical willing buyers and sellers would take into account a pending merger when valuing stock for gift tax purposes. The Service answered affirmatively: under the fair market value standard, known or knowable facts—including an ongoing sale process and offers already received—must be incorporated into valuation. Second, the IRS considered whether the donor retained a “qualified annuity interest” under §2702 when the GRAT was funded using a stale §409A appraisal that ignored the pending merger. The Service held that the retained interest failed to qualify, treating the entire transfer to the GRAT as a taxable gift.The facts of the case reveal a pattern of valuation inconsistencies. The taxpayer used a seven-month-old §409A appraisal—prepared for deferred compensation purposes, not transfer tax purposes—to support the GRAT funding, even though multiple offers had already been received at higher prices. Shortly thereafter, however, the same taxpayer funded a charitable remainder trust using a contemporaneous qualified appraisal that reflected the higher offer price. This inconsistency, coupled with reliance on an outdated and contextually inappropriate appraisal, invited IRS scrutiny and resulted in the Service’s determination that the GRAT was fatally flawed.While CCAs do not carry precedential weight, they are instructive of how the IRS is likely to approach similar fact patterns. CCA 202152018 signals heightened IRS vigilance where GRATs or other transfer tax strategies are executed amidst an ongoing or foreseeable liquidity event. It highlights the necessity of contemporaneous, purpose-appropriate appraisals that consider all relevant facts at the valuation date. Failure to do so risks not only valuation adjustments but also possible disqualification of retained interests under §2702, leading to the result of treating the entire transfer as a taxable gift.Understanding the M&A Process FrameworkTo properly value businesses during transaction processes, estate planners must understand the typical stages of mergers and acquisitions. The process generally unfolds through six distinct phases, each presenting different levels of transaction certainty and information availability.During the planning phase, when owners hire M&A advisors and organize information, there may be little quantifiable expectation of proceeds. However, once confidential information memorandums are distributed to potential buyers, expectations around selling prices become clearer. As the process progresses through qualification phases with indications of interest, buyer selection with letters of intent, due diligence, and final negotiations, the probability of completion and the certainty of proceed size generally increase.The critical insight for estate planners is that valuation weight should shift toward transaction proceeds as deal certainty increases. A business in early marketing phases might warrant only modest consideration of potential proceeds, while a company with binding letters of intent is more likely to merit substantial weighting of expected transaction value.Market Reality of Deal Success and FailureUnderstanding transaction success rates provides crucial context for valuation decisions. In a McKinsey & Company analysis of over 2,500 large deals valued above €1 billion, approximately 10.5% of deals were canceled, with larger transactions facing higher failure risks. Deals exceeding €10 billion experienced cancellation rates above 20%, while those under €5 billion maintained consistent 10% annual cancellation rates.In this analysis, industry factors significantly impacted success probability. Energy and financial sector deals showed the lowest cancellation rates at around 7%, while consumer discretionary and communications services faced higher failure rates of 13% and 19% respectively. Nearly 75% of canceled deals failed due to price expectations, regulatory concerns, or political issues.However, these statistics apply primarily to publicly announced transactions, making them most relevant for closely held companies in later deal stages. Earlier-phase failures often remain private, suggesting estate planners should shift weight toward no-sale scenarios when businesses are in preliminary transaction stages.Critical Success FactorsSeveral factors influence deal completion probability and should inform valuation weightings. Expected deal timelines matter significantly—longer processes face higher failure rates. Deal structure complexity creates additional risk, as mixed cash-and-stock transactions prove less successful than simpler all-cash or all-stock arrangements.The number and quality of bidders affect completion likelihood. Multiple interested parties provide fallback options, though this dynamic can shift if secondary bidders lose interest. More sophisticated bidders, such as private equity firms or strategic acquirers with dedicated M&A teams, typically conduct more thorough early evaluation but also identify issues that might derail transactions.External factors including economic conditions, political stability, and regulatory environment all influence completion probability. Companies with clean financial records, predictable cash flows, and minimal discretionary items in recent results face higher completion probabilities due to reduced due diligence risks.The Levels of ValueBusiness owners and their professional advisors are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts, but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.Business valuation experts use the term “level of value” to refer to these differing perspectives. As shown in the figure below, there are three basic “levels” of value for a business.Estate planning transfers typically involve minority interests valued at the nonmarketable minority level, which may incorporate discounts for lack of control and marketability. In contrast, M&A transactions occur at control levels and may include strategic premiums for synergies.This creates significant value gaps. A business with $100 per share marketable minority value might be valued at $65 per share for estate planning purposes after appropriate discounts. However, strategic buyers might pay $130 per share, creating a substantial differential between transfer values and transaction proceeds.Understanding Deal ProceedsExpected transaction proceeds require careful analysis beyond headline multiples. Deal terms may include earnouts, contingent payments, or non-cash consideration that should be risk-adjusted and converted to cash equivalency. The proposed transaction could trigger corporate-level taxes that would need to be considered in valuing an equity interest. A transaction appearing to price at 12x EBITDA might only deliver 9x value on a cash-equivalent basis after considering payment timing, corporate taxes, and performance risks.Practical Application FrameworkEstate planners working with businesses in transaction processes should expect valuation frameworks that appropriately weight no-sale scenarios against expected proceeds based on process stage and specific circumstances.As transaction processes progress through marketing phases with distributed information memorandums, modest weighting of expected proceeds becomes appropriate, though determining precise allocations requires careful analysis of company-specific factors and buyer interest levels.Once formal indications of interest are received, increasing weight is likely to shift toward transaction proceeds, with the specific allocation depending on offer quality, buyer sophistication, and deal structure. By the time binding letters of intent are executed, substantial weighting of expected proceeds is typically warranted, though some consideration of failure scenarios remains appropriate until closing occurs.Compliance and Documentation RequirementsThe IRS guidance emphasizes that valuations should ideally use valuation dates matching transfer dates and consider all knowable facts. Using outdated appraisals prepared for other purposes creates significant compliance risks, particularly when those appraisals ignore ongoing transaction processes. Business appraisers should document their consideration of transaction processes and provide clear rationale for their weighting decisions.Strategic Implications for Estate PlanningUnderstanding these dynamics enables more effective estate planning strategies. Business owners contemplating both exit strategies and wealth transfer can time their planning to optimize valuations while maintaining compliance. Earlier transfers in transaction processes may capture lower valuations, though this must be balanced against deal completion risks and the potential for significant value increases.The complexity of these valuations underscores the importance of engaging qualified professionals who understand both IRS transfer tax requirements and M&A market dynamics. Estate planners need valuation specialists who can navigate the technical requirements while providing credible opinions that optimize client outcomes.ConclusionThe intersection of business transactions and estate planning presents both opportunities and pitfalls for wealth transfer strategies.Success in this complex environment requires understanding M&A process stages, deal success factors, valuation methodologies, and compliance requirements. Estate planners who understand these concepts can help business owners navigate simultaneous exit and wealth transfer strategies while avoiding the costly mistakes that have drawn IRS scrutiny.The stakes are significant—business interests often represent the majority of owner wealth, making proper valuation essential for effective estate planning. With careful planning, appropriate professional guidance, and an understanding of regulatory guidance, these complex situations can be managed successfully to achieve both transaction and estate planning objectives.With 40+ years of transfer tax valuation and M&A experience, Mercer Capital understands the complexities that arise when business transactions intersect with estate planning objectives. Our team of credentialed professionals has worked with numerous clients through these challenging scenarios, providing the expertise necessary for these engagements.For estate planners seeking experienced partners who can navigate the intricate requirements of valuing businesses during active transaction processes, Mercer Capital offers the depth of experience and technical proficiency that these engagements demand.

The 2025 Family Business Benchmarking Study

Family business directors are best served by assessing financial performance on both an absolute and a relative basis.

The Family Business Benchmarking Study

Family business directors are best served by assessing financial performance on both an absolute and a relative basis. Absolute financial performance can simply be read off the face of the financial statements, but making appropriate relative comparisons requires reliable data on similarly situated firms.Benchmarking data typically focuses on financial performance but provides little perspective on the strategic financial decisions that can have a major influence on the sustainability of the family business.Family business directors generally have little perspective on how other companies handle certain items like capital allocation, capital structure, and dividend policy. With the release of our Family Business Benchmarking Study, we aim to fill that gap.Each section includes both data analysis and insights to help family business directors interpret the findings and apply them to strategic decisions.

Blue (Sky) Is in the Eye of the Beholder – Part 2

Ongoing Earnings and Other Valuation Considerations

In this post, we discuss our perspective on how dealership earnings are evaluated, adjusted, and normalized, based on our experience and discussions with dealmakers in the space.

Buy, Sell, Plan: The Business of Advisor Succession

Matt Crow on Dimensional Fund Advisors "Managing Your Practice" Podcast

Matt Crow had the pleasure of joining Aaron Hasler, Managing Partner at Skyview, and Catherine Williams, head of practice management at Dimensional Fund Advisors, for a discussion about the financial strategies involved in succession planning. We covered financing options, common roadblocks, generational dynamics, and much more.

Permian Producer Stocks Pummeled

Despite a late-period decline in rig counts, Permian production continued upward over the latest year. However, geopolitical forces and international trade matters pushed oil prices lower, resulting in the Permian producer stock prices being battered since June 2024, particularly in the first quarter and early second quarter of 2025.

3 Strategic Financial Questions for Family Businesses

Our family business advisory practice is focused on three strategic financial questions that weigh on family business directors.

RIA M&A Update: Q2 2025

M&A activity in the RIA industry, which had been trailing 2023 levels for much of 2024, experienced a surge in the first half of 2025. A spike in January set a new record for monthly deal volume, exceeding the high watermark previously set in October of 2024.

Royalty Consolidation Accelerates Amid Broader E&P M&A Wave

The mineral and royalty sector remains active beneath the surface of headline E&P consolidation. Public mineral aggregators are executing both asset-level and corporate-scale transactions, using a disciplined mix of equity, credit, and structured consideration.

Kellogg Shareholders Complete the Cash-In

The Kellogg story offers family business directors and managers plenty of food for thought.

June 2025 SAAR

The June 2025 SAAR came in at 15.3 million units, down 1.7% from last month but up 2.3% from June 2024. When looking at the year-over-year comparison, it is important to consider that June 2024 sales were impacted by the CDK software outage. As such, the year-over-year change in the SAAR presents the June 2025 performance in a better light than it would be without the impact of the 2024 CDK event.

Independent Trust Company Trends in 2025

One of the most frequently overlooked sectors in the wealth management industry may be its first cousin, the independent trust industry. While many still associate trust administration with banks, which account for more than 75% of the space, the growing prominence of independent trust companies is capturing the attention of many participants in the investment management community.

Understanding the EV/Production Multiple

Multiples such as EV/Production can provide context for market pricing in the form of a range. Relying solely on a single market multiple as an indication of value can be limiting, especially when valuing a privately held company.

Private Equity and Family Business

A Complicated Relationship

If private equity and family business had a relationship status on social media, it would undoubtedly be “It’s Complicated.”

RIA Market Update: Q2 2025

RIAs generally outperformed the S&P in Q2 2025, with smaller asset managers returning over 13%, and alternative asset managers facing another quarter of underperformance after a year of strong growth. Year-over-year, alternative investment managers saw the strongest AUM growth, while traditional managers proved better at converting this growth to earnings.

Financial vs. Strategic Buyers

Understanding the differences between financial and strategic buyers is critical when selling a business. While financial buyers focus on cash flow, leverage, and exit returns, strategic buyers evaluate how an acquisition fits into their long-term plans and may pay premiums for synergies. The right buyer ultimately depends on the seller’s goals—whether maximizing price, preserving employees, or remaining involved post-transaction.

2025’s Halftime Performance

When it comes to investor sentiment, 2025 has been a tale of two very different quarters.

2025’s Mid-Year Performance

Reprint from Mercer Capital's Family Business Director Blog

When it comes to investor sentiment, 2025 has been a tale of two very different quarters.

Middle Market Transaction Update Summer 2025

Middle market M&A activity remained muted in the first quarter of 2025, with political and economic uncertainty weighing heavily on the market.

Bank Watch: July 2025

From Disruption to Deposits: What Circle’s Rise Signals for Banks

As Stablecoins move from the fringes of finance to the center of regulatory and market attention, banks face a familiar but evolving challenge to their deposit base. Nearly 50 years after the introduction of the cash management account, Circle’s IPO and the passage of the GENIUS Act may mark a new inflection point. With investor enthusiasm high and policymakers signaling support, traditional institutions will need to evaluate how, and how quickly, they respond to the rise of tokenized money.

July 2025 | Impact of the One Big Beautiful Bill on Tax and Estate Valuations

Value Matters^® July 2025

The Impact of the One Big Beautiful Bill Act on Tax and Estate Valuations

During the first Trump administration, the Tax Cuts and Jobs Act (“TCJA”) introduced substantial modifications to the tax code, including significant reductions to estate tax liabilities. These reductions, however, were designed to sunset at the end of 2025, and addressing the expiring provisions became a priority for the current Trump administration. These were addressed in the One Big Beautiful Bill Act (“OBBBA”), an extensive legislative package touching on a variety of tax and spending policies. After a series of late-stage amendments, the OBBBA passed both chambers of Congress and was signed into law on July 4. In this issue of Value Matters, we examine the OBBBA’s provisions from a valuation perspective, focusing on implications pertinent to tax and estate planning professionals. Valuation PerspectiveOne of the key determinants of value of an interest in a company – be it a family-owned operating company or a real estate holding company – is the cash flow generated by the company and available to the shareholders for either distribution or reinvestment. The cash flow generated by a company directly impacts its valuation and the level of distributions made to shareholders impacts the magnitude of discounts applicable to non-marketable minority interests in companies. Impact of OBBBA on ValuationThe OBBBA directly impacts cash flows in several key ways. Permanency of TCJA Provisions: The OBBBA makes permanent various TCJA provisions that were scheduled to sunset at the end of 2025. These provisions include: 37% top individual income tax rate21% corporate income tax rate The Section 199A Qualified Business Income (“QBI”) deduction allowing tax pass-through entities to deduct up to 20% of their QBI. The QBI applied to entities that fall under the IRS’s definition of a “specified service trade or business” and includes entities in health, legal, accounting, and consulting fields. Reducing the tax burden owed by owners of S Corporations or members of partnerships increases the economic dividend received. All things equal, this reduces the costs of holding the asset during a nonmarketable period, reducing applicable discounts.Bonus depreciation was also made permanent under OBBBA and expanded to include buildings. Bonus depreciation can impact the timing of fixed asset purchases and allows a company to take advantage of a large upfront expense write-off, as opposed to trickling out the depreciation over the asset’s service life.The OBBBA also changed the definition of adjusted taxable income used to calculate tax loss carryforwards. The changes will ultimately allow businesses to deduct more interest upfront, reducing carryforwards and increasing cash flow in the short term. At the end of the day, asset-heavy pass-through companies are the big winners from these provisions.Changes to Capital Gains Tax TreatmentThe exclusion permitted related to sales of Qualified Small Business Stock (“QSBS”) has also been expanded. For qualified five-year holdings, 100% of the capital gains up to $15 million is exempted from capital gains taxes. The exclusion cap is indexed to inflation beginning in 2026.The OBBBA also introduced partial exclusions for QSBS shares held for shorter holding periods – 50% of gains are exempted for three-year holdings and 75% of gains are exempted for four-year holdings.The QSBS rules apply only to C corporations in non-service industries (for example, tech or retail) but can be advantageous to those planning to transfer shares across generations.Estate Tax ProvisionsOf most immediate relevance to estate planners is the substantial revision of estate tax exemption thresholds. The lifetime exclusion amount – the amount under which estate and gift taxes are not owed – was increased to $15 million for single filers and $30 million for joint filers beginning in 2026. This amount is indexed to inflation and will increase in future years.As shown in Figure 1, the lifetime exclusion amount has varied over time. The TCJA doubled the inflation-indexed exclusion amount from a base of $5 million to $10 million (or $5.49 million in 2017 to $11.18 million in 2018, after the inflation adjustment).Absent the passage of the OBBBA, the expiration of TCJA in December 2025 would have resulted in the exclusion reverting back to the $5 million base level (which would have been just over $7 million in 2026 after the inflation adjustment).It is also important to note that the estate exclusion amount is lifetime amount – gifts, estate, and generation-skipping transfers all work off of the same $15 million “pool” of exemption value. The actual rates applicable to gift and estate taxes are unchanged and portability between spouses remains.Importantly, unlike the TCJA provisions, the OBBBA’s estate tax thresholds do not include sunset provisions, offering greater predictability. Nonetheless, future legislative changes remain a possibility, underscoring the importance of sustained, proactive planning.Additionally, the OBBBA only impacts federal estate tax obligations; individual states may have their own estate tax rates and exemption levels. Taxpayers who maintain a course of consistent and vigilant estate planning will be best positioned to achieve their planning objectives and successfully thwart future challenges once the pendulum of enforcement activity and tax policies inevitably swing in the opposite direction.ConclusionAs Ben Franklin observed over two hundred years ago, “in this world nothing can be said to be certain, except death and taxes.” In navigating these certainties, collaboration with experienced estate planners and valuation professionals is critical.Feel free to reach out to us if you have any questions about the OBBBA’s impact on gift and estate tax valuations or to discuss a valuation issue in confidence.

Value Focus: Insurance Industry | Third Quarter 2025

Insurance sector lagging as valuations ease and M&A slows

Portfolio Valuation: Private Equity and Credit

Fall 2025

The recent Paramount-Rith Capital transaction highlights a growing challenge in private markets—valuations that fail to reflect market reality. As continuation funds become more common, conflicts arise when general partners act as both buyer and seller. Independent fairness opinions have become essential, ensuring transparency, validating valuations, and reinforcing fiduciary duties. In an environment of deep NAV discounts, these opinions are not formalities—they are vital checks that uphold integrity and trust in private market governance.

March 2000 vs. June 2024: How Different Is It?

We at Mercer Capital do not know which way markets will go in the coming quarters and years, but we can speculate. Mercer Capital does know bank valuation and transaction advisory.

Navigating Valuation Challenges in the Great Wealth Transfer

Over the next two decades, an estimated $68 trillion is expected to transfer from Baby Boomers and Gen X to Millennials and Gen Z in what has been dubbed the “Great Wealth Transfer.” For RIAs and trust companies, this transition presents both opportunities and challenges that directly impact firm valuations.

Overview of Auto Finance in 2025

Origination, Delinquency, and Portfolio Trends

Experian releases a “State of the Automotive Finance Market” webinar every quarter. The information in the most recently released webinar outlines origination, portfolio balances, and delinquency trends observed in the first quarter of 2025. We discuss in this post.

Viper-Sitio Transaction Signals Strategic Shift in U.S. Royalty Landscape

The Viper-Sitio merger represents a notable shift in strategy within a traditionally fragmented sector. It signals a move toward greater scale, operational leverage, and investor confidence in the royalty business model.

How to Sell Your Family Business

Selling a business is a three-step process. In reality, each of the phases overlaps to some degree, making the process more of a continuum than a finite set of procedures. A turnkey, orderly process typically requires four to six months. Ultimately, the collective team goal as a family business is to win the race, whether it be at the pace of the hare or the tortoise. In this week’s post, we take a deeper dive into those three phases and what that may look like for you and your family business when the time comes.

Succession Conundrums: Why Sell to Insiders for Less?

(Because It May End Up Making You More)

A frequent question among RIA owners is whether internal buyers, such as employees or partners, pay less for their equity stakes compared to external buyers, and if so, why pursue internal succession?

Capital Shifts and LNG Lifts

Takeaways from the 2025 Hart Energy Capital Conference

The energy industry is at a critical point, where producers must not only meet the ever-growing global energy demand resulting from population growth, industrialization, and the increasing electrification of uses, but also adapt to ever-changing environmental regulations and shifting societal expectations related to sustainable practices.

Review of Key Economic Indicators for Family Businesses

As we approach mid-year 2025, uncertainty in the U.S. economy remains elevated, making this a good time for family businesses to return to the fundamentals and review key macroeconomic indicators from the first quarter of 2025 and into the second quarter.

May 2025 SAAR

The May 2025 SAAR came in at 15.6 million units, down 9.3% from the previous month and representing a 1.1% decline from May 2024.

Don’t Punt on Succession Planning, Even if You Plan to Sell Externally

While external sales can be a viable exit option, we caution against viewing them as a substitute for a robust succession planning process. Having a viable succession plan in place is not just a fallback option; it’s a cornerstone of a successful external sale.

The Quest for Shareholder Alignment

At their best, multi-generation family businesses foster superior outcomes for shareholders, employees, customers, suppliers, and the communities in which they operate. Those are powerful incentives for maintaining family control of businesses across generations and through decades. Yet this remains the exception rather than the rule. Why? Enterprising families that are not aligned around key issues cannot expect to last.

Upstream Natural Gas Valuations: A Big Year

Cash flows are seen to pick up significantly in the future for upstream natural gas producers.

Webinar Replay: Succession Planning for RIAs

Transition with Confidence

In this webinar, Matthew R. Crow, CFA, ASA and Brooks K. Hamner, CFA, ASA guide you through the critical steps of succession planning, ensuring your firm's legacy thrives while maximizing its value. They discuss different ownership models and their implications, key considerations for maximizing firm value during a transition, and practical tools and steps to start planning for a successful transition today.

Value Amidst Uncertainty

How Will Your Family Business Fare If a Recession Sets In?

The month is June 2025, the windows in the car are rolled down, and “School’s Out” by Alice Cooper is playing. Summer of 2025 is here, and it should be a hot one. Outside, of course, but what about the U.S. economy? In 2025, the S&P 500 is up roughly 1% to date, recovering from what was a 15% year-to-date decrease in early April.

June 2025 | Fairness Opinions: Evaluating a Buyer’s Shares from the Seller’s Perspective

Bank Watch: June 2025

Fairness Opinions: Evaluating a Buyer’s Shares from the Seller’s Perspective - 2025 Update

While bank M&A activity has been steady in 2025, boards evaluating offers should look beyond headline prices to scrutinize the real value of consideration—especially when deals are paid in acquirer stock. A high stock price can make a transaction look attractive, but it also masks risks tied to dilution, liquidity, and the buyer’s future performance. Fairness opinions, detailed due diligence, and a clear-eyed assessment of the acquirer’s shares are essential to protect selling shareholders from unpleasant surprises once the deal closes.

Value Matters^® June 2025

Takeaways from the Pierce Case

The Importance of Relevant Data and Reasoned AnalysisThe recent U.S. Tax Court opinion in Kaleb J. Pierce v. Commissioner of Internal Revenue (T.C. Memo 202529) offers insight on several issues that regularly feature in the valuations of privately held business interests. By presenting an issue-by-issue analysis, the Pierce decision reinforces an important message for appraisers and estate planners: relevant data and reasoned analysis carry the day in court.BackgroundThe subject company, Mothers Lounge, LLC, an S corporation for tax purposes, sold mother and baby products. The company sold cheaply manufactured goods directly to consumers. The business relied on a “free, just pay shipping” no returns model, which afforded it a high profit margin, but came with a plethora of unsavory business practices, including copying competitor products, over-charging customers for shipping, undermining wholesalers and marketing affiliates, and suppressing customer reviews. The business history and practices detailed in the Findings of Fact are sufficient to raise eyebrows in a room full of former FTX executives. The dubious business model invited frequent litigation, with most lawsuits filed for trademark infringement. Two lawsuits were specifically described, one of which was for patent infringement and illegal marketing practices that had “ballooned into an existential threat.” Adding to these murky undercurrents were an affair of one of the business principals and a blackmail demand letter that spurred an FBI investigation. As noted by the Tax Court, these developments had “caused extreme dysfunction with the company’s management and demoralized the workforce” in the timeframe before the valuation date.The company’s business practices may have raised eyebrows, but they were lucrative. The first successful product, a nursing cover, illustrates the model (see Figure 1).Despite giving the product to customers for “free,” Mothers Lounge, LLC earned a healthy 64% contribution margin on each unit sold, which was more than sufficient to cover all other operating expenses of the business. In 2013, the company had an EBITDA (earnings before interest, taxes, depreciation and amortization) margin of 29%, which many readers will recognize as above average for a consumer products business. The company was debt-free and required minimal investments in depreciating assets, making EBITDA a good proxy for pre-tax cash flow. The Pierce court had to decide the proper value for gift tax purposes of two minority interests in Mothers Lounge, LLC that were transferred in 2014 (a 29.4% interest and a 20.6% interest).Expert WitnessesThe taxpayer’s expert prepared a valuation report submitted at trial. During the administrative appeal of the case in 2017, the taxpayer’s expert had also prepared a forecast for the business (the “2017 Forecast”). The taxpayer’s expert did not rely on the 2017 Forecast in his appraisal of the subject interests before the Tax Court, but the valuation expert for the IRS did. To recap, there were two valuation experts at trial, one for the taxpayer and one for the IRS. In preparing his appraisal, the IRS’s valuation expert relied on the 2017 Forecast prepared by the taxpayer’s expert, but the taxpayer’s expert did not rely on the 2017 Forecast in preparing his appraisal.Key IssuesForecastWhile both experts agreed on the application of the income approach, they relied on different forecasts. The forecast prepared by the taxpayer’s expert for his appraisal report relied on an analysis and assessment of relevant factors and market trends “known or knowable” as of the valuation date, which the Court deemed credible. In contrast, the IRS’s valuation expert relied on the 2017 Forecast “without independent verification,” which the Court easily rejected.The fact that the taxpayer’s expert prepared the forecasts underlying both his own report and that of the IRS’s valuation expert is a unique feature of the case. While the Pierce court deemed the forecast used by the taxpayer’s expert credible, it declined to ascribe weight to the 2017 Forecast used by the IRS’s valuation expert (which was prepared by the taxpayer’s expert). According to the opinion, the taxpayer’s expert “was in a time crunch” to prepare the 2017 Forecast and he ultimately relied on post-valuation data to support its projections. The Court noted that the 2017 Forecast lacked any analysis or discussion of the events surrounding the FBI investigation and inappropriately relied on post-valuation data. The Court pointedly stated that “this reliance blurs the line between information that was known or knowable as of the valuation date and the information that was not reasonably foreseeable as of the valuation date.”Tax AffectingBoth experts agreed that tax affecting the earnings of the company (an S corporation) was appropriate and used the Delaware Chancery method to calculate substantially equivalent tax rates (26.2% and 25.8%).The Court commented that tax affecting earnings of tax pass-through entities can be rejected where “a party fails to adequately explain” its necessity or where the experts “have not accounted for the benefits of S corporation status to shareholders.” We note that the 2017 Tax Cuts and Jobs Act brought C and S corporations closer to parity in taxation, diminishing the additional economic benefits formerly realized by owners of pass-through entities. Nonetheless, the Pierce opinion affirms that the valuation of an interest in a tax pass-through entity should account for the effect, if any, of tax status on the value of the interest.Discount RateMothers Lounge, LLC had no debt and both experts developed a cost of equity capital (COEC) discount rate using the build-up method. The key differences between the experts were in the presentation of the underlying data and the application of a company-specific risk premium (CSRP).The taxpayer’s expert used the Kroll Cost of Capital Navigator platform, which includes tables with output results, but does not present the underlying data. In contrast, the IRS’s valuation expert “provided a thorough review of his process and the academic papers that supported his equations.” Citing the lack of supporting data in the taxpayer’s expert report, the Court accepted the COEC rate concluded by the IRS’s valuation expert.Of particular interest is the issue of company-specific risk premium. The taxpayer’s expert added a CSRP of 5% to the build-up analysis, while the IRS’s valuation expert applied a 0% premium. In discussing the company-specific risk premium, the Court acknowledged that the build-up method allows for the consideration of such risks, but expressed concern that such risk factors may already be accounted for in other elements of the build-up approach (such as the size premium). Ultimately, the Court did not accept the premium applied by the taxpayer’s expert, who had cited five risk factors he considered in arriving at his conclusion for the premium. The Court chided the taxpayer’s expert for failing to provide sufficient details to allow the Court to understand the derivation of the selected premium. The Court’s conclusion confirms the need to support the application of a company-specific risk premiums with reference to available market evidence and the overall reasonableness of the resulting conclusion of value.Applicable DiscountsBoth experts applied discounts for lack of control and lack of marketability in the valuation of the subject minority interests.With respect to the discount for lack of control, the experts differed in the approach used to determine the discount and its application. The Court adopted the taxpayer’s expert 5% discount which was based on analysis of the company’s operating agreement, capital market evidence, and consideration of relevant facts and circumstances. In contrast, the IRS’s valuation expert applied a 10% discount, but only to the non-operating assets of the business. In its rejection of the latter approach, the Court once again cited the lack of underlying supporting data and analysis.The experts applied similar (25% and 30%) discounts for lack of marketability supported by detailed explanations of their methodologies and conclusions. The Court found the methodology used by the taxpayer’s expert to be “slightly more persuasive.” The Court once more expressed concern that the IRS valuation expert relied on the 2017 Forecast. Of note, the Court’s finding in favor of the (lower) marketability discount proffered by taxpayer’s expert was actually adverse to the taxpayer’s overall position.ConclusionThe material valuation issues in the Pierce case include the proper data to use in preparing a forecast, tax affecting pass-through earnings, and supporting appropriate risk factors and discounts to be applied in the valuation of closely held business interests. The Court’s consideration of each issue underscores the importance of marshalling relevant data and presenting reasoned analysis in valuation reports.

Issue No. 15 | Updated Metrics for Mid-Year 2025

Feature Articles: Q2 2025 Earnings Calls and 2025 Auto Industry Tariff Update

Should You Choose an Industry or Valuation Expert?

Blue (Sky) Is in the Eye of the Beholder – Part 1

Perspectives on Auto Dealership Blue Sky Multiples and Valuations

On a recent client engagement, I was asked the question, “Why are Haig and Kerrigan’s multiples so far apart?” I’ve never really viewed them that way, as the blue sky multiples published in their quarterly newsletters tend to cluster reasonably close together.

Succession Planning and Its Impact on RIA Valuations

For the investment management industry, succession planning is not just a strategic necessity—it’s an important driver of firm value.

Whitepaper: Succession Planning for Investment Management Firms

Read our updated whitepaper.

Understand the Market Approach in a Business Valuation

What Is the Market Approach and How Is it Utilized?

Corporate Finance in 30 Minutes

A Guide for Family Business Directors and Shareholders

We put this piece together to give family business directors and shareholders a vocabulary and conceptual framework for thinking about strategic corporate finance decisions. An informed and engaged shareholder base is the most important factor in preserving stability within the family business.

Video: Corporate Finance in 30 Minutes

A Guide for Family Business Directors and Shareholders

In this short video Travis Harms discusses three fundamental corporate finance questions that will help family business shareholders understand the basics of corporate finance and will ultimately result in more engaged and valuable shareholders.

Oilfield Services Companies and How To Value Them

Understanding the value of an oilfield services (OFS) company is by its very nature a complex matter. As participants in the greater energy industry, situated between the exploration and production (E&P) companies and midstream companies, the OFS sub-sector is quite broad and includes a wide variety of businesses.

Managing Your RIA’s Priorities

The Owner Strategy Triangle

Sometimes we come across an idea that is so good we’re jealous of the person or persons who developed it. The Owner Strategy Triangle is one such idea.

Understanding Family Ownership Roles

In a Harvard Business Review article entitled “5 Kinds of Ownership Roles in a Family Business,” author Nick Di Loreto describes five types of family business owners based on what they are willing to commit to the business: capital, intellect, heart, time, and career.

Succession Is a Process, Not an Event

Why RIA Owners Need to Plan Early and Continuously

In this post, we address the process of succession and the role of internal resources such as next-generation leadership, as well as how investing in these areas increases your firm’s value—regardless of whether you choose an internal or external transition.

April 2025 SAAR

The April 2025 SAAR came in at 17.3 million units, down 3.1% from last month but up 7.8% from April 2024. Even with a slight month-over-month decline from the short-term peak of last month’s SAAR, April 2025 still saw the second-highest SAAR since April 2021. This highlights the strong demand in the current market as consumers are motivated to purchase a vehicle before potential tariff-related price increases.

Oilfield Services Update for 2025

In this post, we focus on the Oilfield Services (OFS) industry. In particular, we cover changes related to the recent recovery in activity level, the influences of technological advances, the push for energy independence, and expectations going forward.

Does Your Family Business Have More Than One Value?

It is understandably frustrating for family business directors when the simple question — what is our family business worth? — elicits a complicated answer. While we would certainly prefer to give a simple answer, the reality that a business valuation attempts to describe is not simple. The main reason is that this answer depends on why the question is being asked. We know that sounds suspect, but in this post, we demonstrate why it is not.

Just Released: Q1 2025 Oil & Gas Industry Newsletter

Regional Focus: Eagle Ford

The Impact of Market Volatility on RIA Valuations

An Illustrative Example of the Dangers of Formula Pricing in a Buy-Sell Agreement

In this post, we show an illustrative example of how the market volatility we’ve endured so far this year could impact the formula pricing valuation of a $1 billion AUM RIA that has 70% of its clients’ assets in the S&P 500 and 30% in a diversified bond fund.

Estate Planning for Auto Dealers

For this week’s edition of Auto Dealer Valuation Insights, we revisit a timely article on estate planning for auto dealerships.

Bank Watch: May 2025

Dividends and Shareholder Returns | A Ten-Year Lookback

With investors favoring dividend-paying funds amid equity market volatility, we examined the role of dividends in bank shareholder returns over the past decade. While dividends made up a significant portion of total returns, especially in a middling decade for bank stocks, our analysis shows they are not the sole driver. Long-term shareholder value is still rooted in growing earnings and book value—even in uncertain times.

Potential Intersection of Estate Planning During the Divorce Process

Divorce is often an emotionally and financially draining process, and estate planning may be the last thing on the minds of the divorcing parties.

BOOKLET | Business Valuation 101

This guide is designed to provide readers with a foundational understanding of key valuation concepts, definitions, and methodologies.

Market Volatility & Shareholder Liquidity

We make no predictions as to how long the elevated market volatility will persist. Some of the world’s wealthiest families are seeing opportunity in the chaos. What about yours?

Uncertainty Rules the Day

Oil Markets Bewildered as World Trade Patterns Shift

Oil markets and energy companies are wrestling with understanding changes in domestic and international energy markets. As company outlooks become cloudier, uncertainty is on the rise. This has been developing for several weeks now, with some early indications showing that executives and investors don’t quite know how to respond yet.

Market Volatility and the Enduring Value of Wealth Management

Following a comparatively placid first quarter, this month hasn’t been kind to anyone working in investment management. Y

Next Gen Up

The transition to the next generation has been one of the main impediments to family businesses trying to establish a multigenerational enterprise. For many family businesses, this transition can be rocky (and often unsuccessful) due to the next generation’s lack of exposure to the business and last-minute succession planning.

RIA M&A Update: Q1 2025

M&A activity in the RIA industry, which had been trailing 2023 levels for much of 2024, experienced a surge in January. This spike set a new record for monthly deal volume, exceeding the high watermark set in October 2024. Q1 2025 was a record-setting quarter for deal volume. Fidelity’s March 2025 Wealth Management M&A Transaction Report listed 72 deals through March, which exceeds the 70 deals executed during the same period in 2023, the next highest Q1 on record.

Eagle Ford Production Edges Downward Again on Reduced Drilling

The economics of oil & gas production vary by region. Mercer Capital focuses on trends in several plays including the Eagle Ford, Permian, Haynesville, and Marcellus and Utica. This quarter we take a closer look at the Eagle Ford.

April 2025 Auto Industry Tariff Update

Where Do We Stand and What Does That Mean for My Dealership?

The U.S. automotive industry has been navigating an increasingly uncertain landscape since the 2024 presidential election. Given how deeply globalized the industry is, automotive manufacturing often involves complex supply chains where parts and materials may cross borders multiple times before a vehicle reaches the end consumer.

Middle Market Transaction Update Spring 2025

Middle market M&A activity rebounded in the fourth quarter of 2024, albeit, marginally, over the “summer slowdown” experienced in the third quarter of 2024.

Capital Budgeting and the Meaning of Your Family Business

When it comes to capital budgeting, deciding the “what” is often just as (or even more) difficult than the “how.” In other words, what types of capital projects should be going into your capital budgeting funnel?

Negotiating Net Working Capital Targets in a Transaction

Net working capital targets are among the most consequential—and often misunderstood—components of middle-market M&A negotiations. Because these targets directly affect purchase price adjustments at closing, buyers and sellers must carefully define, analyze, and negotiate working capital levels to ensure the transaction economics hold up beyond day one.

Asset Managers Underperform the S&P

Tariff Meltdown Presents Opportunity

Amid stabilizing interest rates and inflation, the asset management industry (and the stock market as a whole) experienced moderate growth over the past year.

Where Have All the Eagle Ford Deals Gone?

Over the past 12 months, deal activity in the Eagle Ford remained stagnant, with only two pure Eagle Ford Shale deals closing compared to two transactions closed in the prior 12-month period, according to Shale Experts.

The Patience to Prevail, Revisited

We formerly wrote a post comparing the challenges presented in golf’s Open Championship to those of operating a family business in times of economic uncertainty. We highlight those challenges again in this week’s post for two reasons. With global financial markets in turmoil stemming from proposed retaliatory tariffs by the United States on effectively the rest of the world, it is more important than ever for family businesses to circle the wagons and turn their focus inward in an effort to respond to potential challenges from outside forces.

RIA Market Update: Q1 2025

RIAs underperformed the S&P in Q1 2025, with alternative asset managers declining almost 20% after a year of outperformance. Year-over-year, traditional investment managers saw the strongest AUM growth, while alternative managers proved better at converting this growth to revenue. We explore further in our Q1 2025 Market Update.

Challenges for U.S. Drilling Amid Tariff Uncertainties

Natural gas producers have continued to reduce costs and refrain from increasing production despite strong fourth-quarter earnings that surpassed consensus expectations.

March 2025 SAAR

The March 2025 SAAR came in at 17.8 million units, up a staggering 11.0% from last month and 13.3% from March 2024. March 2025 saw the highest SAAR since April 2021, reflecting not only the recent trend of strong consumer demand but also the additional demand generated by consumers motivated to purchase a vehicle to avoid potential tariff-related price increases.

April 2025 | Mortgage Banking’s Next Chapter

Bank Watch: April 2025

Mortgage Banking’s Next Chapter: Is a Recovery Taking Root?

After years of booming mortgage profits driven by ultra-low rates, the industry has faced a prolonged slump amid stubbornly high mortgage rates and weakened housing demand. Despite rate cuts by the Fed, affordability remains strained, and mortgage volumes lag forecasts. However, transaction volume is expected to pick up despite high rates while home prices remain flattish, which should serve to boost mortgage originations. Major moves by Rocket Companies, including acquisitions of Redfin and Mr. Cooper, hint that the worst may be over and a recovery in mortgage banking could be taking shape.

The Value of Carried Interest: A Guide for Matrimonial Litigation

Carried Interest Explained

April 2025 | The Value of Carried Interest in Estate Planning

Value Matters^® April 2025

The Value of Carried Interest in Estate Planning: A Guide for Newly Formed Funds

As we stated in the March 2025 issue of this newsletter, we believe that prudent federal estate and gift tax planning involves a lifetime horizon with adherence to best practices that yield optimal outcomes. When economic and market conditions present an opportunity for estate planning, assets with low current values and potential for significant appreciation should be considered for efficient estate planning. One type of asset that fits this category is carried interest. This article explores the strategic incorporation of carried interests in estate planning, particularly for newly formed private equity funds. It discusses the benefits and complexities of leveraging such interests under current economic conditions and tax regulations to optimize estate outcomes. We will discuss specific valuation approaches and methods in the valuation of carried interests in a future article.Carried Interest ExplainedWhat is carried interest? It is the profits interest that a private equity, venture capital, or hedge fund principal receives if the fund exceeds certain performance benchmarks. Carried interest can also be referred to as performance allocation, incentive allocation, or promote interest in the case of real estate funds. Separately, fund principals also receive economics from management fees and direct investments in the fund. Fund Structures and Carried Interest AllocationA basic private equity fund structure is shown in Figure 1. Typically, the fund principals form a general partner entity and a management company entity. The principals then raise capital from limited partners and make investments over the term of the fund. The management company receives management fees, often around 2% per year, for investment management services provided. The general partner entity typically invests alongside the limited partners and receives its pro-rata share of returns along with the limited partners. If the fund exceeds certain benchmarks, the general partner also receives carried interest, often around 20% of fund returns beyond the benchmark. It is important to note that private equity fund structures come in many forms, from basic to complex. Even though this article is focused primarily on private equity funds, similar concepts apply to certain hedge funds and venture capital funds.Navigating Uncertainty and Valuation ChallengesUncertainty exists regarding the fund’s performance, more so earlier in the fund’s life. When the fund entities are formed, and before capital is raised, there is also uncertainty regarding how much capital will be raised. These uncertainties result in low values for the fund entities at inception. The fund entity values will appreciate significantly if the fund is able to successfully raise capital and achieve strong investment returns.Why would a newly formed fund entity have any value before capital is raised? The IRS’ Revenue Procedure 93-27 provides that if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will not treat the receipt of such an interest as a taxable event for the partner or the partnership. It has been argued that 93-27 means that a profits interest has no value at issuance. However, the IRS has made it clear that 93-27 is not applicable to valuing carried interest.Challenges in Valuing Interests in Fund EntitiesA qualified appraisal prepared by a qualified appraiser with experience valuing carried interest is paramount when making estate planning transfers with newly formed fund entity interests given the complexity involved. In addition to fund structure, other items that require appraiser familiarity with carried interest include the following:Fundraising: What is the fund’s target size? What is the minimum required investment? Will the fund offer special terms for early investors or for a large “anchor” investor?Fund investment strategy: What types of investments will the fund make in terms of asset classes, industries, size of interests, number of investments, etc.? How will the investments shape expected returns for the fund? What is the expected holding period for the investments? Will capital from the sales of investments be reinvested? Will the fund use leverage?Fund terms: How is the management fee calculated and how often will it be assessed? Who will pay for fund expenses? Is there a general partner catch-up after the hurdle is reached? Are distributions made on a deal-by-deal basis, or on a cumulative basis? Can the general partner waive management fees associated with their direct investments in the fund?ConclusionIn conclusion, carried interests in newly formed fund entities present a valuable estate planning opportunity, particularly during times of economic uncertainty and where there is potential for fund appreciation.It is essential to work with qualified appraisers familiar with the complexities of fund structures and tax regulations to ensure optimal outcomes. Engaging with experienced advisors can significantly enhance the outcomes of your estate planning efforts.The professionals at Mercer Capital have experience in the valuation of carried interests. For more information or to discuss a valuation issue in confidence, feel free to contact us.

Second Quarter 2025 | Segment Focus: Building Materials

Concrete prices grew at a steady rate over the past year, lumber prices experienced a significant drop in Q2 2025, and steel prices soared in the second quarter due to industry effects from tariffs. The Trump Administration’s “Liberation Day” tariffs took effect early in the quarter, leading to an immediate sell-off in the market. However, major indexes recovered quickly. Trade policy is in a state of limbo as the administration continues to negotiate terms with trading partners.

Healthcare Facilities Q2 2025

Segment Focus: Senior Care / Long-Term Care

Senior care is a large and growing industry in the United States. Growth is primarily predicated on demographic shifts, with an aging population likely to need both general and specialized living assistance.

Value Focus: Insurance Industry | Second Quarter 2025

Mixed results for insurance stocks in the second quarter of 2025

Medtech and Device Industry Newsletter - Q2 2025

EXECUTIVE SUMMARYThis quarterly update includes a broad outlook that divides the healthcare industry into four sectors:Biotechnology & Life SciencesMedical DevicesHealthcare TechnologyLarge, Diversified Healthcare CompaniesWe include a review of market performance, valuation multiple trends, operating metrics, and other market data. This issue also includes a review of M&A and IPO activity

E&P Third Quarter 2025

Region Focus: Appalachia

Appalachia // The Appalachian basin enters late-2025 on firmer footing than a year ago, characterized by stable production, recovering equity performance, and improving infrastructure fundamentals

E&P Second Quarter 2025

Region Focus: Permian

Permian // The Permian basin continues to serve as the centerpiece of the U.S. shale revolution.

Transportation & Logistics Newsletter

Second Quarter 2025

The second quarter’s tariff news started on April 2nd, when President Trump announced the levels of the previously proposed “reciprocal” tariffs. All imports would be subject to a base tariff of 10%, and various countries would have additional tariffs levels, ostensibly based on the trade deficit with each respective country. The European Union, South Korea, and Taiwan would be subject to tariffs of 20%, 25%, and 32%, respectively. Two days later, China would face a total tariff of over 50%. China announced a retaliatory 34% tariff on U.S. imports. The 10% baseline tariffs were scheduled to go into effect on April 5th, and the reciprocal tariffs were going to be effective as of April 9th.

Dividend Policy & the Meaning of Your Family Business

Our multi-generation family business clients ask us about dividend policy more often than any other topic. This isn't surprising, since returns to family business shareholders come in only two forms: current income from dividends and capital appreciation. For many shareholders, capital appreciation is what makes them wealthy, but current income is what makes them feel wealthy.

Webinar Replay: Understanding RIA Valuations

A Guide for Today's Market

In our latest webinar, Brooks K. Hamner, CFA, ASA and Zachary C. Milam, CFA explore the critical elements shaping RIA valuations in today's market. They discuss the key factors influencing RIA valuations, the latest industry trends, methodologies for valuing RIAs, and best practices to maximize firm value.

Key Components in a Typical Oil & Gas Lease

When negotiating and drafting oil and gas leases, understanding the basic framework that governs these agreements is essential. While there is no true “standard” lease, the primary areas and considerations of an oil and gas lease are discussed in this post.

Basics of Financial Statement Analysis

A Guide for Private Company Directors and Shareholders

We are excited to offer our readers a physical version of our piece, “Basics of Financial Statements: A Guide for Private Company Directors and Shareholders.”

What Drives RIA Value – Growth or Margin?

More of Both Is Best, but the Tradeoff Is Measurable

We regularly get asked how to optimize the value of an RIA. The answer is easier spread than done. Starting with the obvious, value is a function of cash flow, risk, and growth.

U.S. LNG in 2025

The Future is Bright, Though with Potential Headwinds

Expectations for the LNG industry in 2025 were modestly positive before the November 2024 U.S. elections but are notably more robust with the transition from the decidedly pro-green/renewable, anti-carbon energy Biden administration to the decidedly pro-American energy dominance Trump administration. However, as always true of domestic commodity markets subject to international market influences, the outlook for the U.S. LNG industry in 2025 is tempered by a number of potential domestic, international, and geopolitical pressures that could hamper actual results relative to expectations.

Q4 2024 Earnings Calls

Auto Industry Volumes and Per-Unit Profitability Continue to Normalize

Themes for this seasons' earnings calls were 1: Volume growth and GPU normalization in the new vehicle market, Technician expansion and strong profitability in Parts and Service, and Policy uncertainty in the U.S. surrounding tariffs and EVs

Crown Castle's Lessons for Family Businesses

Crown Castle’s divestiture of its Fiber segment offers plenty for family business directors to chew on. The story highlights the need for an integrated framework for directors to evaluate and monitor the key strategic finance decisions that influence family shareholder returns for the years and decades to come.

5 Takeaways from Dimensional Fund Advisors’ Deals & Succession Conference

The 2025 Dimensional Fund Advisors’ Deals and Succession conference was held at Dimensional’s offices in Charlotte, North Carolina. The event focused on the current M&A environment and best practices for internal succession planning and ownership expansion.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of March 12, 2025

Why the Value of Your Family Business Matters

In this week’s post, we have compiled a selective list of reasons why it is essential for both family shareholders and family business directors to know what the family business is worth (even if the family has no intention of selling).

The 2025 Tariff Surge: Timeline and Industry Impact - Part II

In the Q1 2025 Transportation Industry newsletter, we discussed the impact of the newly levied tariffs on the transportation sector. We focused on the main targets of the original tariffs (Canada, China, and Mexico) and the proposed removal of the De Minimis exemptions. These actions led to an increase in imports due to companies rushing to acquire inventory prior to the start of the tariffs, and speculation that inflation would be on the rise shortly after. Since Q1, the ever-evolving tariff landscape has created new implications for importers and exporters alike.

The 2025 Tariff Surge: Timeline and Industry Impact

In the Q1 newsletter, we discussed the impact of the newly levied tariffs on the transportation sector. We focused on the main targets of the original tariffs (Canada, China, and Mexico) and the proposed removal of the De Minimis exemptions. These actions led to an increase in imports due to companies rushing to acquire inventory prior to the start of the tariffs, and speculation that inflation would be on the rise shortly after. Since Q1, the ever-evolving tariff landscape has created new implications for importers and exporters alike.

How to Understand Your Mineral Interests

Because of the popularity of this post, we revisit it this week. Originally published in 2019, this post is as a guide for mineral owners who are seeking to learn more about what they own.

Succession Planning Options for RIAs

Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The industry’s demographics suggest that increased attention to succession planning is well warranted: a majority of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. While there is growing recognition of the importance of succession planning, it often lags far behind other strategic initiatives with more immediate benefits like new client and staff growth1. In the long run, however, firms with a well-developed succession plan have a distinct competitive advantage over those without. Fortunately, many viable options exist for RIA principals looking to solve succession planning issues. In this post, we review several of the more common options.Internal transition to the next generation of firm leadership. Internal transitions of ownership are the most common type of transaction for investment management firms and for good reason. Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor.Internal transitions allow RIAs to maintain independence over the long term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned. A gradual transition of responsibilities and ownership to the next generation is usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit. While this option typically requires the most preparation and patience, it allows the founding shareholders to handpick their successors and future leadership.Debt financing. Debt financing has become a readily available option for RIAs in recent years as the number of specialty lenders focusing on the sector has increased. External debt financing is often used to finance internal transactions as an alternative to seller financing. Such arrangements avoid introducing a new outside equity partner and can work well when the scope of succession issues to solve is limited to financing the transaction.There are potential drawbacks, however. For example, debt financing for RIAs typically requires a personal guarantee, which many borrowers oppose. Borrowers are also more exposed to their own business by levering up to purchase an equity stake.Sale to a consolidator or roll-up firm. RIA consolidators have emerged, promising a means for ownership transition, back-office efficiencies, and best practices coaching. The consolidator model has been gaining traction in the industry in recent years. Most well-known RIA consolidators have grown their AUM at double-digit growth rates over the last five years, and acquisitions by consolidators represent an increasing portion of overall deal volume in the sector.For RIA principals looking for an exit plan, a sale to a consolidator typically provides the selling partners with substantial liquidity at closing, an ongoing interest in the firm’s economics, and a mechanism to transfer the sellers’ continued interest to the next generation of management. There’s a wide spectrum of consolidator models, and they can vary significantly in terms of their effect on the day-to-day operations of the acquired RIA. RIA owners considering selling to a consolidator should think carefully about which aspects of their business they feel strongly about and how those aspects of the business will change after the deal closes.Sale to a private equity firm. Drawn to the industry’s typically high margins, low capital expenditure needs, and recurring revenue model, private equity managers have sharpened their focus on investment management firms in recent years. Private equity can be used to buy out a retiring partner, but it is not typically a permanent solution. While PE firms provide upfront cash, remaining principals must sacrifice most of their control and potentially some of their ownership at closing.Minority financial investment. Minority financial investments can provide existing ownership with liquidity while allowing remaining shareholders to maintain control and an ongoing interest in the firm’s Minority investors typically do not intrude on the firm’s operations as much as other equity options, but they will seek deal terms that adequately protect their interest in future cash flows.Sale to a strategic buyer. A strategic buyer is likely another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. On paper, this scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees, clients, or the company’s identity.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.1 See https://content.schwab.com/web/retail/public/about-schwab/2024-Charles-Schwab-RIA-Benchmarking-Study.pdf

February 2025 SAAR

The February 2025 SAAR came in at 16.0 million units, up 3.2% from last month and 2.1% from February 2024. While February typically records one of the lowest sales volumes each year, this month's SAAR exceeded the average of the last five Februarys (approximately 15.3 million units). February 2025 performance reflected strength in consumer demand, primarily driven by improved inventory and incentive spending.

Back to Valuation Basics

Early in his career, our founder, Chris Mercer, considered six underlying financial, economic, logical, and psychological principles that provide a solid basis for considering valuation questions and issues. Each principle provides a way of looking at the world from a valuation perspective, and integrating the perspectives provides a logical framework to examine elements within business valuation.

BankWatch: March 2025

Profitability, Growth and Valuation

After a strong 2H24, community and regional bank stocks are down 5% in Q1 2025 and are down about 15% from late November when bank stocks peaked in a run that started mid-year. Valuations for individual stocks, a sector such as banking and the overall market will ebb and flow with a variety of factors, but ultimately earnings and earnings growth are the mother’s milk of investing. One asset manager years ago provided a useful framework to think about profitability, growth, and valuation as a framework for stock selection.

Personal vs. Enterprise Goodwill: Issues to Consider in Divorce Valuations

This article discusses important concepts of personal vs. enterprise goodwill in valuations for divorce.

Personal vs. Enterprise Goodwill: Issues to Consider in Divorce Valuations

For this month’s edition of Family Law Valuation and Forensic Insights, we revisit a timely article on personal vs. enterprise goodwill.

March 2025 | Estate Planning Amid IRS Changes and Tax Reforms

Value Matters^® March 2025

Navigating Uncertainty: Estate Planning Amid IRS Changes and Tax Reforms

Themes from Q4 2024 Earnings Calls

Upstream (E&P) and Oilfield Service (“OFS”) Companies

Companies are evaluating the trade-offs between optimizing existing assets and pursuing mergers and acquisitions. Capital allocation remains a focal point, with an emphasis on debt reduction and shareholder returns. Additionally, firms are positioning themselves to navigate evolving market conditions, ready to capitalize on emerging opportunities. This analysis offers valuable insight into the strategies industry leaders are employing for the future.

Specter of Stagflation Threatens RIAs

Time to Stop and Consider a Trifecta of Possible Headwinds for Investment Managers

Stagflation is a term coined by British politician Ian Macleod in the 1960s to describe an economic period that simultaneously exhibits high inflation, stagnant economic growth, and elevated unemployment. It’s too early to tell if the current focus on tariffs and government austerity, layered on top of private sector weakness, will lead to stagflation in the U.S. But it’s starting to be discussed, and it isn’t too early to consider what it might mean to the RIA sector.

The Most Efficient Way to Increase the Value of Your Family Business

Is it really true that a higher EBITDA margin will also bring a higher multiple, or were we just getting carried away with our own thesis?

Asset Retirement Obligations in Oil & Gas

Their Impact on Valuation & Transactions

An asset retirement obligation (ARO) in oil and gas refers to the legal or regulatory requirement for a company to dismantle, remove, and restore a site once an asset (such as an oil well, offshore platform, or pipeline) reaches the end of its useful life. These obligations arise due to environmental laws and lease agreements requiring companies to clean up and restore the land or seabed. Typical costs include plugging and abandonment, reclamation, and remediation.

Nissan’s Search for a Merger Partner

If you own or manage a Nissan dealership, you likely have questions about what the company’s next steps mean for your business. Many of these questions are prudent, as Nissan’s ongoing search for strategic partnerships could still have significant implications for dealers down the line. Below are the key factors that could shape the future for Nissan dealers.

RIA Valuations and How to Maximize Yours

This episode of the The Buyer’s Boardroom podcast discusses RIA valuation methods, misconceptions surrounding rule-of thumb measures, key value drivers, and the pros and cons associated with internal versus external sales of your business.

Is All EBITDA Created Equal?

In the world of family-owned and other private businesses, most everyone looks to EBITDA (earnings before interest, taxes, depreciation, and amortization) as an indicator of financial performance. Legendary investor Warren Buffett, however, holds a long-standing grudge against EBITDA. We believe there is a time and a place for EBITDA in financial analysis, but Mr. Buffett does have a point — some EBITDA is better than others. But why?

The Oil & Gas Industry is Pumped Up

NAPE 2025 Recap

Mercer Capital’s Bryce Erickson and Andy Frew insights from the NAPE (North American Prospect Expo) summit on February 5th and 6th, 2025 in Houston, Texas.

Unpacking the Relative Success of Victory Capital

Victory Capital is a relative newcomer to the small list of publicly traded asset managers. Since its IPO, it has quietly outperformed many publicly traded peers by employing an acquisition-driven growth strategy that has delivered impressive shareholder returns. In this post, we take a closer look at the factors driving Victory’s success.

What Family Business Director Has Been Reading

Fresh off Super Bowl 2025 with no more football in sight, it’s time to pick up that book collecting dust on the shelf. To help ease you back into the routine of things as we head into the dog days of winter, here’s a quick roundup of what we have been reading.

The Uinta Basin Resurgence

The Uinta Basin has gained renewed relevance due to advancements in fracking and horizontal drilling and is increasing in significance as oil and gas companies are priced out of the Permian. While transportation challenges remain due to the unique properties of the basin's waxy crude oil, the region's potential is attracting significant attention, especially as companies seek acreage outside the increasingly competitive and expensive Permian Basin. With renewed investment and interest from both public and private operators, the Uinta Basin is poised to play a growing role in U.S. oil production.

Who Should Own Your RIA?

The Best Ownership Model Is One That Supports the Business Model

Aside from the initial startup years, when fledgling RIAs struggle to achieve profitability, the most difficult period that most firms endure is the transition from the founding generation of leadership to G2. For those that make the transition, getting from the second generation to the third, and so forth, is comparatively easy. Much of this difficulty relates to a contemporaneous transition of ownership — not just the identities of the owners but also the structure of the ownership.

January 2025 SAAR

The January 2025 SAAR came in at 15.6 million units, down 7.5% from last month and up 3.8% from January 2024. January is typically one of the lowest months of sales volume each year, but as seasonal adjustments usually account for this, it is notable that this month’s SAAR dipped to the lowest point since January 2024. It is also worth mentioning that this month’s SAAR exceeded the average of the last five Januarys (approximately 15.4 million units).

Tariff Talk and Adaptive Forecasting

How Family Business Directors Can Stay Ahead of Unpredictable Times

For family business directors, it is critical to keep a pulse on current developments and understand the different implications that may impact or change their industry moving forward. Maintaining an adaptive forecast is one of the best practices for being able to pivot during unpredictable times.

February 2025 | A Cautiously Optimistic Outlook for Bank M&A

Bank Watch: February 2025

A Cautiously Optimistic Outlook for Bank M&A: AOBA 2025 Recap

The 2025 Acquire or Be Acquired (AOBA) Conference in Phoenix reflected a renewed sense of optimism for the banking industry. With small-cap banks rebounding in late 2024 and earnings growth on the horizon, the outlook for M&A is improving. Increased capital market activity, pent-up demand from buyers and sellers, and a shifting regulatory environment all signal a potential acceleration in bank deals this year.Read our full breakdown of AOBA’s key themes and insights in this month’s BankWatch.

Relative Total Shareholder Return Compensation

Financial Reporting Flash: Issue 2, 2025

Relative total shareholder return (TSR) has become a central metric in long-term incentive plans, particularly for aligning executive compensation with shareholder outcomes. As companies navigate market volatility and evolving governance standards, a clear understanding of relative TSR-based awards is essential for effective plan design and regulatory compliance.

Valuation of Stock Options for Marital Dissolution

The valuation of stock options is a complex issue that divorcing parties may face during the determination and division of property.

February 2025 | Broader Lessons from Connelly

Value Matters^® February 2025

Beyond Life Insurance: Broader Lessons from Connelly

In the practice of professional services sometimes a single issue or event garners much attention. Such is the situation with the Connelly case and the valuation of an equity interest in a small building supply company, Crown C Supply (“CCS”).The question to be resolved in the case was how $3 million in life insurance proceeds received by CCS and purposed for the redemption of an equity interest from the estate of one of the company’s two shareholders should be treated when valuing the equity interest.The Connelly case attracted much attention when the United States Supreme Court agreed to hear it, and rightfully so, as few estate tax cases are heard by the highest court in the land.Much has been written about the case since then and the implications of the Court’s decisions for life-insurance funded entity purchase buy-sell agreements and business valuation are important to understand. We have written about the case in our most recent book published by the ABA, Buy-Sell Agreements: Valuation Handbook for Attorneys.Alongside a detailed analysis of these issues, however, it is instructive to also consider the timeless lessons that can be drawn from the case.These lessons become evident when one ponders the inevitable question: Why did the estate of a shareholder in a small, family-owned business with a value of less than $7.0 million have to appeal and argue its case in front of the United States Supreme Court?Some of the answers to the question lie in the errors, often ones of omission, that can be made by taxpayers when planning for the eventual estate tax liability from their ownership of a family-owned business.Four Lessons from ConnellyBelow we review four lessons that lie in the puzzle of the Connelly case.Estate Plans Accomplished Through a Family Business Will Inevitably Have Implications for All Stakeholders That Need to Be Considered and BalancedWhen the primary source of wealth is an interest in a family-owned business, there may be an understandable inclination for family members to implement an estate plan that will be executed within the bounds of the business.However, it is important to keep in mind that estate taxes are the responsibility of the individual shareholders rather than the family business.In the Connelly case, after the redemption of the deceased brother’s 77.2% controlling interest in CCS with $3.0 million in life insurance proceeds, the surviving brother’s pre-redemption 22.8% minority interest in the business effectively converted to a 100% controlling ownership interest. Thus, the redemption of the estate’s interest increased both the ownership share and basis of value of the surviving shareholder.The increase in value to the surviving shareholder was not captured by the transfer system in the sequence of steps and reportable transactions and therefore likely attracted greater scrutiny by the IRS.1To the Extent Shareholders Do Not Respect the Formalities of a Shareholders’ Agreement, Don’t Expect the IRS or a Court to Do So EitherWhen an estate plan is put in place, its provisions may require regular follow-up by the parties.It is not surprising that the time demands of running a successful business often limit the attention business owners can devote to estate plan requirements. Thus, estate plans can sit on the proverbial back shelf for years. Such lack of attention can unravel even well laid out plans.The Connelly brothers had entered into a stock-purchase agreement (“SPA”) with buyout provisions for their respective ownership interests in the event of the death of either brother.The SPA required the shareholders to annually determine the value of CCS shares and had provisions for an appraisal process to be used in determining the fair market value of CCS shares in redemption. None of these requirements were fulfilled by the Connelly brothers.Buy-Sell or Other Restrictive Agreements Need To Be Properly Drafted in Order to Have the Desired Effects for Estate Planning PurposesBuy-sell agreements (“BSAs”) are used by private business owners for a variety of purposes, including ownership control, succession planning, and liquidity needs. BSAs and similar restrictive agreements are also important tools in estate planning and can establish the value of an equity interest for estate or gift tax purposes.In order for an agreement transfer price to be considered as a factor in determining value for estate or gift tax reporting purposes, the agreement needs to meet three exception test requirements of Section 2703 of Chapter 14, namely, the agreement needs to be 1) a bona fide business arrangement, 2) not a device to transfer property for less than full and adequate consideration and 3) have terms comparable to similar arrangements entered into by unrelated parties in an arms’ length transaction.The IRS did not put forth an argument on whether the purchase price for Michael Connelly’s interest in CCS should be disregarded for estate tax reporting purposes based on the provisions of Section 2703 of Chapter 14.While such an argument was not part of the Connelly case, many legal commentators believe that the facts of the case should be examined with regard to both the provisions of Section 2703 and related case law.Estate Plans Should Incorporate Appraisals by Qualified Professionals When Fair Market Value Cannot Be Readily Established by Other MeansFair market value, defined as the price at which an asset would change hands between a willing buyer and a willing seller when neither is under any compulsion to buy or to sell and both have reasonable knowledge of relevant facts, is the standard of value for estate and gift tax reporting purposes.When fair market value cannot be readily established by reference to market or transaction prices, the opinion of a management representative will not be a suitable substitute for the opinion of a qualified appraiser.One of the missing puzzle pieces in the Connelly case is the appraisal of the subject interest by a qualified appraiser.The SPA had specific provisions for an appraisal process for shares subject to redemption, but this process was not followed by the parties. Rather, the redemption price was agreed upon in an “amicable and expeditious manner” by the estate executor and a son of the decedent.Counsel for the estate argued that the $3.0 million redemption price “resulted from extensive analysis of CCS’s books and the proper valuation of assets and liabilities of the company. Thomas Connelly, as an experienced businessman extremely acquainted with Crown C’s finances, was able to ensure an accurate appraisal of the shares.”These decisions made by the parties in the Connelly case ultimately failed to establish a supportable fair market value conclusion for the subject interest.Defining Fair Market Value and Selecting Qualified AppraisersFair Market ValueFair market value is referenced in the Connelly SPA as part of the definition of appraised value per share. Fair market value itself, however, is not defined in the SPA.Without a specific, clear definition of fair market value, such as that from the ASA Business Valuation Standards or the Internal Revenue Code, the interpretation of fair market value is left to the appraiser(s).In the Connelly matter, upon a triggering event two appraisers were to be engaged (one by CCS and one by the selling shareholder). Should the opinions of these two appraisers diverge by more than 10% of the lower appraised value, a third appraiser could have been engaged. The SPA as drafted opened the door for three interpretations of fair market value. And with multiple interpretations comes the increased likelihood of litigation.Appraiser QualificationsAdditionally, if the qualifications of an appraiser are not specified, just about anyone can do the appraisal.The Connelly SPA mentions that an appraiser “shall have at least five years of experience in appraising businesses similar to the Company.” That’s it. The SPA makes no mention of formal education, valuation credentials such as ASA, ABV, or CVA, or continuing education and training requirements.What could happen if an unqualified appraiser is hired to perform a valuation? A recent tax court case, Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent (T.C. Memo 2023-34), addressed this situation head-on.While the case was related to the donation of closely held stock, not using a qualified appraiser had a damaging impact on the taxpayer.The company whose shares were subject to the charitable gift had been marketed for sale by an investment banker prior to the gift. In court, the petitioners argued that the investment banker was qualified to prepare the appraisal for charitable giving purposes because he had prepared “dozens of business valuations” over the course of his 20+ year career as an investment banker.According to the Court, an individual’s “mere familiarity with the type of property being valued does not by itself make him qualified.” The Court further noted that the investment banker “does not have appraisal certifications and does not hold himself out as an appraiser.”The end result for the taxpayer in Hoensheid: the Tax Court found that the taxpayer failed to comply with the qualified appraisal requirements and denied the charitable deduction.Appraisal StandardsOccasionally, buy-sell agreements lay out the specific business appraisal standards to be followed by the appraiser.Standards most often cited in buy-sell agreements are the Uniform Standards of Professional Appraisal Practice (commonly referred to as “USPAP”), the ASA Business Valuation Standards, AICPA’s Statement on Standards for Valuation Services No. 1 (commonly referred to “SSVS”) and NACVA’s Professional Standards.The Connelly SPA did not reference any of these standards.Without any appraisal standards referenced, any appraiser elected to perform a valuation under the SPA who was not a member of one of the national appraisal organizations has no requirement to follow any set of standards or code of ethics.Final ThoughtsThis tale of a small building supply company making its way to the Supreme Court emphasizes how significant — and tricky — managing business and family interests can be.Aside from the issues surrounding how to treat life insurance proceeds, Connelly is a vivid reminder of the simple errors of omission that can spiral into monumental issues, and it highlights some timeless lessons about the necessity of dotting i’s and crossing t’s in estate planning and business agreements. It also underscores the importance of clearly defining fair market value, ensuring appraisers are properly qualified, and strictly adhering to appraisal standards.This whole saga reminds us of the importance of getting things right from the start to avoid a domino effect of complications down the road.

The Latest in Natural Gas Valuations

Continued Optimism for Global Demand Buoys Multiples

The world is getting more direct access to LNG than ever before. Natural gas is becoming more globally portable. Going forward, it will help stabilize regional prices and market volatilities, which, in turn, will help U.S. producers that have more gas than the U.S. needs. Investors are optimistic that as more global portability of gas becomes available, more opportunities await to maximize potential in U.S. gas plays.

What Does the RIA Valuation Process Entail?

For this week’s post, "What Does the RIA Valuation Process Entail?," we’ll channel our inner Nick Saban and focus on the process.

A New Approach for Business Succession Planning

While not “new” under the law, the use of purpose trusts for business succession planning became more prominent when Yvon Chouinard, founder of clothing company Patagonia, transferred ownership of the company to a purpose trust in September 2022.

Just Released: Q4 2024 Oil & Gas Industry Newsletter

Regional Focus: Bakken, DJ Basin, Woodford Shale, Uinta, and the SCOOP/STACK

Mercer Capital’s Value Focus: Exploration & Production newsletter provides an overview of the industry through supply and demand analysis, commodity pricing, and public market performance. In addition, this quarterly issue focuses on the Bakken, DJ Basin, and Woodford Shale, along with the Uinta Basin and the SCOOP/STACK.

New Update: Understand the Value of Your Auto Dealership

If you own an interest in an auto dealership, we encourage you to take a look. While the value of your dealership may not be top of mind today, chances are one day it will be.

Personal Goodwill: Implications for RIAs

Goodwill and the distinction between personal and enterprise goodwill can have important economic consequences in RIA transactions and disputes.

Winter M&A Update for Family Businesses

Middle market M&A activity in the third quarter of 2024 showed signs of the “summer slowdown,” as fewer PE deals were reported compared to the first two quarters of the year. However, as deal activity begins to revert to pre-2023 levels, the outlook for 2025 points to signs of optimism, while some hurdles remain on the horizon. In this week’s post, we look back at middle market (defined as total enterprise value of $100 - $500 million) transaction activity in 2024 and look ahead to what may be on the horizon for middle market M&A in 2025.

2025 U.S. Oil Outlook

Don’t Count On A "Drill Baby Drill" Mentality

The November election brought optimism to many oil producers who felt hamstrung by the Biden Administration’s policies. Even Biden’s ban on offshore drilling is expected to be challenged or changed when Trump is sworn in. However, administrations can only do so much when it comes to global supply and demand dynamics. In fact, they can usually do little in the big picture; and the big picture is that there is probably going to be more supply coming online in 2025 than demand to meet it. Therefore, U.S. upstream producers are not planning on blowing their budget on aggressive drilling plans, no matter what Trump says, especially considering the lukewarm pricing environment that the market foresees. In addition, the U.S.’ shale dominance may be headed towards inevitable decline. There’s a lot to consider, so let us jump in.

Reviewing 2024 RIA Performance: Wealth Management

The wealth management industry experienced remarkable growth in 2024, driven by robust market performance, inflation cooling, and shifts in monetary policy. Contrary to earlier concerns of economic instability, the year delivered substantial growth across the RIA sector, signaling resilience and adaptability in an ever-changing financial landscape.

Three Considerations for Capital Projects

Capital budgeting tools are ideal for answering the question: Is the proposed capital project financially feasible? Too often, however, we see these tools being used to answer what seems to be a related question, but one that the tools are simply not designed to answer: Should we undertake the proposed capital project? The first question opens the door to the second, but the tools of capital budgeting — no matter how sophisticated or quantitatively precise — cannot answer the second. To answer the second question, family business directors need to consider three qualitative questions identified in this post.

Examining Bakken, DJ Basin, and Woodford Shale Production and Activity

The economics of oil & gas production vary by region. Mercer Capital regularly covers trends in the Eagle Ford, Permian, and Appalachian plays. The cost of producing oil and gas depends on the geological makeup of the reserve, its depth, and the cost of transporting raw crude to market. These factors lead to varying production costs across regions. This quarter, we depart from our regular coverage and take a closer look at the Bakken, DJ Basin, and Woodford Shale.

RIA M&A Update: Q4 2024

M&A activity in the RIA industry, which had been trailing 2023 levels for much of 2024, experienced a dramatic surge in October. This spike set a new record for monthly deal volume and brought year-to-date transaction figures through November in line with 2023’s pace.

December 2024 SAAR

The December 2024 SAAR came in at 16.8 million units, just slightly higher than last month and up 4.2% from December 2023. Notably, this month’s SAAR outpaced the last three Decembers and was the highest monthly SAAR since May 2021 (17.0 million units).

The Elements of a Quality Business Valuation: A Guide for Estate Planners

In the course of a business valuation practice, a business appraiser may either be involved in an examination of an opinion that they have issued or serve as a consulting expert to assist legal counsel in an opinion issued by an unaffiliated business appraiser.While an accepted-as-filed resolution of an independent and objective opinion of value for a federal tax matter is the desired outcome, an IRS examination also provides an opportunity for appraisers to critically evaluate their work, and, in so doing, strengthen future work product.As Mercer Capital is frequently requested to provide expert consulting services related to federal tax valuation matters under examination, this issue of Value Added® explores the elements of a quality valuation that increase the prospects of a favorable resolution of an examined matter, or the desired accepted-as-filed outcome at an initial reporting stage.Elements of a Quality ValuationQuality business valuations possess four common elements:Identification of the rights and benefits of the business interest being valued;Relevant and sufficient capital market evidence;Sound financial analysis; and,Effective reporting to the intended audience.Identification of the Rights & Benefits of the Business InterestFundamental to any sound valuation is a thorough understanding of the rights and benefits of the business interest being valued.Most often this involves a close review of the basic governance documents of the business such as corporate articles of incorporation and bylaws, partnership or limited liability operating agreements, buy/sell agreements, and additional legal documents that address the rights and benefits related of the subject business interest. Absent formal governance documents, relevant statutory provisions in the entity’s state of domicile provide this guidance. This guidance directs the appraiser as to the appropriate level of value for the assignment, i.e., controlling interest, minority interest or veto block interest.While it is not the role of the business appraiser to be the ultimate arbiter of the legal rights and benefits related to the interest, it is the responsibility of the appraiser to have as complete an understanding as they can of these defining attributes. In cases of ambiguous governance documents or situations of default to statutory provisions, assistance from legal counsel is warranted to provide legal direction as to the attributes of an interest.Once a complete understanding of the legal rights and benefits of the interest is gained, it is critical for the business appraiser to keep this understanding at hand throughout the appraisal process and report on this understanding in a concise and clear manner.Relevant and Sufficient Capital Market EvidenceA cornerstone of every sound opinion of value resides in the capital market evidence that is relied upon for its support. Relevancy and sufficiency are two essential concepts for consideration in evaluating capital market evidence.RelevanceThe relevance of capital market evidence is a key component of the valuation of interests in privately held businesses, as often there is a dearth of pertinent capital market evidence related to the interest being valued. This reality illustrates the inherent challenge associated with the valuation of privately held business interests; by definition financial and transactional information related to private businesses is most often not in the public domain. As a consequence, business appraisers frequently look to capital market evidence related to publicly traded businesses to find the capital market evidence necessary to support their opinion. Material differences between the subject business interest and the capital market evidence relied upon must be reconciled and explained.SufficiencySufficiency is the second core concept related to capital market evidence. The time-tested adage that “one sale does not make a market” certainly applies.Often, the business appraiser is faced with a scenario of capital market evidence of limited quantity. In such instances the appraiser should expand search parameters in order to obtain capital market evidence with similar investment risk attributes as the subject interest.A default to the opinion based on the personal experience of the appraiser without sufficient market evidence will be subject to intensive scrutiny, and quite likely, may be considered a failure of the opinion for its intended use.Sound Financial AnalysisThorough and sound financial analysis is crucial to any supportable valuation. The fundamental valuation principle is that the value of a business is a function of three components: (1) expected cash flows, (2) risk profile, and (3) growth prospects.Expected Cash FlowsIdentifying and estimating the expected cash flows of a business requires careful consideration of historical financial results, anticipated economic and industry conditions, and the capital needs of the business (a more exhaustive list of data and factors that should be considered is included in IRS Revenue Ruling 59-60).RiskAn evaluation of the risk profile of a business cannot be done without understanding the key drivers of the business. A business is subject to and impacted by a litany of factors including market risks, operational risks, and financial risks that must be evaluated.GrowthAn appraiser's assessment of growth prospects should consider growth due to market share, growth of the market, growth from profitability, and the sustainability of each.Business appraisers should conduct robust financial analyses and due diligence to evaluate these three components, and quality appraisals will provide sound and reasonable support for the concluded estimates of each.Effective Reporting to the Intended AudienceThe most important aspect of the valuation may well be how effectively the appraiser communicates to the intended audience of the valuation report.For federal transfer tax valuation matters, the intended audience consists of estate planning and tax attorneys as well as Internal Revenue Service trust & estate examining attorneys.For federal income tax matters the intended audience consists of tax attorneys, certified public accountants, enrolled agents and Internal Revenue Service agents, typically individuals with an accounting and tax background.As the readers of a valuation report may be more verbally rather than numerically oriented, a valuation report prepared for a transfer tax matter should be written in a communication style and structure that matches this orientation. In contrast, it may be more appropriate for reports prepared for income tax matters to have a quantitative tilt.ConclusionWhile the examination of a federal tax valuation matter can be a challenging exercise laden with complexity, past examination experience also provides opportunities to focus on the fundamentals of the valuation process that underlie a quality valuation.Adherence to the concepts presented in this article will improve the likelihood of accepted-as-filed outcomes as well as place the valuation work product in a position of strength in the event of an examination.At Mercer Capital, we diligently incorporate each of the four elements of quality valuations into our reports. To discuss your valuation need on a confidential basis, please contact one of our professionals.

Middle Market Transaction Update Winter 2024

Middle market M&A activity in the third quarter of 2024 showed signs of the “summer slowdown,” as fewer PE deals were reported compared to the first two quarters of the year.

For the Love of the Game?

What Can the San Diego Padres Teach Us About Succession Planning?

Every business has a succession plan, whether formulated or not. Careful planning today can stave off heartache in the future. Successful family businesses need to prioritize flexible succession planning to be prepared for potential adverse or unforeseen changes.

Shining Some Light on Four Overshadowed Oil and Gas Plays

Uinta Basin, Bakken Shale, DJ Basin, and SCOOP/STACK

The Mercer Capital Oil and Gas industry team covers merger and acquisition activity as well as provides an economic profile for four primary oil and gas plays: Permian Basin, Eagle Ford Shale, Haynesville Shale, and Marcellus & Utica Shale. This week's blog offers economic and M&A snapshots into four more plays: Uinta Basin, Bakken Shale, DJ Basin, and SCOOP/STACK.

RIA Market Update: Q4 2024

RIAs continued to outperform the S&P in Q4 2024, with alternative asset managers boasting an impressive 60% price gain year-over-year. In 2024, traditional investment managers saw the strongest AUM growth, while alternative managers proved better at converting this growth to revenue. We explore further in our Q4 2024 Market Update.Download update

Insurance Valuation Services for Financial Sponsors

In recent years, financial sponsors such as private equity, venture capital firms, investment companies, and family offices have taken a more prominent role in funding and growing firms in the insurance industry. From insurance brokerage/distribution to underwriting to InsurTech start-ups, there are many opportunities for investment in the insurance sector and transaction activity in the space has steadily been increasing.Mercer Capital has worked with financial sponsors in the insurance industry for years and we understand both the dynamics of the industry as well as the accounting and valuation issues that are likely to be encountered.Key areas where Mercer Capital can help include:Valuations of Shares/Units for 409A / ASC 718 Compliance – If you anticipate granting equity to founders or key management at acquired companies, using rollover equity as part of a growth strategy, or issuing options or RSUs as part of your employee compensation plans, supportable and defensible valuations are critically important.Valuations for Financial Reporting – Acquisitive growth strategies will likely necessitate ASC 805 purchase price allocations, earn-out liability measurements, and goodwill impairment testing.Financial Due Diligence – We provide financial due diligence and quality of earnings reports on target companies, including analysis/trending of the pro forma P&L, potential earnings adjustments, working capital assessments, unit economics analysis, and other areas of financial analysis.Financial Opinions (Fairness and Solvency Opinions) – Certain types of transactions, related-party issues, or fiduciary concerns can lead a board to seek an independent opinion of fairness or solvency as it pertains to a transaction involving the subject company. These situations might include going-private transactions, special dividends, and leveraged recapitalizations.Portfolio Valuation for ASC 820 Compliance – We provide a range of services to assist fund managers with the preparation and/or review of periodic fair value marks. These services are cost-effective and include a series of established procedures designed to provide both internal and investor confidence in the fair value determinations.To discuss any of these services in confidence, please contact a Mercer Capital professional today.

Bank Watch: January 2025

2024 Recap: Bank Stock Performance

After the turbulence caused by rising interest rates and regional bank failures, 2024 marked a turning point for community and regional bank stocks. The S&P Small Cap Bank Index surged 23% in the second half of the year, buoyed by optimism around net interest margins and a friendlier regulatory environment. However, challenges remain for smaller banks in 2025, such as weak loan growth and higher-for-longer short-term interest rates that may limit NIM expansion. Meanwhile, larger banks look poised to benefit from rising capital markets activity. While the outlook for bank earnings in 2025 is positive, this should be viewed in the context of a richly valued stock market where index fund and ETF outflows pose a threat to bank stock performance. We look back on 2024 performance and consider factors that may influence bank stock performance in 2025.

Goodwill Impairment Troubles Cost UPS $45 Million

Financial Reporting Flash: Issue 1, 2025

A recent $45 million settlement between UPS and the SEC over allegedly flawed goodwill impairment tests and earnings overstatements puts a spotlight on the goodwill impairment testing process.

6 Ways to Evaluate Business Value

Along the road to building the value of a business it is necessary, and indeed, appropriate, to examine the business in a variety of ways.

January 2025 | Elements of a Quality Valuation

Value Matters^® January 2025

Elements of a Quality Business Valuation

A Guide for Estate PlannersIn the course of a business valuation practice, a business appraiser may either be involved in an examination of an opinion that they have issued or serve as a consulting expert to assist legal counsel in an opinion issued by an unaffiliated business appraiser.While an accepted-as-filed resolution of an independent and objective opinion of value for a federal tax matter is the desired outcome, an IRS examination also provides an opportunity for appraisers to critically evaluate their work, and, in so doing, strengthen future work product.As Mercer Capital is frequently requested to provide expert consulting services related to federal tax valuation matters under examination, this issue of Value Added® explores the elements of a quality valuation that increase the prospects of a favorable resolution of an examined matter, or the desired accepted-as-filed outcome at an initial reporting stage.Elements of a Quality ValuationQuality business valuations possess four common elements:Identification of the rights and benefits of the business interest being valued;Relevant and sufficient capital market evidence;Sound financial analysis; and,Effective reporting to the intended audience.Identification of the Rights & Benefits of the Business InterestFundamental to any sound valuation is a thorough understanding of the rights and benefits of the business interest being valued.Most often this involves a close review of the basic governance documents of the business such as corporate articles of incorporation and bylaws, partnership or limited liability operating agreements, buy/sell agreements, and additional legal documents that address the rights and benefits related of the subject business interest. Absent formal governance documents, relevant statutory provisions in the entity’s state of domicile provide this guidance. This guidance directs the appraiser as to the appropriate level of value for the assignment, i.e., controlling interest, minority interest or veto block interest.While it is not the role of the business appraiser to be the ultimate arbiter of the legal rights and benefits related to the interest, it is the responsibility of the appraiser to have as complete an understanding as they can of these defining attributes. In cases of ambiguous governance documents or situations of default to statutory provisions, assistance from legal counsel is warranted to provide legal direction as to the attributes of an interest.Once a complete understanding of the legal rights and benefits of the interest is gained, it is critical for the business appraiser to keep this understanding at hand throughout the appraisal process and report on this understanding in a concise and clear manner.Relevant and Sufficient Capital Market EvidenceA cornerstone of every sound opinion of value resides in the capital market evidence that is relied upon for its support. Relevancy and sufficiency are two essential concepts for consideration in evaluating capital market evidence.RelevanceThe relevance of capital market evidence is a key component of the valuation of interests in privately held businesses, as often there is a dearth of pertinent capital market evidence related to the interest being valued. This reality illustrates the inherent challenge associated with the valuation of privately held business interests; by definition financial and transactional information related to private businesses is most often not in the public domain. As a consequence, business appraisers frequently look to capital market evidence related to publicly traded businesses to find the capital market evidence necessary to support their opinion. Material differences between the subject business interest and the capital market evidence relied upon must be reconciled and explained.SufficiencySufficiency is the second core concept related to capital market evidence. The time-tested adage that “one sale does not make a market” certainly applies.Often, the business appraiser is faced with a scenario of capital market evidence of limited quantity. In such instances the appraiser should expand search parameters in order to obtain capital market evidence with similar investment risk attributes as the subject interest.A default to the opinion based on the personal experience of the appraiser without sufficient market evidence will be subject to intensive scrutiny, and quite likely, may be considered a failure of the opinion for its intended use.Sound Financial AnalysisThorough and sound financial analysis is crucial to any supportable valuation. The fundamental valuation principle is that the value of a business is a function of three components: (1) expected cash flows, (2) risk profile, and (3) growth prospects.Expected Cash FlowsIdentifying and estimating the expected cash flows of a business requires careful consideration of historical financial results, anticipated economic and industry conditions, and the capital needs of the business (a more exhaustive list of data and factors that should be considered is included in IRS Revenue Ruling 59-60).RiskAn evaluation of the risk profile of a business cannot be done without understanding the key drivers of the business. A business is subject to and impacted by a litany of factors including market risks, operational risks, and financial risks that must be evaluated.GrowthAn appraiser's assessment of growth prospects should consider growth due to market share, growth of the market, growth from profitability, and the sustainability of each.Business appraisers should conduct robust financial analyses and due diligence to evaluate these three components, and quality appraisals will provide sound and reasonable support for the concluded estimates of each.Effective Reporting to the Intended AudienceThe most important aspect of the valuation may well be how effectively the appraiser communicates to the intended audience of the valuation report.For federal transfer tax valuation matters, the intended audience consists of estate planning and tax attorneys as well as Internal Revenue Service trust & estate examining attorneys.For federal income tax matters the intended audience consists of tax attorneys, certified public accountants, enrolled agents and Internal Revenue Service agents, typically individuals with an accounting and tax background.As the readers of a valuation report may be more verbally rather than numerically oriented, a valuation report prepared for a transfer tax matter should be written in a communication style and structure that matches this orientation. In contrast, it may be more appropriate for reports prepared for income tax matters to have a quantitative tilt.ConclusionWhile the examination of a federal tax valuation matter can be a challenging exercise laden with complexity, past examination experience also provides opportunities to focus on the fundamentals of the valuation process that underlie a quality valuation.Adherence to the concepts presented in this article will improve the likelihood of accepted-as-filed outcomes as well as place the valuation work product in a position of strength in the event of an examination.At Mercer Capital, we diligently incorporate each of the four elements of quality valuations into our reports. To discuss your valuation need on a confidential basis, please contact one of our professionals.

First Quarter 2025 | Segment Focus: Residential Construction

Growth in residential and non-residential building sectors has slowed, with Value Put-in-Place up 2.8% and 2.9% Y-o-Y, respectively, on a seasonally adjusted annual basis. Residential building sentiment has slowed, as the NAHB Housing Market and Remodeling Market Indices have fallen 23.5% and 4.6% Y-o-Y as of Q1 2025. The presence of a new presidential administration and policy will have a significant impact on the industry.

Healthcare Facilities Q1 2025

Segment Focus: Dental Service Organizations (DSOs)

Over the past decade, Private Equity (PE) funds have scaled their platform and add-on expansions in healthcare, deploying over $1 trillion worth of capital. In 2021 alone, the sector saw over $200 billion in acquisitions.

Value Focus: Insurance Industry | First Quarter 2025

Insurance Stocks Proved Resilient During a Volatile First Quarter 2025

Medtech and Device Industry Newsletter - Q1 2025

This quarterly update includes a broad outlook that divides the healthcare industry into four sectors: Biotechnology & Life Sciences, Medical Devices, Healthcare Technology, Large, Diversified Healthcare Companies

E&P First Quarter 2025

Region Focus: Eagle Ford

Eagle Ford // Despite a notable rig count decline, Eagle Ford production generally remained about flat over the twelve months ended March 2025.

Bank M&A 2024 — Off the Bottom

In our year ago M&A epistle, we speculated that activity would improve and that a related theme could be equity recap transactions. The prediction was hardly heroic because M&A activity in 2023 represented a multi-decade low, while low public market multiples for a small subset of banks with high CRE exposure signaled investor expectations that an equity infusion was possible.

Anatomy of Volatility: Evolent (EVH)

A few notes on EVH price volatility in recent quarters – we remain observers and may report further notable developments.

Trends in MedTech Valuation Step-Up Multiples 2024

The medtech industry followed the overall venture runup in 2020 and 2021 and was not immune to the drop in funding in 2022 and 2023.

What Is the Makeup of the Car Parc?

Data from Q3 2024

Each quarter, Experian releases an Automotive Market Trends report. This report includes vehicle registration data from each state's Department of Motor Vehicles, vehicle manufacturers, and captive finance companies. This week, we summarize the data from the Q3 2024 report and add insights for our dealership audience.Vehicles in OperationThe makeup of vehicles in operation ("VIO") in the U.S. and Canada can be a leading indicator of what to expect from automotive sales over the medium term. For example, VIO can inform industry-wide estimates of what models are currently the most popular to own, how many of those models should be manufactured, and, inevitably, how many should be marketed and sold. These estimates can be made based on changes in VIO, the average age of VIO, and what vehicle segments and brands make up VIO.Changes in Total VIO over the Past YearAs of Q3 2024, VIO in the United States and Canada was 341.9 million. This includes light vehicles (cars, pickup trucks, SUVs, etc.) as well as medium and heavy-duty vehicles (large vans, delivery trucks, RVs, etc.) and power sports vehicles (motorcycles, snowmobiles, etc.). While tracking total VIO can be a valuable insight from a macroeconomic perspective, light vehicle totals are the most relevant to our auto dealer clients.In the U.S. and Canada, light duty vehicles in operation were 292.1 million on September 30, 2024, a positive difference of 3.6 million units or 1.2% higher than the same figure in Q3 2023. In fact, light-duty VIO has increased by 3.6 million units for two years in a row. These two consecutive, identical increases may have happened by chance but certainly highlight a longer-term trend of expansion in the car parc due to increased manufacturing activity post-COVID and fewer retirements due to longer-lasting vehicles. A segment of consumers being financially stretched also contributes to an increasing age of VIO. The specific components of light vehicle VIO change over the last twelve months are 15.6 million new vehicle registrations minus 12.0 million vehicles taken out of operation. See the chart below for a visualization of the change in VIO over the last year. New vehicle registrations were up 5.3% to 4.0 million during the third quarter of 2024, while used vehicle registrations were up 2.0% to 10.1 million. These positive growth rates over the third quarter tell the story of the past two years for the auto dealer industry: new vehicle inventories have been recovered for some time now after the pandemic and ensuing disruption from the chip shortage in 2020-2022 when registrations of both new and used vehicles fell before changing course and normalizing over the last two years. As one might expect, used vehicle transactions do not directly affect VIO. These types of transactions do not add new vehicles to the car parc but rather represent existing vehicles changing hands. Over the past year, approximately 38.9 million used vehicles changed owners. When you combine the retirement of used vehicles and used vehicle changing-of-hands transactions, 17.4% of the total car parc was involved in a used vehicle transaction or retirement over the past year. VIO by Model YearOver the past decade, drivers have been holding on to their vehicles for longer, partially due to improved longevity in modern vehicles and, at times during the pandemic, due to market conditions like availability and pricing of new and used vehicles. Factors are also at play, such as persistently high transaction prices for new vehicles and consumer worries over the shift to electric vehicles.The average age of a vehicle on the road hit 12.6 years in May 2024, according to Business Insider, which is up from 2023's average and marks the seventh year in a row that the average age of vehicles on the road has increased. In the context of an aging car parc, most of the country's VIO is still newer than 20 years old. As of Q3 2024, 83.9% of total VIO was less than 20, and 93.1% were less than 25 years old.According to the Automotive Market Trends report, there is an aftermarket "sweet spot" for the age of used vehicles, namely six to twelve years. This sweet spot is close to when most vehicles age out of general manufacturer warranties for repairs. As of Q3 2024, 36.2% of total VIO were within the used vehicle sweet spot (model years 2013 – 2019). This proportion is 0.4 percentage points higher than last year and 5.3 percentage points higher than the same time in 2020 when the pandemic was in full swing. Going forward, Experian expects the sweet spot to continue growing until 2026. It is not a coincidence that the sweet spot is expected to stop growing six years after 2020, as pandemic-affected manufacturers released fewer vehicles during the pandemic years than before.From the perspective of auto dealers, the ever-increasing average age of VIO is a double-edged sword. On one hand, a higher average age is likely to increase the volume of parts and service departments nationwide. Parts and service margins are among the most favorable of a dealership's profit centers, and dealers should look forward to increased work. On the other hand, a higher average age means consumers are purchasing vehicles less frequently, which could put slight pressure on selling departments.VIO by Vehicle Source, Type, and SegmentLooking at the makeup of VIO by domestic vs import, 58% of light-duty VIO were import models, and 42% were domestic models during Q3 2024. This represents a notable change from 52% import / 48% domestic just one year ago and emphasizes struggles by domestic manufacturers in recent years. Domestic automakers have lost market share to imports due to consumer perceptions of better reliability, technology, and fuel efficiency from foreign brands. Furthermore, challenges like a slower adaptation to trends such as electric vehicles have further hindered competitiveness between domestic and import brands.Splitting light-duty VIO by type, SUVs/Crossovers (56.7% of total light-duty VIO), passenger cars (20.8%), and light trucks (22.5%) all contribute to light-duty VIO. SUVs and crossovers have exploded over the last few years, making up a larger share of light-duty VIO each period. These vehicles have gained market share from cars due to their versatility, higher seating position, and increased cargo space, which appeals to families and consumers with active lifestyles. The improved fuel efficiency of these models in recent years has made them more practical, while their perceived safety has also drawn consumers away from traditional sedans.These broad vehicle types can be divided into around 20 more specific vehicle segments. The full-size pickup truck segment is the most popular in the United States, representing 16.4% of total VIO. Full-size pickup trucks are followed by midsize cars (13.0%), midsize crossovers (12.7%), and compact cars (8.1%). In recent years, midsize cars have lost some of their share to crossovers and compact cars. Looking at trucks specifically, as of Q3 2024, the Ford F-150 (3.7% of total VIO) and the Chevrolet Silverado 1500 (2.7%) were the two most popular models on the road.VIO by ManufacturerVIO by manufacturer is another way that the car parc can be analyzed. See the chart below for a look at VIO by manufacturer market share. General Motors, Ford, and Toyota are the most popular manufacturers in this cross-sectional data snapshot. VIO by manufacturer data represents what vehicles are currently on the road and includes vehicles of all ages, not just new vehicles. This data does not reflect consumer satisfaction or current sales trends but typically lags because it is more long-term focused. Therefore, this data is best viewed as a rearview mirror rather than a windshield for the industry, though it gives an eye into parts and service departments today. Going forward, we expect these proportions to slowly shift towards prevailing sales trends. GM and Ford continue to lead the way, representing 20.5% and 15.7% of total VIO, respectively. However, these two domestic manufacturers have slowly lost market share to import brands in recent years. The best example is Toyota, which has gained over the last couple of years but still lags behind Ford and GM. Perhaps we may see Toyota jump Ford and approach GM in total VIO soon. Kia is another notable mover on this list over the last year, as it gained two percentage points and jumped one spot from tenth to ninth. In some ways, this data reflects what we've seen with auto dealership values. For example, Toyota has outperformed, as seen in the graph above, which has translated to higher dealership values as reflected in Blue Sky multiples. About UsMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

'Twas the Blog Before Christmas

The Rise of Staying Private

Shareholder Liquidity Strategies for Family Businesses

Cash-strapped early-stage companies have long relied on equity-based compensation to attract, motivate, and retain employees. Employees endure long nights of software coding or other work, comforted by visions of riches when the company reaches the goal line (the initial public offering). For a variety of reasons, the IPO is no longer the goal line for founders, many of whom are now content to remain private far longer than previously expected. While founders may be content with their illiquid billions, most employee-shareholders want to convert at least some of their illiquid thousands to spendable cash.

Are Difficult Partner Discounts Applicable to RIAs?

A few months ago, I attended a business appraisal conference in Portland, Oregon, where I learned about a case involving a “Difficult Partner Discount.” Since we’re often hired when business owners can’t agree on price, we’re well aware of partnership disputes, but I’m pretty confident I’ve never directly applied a “Difficult Partner Discount” to the value of a business or interest therein. That doesn’t mean that partner disputes and departures can’t significantly impair the value of a company, which we address in this post.

Top 10 Oil & Gas Blog Posts of 2024

Year-end 2024 is quickly approaching so that means it's time to take a look back at the year. Here are the top ten posts for the year measured by readership. Click on any of the post titles to revisit the post.

Evolving Need for Estate Planning Amid Legislative Shifts

For estate planning, the stakes are high. The elevated lifetime exclusion amount is one of the most significant opportunities for reducing future estate tax liabilities, allowing individuals to transfer substantial wealth that falls under the threshold tax-free. However, the political and fiscal landscape introduces critical timing considerations.

Nvidia’s Jensen Huang Has an Estate Plan — Do You?

It’s Never Too Early for Family Business Directors to Establish an Estate Plan

Jensen Huang, the chief executive officer of Nvidia, and his family are on track to save north of $8 billion in estate and capital gains taxes. So, how has the tenth-wealthiest person in America managed to protect his wealth from the 40% estate tax? He has a plan.Beginning in 2012, the Huangs set off on their estate tax planning journey by setting up an irrevocable trust. Without getting too far into the weeds, the Huangs and their team of advisors formulated an estate tax plan that involved the use of tax planning maneuvers involving intentionally defective grantor trusts and several grantor-retained annuity trusts (“GRATs”). These tax planning vehicles enabled the Huang family to effectively (and legally) circumvent hefty gift and estate taxes that would apply to a direct transfer of the assets to Huang’s heirs.Just like the Huangs, most family business owners aim to provide financial stability and support for future generations of their families. Putting in the work on the front end and establishing a plan, like the example above, can potentially result in significant estate tax savings for you and your family in the future.Estate TaxThe Estate Tax is a tax on your right to transfer property at your death. The tax is calculated based on the “decedent’s gross estate,” less the taxpayer’s remaining gift and estate tax deduction, which in 2025 will be $13.9 million per individual, as well as other specific deductions. Family business owners face a unique hurdle as a substantial portion of their estate typically consists of illiquid interests in private company stock. If this is the case, liquidating assets to pay the estate tax may prove more difficult as estate taxes are payable only in cash. Family businesses may have to be sold or forced to borrow money to fund the payment of a decedent’s estate tax liability.Ignoring estate taxes altogether is not an affordable option either. While it is true that the legal burden of the estate tax falls to individual shareholders rather than the family business itself, many family shareholders have not accumulated sufficient liquidity to pay those estate taxes without some action on the part of the company. The required actions may range from a shareholder loan to a special dividend to the sale of the business. A bit of forethought can relieve the burden on heirs, but when is the right time to get started?The Sooner, the BetterAs a family business owner, it is never too early to review your estate plan. While there are things that will certainly change over time, taking the pulse on your estate plans can have a major impact on the volume of wealth you pass to your heirs.Preparing to transfer ownership to the next generation in the most tax-efficient way is daunting, but here are some ways you can start thinking about your estate plan:Review the current shareholder list & ownership table: Based on the current shareholder list, are there any shareholders that — were the unexpected to happen — would be facing a significant estate tax liability?Identifying current estate tax exposures: Will shareholders have to look to the family business to redeem shares or make special distributions to fund estate tax obligations?Identify tax & non-tax goals of the estate planning process: If there was no estate tax, what evolution would be the most desirable for your family and business?Obtain a current opinion of the fair market value of the business at each level of value (control, marketable minority, and nonmarketable minority). The most difficult time to make decisions regarding your estate plan is the short term. Should we accelerate plans to sell so we can avoid a larger tax bill? Should we realize some gains in the family securities portfolio to avoid the possibility of an increase in long-term capital gains rates? We believe these questions can be avoided when a well-thought-out estate plan is established. Diligent planning on the part of family shareholders allows directors to focus on the long-term success and sustainability of the business without the distraction of potential estate tax exposures. Give one of our family business professionals a call today to talk about balancing tax concerns with the long view on your family business.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of December 3, 2024

November 2024 SAAR

The November 2024 SAAR came in at 16.5 million units, which is 1.5% higher than last month and 6.2% higher than November 2023. Of note, November 2024 had one more selling day than November 2023.

The Four Types of RIAs

And What It Means for Practice Management

There are 15,000 or so RIAs in the US. No two are identical, of course, but broadly speaking, firms that seek to serve the same types of clients tend to end up with similar-looking business models, whether intentionally or through some form of convergent evolution. A firm’s structure—its org chart, compensation model, advisory team model, internal processes, marketing, technology, and so on—tends to reflect the types of clients the firm seeks to serve and, relatedly, the value proposition it offers to those clients. The result is that firms tend to cluster around a handful of distinct models, and identifying what those models are and how they differ can be a useful exercise both in analyzing a particular firm and in thinking about practice management issues.Back in 2021, Ashish Nanda and Das Narayandas—both economists and professors specializing in professional services and client management strategies—published an article in the Harvard Business Review titled What Professional Services Firms Must Do To Thrive. In that article, the authors introduced a framework for thinking about professional services firms based on the type of service they provide to clients. While the framework is generally from the perspective of professional services, we’ve found it to be a particularly useful tool for thinking about asset and wealth management firms.The framework categorizes firms into four buckets based on where they fall along a spectrum of the complexity of services provided. At one end of the spectrum are Commodity Practices—firms that offer undifferentiated services that solve simple problems. Next are Procedural Practices—those firms that offer clients the ability to tackle larger problems that are complicated primarily by larger scope and multiple moving parts. Next are Gray Hair Practices—firms that bring experience and institutional knowledge to solve even more complex problems. At the other end are Rocket Science Practices—firms that solve unique, difficult, and high-stakes problems for sophisticated clients. Firms are defined along this spectrum not by their own self-perceptions but by the selling proposition that brings clients to the firm. If clients select a particular firm because it’s the lowest-cost provider, that’s likely a commodity practice. At the other end of the spectrum, if clients choose a particular firm because they think it’s best suited to solve a particularly difficult and novel problem, that firm is likely best classified as a rocket science practice. What does this look like for RIAs? To illustrate, it’s helpful to look at the profiles of firms that fall in each category. Many firms may have elements that place them into multiple categories, but generally, firms lean most heavily into a single or perhaps two categories at most. For wealth management firms, we think most practices straddle the Procedural and Gray Hair categories.Commodity RIAs. Includes firms that use scale and automation to deliver low-cost, standardized investment services. Firms with algorithm-driven portfolio management strategies and mass-market advisory firms would likely fall into this category.Procedural RIAs. Includes firms with services that involve complex but well-defined processes. For RIAs, this could be offering comprehensive financial planning that follows structured steps. The administratively heavy nature of independent trust companies would also generally place them in this category.Gray Hair RIAs. This category includes RIAs that provide more sophisticated advice to more sophisticated clients than procedural practices, relying heavily on the experience and expertise of their advisors. Firms that predominantly serve ultra-high-net-worth clients, families with multi-generational wealth, or those that offer complex estate planning strategies generally fall into this category.Rocket Science RIAs. Asset managers that utilize complex or novel investment strategies would fall into this category—think those that have developed proprietary, quantitative trading strategies or those that utilize complex, derivative-based hedging strategies or certain alternative investment strategies. This framework has implications for the profit drivers of a business and the resources required to succeed. The farther a firm is towards the commodity end of the spectrum, the more important efficiency and systems for delivery become because these are necessary to deliver while remaining profitable. For RIAs, this typically means that such firms have org charts that are wider at the bottom, lower compensation levels on average, and low margins that are offset by scale and the ability to more easily leverage and grow the business. The farther a firm is toward the Rocket Science end of the spectrum, the more important knowledge management, experience, and analytical expertise become to the firm’s success. For RIAs, this typically manifests in a higher ratio of senior staff to junior staff, higher average compensation levels, higher margins, and less leverage. Such practices are inherently more difficult to scale because they rely more on individual expertise than company-wide systems to deliver their value proposition. Depending on where your practice falls on the spectrum, the type of talent you hire will be different, the way you structure client service teams will be different, the internal systems and processes you develop will be different, the way you market services will be different, and the way you invest in technology will be different.Successful Practices Are Clear About Where They Fall on the SpectrumWhile “commodity” and “rocket science” may elicit different knee-jerk responses in the professional services world, it’s important to note that one type of practice is not categorically better than any other. Success can be found through each of the routes above, and we’ve seen examples from each. But it’s essential to have a clear vision of the type of practice you’re seeking to run. Thinking about the type of practice you’re running is a valuable exercise for identifying the areas you want to lean into and the areas you want to avoid, as it has implications for the resources required for success.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, RIAs, trust companies, broker-dealers, PE firms, and alternative managers.

Portfolio Valuation: Private Equity and Credit

Fall 2024

Perhaps it is back to an alternate future as the Dodgers defeated the Yankees in the World Series after losing to the Yankees in 1977, 1978, and 1996. The market tenor feels like 1996 rather than the high-rate, low P/E multiple markets of the stagflation 1970s. Markets offered a few curveballs and fastballs this fall that should be supportive of PE funds to pick-up the pace of asset monetization while credit funds apparently have less concern that interest income will be eviscerated through draconian Fed rate cuts.

Quality of Earnings Report for Would-Be PE Sellers

After a prolonged slowdown, M&A activity is expected to rebound as economic conditions stabilize and pent-up demand returns. As deal flow recovers, sellers who invest in a Quality of Earnings (QofE) report will be better positioned to articulate sustainable profitability, withstand buyer diligence, and defend value throughout negotiations.

December 2024 | Bank M&A 2024: Off the Bottom

Bank Watch: December 2024

In this issue: Bank M&A 2024 — Off the Bottom

2024 Family Law Valuation & Forensic Insights Highlights

2024 – another year wiser and what a year it has been!

Value Matters^® December 2024

Evolving Need for Estate Planning Amid Legislative Shifts

November 2024 | Moo Deng’s Post-Election Outlook for the Banking Industry

Bank Watch: November 2024

In this issue: Moo Deng’s Post-Election Outlook for the Banking Industry

Moo Deng’s Post-Election Outlook for the Banking Industry

BankWatch was swept up in the viral sensation of Moo Deng, a baby pygmy hippo. What would the Oracle of the Khao Kheow Open Zoo expect for the next four years?

Recap or Rescue?

CI Financial Has One Kind of Leverage, ADIA Has Another

Mubadala Capital is an asset management arm of the Abu Dhabi sovereign wealth fund and has offered to acquire CI Financial for C$32 per share, about a 33% premium to where the stock (CIX.TO) closed last Friday. CI Financial encompasses a Canadian asset, wealth, and custody platform and a U.S. wealth management platform. Including debt, the offer values CI at C$12.1 billion, of which consideration for equity totals C$4.7 billion (US$3.4 billion).

Thanksgiving Resources for Family Business Directors

Over the years, we have used Thanksgiving as a time to remind family business directors that family is indeed the most important part of the family business. See below for some helpful resources before you sit down to eat some turkey with the family this Thursday.

Themes from Q3 2024 Energy Earnings Calls

Upstream (E&P) and Oilfield Service (“OFS”) Companies

The earnings calls from the third quarter focused on technological efficiency, optimized capital allocation, and expectations for natural gas demand in the long term.

Whitepaper Release: Purchase Price Allocations for RIAs

Inventory Management Strategies for Franchised Auto Dealers

While dealers cannot control their allocation from OEMs, they can and should respond with the most appropriate sales strategy for the inventory they receive. There are two main approaches available to dealers: maximize price or volume. The key is balancing these strategies to optimize both sales and profitability. We discuss the pros and cons of each below.

Richard Fuld, Spirit Airlines, and Fairness

Given the price and terms of the JetBlue deal, rendering fairness opinions by Spirit’s financial advisors (Morgan Stanley and Barclays) in July 2022 should have been a straightforward exercise; however, one deal point a board must always consider is the ability of a buyer to close.

Where Do Dividends Come From?

For the unprepared, it is a question that can paralyze any parent: “Mommy, where do dividends come from?” Among our family business clients, the issue of shareholder liquidity is always top of mind, and is occasionally a source of confusion among shareholders, managers, and directors. In this week’s post, we attempt to bring some clarity to the question of where dividends come from. Large or small, regular or “special” dividends paid to family shareholders can really only come from five places.

WHITEPAPER | Purchase Price Allocations for RIAs

Mercer Capital Acquires Business Valuation Analysts, LLC

Mercer Capital is pleased to announce the acquisition of Business Valuation Analysts, LLC, recognized experts in the valuation of privately held business interests for federal estate, gift, income tax and corporate transactional matters.

Is There a Ticking Time Bomb Lurking in Your Buy-Sell Agreement?

Buy-sell agreements don’t matter until they do. When written well and understood by all the parties, buy-sell agreements can minimize headaches when a company hits one of life’s inevitable potholes. But far too many are written poorly and/or misunderstood. Directors are always eager to discuss best practices for buy-sell agreements. In this week's post, Travis Harms, President of Mercer Capital, talks to our founder and author of four books on buy-sell agreements, Chris Mercer, and asks, “Is there a ticking time bomb lurking in your business?”

How Will Trump’s Second Term Affect the RIA Industry?

Now that the dust has finally settled on the 2024 election, we can turn our attention to its expected impact on the investment management industry.

What to Look for in a Purchase Price Allocation

Purchase price allocation is a critical step in the transaction reporting process under ASC 805. This article provides an overview of the PPA process, discuss common intangible assets, and review some best practices and potential pitfalls.

Port Strikes, Supply Chains, and a Looming Deadline

In October 2024, the International Longshoremen Association (ILA) initiated a strike throughout the Eastern and Gulf Coast ports after negotiations surrounding a new contract stalled with the United States Maritime Alliance (USMX). This strike comes just two years after similar negotiations stalled on the West coast between the USMX and Internal Long shore and Warehouse Union (ILWU) in 2022 which led to decreased traffic and volume for about a year. Many ships were rerouted to other ports across the country during this time, removing volume from the West coast ports.

A Framework for Ownership Strategy – Part II

In our last post, we introduced a simple yet effective framework for developing and managing an ownership strategy. We follow up with some further thoughts on the framework as we look at the implications of the various combinations of the three points of the framework below. Thinking about the combinations of growth, liquidity, and control can allow family business owners to further fine-tune an ownership strategy in that it forces ownership groups to consider the benefits and tradeoffs that come with developing a strategy. We examine these tradeoffs and benefits in this week’s post.Control + GrowthThe combination of control and growth implies that a business has not taken on equity or debt capital to the extent that it has given up control over key operations and financial decisions and that ownership has decided to reinvest residual profits back into the business. The reinvestment rate, which measures the percentage of profits being reinvested into the business as opposed to being distributed, can be a useful metric for observing the extent to which ownership is funding the business’ growth with residual profits. This is an easily understandable measure that can direct owner strategy in the tradeoff between growth and liquidity. The decision to reinvest heavily often comes at the expense of shareholder liquidity, and an impatient shareholder base may start clamoring for returns while the company is still actively reinvesting. At any rate, ownership has retained control over the reinvestment vs. distribution decision by not bringing in large amounts of outside capital.For a further look into the reinvestment rate and its applications, we’d point our readers to this recent article in the Harvard Business Review by Hans Latta, Andy Bahnfleth, and Rob Lachenauer: Is Your Family Business on the Path to Growth?Liquidity + ControlThis situation is the other side of the coin from the control and growth scenario. In this strategic position, ownership controls the business and pays a steady stream of dividends or distributions to its shareholder base. This is a positive in that shareholders will generally be satisfied by this financial return, which can promote long-term sustainability and unity within the business. Owner groups operating with this strategy in mind may also provide liquidity to owner-operators via above-market compensation packages or to owner-board members through board fees. Conversely, giving up growth and reinvestment can be a detriment to the business and its ability to compete with businesses that are actively reinvesting profits into newer facilities, technologies, and processes. Control remains with ownership in this scenario, giving ownership “the ability to act economically irrationally,” as Rob Lachenauer, the co-author of the Harvard Business Review Family Business Handbook, put it last week as we discussed the benefits of control in a family business.Growth + LiquidityThe final combination is that of growth and liquidity. In this scenario, ownership has given up control of the business, whether that be to lenders who have provided debt capital or equity investors. Outside investment can be used to fund a myriad of growth opportunities — both organic and inorganic. Residual profits under this scenario are also sufficient to distribute money back to shareholders, which is likely to be a demand of private equity investors. While the family’s ownership in the business may have been diluted, financial returns and favorable exit prospects have likely increased due to the growth promoted by an infusion of outside capital.The triangle framework provides a simple yet effective starting point for family businesses to develop an ownership strategy. We’d encourage family business owners and board members to consider their current position on the triangle and whether or not they are satisfied with it. If you are considering a decision that would strategically realign your business to another side of the triangle, give one of our family business professionals a call.We’d also like to thank Rob Lachenauer of BanyanGlobal for providing a few minutes of his time to discuss the triangle framework with us. Rob co-authored the Harvard Business Review Family Business Handbook with Josh Baron, which introduces the triangle framework for ownership.

Organic Growth and RIA Valuations

Organic growth is a key metric for the RIA industry, but it’s also one that’s easy for many firms to ignore. Why is that? We think part of the answer lies in the prevailing revenue model of the industry, where fees are assessed against the market value of client assets.

October 2024 SAAR

The October 2024 SAAR came in at 16.0 million units, 1.7% higher than last month and 3.7% higher than October 2023. A strong October 2024 SAAR was accompanied by increased inventories and incentive spending levels industry wide, which put pressure on transaction prices and dealership profits.

National Association of Royalty Owners (NARO) National Convention

This year’s National Association of Royalty Owners (NARO) National Convention was held in Houston and Mercer Capital’s Bryce Erickson, ASA, MRICS and David Smith, CFA, ASA had the privilege of attending. NARO has represented the interests of oil and gas royalty owners for over 40 years, seeking to support, advocate and educate for the empowerment of mineral and royalty owners.

D CEO's 2024 Energy Awards

This year, Mercer Capital had the privilege to sponsor and attend the 2024 D CEO Energy Awards, an event that celebrates the energy sector and honors leadership and companies from across the value chain that impact the Dallas-Fort Worth metroplex.

Component Analysis of RIA Returns

A Method to Examine Valuation, Risk Management, and Return Optimization

If you ask most people to name an entrepreneur who made their mark in cars, they would probably name Henry Ford or Elon Musk. A third and equally compelling story is that of Bernie Ecclestone, the former chief executive of Formula One Group. Ecclestone grew a fairly obscure and marginally sustainable auto racing series into one of the world’s largest and most widely followed sports, with billions of viewers. Even more remarkable is that Ecclestone didn’t “acquire” his ownership in F1 from anybody—he created it.Ecclestone started his career after World War II as a parts dealer, mechanic, and sometimes racecar driver. In the early 1970s, he cobbled together enough money to buy an F1 team (a much cheaper endeavor then). With the perspective of a team owner, Ecclestone realized that the teams needed to band together to collectively negotiate better deals with track owners and television, and formed the Formula One Constructors Association and later the Formula One Promotions and Administration.Eventually, Ecclestone negotiated the Concorde Agreement, yoking together the teams and associations affiliated with F1 to set the terms by which teams compete in races. He then wrapped all of this up in Formula One Group, effectively his holding company. By the late 1990s, Ecclestone had, piece by piece, constructed an enterprise that controlled Formula One racing, and he controlled that enterprise. It made F1 what it is today, and it made him a billionaire.The Sum Is a Function of Its PartsBernie Ecclestone’s assemblage of F1 from various parts that became greater as a whole is a useful reminder that businesses can be viewed not just as a monolithic enterprise but also as an assemblage of individual functions with their own performance attributes, risks, and opportunities. Like a racecar, the whole may be greater than the sum of its parts, but examination of the parts yields valuable information about the whole.This sort of component analysis can be a helpful way to analyze RIAs. Broadly speaking, RIAs exist to manage money, but that business's profitability (and value) over time hinges on 1) servicing existing clients and 2) attracting new clients. Those two functions are usually not thought of independently of each other. An example P&L for a $5 billion AUM firm might look something like this: For purposes of this discussion, it doesn’t matter what flavor of RIA this is (wealth or asset manager, individual or institutional, MFO or OCIO, etc.). In aggregate, our “Generic” RIA has $5 billion in AUM, generates revenue off a blended fee schedule of 65 basis points, spends a bit over half of that on labor, between 15% and 20% on non-labor expenses, and ultimately generates an EBITDA margin of just over 30%.Existing Business on a Stand-Alone BasisThe value of an RIA is a function of recurring revenue. Investment management engenders long-term relationships between firms and their clients, and the persistence of those relationships provides an almost bond-like series of predictable returns. If you take the Generic RIA we’ve set up as an example and look at the revenue from the existing book of business and the cost of servicing that revenue, you get a stand-alone P&L that looks something like this: Returns from the existing book of business can generally be characterized as more plentiful than returns from new business. In an era of growing fee pressure, existing business usually pays more (basis points) than new business. Labor costs remain significant to service existing business but are lower than the cost of acquiring new clients. Even if we charge for an appropriate amount of occupancy and other G&A, the existing book of business, in isolation, generates a profit margin more than 25% higher than that of the aggregate enterprise. It shouldn’t be surprising that existing business is usually the most profitable business.Performance Metric for Existing BusinessThe golden opportunity for RIAs is the higher and more predictable margins associated with existing relationships. The biggest threat to that opportunity is, of course, client attrition. Mitigating attrition requires spending on client service, and from that relationship, you can glean a valuable performance metric.If you’re looking for a useful KPI to help manage your business, think about the tradeoff between the incremental margin generated by servicing existing clients and the net AUM attrition (client withdrawals and terminations net of market returns and client contributions). Theoretically, more spending on servicing existing clients should stem attrition. Optimizing the margin/retention equation will build value in your firm.(RIA) Growth at a Reasonable PriceThe worst-kept secret in the RIA industry is that most firms struggle to generate organic growth. This is often explained in terms of the industry's maturation, the aging advisor base, and the lack of service differentiation. Arithmetically, though, it’s easy to show that growing an RIA is, if you look at it in isolation, very expensive. Assume our Generic RIA shows net AUM growth of 5% per year, absent market activity. That’s $250 million and probably at a somewhat lower fee schedule than legacy clients pay. Attracting new business doesn’t need much of the client service, compliance, administrative, and G&A costs that servicing existing clients requires, but it does require expensive sales and marketing. The cost of attracting new business in any given year usually exceeds the marginal benefit of that new business in the first year and sometimes in the first several years.Growth is expensive, but it isn’t optionalGrowth is expensive, but it isn’t optional. Growth provides opportunities for staff development, which reduces talent attrition and augments shareholder returns. Growth provides a portion of an investor’s required return and supports the narrative that the firm’s business model is viable and sustainable. For these reasons, among others, the RIA community is racing to find multiple arbitrage opportunities to generate growth that isn’t happening organically.Performance Metric for New BusinessWhat is a reasonable cost for growth? As shown above, efforts to deliver new AUM to manage often cost more, initially, than the revenue generated by new business. In our example case, the total expense for new revenue is nearly three times the amount of new business. Put another way, it will take three years for the new business to pay for the investment to generate it. After the payback period, new business becomes accretive to profitability as it becomes part of that existing book, with more predictable revenue and bigger margins.The payback period for new business is a useful way to think about a firm’s investment in generating new business. If the payback period is too long, an RIA may not have an effective marketing plan. If payback is too quick, the firm may be under-exploiting an excellent opportunity. Optimizing the payback period is a function of the growth and investment tolerance of the ownership, and the margin on existing business. If building a larger book is particularly valuable, you’ll have more margin to invest in building more business.Unfortunately, the opposite is also true. Poor margins on existing business won’t provide the cash flow needed to build the business.Volatility and ValuationSegmenting an RIA into component returns also offers opportunities to think about risk and value to the RIA. The steady returns of existing business, in which market gains and client additions may be more than enough to offset withdrawals and attrition, suggest a bond-like return. Mapping returns from new business can show everything from moderate variability (in the case of mass-affluent wealth management) to very lumpy (in the case of institutional platforms like an OCIO) and should be thought of through the lens of probability distribution.Think about risk and value to the RIAAs such, the cost of capital for the existing book of business is necessarily much lower than it would be for new business. How much lower is a function of fact patterns specific to the RIA and some market-informed judgment? Fortunately, a close look at historical investment flows should reveal a pattern for what to expect in terms of net AUM changes from an existing book of business. Applying a lower than firm-wide discount rate offers clues as to the value of the existing book on a stand-alone basis, as well as the proportion of overall firm value.It’s also interesting to think about the value of growth by modeling the internal rate of return for investment in new business.In this case, we’ve assumed that the EBITDA margin for new business in our Generic RIA would be around 60% and modeled the IRR to receive that return for ten years following the marketing expenditure to land the business. (A more thorough analysis would look at the likely attrition rate on new business and model some residual cash flow at the end of the projection period into perpetuity. For the sake of not putting any more numbers on your screen than necessary, a finite ten-year projection is a good guess.) If the investment amount is higher, or the marginal EBITDA return is a lower percentage of new fees, the IRR compresses. If returns are better or the cost to generate them lower, the IRR will improve. One would want an IRR at a good premium to the firm’s aggregate cost of capital to make marketing for new business worthwhile. Optimizing the investment in new business would likely be a tradeoff between the highest aggregate level of new business (more is more) and the IRR of the effort (more is more).Component Analysis of RiskComponent return analysis is also useful to model the risk attributes of an investment management firm. Certain risks affect the existing base of business differently than new business.Certain risks affect the existing base of business differently than new business.For RIAs in businesses facing legislative action, such as attempts to restrict institutional ownership of rental housing, component analysis helps isolate the stroke-of-the-pen risk that would limit opportunities to raise new funds or make new investments to the “new business” side of the equation, leaving the value of servicing existing relationships intact.Other sorts of exogenous shocks, like severe market corrections, may negatively impact existing client relationships but simultaneously increase opportunities for new relationships. This ties well with our thesis that existing business models are like a bond, where risk is asymmetric to the downside, and new business models more like an option, where volatility is accretive to value.In Closing…There’s much more to say about component return analysis, but we don’t offer it as a substitute for keeping your eyes on the big picture. As brilliant as Bernie Ecclestone was in creating his dominant position in F1, he also became a bigger target and was eventually dethroned and lost his position at Formula One Group. He may have focused a bit too much on the upside when he neglected to pay all of his taxes and, consequently, had to face the downside of incarceration.If you’re curious about how to examine your RIA using component analysis, give us a call, and we will think through the exercise with you. You might be surprised by what you learn.

Expanding Reach and Elevating Expertise

Mercer Capital’s Fall 2024 Highlights

As the holiday season is upon us, we would be remiss not to reflect and share highlights from a bustling 2024 fall season at Mercer Capital.

October 2024 | Fed Rate Cut(s) – Now What?

Bank Watch: October 2024

In This Issue: Fed Rate Cut(s) – Now What?

Fed Rate Cut(s) – Now What?

Rate cycles are predictable in one sense: a period of falling rates tends to follow a period of rising rates. The opposite is true, too.

A Framework for Ownership Strategy – Part I

We recently attended a family business symposium where owners, board members, and consultants gathered to share strategies and insights.

Now Available: Mercer Capital’s 2024 Energy Purchase Price Allocation Study

Mercer Capital is pleased to announce the release of the 2024 Energy Purchase Price Allocation Study.This study researches and observes publicly available purchase price allocation data from companies primarily contained in one of the four sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; (iii) midstream; and (iv) downstream. This study is unlike any other in terms of energy industry specificity and depth.The 2024 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that reported their purchase allocation data in calendar year 2023 and not reported in previous annual filings.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity. It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions. The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.DOWNLOAD THE STUDY

RIA Aggregator Investments Trick or Treat

Are Longer Holding Periods a Viable PE Strategy or Just an Extend-and-Pretend Tactic?

Halloween is the ultimate extend-and-pretend film series. From the original 1978 Halloween to 2022’s Halloween Ends, moviegoers estimate that Michael Myers apparently died eight times but somehow appeared in all thirteen films over the series’ 44-year history. The cynical (but likely accurate) rationale for this inconsistency is that the studios recognize that it makes the most economic sense to extend the Halloween saga after each movie and pretend Michael didn’t die in the last one. Private equity firms with investments in RIA aggregators appear to be facing a similar (though less haunting) predicament. A recent CityWire article noted that private equity firms are extending their holding periods for RIA aggregator firms to take advantage of the industry’s higher margins and long-term growth prospects. This stalling tactic shouldn’t spook their LPs since the RIA sector is renowned for its recurring revenue, above-average margins, and demonstrated ability to grow cash flows over an extended period of time. Not many industries have businesses that can sustain The Rule of 40, which posits that venture investors prefer to invest in businesses in which the profit margin plus the growth rate adds up to at least 40%. The investment management industry is a notable exception since it typically boasts EBITDA margins in the 20% to 30% range and annualized growth in revenue on the order of 10% to 15%. It’s like candy corn with a lasting sugar high to prospective investors. So what’s so scary about paying +15x EBITDA for these businesses? If we use the EBITDA single-period income capitalization method to build up an applicable EBITDA multiple for RIA aggregators based on their current cost of capital and expected long-term growth rates, that math probably looks something like this: This analysis suggests that an RIA aggregator’s cost of capital and growth profile support a 15x EBITDA multiple. There’s also market evidence to affirm these valuations — Goldman is estimated to have paid ~18x EBITDA for RIA aggregator United Capital, and PE firm Clayton, Dubilier & Rice purchased Focus Financial for ~13x EBITDA last year. Market evidence supports extending holding periods for these types of investments rather than flipping them to the next investor. PE firm GTCR purchased a 25% stake in RIA acquisitive Captrust Financial Advisors in 2020, which valued Captrust at $1.25 billion before Carlyle bought another minority stake in the business, valuing the firm at just over $3.7 billion three years later. An extended holding period for an RIA aggregator investment at a 15x EBITDA entry multiple appears very reasonable for the PE firms backing these businesses. What about the multiple that these aggregator firms are paying for their underlying RIAs? That math looks a bit different since these investment management firms tend to be much smaller, riskier, and have little or no access to (cheaper) debt financing: When we do see RIA transactions in the +15x EBITDA space, much of the total deal value is typically paid in the form of an earnout or contingent consideration payment based on the target firm’s future financial performance, usually 1-5 years out from the initial down payment. These multiples are often calculated based on the total deal value (including contingent consideration) divided by trailing twelve-month EBITDA prior to closing, even though the earnout portion is unknown at that point, and the time value of money is not factored into the calculation. Paying north of 20x EBITDA for these businesses with no buyer protection in the form of earnout payments could be more horrifying than a hayride with Michael Myers on his ninth life. We’re here to help (with the former).About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, RIAs, trust companies, broker-dealers, PE firms, and alternative managers.

2024 NADC Fall Conference Update

Key Takeaways for Auto Dealers

We provide a few takeaways from sessions we attended at this year’s conference. We believe the topics we cover are especially important for auto dealer counsel and their clients during the remainder of the year and beyond.

ROIC for Family Businesses in 5 Minutes

Revenue growth and profitability are critical measures for the health of any family business, but by themselves, they tell only half of the story. As a family business director, you need the whole story. We’re not aware if Paul Harvey was a financial analyst, but if he were, we suspect his favorite performance metric would have been return on invested capital (ROIC), because it tells you the Rest of the Story.?Don’t forget to check out our dedicated family business site. The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses. There, you’ll find a curated and organized diverse collection of resources from our staff of family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies.The perspectives we offer here are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses like yours. There’s nothing else like it, and we look forward to your visit.

Alternative Asset Managers Outperform as RIA Sector Gains Momentum

Alternative asset managers fared particularly well during favorable market conditions for the RIA sector. Over the past year, both alternative asset managers and large RIAs (with assets under management, or AUM, exceeding $250 billion) outperformed the S&P 500, achieving gains of 64.6% and 37.7%, respectively.

"Hayne" in There, Haynesville!

The Haynesville/Bossier Shale was discovered in 2008 in East Texas and Western Louisiana. As a play, it differs from other reserves. The reservoirs are highly pressured and deeper than most other reservoirs. The average hydrocarbon reservoir in Haynesville is almost 12,000 feet deep, far exceeding the average depth of 6,000 feet (per the most recently available data from the EIA). This extra depth can make drilling activities more expensive. This is not just because of the additional pipe length. Temperatures at such great depths can be extremely high, so the equipment to drill wells must be able to withstand particularly high temperatures. Such equipment typically costs more than standard drilling equipment. Additionally, Haynesville is saturated with smaller independent operators compared to plays like the Eagle Ford and the Permian over the last decade. The greater share of independent operators can lead to relatively higher average drilling costs from smaller average contract sizes.Source: Family Tree Oil & Gas CorporationDespite these challenges, Haynesville has a number of advantages over other basins. While the equipment required to complete projects is more expensive, Haynesville is located extremely close to the Gulf of Mexico and its LNG export terminals, especially compared with the Marcellus in Appalachia. While the Marcellus may have cheaper operating costs at the well level because it is not as deep as the Haynesville, the long transportation distance required for its reserves to be exported eats away at its natural price advantage. The Permian is relatively close to export terminals and has cheaper operation costs, but the gas there has faced transmission problems.TransactionsHaynesville has seen unsteady transaction activity over the last ten years. The chart below shows that M&A has been sporadic, with most activity in the last five years occurring in 2021 and additional smaller closings in 2Q 2022 and 3Q 2023. M&A activity in 2024 has been relatively limited per Shale Experts, likely because of the harsh operating conditions for gas-forward plays.The most notable Haynesville transaction in the Shale Experts data occurred in the second quarter of 2018 when B.P. America Production Company (a subsidiary of B.P.) acquired the assets of Petrohawk Energy Corporation, (at the time) a wholly owned subsidiary of BHP Billiton Petroleum (North America) Inc. The total value of the transaction was $10 billion. Notably, the Petrohawk assets included were not just in Haynesville but also in the Eagle Ford and the Permian Basins. As such, it is not strictly comparable with the other transactions shown in the chart. A specific breakout of the value per basin is unavailable, but the transaction’s press release did include the information summarized in the table below the chart. Data per Shale Experts Notably excluded from the Shale Experts data is Chesapeake Energy’s acquisition of Southwestern Energy in January 2024 (which we have written about previously). The resulting entity, known as Expand Energy, involves a total consideration of $7.4 billion. Through the deal, Chesapeake acquired 7.9 bcf/d from Southwestern’s assets in the Appalachian and Haynesville. In recent news, word has spread that Chevron Corporation (CVX) is discussing selling its Haynesville assets with Tokyo Gas. Chevron’s portfolio includes 72 thousand acres of undeveloped land. In the same publication, the author speculates that the potential transaction could be worth up to $1 billion. Tokyo Gas’s interest in the Haynesville assets may be related to Japan’s reliance on imported fossil fuels. Before its conversations with Chevron, Tokyo Gas had also completed an acquisition of Rockcliff Energy for $2.7 billion. As of the writing of this post, the Rockcliff assets contribute as much as 1.3 bcf of gas per day to Tokyo Gas.ActivityIn the last twelve months, Shale Experts shows that there have been 232 total deals completed in Haynesville. These completions have been heavily concentrated among a few operators, as shown above. The top eight operators have a total of 216 completions, representing 93% of all completed deals since the start of 3Q 2023. The chart below shows that transactions have been trending downward since the second quarter of 2023. [caption id="" align="alignnone" width="1072"]Data per Shale Experts[/caption] Since it is overwhelmingly a gas-focused basin, Haynesville producers have been hit hard by declining natural gas prices. As of February 2024, S&P estimated that the average breakeven price for efficient operators in the Haynesville Shale was $2.67/MMBtu. For less efficient operators, wellhead clearing prices are well above $3.00/MMbtu. For context, the most recent natural gas weekly update from the EIA places the Henry Hub spot price at $2.42/MMbtu. At current prices, there simply is no incentive for new completions in Haynesville despite its large reserves and convenient geography. The Biden Administration’s pause on new LNG export approvals has had a brutal impact on the Haynesville Shale. Companies have hesitated to commit to new projects without the certainty of being able to export LNG. As of the writing of this post, the pause is still in place. In the longer term, things look much more positive. There are already indications that LNG demand is rising faster than previously expected. Shale operators across the board are looking to lower their capital expenditures without negatively impacting production, and the data shows that they have been very successful in the Haynesville Basin. Over the twelve months leading up to September 2024, rig counts decreased by 15.4% YoY, while production only decreased by 10.1% over the same period (for additional detail, see Mercer Capital’s 3Q 2024 E&P Newsletter). If this trend continues, the decreased clearing price for natural gas operators in Haynesville will cause operations in that area to be economical once again. In December 2023, Hart Energy published a report predicting that U.S. LNG capacity will increase from 13 Bcf/d in 2024 to 25 Bcf/d by 2030. Per Hart Energy, Haynesville will be a critical provider of this additional capacity, as the Haynesville is expected to provide 13Bcf/d of that additional demand, making it the dominant provider of a massively ballooning market. One can see the gap between short-term and long-term expectations by comparing the production numbers above with the changes in capacity shown in the graph below (courtesy of Enverus Intelligence). While current production is low, companies are making significant investments in expanding their LNG export capacity. Naturally, a large portion of these exports will be occurring in the Haynesville Basin. But put simply, there are good times ahead. Mercer Capital has assisted many clients with various valuation needs in the oil and gas industry in North America and globally. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate, and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.Additional Sources:Assorted data from Shale ExpertsAssorted data from the U.S. Energy Information Administration“Haynesville/Bossier Shale Information & Statistics”“Haynesville Region Drilling Productivity Report”

Fairness Opinions: Evaluating a Buyer's Shares from the Seller's Perspective

Strong performance of U.S. equity markets in 2024 combined with narrowing credit spreads in the high yield bond, leverage loan and private credit markets are powerful stimulants for M&A activity. According to the Boston Consulting Group, U.S. M&A activity based upon deal values rose 21% though September 30 compared to the same period in 2023 after Fed rate hikes during 2022 and 1H23 weighed on deal activity.Deal activity measured by the number of announced deals is less compelling as deal activity has been dominated by a number of large transactions in the energy, technology and consumer sectors.While large company M&A may continue, the broadening rally in the equity markets (Russell 2000 +13% YTD through October 16; S&P 400 Midcap Index +14%) suggests that deal activity by “strategic” buyers may increase. If so, deals where publicly-traded acquirers issue shares to the target will increase, too, because M&A activity and multiples have a propensity to increase as the buyers’ shares trend higher.It is important for sellers to keep in mind that negotiations with acquirers where the consideration will consist of the buyer’s common shares are about the exchange ratio rather than price, which is the product of the exchange ratio and buyer’s share price.When sellers are solely focused on price, it is easier all else equal for strategic acquirers to ink a deal when their shares trade at a high multiple. However, high multiple stocks represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”A fairness opinion is more than a three- or four-page letter that opines as to fairness of the consideration from a financial point of a contemplated transaction. The opinion should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares.What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be heavily scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends. The analysis should consider the buyer’s historical growth and projected growth in revenues, EBITDA and net income as well as trends and comparisons with peers of profitability ratios.Reported vs Core Earnings. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated (preferably over the last five years and last five quarters) with particular sensitivity to a preponderance of adjustments that increase core earnings.Pro Forma Impact. The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital structure in addition to dilution or accretion in EBITDA per share, earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.Shareholder Dividends. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?Share Repurchases. Does the acquirer allocate some portion of cash flow for repurchases? If not, why not assuming adequate cash flow to do so?Capex Requirements. An analysis of capex requirements should focus on whether the business plan will necessitate a step-up in spending vs history and if so implications for shareholder distributions.Capital Stack.Sellers should have a full understanding of the buyer’s capital structure and the amount of cash flow that must be dedicated to debt service before considering capex and shareholder distributions.Revenue Concentrations. Does the buyer have any revenue or supplier concentrations? If so, what would be the impact if lost and how is the concentration reflected in the buyer’s current valuation.Ability to Raise Cash to Close.What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates.If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation. Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance.Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position. Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities. Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.

The Boar’s Head Family: Why Worry About Succession Planning?

It is hard to imagine the founders of Boar’s Head envisioned this sort of conflict-ridden path for their family business. While avoiding shareholder conflict is never guaranteed, family business directors can add an additional layer of protection to their family legacy and long-term wealth through focused succession planning. Here are a few things to consider when developing your family business succession plan.

Vulcan Materials’ Acquisition of U.S. Concrete

As participants in and observers of mergers and acquisitions, the 2021 acquisition of U.S. Concrete, Inc. (“U.S. Concrete”) by Vulcan Materials Company (“Vulcan Materials”) (NYSE: VMC) is a terrific opportunity to study the valuation nuances of the construction and building materials industry. In this article, we look at the fairness opinions delivered by Evercore and BNP Paribas rendered to the U.S. Concrete board regarding the transaction and provide some observations on the methodologies utilized by these two investment banks.

September 2024 SAAR

The September 2024 SAAR came in at 15.8 million units, 3.3% higher than last month and in line with September 2023. At their September meeting, the Federal Reserve cut benchmark interest rates by 50 basis points and highlighted a slight rise in unemployment. This won’t directly or dramatically impact the industry, but we do expect to see the effects of this rate cut (and likely forthcoming cuts) within the industry over the next couple of months and into 2025.

Just Released: 3Q24 Exploration & Production Newsletter

RIA M&A Update: Q3 2024

Following a year where deal volume in the RIA industry nearly matched the all-time high of 2022, RIA M&A activity has cooled in 2024. Fidelity’s September 2024 Wealth Management M&A Transaction Report listed 155 deals through September 2024, down 11% from the 174 deals executed during the same period in 2023.

Dispatch from the Fed

The ability to be attuned to economic trends that will affect your family business without being distracted by short-term economic “noise” (indeed, the ability to even distinguish reliably between the two) is typically hard-won and learned only through the trial-and-error of being in business for decades. Respect those lessons and strive to collect wisdom from your fellow directors. Markets may overreact to Fed decisions, but you and your fellow directors don’t have to.

RIA Market Update: Q3 2024

RIAs outperformed the S&P in the third quarter of 2024, with alternative asset managers experiencing the strongest returns amid multiple expansion. All groups examined experienced growth in AUM and revenue year-over-year. We explore further in our Q3 2024 Market Update.Download Update

Should Appalachian Natural Gas Producers’ Stock Price Resiliency Be Surprising?

In a year where natural gas prices have spent almost the entire year under $3.00 per mcf, including a few months under $2.00, the stock prices of publicly traded Appalachian gas producers have remained remarkably stable. In fact, Antero Resources’ price is up this year and Range Resources is basically flat for the year so far. Others such as EQT and Coterra Energy are down only marginally. This could come across as surprising. Appalachia has some disadvantages to other US gas producing basins, such as takeaway capacity, logistics, and longer distances to major LNG production facilities. However, since 2022 the stock market has held steady for these companies; of which this confidence has outlasted commodity price and earnings declines over the past two years.

Communication Matters for Family Businesses

How can family business leaders develop effective and sustainable communication programs? For family businesses, the goal is to communicate, not inundate. At some point, too much information can simply turn into noise. Family business leaders should focus on the dimensions in this post.

One Strike and We’re Out?

The ILA Strike and It’s Implications on Industry Data

At the beginning of October, we attended the Memphis World Trade Club’s annual Memphis Logistics Summit. In conjunction with the New Orleans Port Night, the Memphis Logistics Summit gathers players from a wide cross section of the transportation industry to discuss the industry, current events, and new technology. The Summit began on October 2nd and the schedule was filled with excellent panels and speakers. The space between sessions was filled, of course, with discussions of the ILA strike and how it was impacting different aspects of the transportation world.

Connelly v U.S. - Considerations in Divorce

Connelly v. United States – Considerations in Divorce

While the case itself directly addressed tax law, the ruling also has relevance in the realm of divorce valuations, where the accurate assessment of assets is crucial. In this article, we highlight specific areas where the Connelly case has relevance for business owner clients going through a divorce.

Fourth Quarter 2024 | Segment Focus: Non-Residential Construction

Both the residential and non-residential building sectors have enjoyed strong years thus far, with Value Put-inPlace up 5.7% and 3.6% Y-o-Y, respectively, on a seasonally adjusted annual basis. Non-residential construction has experienced strong tailwinds from elevated growth in corporate profits, though this has slowed during the fourth quarter of 2024.

Healthcare Facilities Q4 2024

Segment Focus: Ambulatory Surgery Centers

Ambulatory Surgery Centers (ASCs) have seen a significant increase in popularity during the past few years. Currently in the United States, there are 11,555 active centers, representing a 3% year over year increase.

Value Focus: Insurance Industry | Fourth Quarter 2024

2024: A great year for Brokers, P&C, and Insurtech; Insurance IPOs win big

Medtech and Device Industry Newsletter - Q4 2024

Feature Article | Trends in MedTech Valuation Step-Up MultiplesEXECUTIVE SUMMARYThis quarterly update includes a broad outlook that divides the healthcare industry into four sectors:Biotechnology & Life SciencesMedical DevicesHealthcare TechnologyLarge, Diversified Healthcare CompaniesWe include a review of market performance, valuation multiple trends, operating metrics, and other market data. This issue also includes a review of M&A and IPO activity

E&P Fourth Quarter 2024

Bakken, DJ Basin, and Woodford Shale

Bakken, DJ Basin, and Woodford Shale // As a supplement to our usual regional coverage, this quarter we take a closer look at the Bakken, DJ Basin, and Woodford Shale. On an oil equivalent basis, the DJ Basin ended the review period 2% below production levels from a year earlier, while the Bakken ended at nearly 5% lower. Only the Woodford Shale ended the review period at a level above its November 2023 production, though at a negligible 0.1% higher.

Transportation & Logistics Newsletter

Fourth Quarter 2024

Striking the Right Balance Between Margins and Compensation

New Book: "Buy-Sell Agreements: Valuation Handbook for Attorneys"

We are excited to share the release of our latest book Buy-Sell Agreements: Valuation Handbook for Attorneys authored by Z. Christopher Mercer, FASA, CFA, ASA and published by the American Bar Association. This week, we share an excerpt from the book that discusses what you can expect to find in the full copy. Whether you are an attorney who advises clients on their buy-sell agreements or are a party to a buy-sell agreement, you will find important information in this book.

2024 Core Deposit Intangibles Update

Although deal activity has been slow, we have seen a marginal uptick in core deposit intangible values relative to this time last year.

Is Your Buy-Sell Agreement a Ticking Time Bomb?

With the release of Chris Mercer's new book, we've got buy-sell agreements top of mind, and you should, too. Buy-sell agreements don’t matter until they do. When written well and understood by all the parties, buy-sell agreements can minimize headaches when a family business hits one of life’s inevitable potholes. But far too many are written poorly and/or misunderstood. Directors are always eager to discuss best practices for buy-sell agreements.

Navigating Challenges in Appalachian Production

The economics of oil & gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Haynesville, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of the reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter, we take a closer look at the Marcellus and Utica shales.

Five Ideas to Turn Your RIA’s Success Into Momentum

Understanding why you’ve been successful is important to sustaining your success.

Where Is the Auto Dealer Industry in the Cycle?

For years, it’s been a question of when, not if, things would normalize. The more difficult follow-up question has been, “Where will earnings and margins normalize?”

Three Considerations BeforeYou Sell Your Business

As middle-market M&A activity begins to rebound, business owners considering a sale must prepare thoughtfully. Setting realistic value expectations, understanding the tax implications of a transaction, and clearly defining the strategic reasons for exiting are critical steps toward achieving a successful and well-executed sale process.

"Buy-Sell Agreements: Valuation Handbook for Attorneys" Now Available

Does This Presidential Election Matter to the RIA Industry?

For some reason, we get this question every four years or so, and it’s come up quite a bit in recent weeks. We have to step back and think about what either candidate’s election would mean for the broader financial services industry, taxes, and stock market returns

Observing the Negotiations of the Chesapeake - Southwestern Merger

A Marcellus and Utica Shale M&A Update

M&A activity among upstream participants in the Marcellus and Utica Shales has been sparse in recent years, with Shale Experts reporting only one transaction since November 2022. In a departure from our typical analysis and discussion of recent deals in the upstream oil and gas industry, this week’s Energy Valuation Insights blog takes a break from deal multiples and observes the negotiations of the $7.4 billion merger between Chesapeake Energy Corp. (“Chesapeake”) and Southwestern Energy Co. (“Southwestern”), a significant player in the Marcellus Shale.

Wishful Thinking and the Time Value of Money

What lessons can family business directors glean from the Nordstrom saga? We will consider three in this post.

August 2024 SAAR

The August 2024 SAAR came in at 15.1 million units, notably 4.5% lower than last month. In fact, this month’s SAAR is even lower than June, which was negatively impacted by the CDK cybersecurity attack. We believe consumers are likely finally feeling the pain of a softer labor market, as indicated by the July 2024 Jobs Report from the Bureau of Labor Statistics.

Are Retirement Plans an Underappreciated Growth Opportunity for RIAs?

Beyond deepening relationships with existing clients, offering DC services opens doors to developing connections with SMB business owners (often HNW individuals) and HNW plan participants. The connections formed through defined contribution services can create a valuable pipeline to mine for new HNW advisory clients.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of September 3, 2024

Mind the Margin

Why Margins Are an Important Metric for Your Family Business

Margin analysis can be a beneficial tool for evaluating performance. Becoming familiar with the typical margins of your family business will provide a touchpoint for identifying where opportunities to preserve and grow profits exist for your family business. Since ‘typical’ margins vary from industry to industry, being able to benchmark to similar companies can give family businesses a better idea of where they stack up.

Middle Market Transaction Update Fall 2024

The tale of the tape in middle market M&A activity in the second quarter proved similar to that of the first quarter, though reported multiples for PE deals generally improved in the second quarter.

Bank Watch: September 2024

2024 Core Deposit Intangibles Update

Real Estate and the Family Business in Divorce

For many business owners and their spouses, the marital net worth may be concentrated in the value of the business.

Funding Your RIA’s Buy-Sell with Life Insurance Just Got Much Harder

SCOTUS Compels Closely-Held Business Owners to Review a Potential Problem in Their Ownership Agreement

When is something worth more than it’s supposed to be worth? If it’s a vintage sports car, it might be that a restoration shop has modified the original car to make it more visually appealing, faster, and more useful than new. If it’s a decedent’s interest in an RIA, it’s because life insurance benefits paid upon the death of the shareholder are now included in the value of the business.

Equity Capital Raises

The banking zeitgeist is evolving: 2023 was about a liquidity crisis that claimed three banks who were members of the S&P 500; 2024 is shaping up as the year of capital raises by a handful of regionals to deal with the aftermath of the Fed’s ultra-low-rate environment.

2024 Mid-Year Market Update

After a period of underperformance due to earnings pressure from rising rates and falling margins, banks rallied strongly during the reporting of 2Q24 earnings.

A Private Equity Tactic to Consider for Your Family Business

A few weeks ago, we observed private equity investors learning a lesson about liquidity risk, which family shareholders have always known. This week, we turn the tables and explore a PE strategy that might be worth considering for some family businesses – dividend recapitalizations.

Themes from Q2 2024 Energy Earnings Calls

Upstream (E&P) and Oilfield Service (“OFS”) Companies

In our prior earnings call post, Themes from Q1 2024 Energy Earnings Calls, we touched on how the Upstream (“E&P”) and Oilfield Services (“OFS”) segments emphasized their dividend and share buyback programs and the industry’s response to depressed natural gas prices. This week, we explore the Q2 2024 earnings calls of Upstream and OFS companies, highlighting the significance of this quarter’s themes across the entire sector.

Q2 2024 Earnings Calls

Here is what auto retailer executives had to say during the Q2 2024 earnings calls.

Valuing Asset Managers

Understanding the value of an asset management business requires some appreciation for what is simple and what is complex.On one level, a business with almost no balance sheet, a recurring revenue stream, and an expense base that mainly consists of personnel costs could not be more straightforward. At the same time, investment management firms exist in a narrow space between client allocations and the capital markets. They depend on revenue streams that rarely carry contractual obligations and valuable staff members who often are not subject to employment agreements. In essence, RIAs may be both highly profitable and prospectively ephemeral. Balancing the risks and opportunities of a particular investment management firm is fundamental to developing a valuation.WHITEPAPERValuing Asset ManagersDownload

WHITEPAPER | Valuing Asset Managers

Review of Q2 2024 Key Economic Indicators for Family Businesses

Coming off a run of economic data releases in the last few weeks, we take a look at the numbers and some of their implications for the broader economy in this week’s post. GDP growth in the U.S. economy measured 2.8% in the second quarter of 2024, outpacing growth of 1.4% in the first quarter. Following persistently elevated measures in the first quarter, recent inflation readings have cooled. The following sections provide a brief look at these trends and their implications.

Unlocking Value in the Oil & Gas Industry

The oil and gas industry is constantly changing, with a lot of moving parts and financial complexities. Accurate valuation of assets within this sector is critical for making informed strategic decisions. At Mercer Capital, we have cultivated a deep understanding of the oil and gas industry through decades of experience. To share our knowledge and insights, we have produced three complimentary whitepapers for our blog readers.How to Value Your Exploration & Production CompanyThe valuation of exploration and production (E&P) companies is a complex process influenced by a multitude of factors, including price volatility, technology, regulation, and different drilling economies depending on the play. Our updated whitepaper provides insights into the financial considerations and key valuation methodologies for E&P companies. By understanding the drivers of value, companies can optimize their strategic direction and financial performance. Download hereUnderstanding Oilfield Services Companies & How to Value ThemThe oilfield services (OFS) industry is characterized by its cyclical nature. The unpredictable cyclicality of the OFS industry requires careful consideration of many industry-wide and company-specific factors in developing a reasonable forecast of future operating results. Our whitepaper describes the key drivers and indicators of the OFS industry, as well as the key valuation methodologies of an OFS company. By understanding the key factors that impact the value of OFS companies, industry participants can make informed decisions about mergers, acquisitions, and capital allocation. Download hereHow to Value an Oil & Gas Royalty InterestA lack of knowledge regarding the worth of a royalty interest could be very costly. This can manifest itself in a number of ways. A shrewd buyer may offer a bid far below the interest’s fair market value; opportunities for successful liquidity may be missed; or estate planning could be incorrectly implemented based on misunderstandings about value. Understanding how royalty interests are properly appraised will ensure that you maximize the value of your royalty, whenever and however you decide to transfer it. Download hereConclusionAt Mercer Capital, we are committed to providing valuable insights and resources to the oil and gas industry. Our whitepapers on E&P companies, OFS companies, and valuing royalty interests offer a comprehensive understanding of the valuation complexities within this sector. We hope you find them helpful.

Handling RIA Ownership Disputes

When RIA owners can’t agree on the appropriate price for a shareholder buyout, we’re often jointly retained to value the departing member’s interest in the business pursuant to a buy-sell agreement. Whether we’ve been court-appointed or mutually chosen by the parties to do the project, we’ve done enough of these over the years to learn that the process matters as much as the outcome.

Kellogg Company Case Study

Attempting to Unlock Shareholder Wealth in a Mature Business

Today is was announced that Mars has reached a deal to acquire Kellanova, which was spun off from Kellogg’s last year. Our Family Business Advisory team put together this powerpoint deck, “Case Study: Kellogg Company – Attempting to Unlock Shareholder Wealth in a Mature Business” which tracks key events in Kellogg’s history and comments on the transaction. There are lessons family business owners can learn from the transaction and from Kellogg’s recent moves.

What Does the Valuation Process Entail for an Oil and Gas Royalty Interest?

A lack of knowledge regarding the worth of a royalty interest could be very costly. This can manifest itself in a number of ways. A shrewd buyer may offer a bid far below the interest’s fair market value; opportunities for successful liquidity may be missed; or estate planning could be incorrectly implemented based on misunderstandings about value. Understanding how royalty interests are properly appraised will ensure that you maximize the value of your royalty, whenever and however you decide to transfer it.

July 2024 SAAR

The July 2024 SAAR came in at 15.8 million units, a 4.2% increase from last month and roughly flat with July 2023 (-0.8%). While the month-over-month increase was expected based on the CDK cyber-attack that hit the auto dealer industry in late June, we find it notable that results were still below last year.

Build, Buy, or Outsource

RIAs Need Trust Capabilities, but How?

There’s a growing demand for expanding the suite of services to include trust administration, either by bringing those services in-house and making it a one-stop shop for clients or by seamlessly outsourcing. For RIAs that can figure it out, there are opportunities for higher growth and retention at the margin relative to a field of competitors that lack robust trust capabilities.

Heat Waves, Hurricanes, Selloffs, Oh My

As the heat waves, hurricanes, and potential for a recession loom, we wanted to take a step back and highlight three strategies family business directors can adhere to in these volatile and uncertain times.

Personal Goodwill and Valuation Issues in Marital Dissolution Cases

What is personal goodwill and why is personal vs. enterprise goodwill such an important topic? Find out more in this powerpoint deck.

What Does the Valuation Process Entail for an E&P Company?

A lack of knowledge regarding the value of your business could be very costly. Opportunities for successful liquidity may be missed or estate planning could be incorrectly implemented based on misunderstandings about value. In addition, understanding how exploration and production companies are valued may help you consider how to grow the value of your business and maximize your return when it comes time to sell.

RIA Value Is a Function of Liquidity

Is the Investment Management Industry Missing Part of Its Capital Stack?

The value of any asset is determined by the market in which it trades. The most significant component of that market as it relates to value is the relative access to liquidity of market participants.

August 2024 | 2024 Mid-Year Market Update & Equity Capital Raises

Bank Watch: August 2024

In this issue: 2024 Mid-Year Market Update & Equity Capital Raises

Essential Financial Documents to Gather During Divorce

This booklet is designed to be a resource that will assist you and your clients during one of the most difficult times in their lives, both emotionally and financially.

Economic Pressure on Commercial Real Estate Sector

CRE has long been a hot topic of conversation and CRE regulatory guidance to address elevated concentrations of CRE loans and help institutions manage risk accordingly was released all the way back in 2006.

Real Estate and the Family Business

As the pandemic recedes further into the rearview mirror (4+ years!), long-term business consequences continue to reverberate through the economy. In addition to recalibrating expectations among domestic manufacturers, foreclosures on distressed commercial real estate are accelerating. Since enterprising families often accumulate significant real estate holdings, the lingering pandemic-induced weakness in real estate values may encourage families to evaluate their real estate strategies. There are three broad strategies for families owning and operating businesses.

Will Rate Cuts Improve RIA Multiples?

Naturally, we’re interested in how expected rate cuts will affect the investment management industry’s transaction multiples. Many industry observers believe anticipated rate cuts will have little or no impact on the sector since most RIAs don’t have any debt on their balance sheets. While it’s true that most investment management firms do not employ leverage in their capital structure, lower interest rates will nonetheless impact their cost of equity and, consequently, their valuations. We can illustrate this by way of a common decomposition of the most prevalent valuation metric in the RIA space — the EBITDA multiple.

Personal Goodwill in the Auto Industry

This post discusses important concepts of personal goodwill in divorce litigation engagements. The discussion relates directly to several divorce litigation cases involving owners of automobile dealerships. These real-life examples display the depth of analysis that is critical to identifying the presence of personal goodwill and then estimating or allocating the associated value with the personal goodwill. The issues discussed here pertain specifically to considerations utilized in auto dealer valuations, but the overall concepts can be applied to most service-based industries.It is important that the appraiser understands the industry and performs a thorough analysis of all relevant industry factors. It is also essential to determine how each state treats personal goodwill. Some states consider personal goodwill a separate asset, and some do not make a specific distinction for it and include it in the marital assets.

Premiums for Inventory Scale

In the last year, M&A activity in the upstream area of the oil and gas industry has increasingly become top-heavy, characterized by several headline deals. While the broader North American E&P deal count has been shrinking since 2022, a handful of major acquisitions in the last year have led to a spike in upstream M&A spending.

The Patience to Prevail

What Can Family Businesses Learn from the Open Championship?

It’s no secret that the writers of the Family Business Director blog share a collective affinity for the game of golf. Over the weekend, we enjoyed watching the final major tournament of the professional golf season, the Open Championship. The last of golf’s four “majors” presents a unique and esoteric challenge relative to the other three majors and the rest of the PGA and LIV tour tournaments on which professional golfers compete week in and week out. The Open, as it is often called, is played every year on one of ten courses in the United Kingdom that comprise the venerable “Open Rota.” These courses are among the oldest and most revered in the world and include the Old Course at St. Andrews in Scotland, widely considered the oldest golf course in the world. Aside from the Open being contested on some of the most hallowed grounds in the sport, perhaps its most distinctive characteristics compared to other majors and regular tour events are the conditions and style of play it requires its participants to navigate. Courses within the Open Rota are situated upon the windswept coastal dunes of Scotland, England, and Northern Ireland, where players are often at the mercy of whatever Mother Nature decides to conjure up on a given day, whether that be a persistent grey mist, gale-force winds, or a nasty combination of both. The courses themselves are also a jarring departure from the tree-lined parkland-style courses that dominate the American professional golf landscape. Links golf, as exhibited in the Open, is void of trees and replete with rolling mounds, deep bunkers, and penal natural grasses that punish and often stymie inaccurate shots. In summary, the Open presents a radically different test and set of questions than the other three majors and the typical courses on which tour events are played. Technological advancements in golf equipment and stat tracking devices have created a data revolution within the game. Pros know the yardages that they can hit their clubs to a single yard and can often adjust these yardages for certain variables (wind, turf conditions, etc.) in the relatively benign conditions they face on a week-to-week basis on the tour. Bryson DeChambeau, in particular, exemplifies this data-driven approach that has yielded him two U.S. Open Championships. However, the unpredictable conditions at the Open Championship often render this approach useless, as most obviously displayed in DeChambeau’s score of nine-over-par (+9) for the championship, resulting in a missed cut. On the other hand, there are golfers who not only embrace the volatile conditions presented in the Open but thrive in them. Winners of the Open typically fall into this category because they can conquer unpredictable conditions by understanding that “golf is not a game of perfect” and overcoming the inevitable bad breaks that come with playing links-style golf.With the Open in mind, we considered how family businesses can mirror this approach in today’s ultra-data-rich operating environment, particularly against the backdrop of evolving economic conditions. We believe this thought exercise is prudent given the specter of multiple unknowns looming large in the U.S. economy. Our post from last week highlights several of these unknowns, including the prospect of rate cuts by the Federal Reserve later this year. When times are good and visibility is clear, well-positioned businesses can often go on autopilot, generating robust cash flows and returns on the rising tide of a strong economy. When businesses are presented with operating conditions similar to those in the Open Championship, the uncertainty can make the prospects of generating robust cash flows and returns more precarious. In the following sections, we submit a few practical suggestions for family businesses to successfully navigate the grey mist and pea soup fog of economic uncertainty.Embrace and Amplify Core ValuesDuring times of economic uncertainty, family businesses would be well-served to lean into their core values. Whether these come by way of a mission statement or a set of non-negotiable guiding principles, core values are crafted not only to act as a north star in high times but also as an anchor and ballast in uneven times. Anecdotally, our firm adopted a new mission statement as part of a strategic planning process several years ago. This new mission statement has become so engrained into our firm’s collective mind that it is often the opening slide in any of our internal training presentations. Boards and management teams define an enterprise’s core values for a reason. During operating volatility and economic uncertainty, where results often seem arbitrary regardless of internal processes, these values should be embraced and amplified to ensure that all stakeholders are pulling in the same direction without losing sight of the mission.Exhibit PatienceAs seen again and again throughout history, bad times do not last forever. Golfers who conquer the Open Championship and lift the Claret Jug are acutely in tune with this maxim. The patience to brush off a double bogey resulting from a nasty lie or a bad bounce is one of the most important attributes required to win the Open. Similarly, family business owners should not depart from their core values and management practices in the face of seemingly random results that can manifest themselves in a downturn. More often than not, the ability to patiently grind and stack up “pars” without radically diverging from the plan pays dividends in the end, whether those dividends be in the form of the oldest golf trophy or a robust return to shareholders.Communication and AlignmentIn the face of volatility and uncertainty, the importance of constant communication within a family business is magnified. This communication should flow in all directions—between managers, employees, suppliers, shareholders, and even competitors. Keeping these lines of communication open will ensure that a family business has all the information required to make informed decisions in a changing and dynamic environment.This is not dissimilar to the golfer-caddy relationship, which becomes even more important when playing in volatile conditions like those on display in the Open. Communication between parties not only facilitates the transfer of information between parties but also creates alignment. Alignment regarding a set of values (strategic), course of action (tactical), or internal process (operational) naturally morphs into commitment over time. Commitment to a plan is perhaps the most important lynchpin in hitting a proper golf shot, and this type of commitment often only arises from strong communication and alignment. This chain works through family businesses as well, and keeping the lines of communication open in times of economic uncertainty and volatility is crucial to ensuring that all stakeholders in a family business remain aligned and committed.Current economic uncertainties may have family businesses feeling more like they’re playing in an Open Championship than a routine PGA/LIV tour event. While there are many ways to steer your family business through uneven times, we believe the lessons we’ve prescribed are a good starting point. Feel free to reach out to one of our professionals to discuss further.

What’s “Play”-ing in the DJ Basin?

An Introduction to the Denver-Julesburg Basin

The Denver-Julesburg (“DJ”) Basin is a vast and geologically complex basin marked by sedimentary layering, tectonic shifts, and hydrocarbon generation. Encompassing an area of approximately 20,000 square miles, it stretches across regions of Colorado, Wyoming, Nebraska, and Kansas. Notable within the basin are various fields and geological formations, including the Wattenberg Field, Niobrara, Codell, Greenhorn, Adena Field, Hereford area, and the Redtail Field area.

Independent Trust Company Trends

One of the most frequently ignored sectors in the wealth management industry may be its first cousin, the independent trust industry. While many still associate trust administration with banks, which account for more than 75% of the space, the growing prominence of independent trust companies is capturing the attention of many participants in the investment management community. In this post, we examine current trends impacting independent trust companies.

Supreme Court Upholds Connelly

The primary takeaway from Connelly is that life insurance received at the death of a shareholder is a corporate asset that adds to the value of the company for federal gift and estate tax purposes.

Supreme Court Upholds Connelly

Life Insurance Proceeds and Redemption Obligations in Buy-Sell Agreements

Mild, Medium, or Hot

Will the Fed Cut Interest Rates This Year?

With inflation falling to its lowest level in a year, officials are trying to balance the risk of cutting rates too soon and allowing inflation to persist with the risk of waiting too long and causing unnecessary damage to the job market.

RIA M&A Update: Q2 2024

Following a year where deal volume in the RIA industry nearly matched the all-time high of 2022, RIA M&A activity has cooled in 2024. Fidelity’s May 2024 Wealth Management M&A Transaction Report (most recent available data) listed 86 deals through May 2024, down 17% from the 103 deals executed during the same period in 2023.

June 2024 SAAR

The June 2024 SAAR came in at 15.3 million, a 4.0% drop from last month and a 4.8% drop from June 2023. According to Wards Intelligence, the CDK cyberattack caused a 50,000-unit deficit during June 2024; however, second-quarter sales were still relatively flat (-0.4%) from the second quarter of 2023 as only 11 of 91 days were impacted in the quarter.

Just Released | 2Q24 Exploration & Production Newsletter

Region Focus: Permian

Private Equity Investors Learn What Family Shareholders Have Always Known

Family shareholders bear the risk of illiquidity. So what can family businesses and family shareholders do to manage the burden of illiquidity? Five things come to mind:

Medtech and Device Industry Newsletter - Q2 2024

RIA Market Update: Q2 2024

RIAs underperformed in the second quarter of 2024, with even the largest asset managers facing a decline in stock price in spite of a stronger asset base on which to collect revenue. Despite the price drop, all groups examined experienced growth in fundamentals year-over-year. We explore further in our Q2 2024 Market Update.

The Supreme Court Weighs in on Shareholder Redemptions

The Supreme Court’s Connelly decision is a timely reminder that family businesses and their shareholders need to work together to prepare for possible redemptions. An independent opinion regarding the fair market value of your family business is an essential component in advancing that conversation productively.

July 2024 | Economic Pressure on Commercial Real Estate Sector

Bank Watch: July 2024

In this issue: Economic Pressure on Commercial Real Estate Sector

Middle Market Transaction Update Summer 2024

Middle market M&A activity remained depressed in the first quarter of 2024, although pricing multiples did show signs of improvement relative to 2023 pricing data.

Third Quarter 2024 | Segment Focus: Roads, Bridges, and Highways

Both the residential and non-residential building sectors have enjoyed strong years thus far, with Value Put-inPlace up 4.9% and 5.6% Y-o-Y, respectively, on a seasonally adjusted annual basis. The median sales price of houses sold has further moderated in 2024. Elevated rates and commodity input prices have proved to be strong headwinds for industry activities.

Value Focus: Insurance Industry | Second Quarter 2024

Insurtech leads all sectors in Q2-2024; Market shows strong appetite for insurance IPOs

Value Focus: Insurance Industry | Third Quarter 2024

All four insurance sub-sectors tracked by Mercer Capital outperformed the S&P 500 in the third quarter of 2024.

Medtech and Device Industry Newsletter - Q3 2024

E&P Third Quarter 2024

Appalachian Basin

Appalachian Basin // Appalachian production declined over the last twelve months due to reduced drilling activity, driven by low natural gas prices and high storage inventory.

Transportation & Logistics Newsletter

Third Quarter 2024

BOOKLET | Essential Financial Documents to Gather During Divorce

Mercer Capital has compiled a list of financial documents needed in the divorce process and decoded common financial terms.

The Latest on CDK Global Cybersecurity

Risks Come into Focus after Lurking in the Shadows

As frequent auto conference attendees and sponsors, we discuss trends in the industry with other service providers. In an increasingly digital world, we’ve noted an increase in service providers catering to cybersecurity in a variety of ways. While no dealer gets excited about spending thousands of dollars to mitigate risks rather than grow profits, the CDK Global cyberattack may be a watershed moment for the industry.

New SEC Analysis of Form ADV Data

Insights on RIA Consolidation Trends

A new report published by the SEC reveals that there were approximately 15,400 individual SEC-registered investment advisory firms in 2023, up from about 10,800 in 2013. Deal activity (measured as a percentage of total RIAs) rose from about 0.3% to 1.6% over this time—a dramatic increase, yet not enough to offset new RIA formation. Several factors have contributed to the increase in the number of RIA firms.

Acquisition Premiums Return to the Oil Patch

The shale industry is showing signs of maturity. Some acquisition trends appear to be burgeoning, such as acquisition premiums, more debt, and looser hedging requirements. These portend higher values and perhaps more of an emphasis on longer-term drilling inventory as opposed to nearer-term production metrics. Let us take a quick look at them.

Permian Production Growth Stands Alone

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Permian, Eagle Ford, Haynesville, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, the depth of the reserve, and the cost of transporting the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Permian.

Ken Fisher’s Deal Is Remarkable Because It Isn’t Remarkable

With a proven track record of organic growth like Fisher, 15 times EBITDA seems reasonable, if not cheap. It suggests that Fisher means it when he says he remained in control, and that this wasn’t a minority deal that offered the financial partner many features of control — as we often see happen.

2024 State of Auto Finance

Origination, Delinquency, and Portfolio Trends

In this year’s "2024 State of Auto Finance," we review these themes and lay out new developments and changes in auto finance since this time last year.

How Does a Quality of Earnings Report Differ From an Audit?

A quality of earnings (“QoE”) report and an audit are both essential tools in the business world, but they serve distinct purposes and offer varying insights.Audits are broader and regulatory in nature, whereas QoE analyses are more focused and strategic, catering to the needs of investors and decision-makers who require a deeper understanding of a company’s true financial health and future potential.

5 Reasons Your Financial Projections Are Wrong

Today, we highlight a post written by Travis Harms back in 2019 that focuses on financial projections and the biases that contribute to overly optimistic forecasts. The inspiration for this blog came from Daniel Kahneman, author of Thinking, Fast and Slow and a man whose research in behavioral science changed our understanding of how people think and make decisions. Unfortunately, Mr. Kahneman passed away earlier this year, but the lessons from his legendary work are timeless and still vital for family business directors to consider.

Whitepaper Release: Assessing Earnings Quality in the Investment Management Industry

A thorough QofE analysis plays an important role in evaluating the performance of RIAs. It transcends traditional financial assessments, providing a view of a company’s sustainable earning power by adjusting for nonrecurring items and discretionary expenses and analyzing revenue and cost structures.

WHITEPAPER | Assessing Earnings Quality in the Investment Management Industry

Earnings are a crucial reference point in determining transaction prices negotiated by buyers and sellers of RIA firms. However, reported earnings, even when audited and presented in accordance with Generally Accepted Accounting Principles (GAAP), have limitations. GAAP earnings are backward-looking, reflecting how a business has performed under specific rules in the past. While these historical earnings have their uses, buyers in the RIA industry focus more on the future—what’s visible through the windshield, not the rearview mirror.In this whitepaper, we illustrate how buyers and sellers benefit from a quality of earnings report that extracts a company’s sustainable earning power from the thicket of historical GAAP earnings. We review the most common earnings adjustments applied in QofE analyses and review the role of working capital and capital expenditures as the links between EBITDA and cash flow available to buyers.

May 2024 SAAR

The May 2024 SAAR was just shy of the 16 million mark, coming in at 15.9 million units, generally flat from last month (+0.8%) and reflecting year-over-year growth of 2.5%. Throughout the pandemic years, the auto industry was defined by volatility and uncertainty as inventory levels plummeted and transaction prices skyrocketed. In the first half of 2024, however, we have seen more stability in the SAAR as inventory levels rise and transaction prices moderate.

Large Acquisitions Dominate the Permian M&A Landscape

Transaction activity in the Permian Basin declined over the past 12 months, with the transaction count decreasing 53% to nine deals, a decline from the 19 deals that occurred over the prior 12-month period. This level is also well below the 21 deals that occurred in the 12-month period ended mid-June 2022 and the 27 transactions that closed during the same time period in 2021.

SEC Fairness Opinion Requirement Has Not Slowed GP-Led Secondaries

Rising regulatory burdens contributed to the stunning growth in private equity the last two decades and private credit in recent years. PE investors ultimately require liquidity, however.Subdued M&A and IPO markets since mid-2022 have spurred growth for private equity secondaries, which mostly consists of GP-initiated transactions for continuation funds and LP-initiated transactions for portfolio interests.As shown in Figure 1, secondary transactions rose to $109 billion in 2023 from $102 billion in 2022 based upon data compiled by Lazard as volume soared 57% in 2H23 to $67 billion following depressed activity of about $43 billion in 2H22 and 1H23. Lazard expects secondary volume will improve further in 2024 and 2025 as the investor base for secondaries expands and buoyant markets support narrower bid-ask spreads. The need for LP liquidity also has driven the rise of NAV lending in which the GP arranges for a fund-level loan to fund distributions and/or acquisitions.Figure 1Lazard reports that LP secondaries of buyout funds realized ~88% of NAV whereas LPs realized only ~60% of NAV for interests in funds focused on early stage venture capital assuming NAV was not materially overestimated. LPs averaged 85% for interest in private credit funds, which is less than we would have guessed.LP investors can decide whether it makes sense to transact at a price that is less than NAV and thereby convey to the buyer additional return from investing in an illiquid asset. The LP investor will weigh the cost against the expected return from the current investment, the need for liquidity, and the opportunity to deploy the returned capital in new ventures.GP-led transactions for continuation funds create a corporate governance can of worms because the GP sits on both sides of the transaction as adviser to the fund that is selling an asset and as adviser to the fund that will buy it. LPs can choose liquidity on the terms offered, or they can roll their interest into the continuation fund. Whether a single asset or multi asset investment, presumably the GP is using a continuation vehicle because the exit price for an attractive asset is presently unattractive.The SEC addressed the issue through adopting Rule 211(h)(2)-2 in August 2023 which requires the GP adviser to: (a) obtain a fairness opinion or valuation from an independent valuation firm; and (b) disclose any material business relationships between the GP and opinion provider. Given the increase in GP-led secondaries to $31 billion in 2H23 from $17 billion in 1H23, the SEC governance requirement has not slowed the market.Although not mandated by law, fairness opinions for significant corporate transactions effectively have been required since 1985 when the Delaware Supreme Court ruled in Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985) that directors were grossly negligent for approving a merger without sufficient inquiry. The Court suggested directors could have addressed their duty of care (informed decision making) by obtaining a fairness opinion.The SEC rule takes aim at the corporate duty of loyalty, which with the duty of care and good faith form the triad that underpins the Business Judgement Rule in which courts defer to the decision making of directors provided they have not violated one of their duties. As far as we know, there has been no widespread finger pointing that GP-led transactions have intentionally disadvantaged LPs. Nonetheless, the SEC rule is a regulatory means to address the issue of loyalty.Fairness opinions involve a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed. Due diligence work is crucial to the development of the opinion because there is no bright line test that consideration to be received or paid is fair or not.Mercer Capital has over four decades of experience as an independent valuation and financial advisory firm in valuing illiquid equity and credit, assessing transactions and issuing fairness opinions. Please call if we can be of assistance in valuing your funds private equity and credit investments or evaluating a proposed GP-led transaction.Originally featured in Mercer Capital's Portfolio Valuation Newsletter: Summer 2025

Portfolio Valuation: Private Equity and Credit

Summer 2024

Perhaps it is back to an alternate future as the Dodgers defeated the Yankees in the World Series after losing to the Yankees in 1977, 1978, and 1996.

Mid-Year 2024 Review of the Auto Dealer Industry by Metrics

Tray Tables Up?

In this post, we discuss several key metrics we have tracked in this space over the last several years: new vehicle profitability, the supply of new vehicles, average trade-in equity values of used vehicles, fleet sales, and vehicle miles traveled.

Why Haven’t Higher Interest Rates and Inflation Derailed RIA Dealmaking Activity?

Last year, many RIA industry participants expected a similar cessation to dealmaking in the sector following the adverse impact of higher interest rates and inflation on investment managers’ AUM balances and profitability in 2022. Fortunately for the industry’s bankers, these economic headwinds haven’t derailed the sector’s M&A momentum. Fidelity recently reported 227 deals last year involving RIA sellers with $100 million or more in assets under management, only a 1% decline from 2022 levels.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of June 3, 2024

FASB Provides Clarity on Accounting for Profits Interest Awards Under ASC 718

FASB's issuance of ASU 2024-01 represents a significant step towards enhancing consistency and understanding in accounting for profits interest awards. Clearer guidance and the illustrative example will help entities can make more informed decisions regarding the treatment of these awards, ultimately benefiting stakeholders and investors alike.

Mastering the Dividend Dance

With the competing claims on operating cash flow from the perspectives of the family business and family shareholders, managing dividend expectations can be a delicate dance. Finding and forging consensus on what the family business means to the family can help make sure that everyone is at least dancing to the same tune.

June 2024 | March 2000 vs. June 2024: How Different Is It?

Bank Watch: June 2024

In this issue: March 2000 vs. June 2024: How Different Is It?

Highlights from the 2024 AAML National Family Law Conference

We were proud to sponsor and attend the AAML’s inaugural National Family Law Conference in Nashville, Tennessee on May 16-18, 2024.

Issue No. 13 | Data as of Mid-Year 2024

Feature Articles: Mid-Year 2024 Review of the Auto Dealer Industry by Metrics and Q2 2024 Earnings Calls

Selling Your RIA? Five Ways to Bridge the Valuation Gap

Before parties to an RIA transaction can close, they must first agree on a price. Narrowing that bid/ask spread is tricky, which is often why negotiations between prospective buyers and sellers fail. Buyers and sellers naturally have different perspectives that lead to different opinions on value: Where a seller sees a strong management team, a buyer sees key person risk. “Long-term client relationships” in the eyes of a seller translates to “aging client base” in the eyes of a buyer. When a seller touts a strong growth trajectory, the buyer wonders if that will continue.

What Is the Market Approach and How Is It Utilized for Auto Dealer Valuations?

The market approach enables analysts to determine a value indication by comparing the subject auto dealership to other similar dealerships. These comparable dealerships could be similar in size, geographic location, or, most importantly, franchise.

Is It Time to Eat the Golden Goose?

Even if all the other boxes are checked, is selling the bank’s insurance agency that took 20 years to build the right long-term move? Maybe. Is it shortsighted to sell off the golden goose agency in the name of “balance sheet repositioning”? Maybe not. Every situation and every transaction is unique.

A To-Do List for Evaluating Acquisition Offers

This week, we share a to-do list to help prepare for such offers if and when they come.

Formula Pricing Gone Wrong

What Happens If Your Buy-Sell Agreement Prices Your Firm Too High or Too Low?

Hard to imagine today, but just one year ago, some of the largest prices paid for new cars relative to MSRP were for an EV. The Porsche Taycan, a six-figure ride in any configuration, was commonly selling for 20-25% above sticker. What a difference a year makes. Today, EVs are shunned by many (certainly the press), and Porsche is rushing out a new version of the Taycan for 2025 to address flagging sales. For those who paid premium prices to Zuffenhausen a year ago, the depreciation they’ll experience if they try to trade that year-old Taycan today would be breathtaking. Life’s a gas!Pricing MattersThe backbone of our business at Mercer Capital is valuation, so we have a self-interested bias against formula prices in buy-sell agreements. An independent valuation is, by far, the best way to manage the settlement of transactions between shareholders. Doing so annually has the added benefit of managing everyone’s expectations.Simple is not always betterI’ll concede that annual valuations can be excessive for smaller firms with a few shareholders and transactions that seldom occur. Formula pricing offers a degree of certainty and grounds expectations in what is usually a pretty simple equation. Simple is not always better, however.More often than not, the formula prices we encounter do more harm than good. The simplicity of formula pricing equations means they don’t consider important factors like debt, non-recurring items, loss of key staff or large customers, market conditions, or offers to purchase. Formulas can ground expectations but may set expectations unrealistically low or high, provide a false sense of security, and encourage partner behaviors that do not support the business model.The Object of Transaction PricingIn part, buy-sell agreements offer a mechanism to settle transactions between shareholders when some event forces a transaction. Often the event is many years, if not decades, after the signing of the agreement. Nobody expects to be thrown out of their firm, get divorced, or die — even though we know the former two happen often and, in the case of the latter, happens to everyone. Even retirement is hard to foresee when a firm is in its nascency and crafting a shareholder agreement to handle issues that seem so far off that even the inevitable is irrelevant.Signers to a buy-sell rarely foresee the consequencesAs such, the signers to a buy-sell rarely foresee the consequences of what they’re signing. Many of these consequences involve valuation.If you ask them, most people say they want the pricing mechanism in their shareholder agreement to treat everyone fairly. “Fair” is the first word in Fair Market Value, a standard of value established by the Treasury Department in Revenue Ruling 59-60 and reiterated and expounded upon in professional literature throughout the valuation community.Fair Market Value, generally, is a standard of pricing that considers the usual motivations of typical buyers and sellers, described as hypothetical parties, to distinguish them from the very specific and particular persons involved in a subject matter. The parties to a fair market value transaction are assumed to be funded, informed, and reasonable. Fair market value further assumes an orderly (not forced) transaction, and settlement is on a cash equivalent basis.Most people want something akin to fair market value pricing in a buy-sell agreement, but formulas usually only achieve this by coincidence. Most formulas will either price an interest too high or too low. This creates “winners” and “losers,” depending on who gets the better side of the transaction.When the Formula Price Is Too HighWe often see formula pricing in buy-sell agreements set at what could be called optimistic levels. I suppose this is because these agreements are usually written when firms are first established, too new to evaluate the stabilized economics of the business model when compensation patterns are observable, fee schedules are settled, and margins become regular.Formula pricing commonly relies on rules of thumbFormula pricing commonly relies on rules of thumb that don’t represent the particular economic characteristics of a given RIA’s business model. An example of this would be the old myth that investment management firms were worth 2% of AUM.The 2% rule dates back to the days before wealth management and asset management were well delineated, and money managers commonly earned a realized effective rate of 100 basis points on assets under management. At those fees, a billion-dollar shop could produce pre-tax margins between 25% and 35%. At those margins, 2% of AUM implied a value of 6x to 8x pre-tax net income. At the time, that pricing was reasonable. RIAs were not considered an established money management platform (broker-dealers were still the dominant force), and consolidation activity was minimal. Industry insiders recognized that RIA clients were stickier than those of most professional services firms, so 6x to 8x pre-tax net income was a premium to a more typical 4x-5x for other owner-operator professions.Today, of course, consolidation activity is rampant, and multiples are generally higher. But fees have taken a hit, and not every firm earns a “normal” margin. If realized fees are 60 basis points and margins are 15%, a formula that values the RIA at 2% of AUM looks pretty expensive.There is a very human tendency to get too comfortable with large numbers. Owners like big valuations, even when they aren’t real. And until an event occurs that requires a transaction, people rarely question a robust, if unrealistic, valuation. It’s a game of mental gamma, where everyone hopes imaginary pricing pulls on value like a large block of out-of-the-money call options. It feels good but doesn’t get tested until a triggering event invokes the buy-sell agreement. Then something happens. If a 25% partner in this “Now” RIA passes away unexpectedly, and the buy-sell agreement specifies purchase at 2% of AUM, the transaction price is $5 million. We’re going to posit, for purposes of this post, that the actual fair market value of this interest is 8x-10x pre-tax, the midpoint of which is 9x. At 9x pre-tax, the 25% stake has an implied value of about $2 million. If the RIA is required to purchase the interest pursuant to the formula, they will be paying over 60% of the value of the firm for a 25% stake. The estate “wins,” and everyone else loses. What are the implications of an internal transaction at 22x pre-tax? Let’s assume the buy-sell agreement states the RIA can finance the purchase of the decedent’s interest at SOFR plus 200 basis points (about 7.3% today) over ten years. The annual payment would be nearly $725 thousand, or 80% of pre-tax (a proxy for distributable cash flow). For a decade, 80% of distributions will be claimed by a 25% ownership interest.80% of distributions will be claimed by a 25% ownership interestWe’ve seen this happen, but there are reasons the formula pricing might not hold. Usually, a buy-sell gives the other partners and/or the firm the option to purchase at the formula price but doesn’t require it. In this case, the option is entirely out of the money. In that case, the firm might decide to punt on the option and pay the estate their pro rata portion of distributions ($225K per year, or about $500K less than financing at the formula price). The estate is left as an outside minority owner in a closely held business. If the estate isn’t satisfied with this, the executor will have to negotiate — from a very weak position — with the other partners. In effect, this nullifies the buy-sell agreement.When the Formula Price Is Too LowBuy-sell formulas that undervalue interests are no better than those that overvalue interests. There is no “conservative” or “aggressive” in valuation, only reasonable and unreasonable. If, in the scenario listed above, the formula price specified that the firm was to be valued based on book value, the outcome would be no more favorable.RIAs usually don’t have much balance sheet value. Our valuations in the space rarely employ an asset approach. We consider whether the balance sheet has a normal level of working capital to finance ongoing operations or if it has a material amount of non-operating assets. Beyond that, the balance sheet is rarely more than some cash, leasehold improvements, and short-term payables. Book value for a firm like the one discussed above might be no more than $250K.At book value, that formula would price the decedent’s interest at $62,500 — unreasonable for a stake that was earning over three times that much in annual distributions. The transaction would be highly accretive to the remaining partners, who would share in the distribution stream they got for next to nothing. But the specter of what would happen to their beneficiaries in the event of their deaths would dampen any sense of having won.If this buy-sell formula also applies in the event of retirement or withdrawal from the firm, who would ever leave? It would be very difficult to execute ownership succession for partners who are giving up their distributions in exchange for so little compensation. Of course, without succession, the firm eventually wears out — a circumstance in which book value might be a reasonable measure.What’s Your Aspiration?Ask yourself whether or not you think the pricing of a forced transaction should create “winners” and “losers.” There are legitimate reasons for wanting a somewhat below-market price for transactions because it benefits the ongoing firm and continuing partners. Above-market pricing just creates a race for the exit. But if your formula price is too high and transaction execution is optional, an informed buyer will pass, and you’ll be negotiating as if there were no agreement. Hardly a good solution.If this has prompted you to think about your formula pricing and you’d like to talk specifics to us in confidence, reach out. We work with hundreds of investment management firms like yours to defuse time bombs and create reasonable resolutions. Don’t let your ownership issues disrupt your operations.

Hybrid Vehicles and the Goldilocks Principle

EVs Get the Headlines While Consumers Are Getting Hybrids

In this week's post, we touch on recent developments with electric vehicles and how they are leading to a surge in demand for hybrids.

Themes from Q1 2024 Energy Earnings Calls

Upstream (E&P) and Oilfield Service (“OFS”) Companies

In our prior earnings call post, Themes from Q4 2023 Energy Earnings Calls, we touched on the global focus that both the Upstream and OFS segments had focused on and the persistent drive to optimize efficiency in well operations and services with technological advancements, durable inventory, and more. This week, we explore the Q1 2024 earnings calls of upstream and OFS companies, highlighting the appearance of this quarter’s themes across the entire sector.

How Should Family Businesses Respond to an Acquisition Offer?

Successful businesses don’t have to go looking for potential acquirers—potential acquirers are likely to come looking for them. Most of our family business clients have no intention of selling in the near-term, and yet they often receive a steady stream of unsolicited offers from eager suitors. Many of these offers can be quickly dismissed as uninformed or bottom-fishing, but serious inquiries from legitimate buyers of capacity occasionally appear that require a response.

Are Toxic Cultures the Silent Killers of the Asset Management Industry?

Paul Black, CEO of WCM Investment Management, a $67 billion asset manager headquartered in Laguna Beach, California, provides great insights on the impact of culture on the viability of a money management firm.

Oilfield Water Industry Update, Trends, and the Future

The oilfield water industry (OFW, or midstream water) continues to grow in importance within the general upstream energy industry. So much so that while historically considered part of the Oilfield Services Industry (OFS), midstream water is now considered its own industry within the upstream space, separate from the more general OFS. In this week’s Energy Valuation Insights blog, we explore the current status, trends, and expectations for the future of midstream water.

April 2024 SAAR

The April 2024 SAAR was 15.7 million units, reflecting generally flat month-over-month (+1.1%) and year-over-year (+0.4%) growth. Over the last several months, we have seen more stability in the SAAR than we have seen since the pandemic. This stability will likely give confidence to dealers and consumers alike after years of volatility and uncertainty in transaction prices and vehicle availability. Inventory levels, increased incentive spending, average transaction prices, and per-unit dealer profits will all be discussed later in this post.

Review of Key Economic Indicators for Family Businesses

In this week’s post, we look at recent economic data and the implications of this data regarding the Fed’s monetary policy actions in the coming months.

SilverBow’s Shareholder Brawl

It is an election year, and the battle is on. SilverBow Resources, a publicly traded oil and gas company operating in South Texas’ Eagle Ford shale, is wrapped up in a big conflict with some of its own shareholders. Kimmeridge Energy Management, both a large shareholder and a rival operator in the Eagle Ford, has proposed a merger (which it, at least temporarily, withdrew last month), and now is proposing several new board members in a proxy battle. The primary question centers on the direction of SilverBow’s value enhancement strategy. However, it appears this strategy hinges, in part, on its debt position, and dividend policy. Management has one idea on how this should go; Kimmeridge clearly has another.This clash has arisen from a myriad of circumstances, but it could reasonably be condensed down to two dynamics: leveraged acquisitions in the past few years and the drop in gas prices from their highs in 2022. Since 2021 SilverBow has made several acquisitions. These acquisitions, highlighted by its purchase of Sundance Energy in 2022 and most recently Chesapeake’s Eagle Ford portfolio in the second half of 2023, can be broadly characterized by three things: (i) mostly oil and liquids production driven (a change from their more historically gas heavy portfolio), (ii) purchased at opportunistic prices (SilverBow’s blended acquisition price to flowing barrel metric was approximately $25,000 for its eight deals since the second half of 2021 compared to other publicly traded oil and liquids tilted Eagle Ford producers such as Magnolia and SM Energy who both trade for over $40,000 per flowing barrel), and (iii) mostly funded with debt.The good news for SilverBow is that oil and natural gas liquids tend to be higher-margin products than gas right now, and SilverBow’s EBITDA margin was relatively high (79%) to show for it. By contrast, Comstock Resources, a pure-play gas producer in the Haynesville Shale, has had its margin battered by low gas prices in 2023. Through these acquisitions, SilverBow has shifted its production mix significantly and it creates optionality to drill for oil and liquids during periods of low gas prices. Although SilverBow is still producing relatively more gas than its Eagle Ford peers such as SM Energy, Magnolia, or EOG it is now much more liquids-driven than in recent years. In addition, funding with debt is usually cheaper than equity, so it offers a leveraged return opportunity for shareholders. However, the trade-off is that too much debt can be risky. SilverBow used to be Swift Energy but filed bankruptcy in 2015 and restructured after the collapse of oil prices, so it has a history of too much debt in the capital structure at the wrong time. This is worrisome to investors and it can tamp down on equity value. Equity markets for the upstream sector have frowned on heavy debt loads for several years now in the wake of bankruptcies after 2014.How Much Debt Is Too Much Debt?What defines a heavy debt load? It depends. The ratio of debt to EBITDA is cited often in the industry. These days at or below a 1.0x ratio is what companies frequently aim for, SilverBow included. However, there is not a definitive answer to the question. From a capital structure perspective, SilverBow has a higher debt-to-equity market capitalization percentage than the companies listed below that have varying similarities to SilverBow: Kimmeridge has criticized SilverBow for taking on this much debt and offered to inject cash to pay it down in its now-abandoned merger proposal. Management has countered with its position that the value and optionality it received in its acquisitions will allow the company to reap high margins and cash flow to accelerate debt repayment and eventually get to that 1.0x debt ratio by the end of 2025. Kimmeridge seems to believe that if SilverBow de-levers more quickly, then the stock price will rise more quickly. This is logical, but that would require selling equity or assets or both.Dividends MatterDividends have been a big trend in the oil and gas industry. Investors have pined for oil and gas companies to pay dividends for many years now. Growth and reinvestment have been curtailed in favor of direct shareholder returns in the form of stock buybacks and more importantly, dividends. SilverBow does not pay a dividend. Most publicly traded peers do. Companies that pay a dividend tend to have higher multiples as well. Kimmeridge has pointed this out and also proposed a dividend in their merger proposal. However, adding a dividend is not a guarantee of a value boost. Comstock Resources suspended its dividend early in 2024, and its stock has gone up significantly since then. However, it is also a gas producer only, which has hamstrung it in a cash burn position so far in 2024. SilverBow’s shift towards liquids has buoyed its cash flow.Value Now Or Value Later?The market has shown skepticism from a valuation standpoint of SilverBow’s acquisition appetite over the past few years. As such its valuation metrics lag almost everyone in this group in a meaningful way:It is notable that although SilverBow is increasingly liquids-driven and has excellent margins, its valuation multiples still lag this group. Even Vital Energy, which also has a lot of debt and doesn’t pay a dividend either, has superior metrics. If SilverBow lowers risk by de-levering to industry norms, the equity value may be rewarded. But when? It may be over a year before that happens. A lot can happen between now and then. Kimmeridge does not want to wait. It wants policy changes now. Management has pointed to strong cash flow and results above expectations so far in 2024 as proof that its strategy is working. Management is skeptical of Kimmeridge’s intentions. They believe Kimmeridge’s end game is to force a dilutive transaction with Kimmeridge Texas Gas. Both sides want a higher stock price. Which one presents the better path to get there remains to be seen and will come down to what the shareholders decide.Originally appeared on Forbes.com.

One Dealer Is Not Like the Other

Independent Dealers Industry Segment Highlight

This week, we highlight the auto dealer market: independent dealers.

Internal Transactions Are Still an Option for RIAs

With a constant stream of headlines about M&A and near-daily inquiries from prospective acquirers, it’s easy for RIA owners to get the impression that external transactions are the norm.

The Case for Research and Development

A Case Study of Innovation and Taxes

No family business can be successful over generations without innovation. Consistent investment in research and development is at the heart of many family business breakthroughs. Like any investment, R&D spending consumes family capital today in the expectation of generating more cash flow in the future.

The Inside “SCOOP”

The SCOOP/STACK is a significant oil and gas play found in the Anadarko Basin of Oklahoma. The “SCOOP” part of the name refers to “South Central Oklahoma Oil Province,” and “STACK” is an abbreviated geographic description: the Sooner Trend oil field, the Anadarko basin, and the Canadian and Kingfisher counties.

Should You Accept Rollover Equity?

Road to Riches or “Worst Idea Ever”

Rollover equity is neither inherently good nor bad. It makes pricing a deal a little more challenging, and it requires sellers (i.e., investors in the rollover equity) to do considerable due diligence on prospective buyers — not something we see everyone doing. Like choosing a car to leave one’s wedding, sometimes the option that looks attractive ahead of time can ultimately lead to some discomfort. If someone offers you their equity in exchange for yours, give us a call. Make sure you don’t opt for the “worst idea ever.”

The Noncompete Agreement Is Dead, Long Live the Noncompete Agreement

The FTC Wants to Ban Noncompete Agreements but They Will Likely Endure in Certain Circumstances

Your Family Business Is on the Clock – Are You Ready?

Having a plan for when succession becomes a reality is imperative for continuing on-the-field success. If an unforeseen event occurs, you will have a strategy in place to determine how the business will operate moving forward. While you cannot plan for a devastating injury to your starting quarterback, you can have the framework for how to respond to such an event.

May 2024 | Is It Time to Eat the Golden Goose?

Bank Watch: May 2024

In this issue: Is It Time to Eat the Golden Goose?

What to Look for in a Purchase Price Allocation

Financial Reporting Flash: Issue 5, 2024

What to Look for in a Purchase Price Allocation

Essential Financial Documents to Gather During Divorce – Part 4

Documents Needed to Perform Forensic Analysis

Now Could Be a Great Time for Bank Investors to Consider Estate Planning

It may be an opportune time for bank investors to consider estate planning opportunities. Rising inflation has been top of mind for business owners and bankers (and everyone for that matter) over the last few years.While inflation has decelerated from its peak, business owners, bankers, and investors are adjusting to the new higher for longer interest rate environment.Higher inflation and interest rates have affected every business with few exceptions. All else equal, higher interest rates will negatively affect business value as higher discount rates are used to bring future cash flows to the present. In some industries though, inflation-driven increases in earnings or revenue growth expectations have offset (or even outweighed) the negative impact of higher interest rates.However, not all industries have been immune to pressure from higher interest rates and inflation on the value of their shares. Banking is one of several industries that have underperformed broader market indices as investors remain skeptical of the “new normal” and impact of the rate environment on banks’ cost of funds and net interest margins.As shown in the following tables, small and mid cap public bank stocks have underperformed broad market indices, and valuation multiples (as measured by P/E and P/TBV) remain below long-term historical averages.While it remains uncertain when the interest rate easing cycle will begin, the easing cycle will likely also have divergent outcomes for different industries. At this point between cycles and with bank valuation multiples below long-term averages, it is important to consider the potential opportunity to favorably transfer business value to future generations.A second reason to consider estate planning transactions in the current environment is issues on the tax and policy front.The Tax Cuts and Jobs Act enacted in December 2017 doubled the basic exclusion amounts individuals could give away without paying estate taxes. The sunsetting of this provision on December 31, 2025 and the potential for lower exclusion amounts thereafter and higher estate taxes, makes considering transfers all the more important.The combination of lower bank stock valuations combined with sunsetting favorable estate tax provisions make 2024 a worthwhile year for bank investors to consider estate planning strategies.Many strategies will require a current valuation of your bank, and our professionals are here to help.Originally appeared in the April 2024 issue of Bank Watch.

The Beginning of a Bakken Behemoth

Chord Energy and Enerplus

In a significant development for the energy industry, on February 21, 2024, Chord Energy Corporation and Enerplus Corporation announced a definitive agreement to merge. This strategic combination aims to create a powerhouse in the Williston Basin, leveraging their complementary strengths and operational expertise.

What to Look for in a Quality of Earnings Provider for RIA Transactions

A Quality of Earnings (or QofE) analysis is an essential component of transaction diligence for both buyers and sellers. Optimizing your transaction diligence requires assembling the right team. In this post, we discuss five things RIA buyers and sellers should look for when evaluating potential QofE providers.

What Is the Income Approach and How Is It Utilized for Auto Dealer Valuations?

The income approach is based on capitalizing future expected cash flows using estimates of risk and growth specific to the subject dealership. This analysis is incredibly important for auto dealerships due to the expected future cash flows of most dealerships being the primary driver of value.

What to Look for in a Quality of Earnings Provider

In this article, we discuss four things buyers and sellers should look for when evaluating potential QofE providers.

What to Look for in a Quality of Earnings Provider

The cost of corporate M&A failures is high for both buyers and sellers. In this article, we discuss four things buyers and sellers should look for when evaluating potential QofE providers.

Navigating Change in the Family Business

2024 Transitions Conference Recap

Mercer Capital had the opportunity to sponsor and attend Family Business Magazine’s 2024 Transitions Spring Conference in sunny Tampa, Florida. As always, the team at Family Business Magazine did a great job organizing and hosting the gathering of a few hundred representatives from nearly 90 successful enterprising families.

Market Resilience: Asset Managers Thrive Amidst Economic Volatility in 2023

Despite persistent inflation, elevated interest rates, and heightened geopolitical tensions, the asset management industry and the stock market as a whole saw a resurgence during 2023. Our index of publicly traded asset management firms generally tracked the movement in the broader market, with stock prices for smaller asset managers (AUM under $250 billion) up 30.3% and large asset managers (AUM over $250 billion) up 22.0% over the year ended March 31, 2024, while the broader market (S&P 500) was up 29.9%.Fund FlowsWhile market movement is often the dominant contributor to AUM changes over a particular period, it’s a variable that’s largely outside a manager’s control. On the other hand, organic growth can be influenced by the quality of a firm’s marketing and distribution efforts and can be a real differentiator between asset management firms over longer periods.Many asset managers have struggled with organic growth in recent years, partly due to rising fee sensitivity and the influence of passively managed investment products. This year proved no different, with our index of publicly traded asset/wealth management companies seeing $103 billion in aggregate net outflows, compared to aggregate net outflows of $62 billion in 2022.As expected, considering the performance of the stock and bond markets over the past year, market movement was the primary driver of the change in AUM, accounting for $551 billion additional AUM for the index during 2023. During the challenging market conditions of 2022, the index saw an aggregate $922 billion decrease in AUM due to market movement.Click here to expand the image aboveOutflows from Active Funds AccelerateWhile asset managers saw net outflows over the past twelve months, there were significant variances between active and passively managed funds. Fund flow data from Morningstar (table below) shows that total outflows across active funds for the year ended March 31, 2024, were approximately $377 billion. The aggregate outflows over the past year were most severe for U.S. equity, allocation, and international equity, with these asset classes shedding a combined $427 billion in assets. All categories of actively managed funds except alternative investments, taxable bonds, alternatives, and nontraditional equities saw net outflows over the past year.On the other hand, passively managed funds continued to outpace active funds in terms of net new assets over the past twelve months. The Morningstar data shows that total inflows across passively managed funds for the year ended March 31, 2024, were approximately $621 billion, with all asset classes except commodities and miscellaneous assets reporting positive net inflows.Click here to expand the image aboveAs you can see from the following chart, there has been a trend over the past ten years of investors moving from active to passive funds, and this trend accelerated with the market downturn in 2022. The relative underperformance of active managers, when compared to their benchmarks over the past ten years, has driven investors to low-fee passive funds. This trend will likely continue to pose a challenge for many types of active asset managers in attracting new assets.Click here to expand the image aboveOutlookThe outlook for asset managers depends on several factors. Investor demand for a particular manager’s asset class, recent relative performance, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets.With inflation starting the year higher than expected, it remains to be seen if the Fed will be able to implement the rate cuts that many investors expect to come during 2024. With the prospect of interest rates remaining higher for longer, persistent inflation, and geopolitical tensions, there is much uncertainty in the market heading into 2024. Despite these challenges, the industry enters 2024 with higher starting AUM levels, offering a potential boost to revenues and earnings. Navigating these uncertain times requires a proactive approach to capitalize on emerging opportunities and mitigate risks effectively.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

Just Released | 1Q24 Exploration & Production Newsletter

Region Focus: Eagle Ford

2024 NADC Conference Key Takeaways

In this post, we provide a brief list of takeaways from a few of the sessions we attended at this year’s conference. We believe the topics we cover are especially important for auto dealer counsel and their clients to watch during the remainder of the year and beyond.

Spring M&A Update for Family Businesses

Following up on our post from a couple of weeks ago regarding the acquisition of SRS Distribution by Home Depot, we provide a brief update on private M&A markets in this week’s post.

RIA M&A Update: Q1 2024

Following a year where deal volume in the RIA industry nearly matched the all-time high of 2022, RIA M&A activity cooled in the first quarter of 2024. Fidelity’s March 2024 Wealth Management M&A Transaction Report listed 50 deals through March 2024, down 29% from the 70 deals executed during the same period in 2023. RIA deal activity experienced a greater decline than the broader M&A market. The number of M&A transactions for all industries (excluding the RIA industry) decreased 9% year-over-year through the first quarter of 2024 (per Bloomberg), compared to a decline of 29% in the RIA industry. Despite the decline in the total number of deals, there was a significant uptick in total transacted AUM during 2024. Total transacted AUM through March 2024 was $139.2 billion—a 63% increase from the same period in 2023. The average AUM per transaction during the first quarter of 2024 was $2.8 billion, a 128% increase over the prior year. The increase in deal size has been an encouraging sign, given the rise in the cost of capital over the past two years. The growth in deal size resulted from the completion of several large transactions during the first quarter of 2024, coupled with the overall increase in AUM levels due to market performance. Per Echelon’s RIA M&A Deal Report, “This elevated number of larger transactions, in light of buyers facing a higher cost of capital and economic uncertainty, demonstrates buyer resilience and likely indicates that $1BN+ deal activity will increase to 2021 levels or higher once macroeconomic headwinds, namely higher interest rates subside.” Another contributor to the increase in deal size has been RIAs partnering with private equity firms. According to Fidelity’s March 2024 Wealth Management M&A Transaction Report, private equity backing was involved in 88% of the transactions in March. Per Echelon’s RIA M&A Deal Report, “Another driver of deal size was the heightened creativity in deal structures, adopted by private equity firms seeking to get deals across the finish line in the face of higher borrowing costs. Structured minority investments, with features such as paid-in-kind and preferred distribution rights, have become more popular in the largest transactions, especially those involving sellers with more than $10 billion in assets.”Noteworthy transactions backed by private equity include Caprock’s acquisition of Grey Street Capital, Mariner Wealth Advisor’s purchase of Fourth Street Performance Partners, and Hightower’s acquisition of Capital Management Group of New York.The prevalence of serial acquirers and aggregators has continued in the RIA M&A market. In recent years, the professionalization of the buyer market and the entrance of outside capital have driven demand and increased competition for deals. Serial acquirers and aggregators have increasingly contributed to deal volume, supported by dedicated deal teams and access to capital. Such firms accounted for approximately 70% of transactions during the first quarter of 2024. Mercer Advisors, Miracle Mile Advisors, and Allworth Financial completed multiple deals during the fourth quarter.Deal activity has also been supported by the supply side of the M&A equation, as the impetus to sell is often based on more than market timing. Sellers are often looking to solve succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment and will likely continue to fuel the M&A pipeline even during market downturns.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has trended upwards in recent years, leaving you more exposed to underperformance. Structural developments in the industry and the proliferation of capital availability and acquirer models will likely continue to support higher multiples than the industry has seen. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth than their broker-dealer counterparts and other diversified financial institutions.For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios, where valuation considerations are top of mind. Internal transactions don’t occur in a vacuum, and the same factors driving consolidation and M&A activity have influenced valuations in internal transactions as well. As valuations have increased, financing in internal transactions has become a crucial secondary consideration where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and, in some instances, may still be the best option). Still, an increasing amount of bank financing and other external capital options can provide selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling: Whatever the market conditions are when you go to sell, it is essential to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a broad spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for varying levels of autonomy post-transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision that can significantly impact personal and career satisfaction after the transaction closes.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

March 2024 SAAR

The March 2024 SAAR was 15.5 million units, a 1.3% decrease from last month and a 3.7% increase compared to this time last year. The year-over-year sales improvement, along with declining transaction prices and generally flat inventory levels, may indicate that the industry is reverting to pre-pandemic trends.

Oil & Gas Roadblocks: Prices, Production, and People Holding Sway

There are always going to be barriers to success in an industry. Barriers to entry, barriers to growth, barriers to profitability, and barriers to progress can lurk to name a few. The upstream industry has its share. For gas, its own oversupply and low prices are an issue. For oil, capital constraints are reining in investment. Both commodities also thirst for quality labor to fuel growth and longer-term underlying optimism, but that workforce does not exist right now and may take a while to develop.

The Green Jacket Guide to Family Business Surveys

What Can We Learn from the Masters?

Bringing together a group of any size is undoubtedly challenging, but nothing a little time and planning cannot fix! The Masters has maintained a focus on the long game by building traditions and interest in the game itself. Family businesses are in the unique position to do the same by cultivating a deeper sense of engagement and legacy among the shareholder base.

RIA Market Update: Q1 2024

With Valuations Up, Investor Interest Moves to Alts and Big-Name Managers

Share prices for most publicly traded asset and wealth management firms trended upward with the broader market during the first quarter of 2024. Alternative asset managers continued to outperform the market and other RIAs, ending the quarter up about 12.6%. On a year-over-year basis, all sectors of RIAs experienced growth as the markets rebounded from the 2022 slump. RIAs directly benefit from improving market conditions as they result in a stronger asset base on which to collect fees.Performance by SectorThe market uptick in Q1 translated to increased share prices for most public RIAs. Prices for alternative investment managers experienced a stronger increase than the S&P 500, increasing by 12.6% compared to the S&P’s 10.6%. Both larger RIAs (AUM over $250 billion) and smaller RIAs (AUM under $250 billion) lagged the S&P 500, seeing price increases of 4.3% and 10.3%, respectively, during the quarter.Pricing TrendsThe median Enterprise Value to LTM EBITDA multiples for public RIAs increased modestly during Q1. Smaller RIAs had the strongest increase at 5.4% during the quarter. Alternative asset managers saw a 2.4% increase and larger RIAs saw an increase of 0.3%. After trending downwards for the first three quarters of 2023, multiples began to increase during the fourth quarter of 2023 and into the first quarter of 2024.Growth TrendsOn a year-over-year basis, all sectors of RIAs experienced growth in AUM as the markets rebounded from the 2022 slump. The largest increase came from larger RIAs, which had a median increase in AUM of 13.3% over the past year. The second largest increase in AUM came from smaller RIAs which had a median increase in AUM of 10.8%. This was followed by alternative asset managers, which had a 7.7% increase in AUM over the past year. Revenue growth lagged AUM growth for all groups, reflecting lower effective realized fee levels. Both the larger (>$250B AUM) and smaller (<$250B AUM) groups of traditional asset managers reported negative EBITDA growth.Growth in AUM for the smaller RIA group ranged between 4.6% (Westwood Holdings Group) and 22.1% (Wisdom Tree). For the Larger RIA group, AUM growth was between 3.4% (Affiliated Managers Group) and 16.6% (Janus Henderson Group).Most RIAs experienced organic AUM outflows during the twelve months ending March 31, 2024. These organic outflows were offset by market growth, which led to a net AUM increase for all RIAs we measured.For the smaller RIA group, revenue growth ranged from negative 6.5% (Diamond Hill) to 21.0% (Westwood Holdings). Revenue growth for larger RIAs was between negative 8.1% (Affiliated Managers Group) to 7.1% (Federated Hermes).For the smaller RIA group, EBITDA growth ranged from negative 36.1% (Diamond Hill) to 48.1% (WisdomTree). EBITDA growth for larger RIAs was between negative 25.8% (Invesco) to 7.6% (Federated Hermes).

5 Reasons Upstream Sellers Need a Quality of Earnings Report

Apart from a number of headline deals, M&A activity was sidelined for much of 2022 and 2023. But needing to replenish a depleting asset base with quality mineral acreage, stabilizing interest rates, and pent-up M&A demand are expected to compel buyers and sellers to renew their efforts in 2024 and beyond.As deal activity recovers, sellers need to be prepared to present their value proposition in a compelling manner. For many sellers, an independent Quality of Earnings (“QofE”) analysis and report are vital to advancing and defending their asset’s value in the marketplace. And it can be critical to the ensuing due diligence processes buyers apply to targets.The scope of a QofE engagement can be tailored to the needs of the seller. Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business. The process can encompass both the financial and operational attributes of the business model.In this article, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses or assets to market.1. Maximize value by revealing adjusted and future sustainable profitability.Sellers should leave no stone unturned when it comes to identifying the maximum achievable cash flow and profitability of their assets. Every dollar affirmed brings value to sellers at the market multiple. Few investments yield as handsomely and as quickly as a thorough QofE report. A lack of preparation or confused responses to a buyer’s due diligence will assuredly compromise the outcome of a transaction. The QofE process includes examining the relevant historical period (say two or three years) to adjust for discretionary and non-recurring income and expense events, as well as depicting the future (pro forma) financial potential from the perspective of likely buyers. The QofE process addresses the questions of why, when, and how future cash flow can benefit sellers and buyers. Sellers need this vital information for clear decision-making, fostering transparency, and instilling trust and credibility with their prospective buyers.2. Promote command and control of transaction negotiations and deal terms.Sellers who understand their objective historical performance and future prospects are better prepared to communicate and achieve their expectations during the transaction process. A robust QofE analysis can filter out bottom-dwelling opportunists while establishing the readiness of the seller to engage in efficient, meaningful negotiations on pricing and terms with qualified buyers. After core pricing is determined, other features of the transaction, such as working capital, assumption of asset retirement obligations, thresholds for contingent consideration, and other important deal parameters, are established. These seemingly lower-priority details can have a meaningful effect on closing cash and escrow requirements. The QofE process assists sellers and their advisors in building the high road and keeping the deal within its guardrails.3. Cover the bases for board members, owners, and the advisory team and optimize their ability to contribute to the best outcome.The financial and fiduciary risk of being underinformed in the transaction process is difficult to overcome and can have real consequences. Businesses can be lovingly nurtured with operating excellence, sometimes over generations of ownership, only to suffer from a lack of preparation, underperformance from stakeholders who lack transactional expertise, and underrepresentation when it most matters. The QofE process is like training camp for athletes — it measures in realistic terms what the numbers and the key metrics are and helps sellers amplify strengths and mitigate weaknesses. Without proper preparation, sellers can falter when countering an offer, placing the optimal outcome at risk. In short, a QofE report helps position the seller’s board members, managers, and external advisors to achieve the best outcome for shareholders.4. Financial statements and tax returns are insufficient for sophisticated buyers.Time and timing matter. A QofE report improves the efficiency of the transaction process for buyers and sellers. It provides a transparent platform for defining and addressing significant reporting and compliance issues. There is no better way to build a data set for all advisors and prospective buyers than the process of a properly administered QofE engagement. This can be particularly important for sellers whose level of financial reporting has been lacking, changing, outmoded due to growth, or contains intricacies that are easily misunderstood.For sellers content to work their own deals with their neighbors and friendly rivals, a QofE engagement can provide some of the disciplines and organization typically delivered by a side-side representative. While we hesitate to promote a DIY process in this increasingly complicated world, a QofE process can touch on many of the points that are required to negotiate a deal. Sellers who are busy running their businesses rarely have the turnkey skills to conduct an optimum exit process. A QofE engagement can be a powerful supporting tool.5. In one form or another, buyers are going to conduct a QofE process – what about sellers?Buyers are remarkably efficient at finding cracks in the financial facades of targets. Most QofE work is performed as part of the buy-side due diligence process and is often used by buyers to adjust their offering price (post-LOI) and design their terms. It is also used to facilitate their financing and satisfy the scrutiny of underlying financial and strategic investors. In the increasing arms race of the transaction environment, sellers need to equip themselves with a counteroffensive tool to stake their claim and defend their ground. If a buyer’s LOI is “non-binding” and subject to change upon the completion of due diligence, sellers need to equip themselves with information to advance and hold their position.ConclusionThe stakes are high in the transaction arena. Whether embarking on a sale process or responding to an unsolicited inquiry, sellers have precious few opportunities to set the tone. A QofE process equips sellers with the confidence of understanding their own position while engaging the buy-side with awareness and transparency that promotes a more efficient negotiating process and the best opportunity for a favorable outcome. If you are considering a sale, give one of our senior professionals a call to discuss how our QofE team can help maximize your results.

Just Released: Year-End 2023 Auto Dealer Industry Newsletter

We are pleased to release our latest edition of Value Focus: Auto Dealer Industry Newsletter. The newsletter features industry data from year-end 2023. Additionally, this issue includes two timely articles: "Q4 2023 Earnings Calls" and "No Soup for You: Lessons from Seinfeld on Customer Lifetime Value and Brand Loyalty in the Auto Industry."

Home Depot Announces SRS Distribution Acquisition

An M&A Case Study

Home Depot’s recent announcement that it was acquiring roofing and construction material distributor SRS Distribution may signal the return of more robust deal activity. Even if your family business has nothing to do with construction materials, there is plenty to note in this deal.

April 2024 | Now Could Be a Great Time for Bank Investors to Consider Estate Planning

Bank Watch: April 2024

In this issue: Now Could Be a Great Time for Bank Investors to Consider Estate Planning

FASB Provides Clarity on Accounting for Profits Interest Awards Under ASC 718

Financial Reporting Flash: Issue 4, 2024

In March 2024, the Financial Accounting Standards Board (FASB) issued ASU 2024-01, which clarifies the accounting treatment of profits interest awards.

Essential Financial Documents to Gather During Divorce – Part 3

Documents Needed to Perform a Business Valuation

Middle Market Transaction Update Spring 2024

Although middle market transaction activity remained depressed in the fourth quarter of 2023 compared to 2022, M&A activity and multiples improved a bit compared to recent quarters. Possible Fed rate cuts, an economy that has remained resilient in spite of 525bps of rate hikes by the Fed, and ample dry powder held by PE firms to deploy may be the catalysts for a stronger rebound in 2024.

Second Quarter 2024 | Segment Focus: Building Materials

Residential construction has seen a Q-o-Q increase of 3.6% in value put in place on a seasonally adjusted annual rate basis. The median sales price of houses sold has continued to stabilize following sharp increases in 2021 and 2022. Elevated rates and commodity input prices have proved to be strong headwinds for industry activities.

E&P Second Quarter 2024

Permian

Permian // Permian production growth over the past year was a positive outlier among the four basins covered in our analysis, with Eagle Ford, Appalachia, and Haynesville all posting production declines (albeit Appalachia’s decline being insignificant at 0.3%).

Transportation & Logistics Newsletter

Second Quarter 2024

The level of domestic industrial production directly impacts demand for transportation services.

The Benefits of a Quality of Earnings Analysis for E&P Companies

For buyers and sellers, the stakes in a transaction are high. A QofE analysis is an essential step in getting the transaction right.

Revenue Share Transactions: Considerations for RIAs

As outside capital for RIAs has become increasingly available, so too has the opportunity set for RIAs interested in pursuing minority transactions. One of the structures that’s emerged for minority transactions is that of the revenue share.

Public Auto Dealer Profiles: Group 1 Automotive

We talk a lot about the differences between most privately held and publicly traded auto dealers. Scale, diversification, and access to capital make the business models different, even if store and unit-level economics remain similar. Public auto dealers provide insight into how the market prices their earnings, the environment for M&A, and trends in the industry.

2024: Five Trends to Watch in the Medical Device Industry

Medical Devices OverviewThe medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems.Medical devices range from simple tongue depressors and bandages to complex programmable pacemakers and sophisticated imaging systems.Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices.The U.S. elderly population (persons aged 65 and above) totaled 60 million in 2023 (18% of the population).The U.S. Census Bureau estimates that the elderly will number 92.7 million by 2065, representing more than 25% of the total population.U.S. Population Distribution by Age GroupThe elderly account for nearly one third of total.Personal healthcare spending for the population segment was approximately $22,000 per person in 2020, 5.5 times the spending per child (about $4,000) and more than double the spending per working-age person (about $9,000).U.S. Population Distribution by AgeU.S. Healthcare Expenditure by AgeSource: U.S. Census Bureau, Centers for Medicare and Medicaid Services, Office of the Actuary, National Health Statistics GroupAccording to United Nations projections, the global elderly population will rise from approximately 808 million (10% of world population) in 2022 to 2.0 billion (19.4% of world population) in 2065.Europe’s elderly made up 20% of the total population in 2022, and the proportion is projected to reach 31% by 2065, making it the world’s oldest region.Latin American and the Caribbean is currently one of the youngest regions in the world, with its elderly at 9% of the total population in 2022, but this region is expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand to 25% of the total population by 2065.North America has an above-average elderly population as of 2022 (17%) and is projected to expand to 27% by 2065.World Population 65 and Over (% of Total)Click here to expand the image above2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $4.4 trillion in 2022 to $7.2 trillion in 2031, an average annual growth rate of 5.5%.This projected average annual growth rate is slightly higher than the observed rate of 5.1% between 2013 and 2021, suggesting some acceleration in expected spending. Projected growth in annual spending for Medicare (7.5%) and Medicaid (5.0%) is expected to contribute substantially to the increase in national health expenditure over the coming decade.Growth in national healthcare spending, after significant growth in 2020 of 10.2%, slowed to 2.7% in 2021. Healthcare spending as a percentage of GDP is expected to increase from 18.3% in 2021 to 19.6% by 2031.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures.Medicare currently provides healthcare benefits for an estimated 65 million elderly and disabled people, constituting approximately 10% of the federal budget in 2021.Spending growth is expected to average 7.8% from 2025 to 2031.The program represents the largest portion of total healthcare costs, constituting 21% of total health spending in 2021 and 10% of the federal budget.Medicare accounts for 26% of spending on hospital care, 26% of physician and clinical services, and 32% of retail prescription drugs sales.U.S. Healthcare Consumption Payor Mix and as % of GDPAverage Spending Growth Rates, Medicare and Private Health InsuranceDue to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Medicare spending totaled $944.3 billion in 2022 and is expected to reach $1.8 trillion by 2031.The Inflation Reduction Act (“IRA”) was signed into law on August 16, 2022 by the Biden administration.Among other items, the IRA aims to lower prescription drug costs and improve access to prescription drugs for Medicare enrollees.Two healthcare spending-related items in the IRA include out-of-pocket caps for insulin products (capped at $35 for each monthly subscription under Part D and Part B) and a $2,000 out-of-pocket annual spending cap for drugs under Medicare Part D.These provisions could have significant effects on the growth rates for out-of-pocket spending for prescription drugs, which are projected to decline by 5.9% and 4.2% in 2024 and 2025, respectively.3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients).In most developed economies, the consumers themselves are one step (or more) removed from interactions with manufacturers, and, therefore, pricing of medical devices.Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used).Accordingly, medical device purchasing decisions tend to be largely disconnected from price.Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs.Hospitals are the largest market for medical devices.Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting 1) higher standards to evaluate the benefits of new procedures and devices, and 2) a more disciplined price bargaining stance.The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency.In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively.A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 48.9% of (traditional) Medicare payments were tied to Category 3 and 4 APMs in 2022, compared to 40% in 2021 and 35.8% in 2018.In 2020, CMS released guidance for states on how to advance value-based care across their healthcare systems, emphasizing Medicaid populations, and to share pathways for adoption of such approaches.CMS states that value-based care advances health equity by putting focus on health outcomes of every person, encouraging health providers to screen for social needs, requiring health professionals to monitor and track outcomes across populations, and engaging with providers who have historically worked in underserved communities. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face similar increasing healthcare costs.A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices.Industry participants are required to report manufacturing costs, and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil.Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.4. Competitive Factors and Regulatory RegimeHistorically, much of the growth of medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients.Successful product development usually requires significant R&D outlays and a measure of luck.If viable, new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments.First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period.Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations.Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization.For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S.The 510(k) clearance process may occasionally require clinical data and generally takes between 90 days and one year for completion.In November 2018, the FDA announced plans to change elements of the 510(k) clearance process.Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 10 years.In early 2019, the FDA announced an alternative 510(k) program to allow medical devices an easier approval process for manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria. In February 2020, the FDA launched its voluntary pilot program: electronic Submission Template and Resource (eSTAR) as an interactive submission template that may be used by the medical device submitters to prepare certain pre-market submissions for a device.Starting in October 2023, all 510(k) submissions were required to be submitted using eSTAR unless exempted.The premarket approval (“PMA”) process is more stringent, time-consuming, and expensive.A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical, and manufacturing data.Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days.However, the process typically takes significantly longer and may require several years to complete.Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval.The current iteration of the Medical Device User Fee Act (MDUFA V) came into effect in October 2022.Under MDUFA V, the FDA is authorized to collect $1.8 billion in user fee revenue for the five-year cycle, an increase from the approximately $1 billion in user fees under MDUFA IV, between 2017 and 2022.A significant change from MDUFA IV to MDUFA V relates to performance goals for De Novo Classification requests (requests for novel medical devices for which general controls alone provide reasonable assurance of safety and effectiveness for the intended use). There has also been updated PMA guidance, with the FDA conducting substantive reviews within 90 calendar days for all original PMAs, panel-track supplements, and 180-day supplements.Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations.Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the European Union: Regulation (EU 2017/745), also known as the European Union Medical Device Regulation (EU MDR).The regulation was published in 2017, replacing the medical device directives regulation that was in place since the 1990s.The requirements of the MDR became applicable to all medical devices sold in the EU as of May 26, 2021.The EU is the second largest market for medical devices in the world with approximately €150 billion in sales in 2022, only behind the United States. The EU MDR has introduced stricter requirements for medical device manufacturers, including increased clinical evidence and post-market surveillance. Consequently, there is an increased risk for longer approval processes and delays in manufacturing of these devices.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations.According to the WHO, middle income countries, such as China, Turkey, and Peru, among others, are rapidly converging towards outsized levels of spending as their income scales.When countries grow richer, the demand for health care increases along with people’s expectation for government-financed healthcare.Upper-middle income countries accounted for 16.6% of total global healthcare spending in 2021, up from 8.2% in 2000.As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies.According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades.World Health Expenditure as a % of GDPGlobal medical device sales are estimated to increase 5.9% annually from 2023 to 2030, reaching nearly $800 billion according to data from Fortune Business Insights.While the Americas are projected to remain the world’s largest medical device market, the Asia Pacific market is expected to expand at a relatively quicker pace over the next several years.SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers.While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base.Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy.However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.Post-Script – 2024 OutlookThe medical device industry looked to have put the effects of COVID-19 behind by 2023.A large number of elective procedures were deferred in the early part of the pandemic and a measure of catch-up in procedure volumes was reported in subsequent periods.Back to focusing on the longer-term demographic and other trends?Well, maybe not quite so fast.It was always likely that the pandemic-induced disruptions would linger just a bit longer, creating some uncertainty around consumers’ needs and preferences.But the industry awakened to a different type of potential disruption in mid-2023.Would GLP-1 drugs alter long-term demographic trends by reducing massive obesity rates?And would the industry face widespread lower demand for bariatric surgery devices, glucose monitors, cardiovascular devices, orthopedic implants and other equiptment?A mid-year swoon in medtech stock prices was attributed, at least by some, to the wonder drugs.As 2023 came to a close, however, many appear to have reversed course from that early response.We may or may not get more clarity on the longer-term effects of these treatments in 2024 but, surely, they will also bring opportunities to go along with potential challenges for device makers.Taking a broader view, some trends from recent periods will likely persist in 2024.Companies will continue to focus on profitability and profitable growth in a (relatively) higher-interest rate environment.Some observers suggest that an expected but measured decline in rates over 2024 (if it materializes) may not do much for medtech stock prices, further underscoring the need to shore up margins.On the flip side, since the period of rapid interest rate increases appears to be behind us, transaction volume should pick up from the low levels of the past two years.Finally, innovation, as always, will continue to be part of the conversation as novel treatments that serve unmet needs will help to unlock new markets.2024 Outlook reading list:What To Expect From Medtech In 2024 (McKinsey & Company)5 Medtech Trends To Watch In 2024 (MedtechDive)2024 Outlook For Life Sciences: GenAI, Drug Prices, Economy Likely To Influence Strategy (Deloitte)

NYCB Incurs Heavy Dilution in Its $1.0 Billion Capital Raise

The other significant industry news from the first quarter was the $1.05 billion equity investment in New York Community Bank (NYSE: NYCB) by an investor group led by former Secretary of the Treasury Steve Mnuchin. The investment was necessary to boost loss absorbing capital and to shore up confidence to stem a possible deposit run after its share price collapsed during February following a surprise fourth quarter loss that was later revised higher for a $2.4 billion goodwill write-off.The initially reported 4Q23 loss of $252 million was not catastrophic, especially considering the company reported net income of $2.4 billion excluding the goodwill write-off as a result of the bargain gain from the purchase of the failed Signature Bank; however, the fourth quarter loss that arose from a $538 million provision for loan losses highlighted investor concerns about NYCB’s sizable exposure to NYC rent-controlled apartments and offices.The figure on the right presents our proforma analysis of the transaction and its impact on the consolidated company (NYCB), the parent company in which the group invested, and wholly owned Flagstar Bank, N.A. The adage that capital is exorbitantly expensive if available at all when it must be raised comes to mind here with NYCB.Source: Mercer Capital, NYCB SEC filings, and S&P Global Market IntelligenceWe note the following:The investor group paid $1.05 billion for 525 million common share equivalents consisting of 59.8 million common shares for $2.00 per share and $930 million of Series B and C preferred stock with a 13% dividend that is convertible into 465 million common shares at $2.00 per share.Tangible book value per share (“TBVPS”) declined by about one-third from $10.03 per share as of year-end 2023 to $6.65 per share on a proforma basis.Inclusive of 315 million seven-year warrants with a $2.50 per share strike price, diluted proforma TBVPS is ~$5.80 per share.The 525 million common shares represent ~40% of the 1.25 billion proforma shares while dilution to existing shareholders exceeds 50% inclusive of the warrants.The capital injection boosted the Company’s consolidated leverage ratio by ~80bps to 8.6% and total risk-based capital ratio by ~120bps to 13.0%.NYCB will generate ~$1.4 billion of pretax, pre-provision operating income in 2024 and 2025 based upon consensus analyst estimates that will supplement the new capital to absorb loan losses.Given NYCB’s shares are trading around 50% to 60% of proforma TBVPS, investors are questioning the magnitude of loan losses to be recognized; whether more capital will be required; and long-term earning power.Our additional thoughts on the transaction can be found HERE, and a link to NYCB’s investor deck announcing the transaction can be found HERE.If we can assist your board with a capital raise or other significant transaction, please call us.Originally appeared in the March 2024 issue of Bank Watch.

Capital One Financial Corporation to Acquire Discover Financial Services

The four major credit card networks are American Express, Discover, Mastercard, and Visa.In 2023, Discover had only 2.1% of the total market share in the U.S. based on the value of transactions, compared to Visa’s 61.1% market share and Mastercard’s 25.4% market share.1 Prior to its acquisition of Discover, Capital One partnered with both Visa and Mastercard for issuing their credit cards.So, why would Capital One pay $35.3 billion to acquire Discover’s 2.1% market share?Discover Financial Services operates as both a credit card issuer and credit card network.By owning its own credit card network, Discover is not partnered with any payment processors (Visa, Mastercard, etc.) and avoids “swipe fees” that payment processors collect. Therefore, one of Capital One’s primary objectives in acquiring Discover is to move its credit and debit cards onto Discover’s network over time and reduce its purchase volume on the Visa and Mastercard networks.The two companies entered into a definitive agreement on February 19, 2024, in which Capital One Financial Corporation agreed to acquire Discover Financial Services in an all-stock transaction valued at $35.3 billion.The deal represents a 26.6% premium to Discover’s closing price of $110.49 (2/26/24) as Discover shareholders will receive 1.0192 Capital One shares for each Discover share.More details on the transaction as well as the companies’ financials as of fiscal 2023 are displayed on the right.Summary of Transaction AnalysisFinancial ComparisonPreparing for the FutureAs technology continues to advance, both traditional, tech-heavy banks and Fintech companies have increased competition in the global payments industry.If the acquisition is approved, Capital One will surpass JPMorgan as the largest credit card company based on loan volume and become the third largest company based on purchase volume. With increased volume and market share, Capital One would be better prepared to compete against these other banks and Fintech companies. Richard Fairbank, the CEO of Capital One, strives to deal directly with merchants by owning his own payments network. This rare asset allows Capital One to create a closed loop between consumers and merchants, which better positions the company to deal with increasing threats from buy-now, pay-later companies (Affirm, Afterpay, Klarna, etc.).Both Capital One and Discover customers may have a lot to look forward to in the future should the deal be approved.Capital One intends to move 25 million cardholders onto the Discover network by 2027 and offer more attractive rewards for both debit and credit cardholders. The proposed merger would expand both issuers’ physical presence, and Discover customers would gain access to physical bank locations.Capital One will also leverage its international presence to increase accessibility and convenience for Discover cardholders on an international scale.In terms of credit and debit rewards, the increased competition in the industry is expected to drive companies to bolster their rewards program to seem more attractive to consumers.Regulatory HurdlesThe proposed deal between Capital One and Discover is expected to close by the end of 2024 or the beginning of 2025. However, the completion of the deal could depend on the results of the presidential election. Senators Elizabeth Warren and Josh Hawley have both expressed interest in blocking the deal as they believe the deal will create a “juggernaut” in the industry and lead to the extortion of American consumers. The Biden administration is more likely to block the deal or implement limitations and requirements in order for it to be executed.On the other hand, the proposed deal could stop legislation that threatens credit card rewards. Congress is considering new legislation known as the Credit Card Competition Act (CCCA).The purpose of this legislation is to reduce the swipe fees paid by merchants by enabling access to a wider range of payment networks. If the legislation is approved, credit card networks and issuers would face reduced transaction fees causing issuers to potentially reduce the wide range of rewards offered. However, the primary objective of the CCCA could be accomplished through the proposed merger, as routing Capital One’s purchase volume through Discover’s payment network would create a more viable competitor to the Visa/Mastercard duopoly.ConclusionMercer Capital has roughly 40 years of experience in assessing mergers, the investment merits of the buyer’s shares, and providing valuations of financial institutions. If you are considering acquisition opportunities or have questions regarding the valuation of your financial institution, please contact us. 1 Statista.com; Market share of Visa, Mastercard, American Express, Discover as general purpose card brands in the United States from 2007 to 2023, based on value of transactionsOriginally appeared in the March 2024 issue of Bank Watch.

Potential Impact of Baltimore Bridge Collapse on the Logistics Industry

It’s been hard to miss the news footage and video of the cargo ship Dali colliding with the Francis Scott Key Bridge across the Chesapeake Bay. The bridge collapse – as sudden as it is surprising – is another landmark in what has been a series of tumultuous years in the logistics industry. We recently wrote about global impacts on the supply chain, particularly East Coast ports, and this is another reminder about how unpredictable events can have a wide reach.The Port of BaltimoreThe Port of Baltimore is in the top twenty ports by volume in the United States and is the 5th largest port for foreign trade on the East Coast. TheWashington Postestimates that the port handled over 50 million tons of foreign cargo with value in excess of $80 billion during 2023. The port is the 2nd largest exporter of coal from the U.S. (though still a relatively small player on a global scale) and is the largest port for imports of automobiles, sugar, and gypsum. Baltimore is also equipped to handle Neo Panamax ships passing through the Panama Canal.Sharing the fortunes of several other East Coast ports of the last several years, the Port of Baltimore posted several records in 2023, including for the largest number of TEUs handled (1.1 million) and general cargo tons (11.7 million). Baltimore posts these growth records despite the overall decline in imports to the U.S. during 2022.Potential Short-Term and Long-Term ImpactShort term impacts will include delays of cargo already in transit for East Coast ports, whether originally bound for Baltimore or not. Just as we saw chokepoints on the West Coast lead to a redistribution of cargo among ports, the loss of the Baltimore port for the foreseeable future will cause ripple effects throughout the industry.Source: The Washington Post Other East Coast ports will likely take up the bulk of cargo previously destined for Baltimore. In particular, soybean shipments are expected to transfer to Norfolk, Savannah, and Charleston, while containers are expected to be processed in either Philadelphia or Norfolk. In any case, the truck routes and rail cars that previously serviced Baltimore will need to be recentered on other ports. However, this will be somewhat mitigated by global events that were already impacting East Coast ports—namely, the ongoing drought limiting capacity through the Panama Canal and the Houthi rocket attacks in the Red Sea, both of which had diverted some cargo away from East Coast ports prior to the bridge collapse. An additional concern is the International Longshoreman’s Association contract, which covers port workers from Texas through the Northeast. The contract is set to expire in September 2024. Talks stalled in early 2023 before resuming again in February 2024. The West Coast freight bottleneck that dominated transportation headlines in 2022 was brought on by labor disputes combined with a drastic increase in demand for shipping services due to COVID-fueled shopping. Conversely, the national freight market has been soft through 2023 and demand is not expected to rapidly escalate as it did a few years ago. This should limit long-term bottlenecks and chokepoints from forming on the East Coast.ConclusionMercer Capital’s Transportation & Logistics team constantly watches the transportation industry and global events and economic factors that can impact the overall industry, the supply chain, or various aspects of transportation.Mercer Capital provides business valuation and financial advisory services, and our transportation and logistics team helps trucking companies, brokerages, freight forwarders, and other supply chain operators to understand the value of their business. Contact a member of the Mercer Capital transportation and logistics team today to learn more about the value of your logistics company.

News Update: How the Collapse of the Baltimore Bridge Might Impact the Auto Supply Chain

By now, most of us have seen the harrowing images of cargo ship Dali wrecking into the Francis Scott Key Bridge in the Port of Baltimore in the early morning hours on Tuesday. Besides the tragedy of lives lost, the disruption for Baltimore commuters, and the time needed for recovery and rebuilding of the bridge, the catastrophe will have a major impact on the global supply chain and will also impact the auto supply chain. But how?

Your Family Business Will Transact: Are You Ready?

Approximately 75% of business owners regret selling their business within the first year following the sale, according to a new report. Why? The emotions of running and owning a family business are complex, and disentangling your identity from the business can be challenging. However, we suspect some of the heartache comes down to poor planning, the feeling of leaving money on the table, and a harried transition process. So, have you checked in on your succession plan?

Eagle Ford Production Edges Down on Sharply Reduced Drilling

The economics of oil & gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Haynesville, and Marcellus and Utica plays. This quarter we take a closer look at Eagle Ford.

An Ontological Approach to Investment Management

Review of “Winning at Active Management” by William W. Priest et al.

When we started writing about investment management in 2007, my colleagues and I went looking for materials on practice management and, in general, found nothing. There was next to nothing out there about structuring and running an RIA. During our search, we missed the 2016 publication of “Winning at Active Management: The Essential Roles of Culture, Philosophy, and Technology” by Bill Priest and his colleagues at Epoch Investment Partners.

It’s Not About the Mangos: Focus on People

What We've Been Reading

With school in the home stretch and summer just around the corner, I wanted to share some insights I learned from reading “It’s Not About the Mangos” by Kent Coleman.

Now Could Be a Great Time to Transfer Stock to Heirs

Issues on the tax and policy front also should be top of mind in current estate planning discussions. The Tax Cuts and Jobs Act enacted in December 2017 doubled the basic exclusion amounts individuals could give away without paying estate taxes. The sunsetting of this provision on December 31, 2025, makes considering transfers all the more important.

Eagle Ford M&A Update

Transaction Activity Plummets Over the Past 4 Quarters

Over the past twelve months, deal activity in the Eagle Ford has fallen off a cliff, with only two deals closing compared to 13 transactions closed in the prior twelve-month period. Significant volumes of wet gas, NGLs, and rich condensate combined with the proximity to the Port of Corpus Christi fueled deal momentum in the twelve months ended February 28, 2023. So why did this momentum come to a screeching halt during the remainder of 2023 and into the first two months of 2024?According to a report from Deloitte, M&A activity declined as E&P companies committed themselves to capital discipline. Free cash flows were diverted away from investing, acquiring for growth, and increasing market share toward paying dividends and share buybacks. The old drivers of M&A activity seem to have been replaced by new drivers.Recent Transactions in the Eagle FordDuring the twelve months ended February 29, 2024, Silverbow Resources purchased 42,000 acres from Chesapeake Energy for $700 million, while Crescent Energy purchased 75,000 acres from Mesquite Energy for $600 million. The total deal value of the two deals, $1.3 billion, equals the median deal value of the 13 deals for the twelve months ended February 28, 2023. A table detailing these two transactions is shown below.Click here to expand the image aboveChesapeake’s sale to Silverbow Resources is an extension of Chesapeake’s sell-off during the twelve months ended February 28, 2023 (see table below), during which Chesapeake sold a combined 549,000 acres over two deals. On the flip side, Silverbow Resources has continued its buying binge by purchasing assets from Chesapeake, adding to the four purchases it made during the twelve months ended February 28, 2023 (see table below). Silverbow Resources spent $547 million on these four purchases, adding 76,000 acres to its portfolio at $7,197/acre.Click here to expand the image aboveRock, Returns, and Runway: Why Chesapeake is a SellerChesapeake announced the sale of its remaining Eagle Ford shale assets to Silverbow Resources on August 14, 2023. The sale of these assets affirmed Chesapeake’s commitment to the Marcellus and Haynesville shales, noting that the Eagle Ford was no longer core to its strategy. Further, Chesapeake’s activist investor Kimmeridge Energy Management, had urged a shift toward solely natural gas production. The Marcellus and Haynesville shales are both natural gas-rich formations. We note that the shift out of the Eagle Ford shale preceded Chesapeake’s merger with Southwestern Energy, which was announced on January 11, 2024. As Chesapeake’s CEO Nick Dell'Osso noted, the divestiture of the remaining Eagle Ford assets allows Chesapeake “to focus our capital and team on the premium rock, returns, and runway” of its assets within the Marcellus and Haynesville shales.Scale, Capital Efficiency, and Commodity Exposure: Why Silverbow Is BuyingWhile Chesapeake has completely exited the Eagle Ford, Silverbow Resources is the other side of the coin. The acquisition of the Chesapeake assets has propelled the company into the largest public pure-play Eagle Ford operator.Silverbow Resources CEO Sean Woolverton noted “We are excited to close the Chesapeake transaction, which materially increases our scale in South Texas…Our differentiated growth and acquisition strategy has positioned us with … a portfolio of locations across a single, geographically advantaged basin. The acquired Chesapeake assets further enhance our optionality to continue allocating capital to our highest return projects and will immediately compete for capital.”ConclusionM&A activity in the Eagle Ford has plummeted over the last twelve months, with only two deals announced, one of which portrays two very different attitudes towards the Eagle Ford. However, according to Enverus Intelligence Research, the Eagle Ford shale is one of a few areas that can expect an uptick in M&A activity in 2024 as the list of attractive targets in the Permian Basin has dwindled due to heavy M&A activity in that play in 2023. Enverus also notes that “The core of the Eagle Ford is the gift that keeps giving for operators with the best acreage.” Despite denser development, recoveries remain high in these core areas of the Eagle Ford.Mercer Capital has assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space. We can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate, and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Q4 2023 Earnings Calls

New Vehicle Resilience, Lightly Used Inventory Scarcity, and Disappointing EV Sales

After reviewing earnings calls from executives of the six publicly traded auto dealers, the market for new vehicles appears resilient. Improved inventory balances and wider availability of models have relieved pressure from the new vehicle market. As a result, transaction prices have been falling, and consumers have been able to find the models they are looking for with more success. Meanwhile, used vehicle availability has been mixed, with lightly used models falling short. However, the demand for electric vehicles has been disappointing, and capital allocation decisions have become more complicated in the current environment.

How EBITDA Margins Affect Revenue Multiples

Whenever someone asks me what their RIA is worth as a multiple of revenue, I respond by asking about their firm’s EBITDA margin. My response is largely driven by the math behind the enterprise value (EV) to revenue ratio.

5 Reasons Sellers Need a Quality of Earnings Report

M&A deal flow was sidelined for much of 2022 and 2023, but the economy’s soft landing, stabilizing interest rates, and pent-up M&A demand are expected to compel buyers and sellers to renew their efforts in 2024 and beyond.As deal activity recovers, sellers need to be prepared to present their value proposition in a compelling manner. For many sellers, an independent Quality of Earnings (“QofE”) analysis and report are vital to advancing and defending their asset’s value in the marketplace. And it can be critical to the ensuing due diligence processes buyers apply to targets.The scope of a QofE engagement can be tailored to the needs of the seller. Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business. The process can encompass both the financial and operational attributes of the business.In this article, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses to market.1. Maximize value by revealing adjusted and future sustainable profitability.Sellers should leave no stone unturned when it comes to identifying the maximum achievable cash flow and profitability of their businesses. Every dollar affirmed brings value to sellers at the market multiple. Few investments yield as handsomely and as quickly as a thorough QofE report. A lack of preparation or confused responses to a buyer’s due diligence will assuredly compromise the outcome of a transaction. The QofE process includes examining the relevant historical period (say two or three years) to adjust for discretionary and non-recurring income and expense events, as well as depicting the future (pro forma) financial potential from the perspective of likely buyers. The QofE process addresses the questions of why, when, and how future cash flow can benefit sellers and buyers. Sellers need this vital information for clear decision-making, fostering transparency, and instilling trust and credibility with their prospective buyers.2. Promote command and control of transaction negotiations and deal terms.Sellers who understand their objective historical performance and future prospects are better prepared to communicate and achieve their expectations during the transaction process. A robust QofE analysis can filter out bottom-dwelling opportunists while establishing the readiness of the seller to engage in efficient, meaningful negotiations on pricing and terms with qualified buyers. After core pricing is determined, other features of the transaction, such as working capital, frameworks for roll-over ownership, thresholds for contingent consideration, and other important deal parameters, are established. These seemingly lower-priority details can have a meaningful effect on closing cash and escrow requirements. The QofE process assists sellers and their advisors in building the high road and keeping the deal within its guardrails.3. Cover the bases for board members, owners, and the advisory team and optimize their ability to contribute to the best outcome.The financial and fiduciary risk of being underinformed in the transaction process is difficult to overcome and can have real consequences. Businesses can be lovingly nurtured with operating excellence, sometimes over generations of ownership, only to suffer from a lack of preparation, underperformance from stakeholders who lack transactional expertise, and underrepresentation when it most matters. The QofE process is like training camp for athletes — it measures in realistic terms what the numbers and the key metrics are and helps sellers amplify strengths and mitigate weaknesses. Without proper preparation, sellers can falter when countering an offer, placing the optimal outcome at risk. In short, a QofE report helps position the seller’s board members, managers, and external advisors to achieve the best outcome for shareholders.4. Financial statements and tax returns are insufficient for sophisticated buyers.Time and timing matter. A QofE report improves the efficiency of the transaction process for buyers and sellers. It provides a transparent platform for defining and addressing significant reporting and compliance issues. There is no better way to build a data set for all advisors and prospective buyers than the process of a properly administered QofE engagement. This can be particularly important for sellers whose level of financial reporting has been lacking, changing, outmoded due to growth, or contains intricacies that are easily misunderstood.For sellers content to work their own deals with their neighbors and friendly rivals, a QofE engagement can provide some of the disciplines and organization typically delivered by a side-side representative. While we hesitate to promote a DIY process in this increasingly complicated world, a QofE process can touch on many of the points that are required to negotiate a deal. Sellers who are busy running their businesses rarely have the turnkey skills to conduct an optimum exit process. A QofE engagement can be a powerful supporting tool.5. In one form or another, buyers are going to conduct a QofE process – what about sellers?Buyers are remarkably efficient at finding cracks in the financial facades of targets. Most QofE work is performed as part of the buy-side due diligence process and is often used by buyers to adjust their offering price (post-LOI) and design their terms. It is also used to facilitate their financing and satisfy the scrutiny of underlying financial and strategic investors. In the increasing arms race of the transaction environment, sellers need to equip themselves with a counteroffensive tool to stake their claim and defend their ground. If a buyer’s LOI is “non-binding” and subject to change upon the completion of due diligence, sellers need to equip themselves with information to advance and hold their position.ConclusionThe stakes are high in the transaction arena. Whether embarking on a sale process or responding to an unsolicited inquiry, sellers have precious few opportunities to set the tone. A QofE process equips sellers with the confidence of understanding their own position while engaging the buy-side with awareness and transparency that promotes a more efficient negotiating process and the best opportunity for a favorable outcome. If you are considering a sale, give one of our senior professionals a call to discuss how our QofE team can help maximize your results.WHITEPAPERQuality of Earnings AnalysisDownload Whitepaper For buyers and sellers, the stakes in a transaction are high. A QofE report is an essential step in getting the transaction right.

5 Reasons Sellers Need a Quality of Earnings Report

The scope of a QofE engagement can be tailored to the needs of the seller. Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business. The process can encompass both the financial and operational attributes of the business. In this post, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses to market.

Employee Alignment Is Essential in Wealth Management

Employee alignment is important for most companies, but in asset and wealth management, it’s essential.

February 2024 SAAR

The February 2024 SAAR was 15.8 million units, a 6.0% increase from last month and a 6.3% increase compared to this time last year. February 2024’s year-over-year sales improvement and consistently improving inventory levels may indicate that the industry is reverting to its pre-pandemic ways. As nationwide inventory balances continue to expand, incentive spending from auto manufacturers has followed in tandem as OEMs and retailers compete to draw in buyers. Check out our recent blog for a deep dive into Customer Lifetime Value and the importance of getting buyers in the door for both dealers and manufacturers.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of March 4, 2024

Worldwide Impacts on Marine Shipping – Q4 2023

We discussed reshoring and nearshoring trends a bit in the last Value Focus Transportation and Logistics newsletter.There’s been some developments on that front, especially as it relates to the ongoing battle between East Coast and West Coast ports.As we mentioned last time, a variety of pandemic-related and regulatory issues resulted in long delays at California ports, the traditional import location for the majority of goods from East Asia.Many carriers shifted their import handling to East Coast ports – with the port of Savannah being one of the biggest winners.Georgia has posted three straight record–setting years for exports. A study by Cushman Wakefield that ran through October 2023 shows that volumes at East Gulf Ports exceeded West Coast volumes for the majority of 2022 and 2023.However, early results indicate the West Coast ports grew faster than East Coast ports in November and December 2023, and there are a couple of reasons behind that.(click here to expand the image above)The El Niño weather event has hit the Panama Canal hard.Under normal conditions, between 36 and 38 ships per day will make the transit.Due to the worst droughtPanama has experienced in over 70 years, the Canal Authority began reducing the number of ships passing through on a daily basis in July 2023.In February 2024, the Canal Authority reduced the total number of ships to 18 per day.Meanwhile, approaching from the other direction has been made harder by attacks on vessels in the Red Sea.About one-fifth of freight reaching East Cost ports travels through the Red Sea and the Suez Canal.Shippers continuing to use the Suez canal route will face higher insurance charges, while shippers opting to go around the Cape of Good Hope can expect to add at least a week to transit times.More recently, the first fully sunk ship from the conflict also disrupted underwater data cables.So far, analysts have had mixed opinions on the overall impact that will arise from the Houthi attacks.Between Red Sea disruptions and climate issues in Latin America the impact of worldwide current events on marine logistics cannot be ignored.

The Times They Are A-Changin’

The Tax Cuts and Jobs Act as the largest tax code overhaul in the last three decades. Built into the TCJA was the sunset of certain provisions on December 31, 2025. Meaning that on January 1, 2026, certain portions of the tax law revert to pre-TCJA unless Congress acts to prevent it. With time change on the horizon, we discuss two of the more significant sunsetting provisions that will affect you and your family business.

Capital Budgeting for Team Building

Tools for Long-Term Greedy Practice Management

This week, news that Apple was canceling what was known as its “Apple Car” project after a decade of work and billions invested puts a spotlight on the troubles facing EV development. As little as one year ago, EVs seemed inevitable, as several automakers declared they would abandon internal combustion engines (ICEs) within the next decade and dedicate their entire fleets to battery propulsion. A decade from now, we’ll know whether media hype over EVs pushed the industry too far ahead of their buyers, whether media hype turned willing EV buyers against battery-powered cars, or some combination of the two.

An Estate Planning Primer

Why Auto Dealers Need to Start Thinking About Estate Planning Again

One thing we’ve hardly written about in this space is estate planning, in part because dealerships have experienced record performance. However, as record profits have receded towards more normalized levels, and with the significant cliff looming at the end of 2025, it’s time for auto dealers to revisit their estate planning.

Themes from Q4 2023 Energy Earnings Calls

Upstream (E&P) and Oilfield Service (“OFS”) Companies

This week, we delve into the Q4 2023 earnings calls of upstream and OFS companies, underscoring the consistent emergence of these themes across the entire sector.

March 2024 | Capital One Financial Corporation to Acquire Discover Financial Services

Bank Watch: March 2024

In this issue: Capital One Financial Corporation to Acquire Discover Financial Services and NYCB Incurs Heavy Dilution in Its $1.0 Billion Capital Raise

The Noncompete Agreement Is Dead, Long Live the Noncompete Agreement

Financial Reporting Flash: Issue 3, 2024

The FTC Wants to Ban Noncompete Agreements but They Will Likely Endure in Certain Circumstances

Essential Financial Documents to Gather During Divorce – Part 2

Documents Needed to Analyze Support and Need (A Lifestyle Analysis)

Themes From the 2024 Acquire or Be Acquired Conference

For those who haven’t been to Bank Director’s Acquire or Be Acquired conference (AOBA) before, it is a two-and-a-half-day conference in the desert (Phoenix) that typically includes great weather, golf at the end, and has broadened over the years to focus on a combination of M&A, growth, and FinTech strategies.Cautious OptimismWhile the 2024 version of AOBA included a number of discussions around headwinds facing the sector, there was optimism for 2024 when compared to 2023.For example, the banking audience was asked during the conference: How do you feel about 2024 compared to your experience in 2023?~90% responded that they felt more optimistic about 2024 when compared to 2023. Additionally, several sessions noted that optimism exists for an uptick in deal activity in the second half of 2024.Traditional Bank M&A Tailwinds and HeadwindsWhile the turbulence and potential headwinds for bank M&A that slowed deal activity in 2023 continue to persist at the outset of 2024, traditional bank M&A remained a much discussed topic at the 2024 AOBA conference. Discussions focused on the nuts and bolts of M&A from valuation to due diligence to structuring and ultimately to integration. While certain themes change and evolve, the strategy to achieve greater scale and growth through M&A and to enhance efficiency and profitability that create value over the long run, persist. The challenging M&A landscape could present an opportunity for acquirers with the balance sheet and capacity to engage in a transaction, and the silver lining for those acquirers may be less competition for sellers as some buyers focus internally during the challenging operating environment.Balance Sheets in FocusThere were definitely more sessions this year discussing balance sheets. A number of sessions noted that one key to dealmaking in the current environment was managing the balance sheet, and several discussed the impact of fair value marks on sellers and pro forma combined balance sheets and the impact on deal activity. For acquirers, a strong balance sheet and capital level can position their institution to be able to take advantage of the current deal environment. For sellers, having a balance sheet that is less impacted from the fair value marks to loans and bonds and with more valuable deposits enhances their attractiveness to potential acquirers.In one session, my colleagues Jeff Davis and Andy Gibbs discussed the impact of taking a loss today on low-coupon bonds that are worth less than the current market price versus holding the bonds to maturity on the value of a bank’s equity. They also reviewed an intermediate strategy referred to as the installment method.Deposits, Deposits, DepositsConsistent with discussions around the balance sheet, the interest rate environment, and impact on the banking industry & M&A, discussions about deposits came up often.These discussions covered strategies to retain business or consumer deposits, the attractiveness of core deposits for acquirers in the current environment, how to grow deposits organically (some of the largest banks are even turning back the clock and building branches again), trends in core deposit intangible valuations, and how to provide your customers with the technology and digital banking solutions to onboard and retain deposits more efficiently. One question discussed in several sessions that will be interesting to see the answer to in 2024 was: Has the cost of funds peaked?Technology Brings OpportunitiesOver the last few years, technology has been an increasing topic discussed during sessions of AOBA. Technology topics discussed included leveraging payments to enhance retail and small business banking, using software and/or digital banking to more efficiently make loans and/or open deposit accounts and best practice for developing and managing risk of FinTech partnerships. Even AI, the market’s favorite topic of 2024, was discussed. A consensus on how best to leverage AI in banking has not yet emerged in my view but topics discussed included leveraging AI to enhance loan growth or efficiency of common tasks in the back office. Traditional M&A has historically focused on the potential diversification benefits of combining loan portfolios, deposit portfolios, and geographic footprints but increasingly the tech stacks of buyers and sellers are being compared to see what diversification benefits exist and what the cost may be to combine the tech stack after closing.Technology Also Brings Potential RisksOne challenging aspect of technology for banks was how best to balance the potential benefits of technology with the risks inherent in them, particularly new technologies and FinTech partnerships. Tech-forward banks and their valuations were also discussed. As we have noted in the past, this tech-forward bank group has seen increased volatility in market performance than their peers as the market digests some of the tech-oriented business models (such as banking-as-a-service) and weighs the potential for higher growth and profitability against the potential risk of these business models and regulatory scrutiny.Non-Traditional DealsSimilar to traditional bank deals, bank acquisitions in non-traditional areas like specialty finance, insurance, and asset management have been modest and challenging given the difficult operating environment, higher cost of debt, and opportunity cost of excess liquidity. However, there were some discussions around best practices and lessons learned from specialty finance transactions and that additional opportunities may emerge as non-bank lenders also deal with the challenging funding and interest rate environment. Additionally, Truist recently announced the sale of its insurance business to book a gain, focus on core banking, and enhance capital. The announced bank acquisitions by credit unions and private investors also illustrate that non-traditional deals remain a part of a bank’s strategic playbook.ConclusionWe look forward to discussing these issues with clients in 2024 and monitoring how they evolve within the banking industry over the next year. As always, Mercer Capital is available to discuss these trends as they relate to your financial institution, so feel free to call or email.Originally appeared in the February 2024 issue of Bank Watch.

Capital Planning and IRS Section 6166

For family businesses with significant ownership concentrations, the estate taxes eventually payable upon the death of a primary shareholder can represent a significant contingent “non-operating” liability. Unlike the uses of capital typically evaluated in capital budgeting, the obligation to pay estate taxes is not discretionary. But if the deceased shareholder’s estate does not include sufficient liquidity, the economic burden of the tax effectively falls upon the family business, which must allocate capital toward either a redemption of the estate’s shares or a pro rata distribution. From the perspective of the business, this obligation may “crowd out” other, more attractive uses of capital that would help build value for subsequent generations. In specific circumstances, Section 6166 of the Internal Revenue Code provides a capital planning alternative for family businesses facing large contingent liabilities for shareholder estate tax obligations.

No Soup for You

Lessons from Seinfeld on Customer Lifetime Value and Brand Loyalty in the Auto Industry

Like the price elasticity of automobiles, especially high-end automobiles, OEMs and auto dealers must confront the challenges of brand loyalty and customer retention. In this week’s post, we discuss customer lifetime value ("CLV") and cost of customer acquisition ("CAC") and offer tips to auto dealers to achieve greater customer retention.

Texas Statewide Rule 8 Overhaul

What's in Store for Texas Oilfield Waste Disposal Operators?

In October 2023, the Railroad Commission of Texas (the "RRC," or the "Commission") announced that for the first time in nearly 40 years, 16 Texas Administrative Code (TAC) §3.8 (relating to Water Protection), also known as Statewide Rule 8 ("Rule 8"), would undergo a significant overhaul. We discuss that in this post.

Will RIAs Be Subject to Anti-Money Laundering Rules?

Last week, the U.S. Treasury’s Financial Crimes Enforcement Network (“FinCEN”) proposed a rule to require investment advisors to comply with Bank Secrecy Act requirements, including implementing anti-money laundering (“AML”) controls and filing suspicious activity reports to FinCEN. The agency has attempted to bring investment advisors under Bank Secrecy Act provisions twice in the past, most recently in 2015. Unlike prior attempts, however, this proposal does not hold investment advisors accountable for identifying their clients. Still, the agency is contemplating a separate joint proposal with the SEC outlining future customer ID requirements for investment advisors.

Ownership Succession and the NFL

Per a recent article from Bloomberg, the NFL will consider another change to its ownership rules at its league meetings next month — allowing private equity groups to take ownership stakes in teams. Given this, we take a brief look at some of the pros and cons of allowing private equity to enter NFL ownership structures and their broader applications to family businesses.

Non-Operating Working Interests in Oil & Gas: Part II

Markets and Valuation Characteristics of Non-Op Working Interests

As we continue our discussion on non-op working interests from Part I of this series, we turn to how the markets and valuation parameters are structured.

Reconciling Real-World RIA Transactions with Fair Market Value

The value of asset and wealth management firms depends very much on context. In the valuation community, we refer to the context in which the firm is being valued as the “standard of value.” A standard of value imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control the identity of the buyer and the seller, the motivation and reasoning of the transaction, and the manner in which the transaction is executed.

How a Quality of Earnings Analysis Benefits Auto Dealership Buyers

As our readers know, the auto dealer transaction space has been white hot for the last several years. What else could impact transactions in 2024? After sitting on the sidelines for much of 2022 and 2023, the prospect of Fed rate cuts may lure even more buyers back onto the field in 2024. And if deal activity continues to be hot, due diligence will be as critical to buyers as ever. For many buyers, a quality of earnings (“QofE”) report is a cornerstone of their broader diligence efforts.

Pay Versus Performance: What’s New in Year 2?

The complexity of implementing the Pay Versus Performance rules in Year 2 will vary by firm.

Viva Diversification: The Vegas Transformation and Your Family Business

As markets move and tastes evolve, what worked for your family’s business in the first generation may not work for the second or third. Diversification and how you approach where to invest limited family capital should not take a backseat to the tyranny of the now. Perpetuating your family business takes thinking about generations rather than quarters and strategizing for the next phase in your family’s journey today.

RIA M&A: What Can Possibly Go Wrong?

A Very Incomplete List of What Not to Do in Transactions

As business combinations go, it’s hard to imagine a better press release: Ferrari, the most storied and most successful name in Formula One racing history and the only team to compete in every world championship ever held, boasting a top 16 Constructors’ Championships and 15 Drivers’ Championships……signs Lewis Hamilton, the most recognizable and winningest driver in Formula One, tied with Michael Schumacher for the most Drivers’ Championships, who serves as a global ambassador for Formula One, built McLaren’s reputation and cemented Mercedes’s, and was knighted by Queen Elizabeth.Ferrari brings unparalleled intellectual property and commitment to racing, capital from a robust market valuation, and a history of being on top. Hamilton brings unparalleled driving skills, a following among not just fans but also mechanics and builders, and a history of being on top.What Could Possibly Go Wrong?I’ll get back to the Ferrari/Hamilton deal later. In the RIA community, nothing gets people’s blood flowing like a transaction. Big mergers are fantastic, but even deals involving a few hundred million of AUM are widely reported. For all the hype, making M&A successful requires minding Ps and Qs, and is as much, if not more, about attention to detail and being realistic as it is about sweeping vision and uplifting pronouncements.I’ve written in the past about the perils of focusing on the volume of press releases instead of the volume of earnings. Today, I thought it would be worthwhile to discuss what can go wrong in an RIA deal and how to protect yourself from it.Here’s a partial list of mistakes we’ve seen (some from buyers, some from sellers) in no particular order.Failing to Get an Independent Quality of Earnings AssessmentA Quality of Earnings assessment is like a SWOT analysis of your financial statements, looking at all of the risks and opportunities inherent in your revenue, expenses, and earnings.Is this a seller issue or a buyer issue? Both.The Quality of Earnings analysis is designed to show you how a buyer would look at youIf you are a seller, a Q of E assessment can alert you to issues that will be exhumed during due diligence and held against you by the buyer in negotiations. If you have real opportunities for earnings enhancement, it will help you get paid for those opportunities. The Quality of Earnings analysis is designed to show you how a buyer would look at you so you’re realistic about what you bring to the table and ready to negotiate the best deal for you. Whatever you do, don’t hire the Q of E firm that does regular work for the buyer — they have an inherent conflict of interest, and they will find things that the buyer can use against you in the due diligence process to whittle down the offer price to help create a “gain on purchase” (to buy you for less than you’re worth).If you are a buyer, a Q of E analysis is a deep dive into a range of qualitative and quantitative issues that protect you from simply trusting seller representations. If the seller presents you with their own Q of E, get that analysis in its native format (usually Excel) and hire someone to review and critique it. It’s not unusual to see adjustments to reported results that are realistic. Others might just be possible. Others might be fantasy.Failing to Meet with Multiple Generations of LeadershipIf a selling firm has two owners of retirement age and a half dozen senior managers below them in their forties and fifties, who will ultimately be tasked with making the transaction successful? I know this sounds obvious, but we’ve seen multiple deals in which the buyer didn’t meet with anyone other than the owner selling the firm so they can retire in the foreseeable future.On signing day, the buyer is introduced to the staff, who are presented with employment agreements. This may be a tough announcement if the next-gen was expecting to buy out their owners and take over themselves. And if their existing employment agreements aren’t pretty good, this could be the scene in which the proverbial assets get on the elevator, go home, and don’t come back. Yes, this has happened.Whether you are a buyer or a seller, it’s important to involve all the relevant stakeholders in preparing for a transaction to ensure continuity of operations after closing. It’s not always easy, but it’s always necessary.Misunderstanding the Economics of the Transaction StructurePop quiz: if deal consideration is five times EBITDA in cash, five times EBITDA in rollover equity, and five times EBITDA in earnout payments, what is the deal multiple? If you guessed 15 times EBITDA, you’d make a typical trade journalist, but you would also, very likely, be wrong.Cash consideration is easy enough to understand, but precious few RIA deals are “cash for keys.”Rollover equity is complicated because it’s based on the relative value of the buyer’s equity. Buyers naturally want accretive transactions in which they are picking up more dollars of earnings per share than they make themselves. But if the deal is accretive to the buyer, it’s symmetrically dilutive to the seller. And if the acquiring firm sells one day for a lower multiple than it was valued at the date of your transaction, it will be even more dilutive. We are always surprised when RIA acquirers boast about the high multiples at which they are valued (by firms they hire to value them…); savvy sellers will know those high valuations work against them.As for contingent consideration, the question revolves around how realistic the earnout targets are and whether those payments will be made in cash or stock. And then there’s the time value of money. Our advice is to be realistic about risk adjusting contingent payments and then discount them. It doesn’t take much to turn a 5x EBITDA headline earnout into 3x on an economic basis.So, what’s our hypothetical five-plus-five-plus-five deal worth? Probably less than 15 times EBITDA.Unrealistic Compensation ExpectationsCompensation can be highly idiosyncratic, especially for founder partners. You might only “pay” yourself $100 thousand per year because you get distributions on 40% of your firm’s earnings. That’s fine as an independent enterprise, but a buyer isn’t going to pay a multiple for your compensation just because you characterize it as earnings.Occasionally, you’ll meet an unsophisticated buyer who is willing to pay a multiple on what would be part of a normal compensation package. This never ends well. A selling partner with eight figures in sale proceeds usually won’t exert himself or herself at the same level for comparatively de minimis pay.Conversely, don’t leave money on the table. If you are a selling partner and take out more in wages than it would reasonably take to replace you, make that adjustment and get paid a multiple on the difference.Consider what a realistic, market-based compensation package is for the partnersIn any event, prior to going to market, consider what a realistic, market-based compensation package is for the partners. That may increase or decrease earnings, but it will probably bend the margin toward something a buyer would consider “normal” or at least sustainable. Negotiating deal pricing over partner compensation is unnecessary. Pick a reasonable balance between returns to capital and returns to labor, and craft your transaction accordingly.Viewing a Merger as a SaleIn a typical RIA transaction, the “seller” is making a bigger investment in their “acquirer” than the other way around. Why? Because, outside of the initial cash consideration, the seller is accepting rollover equity and earnout payments in exchange for their company.Rollover equity is essentially an investment in the acquirer, with what might be an indefinite holding period and an uncertain ultimate liquidity event. Earnout payments, also known as contingent consideration, mean the selling principals are actually going to be partners with the acquirer in their firm until such time as those earnout payments are, well, earned (or not).Also, remember that the scale of economics between seller and buyer is disproportionate. The seller is handing over their life’s work, often in exchange for a small percentage of the acquirer’s enterprise. The deal’s success matters to everyone, but it matters far more to the seller.Not Considering Post-Transaction RealityThis one could be titled “Viewing a Sale as a Merger.”For sellers, it’s important to remember that selling your firm, even part of it, is giving up control. There is no such thing as a no-touch acquirer.There are ways to minimize the invasiveness of a new owner with revenue-sharing arrangements and employment agreements. But we’ve seen supposed financial buyers taking minority stakes who find clauses in their agreement that allow them to exert as much pressure as they think they need after the ink dries. The subsidiary leadership’s only leverage is that they generate the revenue and can leave.For buyers, remember that you are hiring entrepreneurs, and entrepreneurs are often that way because they don’t want (can’t live with) a boss. The great irony of the consolidation movement in the RIA space is that the RIA space formed in the first place because ambitious people at wirehouse firms and bank trust departments decided they could do better if they left the mothership and headed out on their own. Consolidation negates much of that spirit, but to the extent it involves second and third-generation leadership at RIAs, those folks may be more accustomed to having a boss and will be more adaptable to working for a parent organization.Press Releases Don’t Build BusinessesGetting back to the dream combination of Ferrari/Hamilton: What could possibly go wrong? Lots.Ferrari hasn’t won a Constructors’ Championship in sixteen years. Not since before the GFC. Translated to our world, that’s a lot of negative alpha. Enzo Ferrari sold road cars to fund his racing ambitions; now, his company is public, a global branding house that races to sell cars, media, and lifestyle accoutrements. If you’ve seen the excellent movie Ford versus Ferrari, you know that Ford tried to buy Ferrari in the 1960s. Today, Ferrari’s buyer would more likely be LVMH.Hamilton. Is. Old. At 225 miles per hour, age isn’t just a number. This is my unvarnished opinion and the subject of much debate in the F1 community, but Lewis Hamilton turned 39 last month, and his last Drivers’ Championship was four years ago. In the past fifty years, only one driver as old as Hamilton has managed to win the F1 season. Even if he’s the greatest F1 driver in history, Hamilton’s instincts, eyesight, reaction time, and nerves are off-peak in a ridiculously competitive field.So, a little due diligence suggests that pairing an also-ran team with an aging icon won’t produce many podiums. But it will garner millions, if not billions, of dollars of free publicity for both Ferrari and Hamilton. If that is their actual ambition, the deal will be wildly successful. For RIAs, unfortunately, press releases don’t build firms.

January 2024 SAAR

The January 2024 SAAR was 15.0 million units, down 6.9% from last month and roughly flat (down 0.7%) compared to this time last year. Following 17 consecutive months of year-over-year improvements, the January 2024 SAAR ended the streak with a slight decline. Since January is generally a low-sales month, a decline in the SAAR itself does not necessarily dampen expectations for the remainder of 2024.

Just Released | 4Q23 Exploration & Production Newsletter

Regional Focus: Haynesville Shale

A Matter of Life (Insurance) and Death

Life Insurance as a Funding Mechanism for Shareholder Buyouts

A buy-sell agreement among family shareholders should provide clear instructions for how the company’s stock is to be valued upon the occurrence of a triggering event, such as the departure or death of a shareholder. For companies using life insurance as a funding mechanism for shareholder buyouts, the treatment of life insurance proceeds in determining the buyout price is always a thorny issue. A recent estate tax case (Connelly v. United States) addresses this issue. For our full analysis, read the article here.

Observations from a Buy-Sell Agreement Gone Bad

How to Increase the Value of a Non-Controlling Interest in a Closely Held Business by 338% with No Money Down

A Matter of Life (Insurance) and DeathA buy-sell agreement among family shareholders should provide clear instructions for how the company’s stock is to be valued upon the occurrence of a triggering event, such as the departure or death of a shareholder. The United States Court of Appeals for the Eighth Circuit recently heard Thomas A. Connelly, in his Capacity as Executor of the Estate of Michael P. Connelly, Sr., Plaintiff-Appellant v. United States of America, Department of Treasury, Internal Revenue Service, Defendant-Appellee. The Eighth Circuit court affirmed a district court decision that concluded that life insurance proceeds received by a company triggered by a shareholder’s death should be included in the valuation of the company for estate tax purposes.[1]Connelly is an estate tax deficiency case dominated by two themes: (i) the treatment of life insurance in the valuation of stock of a private company when a shareholder dies and (ii) the consequences of executing a buy-sell agreement that fails to meet the requirements under the Internal Revenue Code, Treasury regulations, and applicable case law, for purposes of controlling the valuation of a closely held company.[2] Using Connelly as a backdrop, we first demonstrate how opposing applications of life insurance proceeds received upon the death of a shareholder impact a company valuation. We then offer observations from a study of the Connelly buy-sell agreement from a valuation perspective that private business owners and their advisors should mind when drafting, reviewing, and amending buy-sell agreements.The Stock Purchase AgreementCrown C Supply Company, Inc. is a roofing and siding materials company founded in 1976 and headquartered in St. Louis, Missouri.[3] Crown C (an S corporation) and brothers Michael, Thomas, and Mark Connelly originally entered into a stock purchase agreement (“SPA”) on January 1, 1983. Mark’s interest in Crown C was terminated prior to the stock purchase agreement being amended and restated on August 29, 2001.[4] Crown C had 500 shares of common stock at the date of the SPA’s execution. Michael, via a trust, owned 385.9 shares of Crown C stock representing a 77.18% ownership interest. Thomas, individually, owned the remaining 114.1 shares representing a 22.82% ownership interest.Pursuant to the terms of the SPA, Michael and Thomas executed a certificate of agreed value that set the purchase price of Crown C’s stock upon a triggering event at $10,000 per share (see graphic below). Based on this purchase price per share, which disregarded accepted valuation principles and methodologies, the implied aggregate market value of the company’s stock on August 29, 2001, was $5.0 million.Therefore, at that date, Michael’s shares would have had an agreed value of approximately $3.9 million, while Thomas’s shares would have had an agreed value of approximately $1.1 million. In July 2009, with no update to the agreed value of the company’s equity, Crown C purchased life insurance policies on both Michael’s and Thomas’s lives in the amount of $3.5 million each. The rationale for purchasing the same amount of life insurance on each brother’s life when one brother’s ownership interest was approximately 3.4x larger than the other brother’s is unclear. The SPA dictatedthat life insurance proceeds were to be used to redeem a deceased shareholder’s interest.The Sale and Purchase AgreementMichael, who served as Crown C’s president and CEO, died on October 1, 2013. Thomas was the executor of Michael’s estate. Effective November 13, 2013, Thomas, as trustee of Michael’s trust and a second trust for Molly C. Connelly, Michael’s daughter, recused himself from “all matters touching upon the sale, pricing, negotiation, and transaction of any sale of the stock of Michael P. Connelly, Sr.’s interest in Crown C Supply Company, Inc.”[5] Had Thomas not recused himself he would have been in the conflicted position of negotiating on behalf of Michael’s estate with the company, of which he was now the sole surviving shareholder. Effective the same date, Thomas and Michael’s son, Michael P. Connelly, Jr., executed a sale and purchase agreement governing the redemption of the estate’s shares in Crown C as well as in other entities.[6] Thomas (representing Crown C) and Michael Jr. (representing Michael Sr.’s estate) agreed, without relying upon a formal valuation, to a purchase price of $3.0 million for the estate’s shares (see graphic below).The estate noted, however, that the $3.0 million purchase price “resulted from extensive analysis of Crown C’s books and the proper valuation of assets and liabilities of the company. Thomas Connelly, as an experienced businessman extremely acquainted with Crown C’s finances, was able to ensure an accurate appraisal of the shares.[7] I’ll discuss the importance of engaging a qualified appraiser in matters such as these below.The Estate’s Argument: Life Insurance Proceeds Are Not a Corporate AssetCrown C received $3.5 million in life insurance proceeds upon Michael’s death. Crown C immediately recognized a corporate redemption liability and used $3.0 million of the life insurance proceeds to redeem the estate’s interest in Crown C. It is interesting to note from the graphic above that Michael’s estate’s interest originally was equal to the total cash value of the life insurance proceeds, but at some point was reduced by $500,000 because the company needed additional funding.[8] Exhibit 1 demonstrates this narrative.(click here to expand the figure above)Key takeaways from this scenario:One would expect to see a “top-down” valuation methodology in which the value of 100% of Crown C’s equity is established first, followed by the determination of value attributable to the estate’s shares. However, the aggregate value of Crown C’s equity of $3.9 million was implied based on the value of the estate’s interest of $3.0 million.Crown C immediately recognizes a redemption liability equal to $3.0 million in life insurance proceeds and pays $3.0 million to Michael’s estate in exchange for redeeming the estate’s 385.9 shares; Michael’s estate is redeemed at $7,774 per share.[9]Post-redemption, the total value of the company’s equity does not change while the share count decreases from 500 shares to 114.1 shares, all owned by Thomas.Thomas now owns 100% of the company at a value of $34,067 per share,[10] which is approximately 4.4x the value at which Michael’s estate was redeemed. The value of Thomas’s ownership interest increased by 338% with no additional investment.The IRS’ Argument: Life Insurance Proceeds Are a Corporate AssetThe IRS saw things differently, arguing that the insurance proceeds should be included in Crown C’s equity value. See Exhibit 2 below.(click here to expand the figure above)Key takeaways from this scenario:The equity value of the business for estate tax purposes was $6.9 million inclusive of the $3.0 million in life insurance proceeds. The IRS did not include the excess $500,000 of life insurance in its valuation.The resulting value per share is $13,728[11].The estate’s 385.9 shares have a total value of $5.3 million and Michael’s estate is redeemed at $13,728 per share, reducing the company’s equity value to $1,566,323.Post-redemption, the share count decreases from 500 shares to 114.1 shares, all owned by Thomas at a value of $13,728 per share, which is equal to the pre-redemption value per share.As the life insurance proceeds utilized only totaled $3.0 million, the redemption liability of $5.3 million would have been underfunded by approximately $2.3 million, leaving the company (in this case, solely Thomas) on the hook to finance the shortfall.The Funding Mechanism DilemmaIt should be obvious that the manner in which life insurance proceeds are treated can have a dramatic impact on the selling shareholder, the remaining shareholders, and the company’s ability to buyout the selling shareholder. In one scenario, the estate is redeemed relative to a windfall received by the surviving shareholder. In the second scenario, the estate is redeemed at a higher value, but to the detriment of the company most likely having to finance a portion of the buyout. So, what is the fair way to treat life insurance in this situation? Ultimately, the parties to the buy-sell agreement decide what is fair with the help of their legal and other professional advisors, but such a decision must be addressed directly and without vagueness in the buy-sell agreement.The Defining Elements of a Valuation Process AgreementWe now turn to observations of the Connelly SPA itself from a valuation perspective. Valuation process agreements such as the Connelly SPA have six defining elements:[12] (i) standard of value; (ii) level of value; (iii) the “as of” date; (iv) qualifications of the appraiser; (v) appraisal standards; and (vi) funding mechanisms. The first five elements are required to specify an appraisal that is consistent with prevailing business appraisal standards. We’ve seen how the Connelly SPA addressed element #6, funding mechanisms. So, how, then, does the Connelly SPA stack up regarding defining elements #1 through #5?Standard of ValuePer the American Society of Appraisers ASA Business Valuation Standards, the standard of value is “the identification of the type of value being used in a specific engagement; e.g. fair market value, fair value, investment value.”[13]Fair market value, the standard that applies to nearly all federal and estate tax valuation matters and which is specified in most buy-sell agreements, is referenced in the Connelly SPA as part of the definition of appraised value per share. Fair market value itself, however, is not defined in the SPA. Without a specific, clear definition of fair market value, such as that from the ASA Business Valuation Standards or the Internal Revenue Code, the interpretation of fair market value is left to the appraiser(s). In the Connelly matter, upon a triggering event two appraisers were to be engaged (one by Crown C and one by the selling shareholder). Should the opinions of these two appraisers diverge by more than 10% of the lower appraised value, a third appraiser could have been engaged. The SPA as drafted opens the door for three interpretations of fair market value. And with multiple interpretations comes the increased likelihood of litigation.Level of ValueValuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. The graphic below depicts these levels. A formal business valuation for gift and estate tax purposes will clearly state the level of value, and therefore, no interpretation is needed as to the applicability of control premiums or discounts for lack of control and lack of marketability.Per the Connelly SPA, in the scenario in which appraisers are utilized in lieu of issuing a certificate of agreed value, “the appraisers shall not take into consideration premiums or minority discounts in determining their respective appraisal values.” In the absence of minority interest discounts, Thomas’s minority interest (22.82%) would have been valued on a pro-rata basis relative to Crown C’s total value.The As-Of DateEvery appraisal has an “as-of” date, more commonly referred to as the valuation date. Why is the valuation date important? Business appraisers rely upon information that was “known or reasonably knowable” on the valuation date. For purposes of filing Form 706, the valuation date is the date of death (estates may elect the alternate date, six months from the date of death, as the valuation date). For redemption purposes, however, the Connelly SPA refers to “Appraisal Date,” which is “the date an option is exercised or a mandatory purchase is required.” As such, the Connelly SPA does allow for a redemption to occur on a specific date.Qualifications of AppraisersIf the qualifications of an appraiser are not specified, just about anyone can do the appraisal. The Connelly SPA mentions that an appraiser “shall have at least five years of experience in appraising businesses similar to the Company.” That’s it. The SPA makes no mention of formal education, valuation credentials such as ASA, ABV, or CVA, or continuing education and training requirements. Ultimately, this was a moot point for Connelly because no appraiser was ever hired to do a valuation. But what could happen if an unqualified appraiser is hired to perform a valuation? A recent tax court case, Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent (T.C. Memo 2023-34), addressed this situation head-on. While the case was related to the donation of closely held stock, not using a qualified appraiser had a damaging impact on the taxpayer. The company whose shares were subject to the charitable gift had been marketed for sale by an investment banker prior to the gift. The taxpayer’s attorney suggested that the investment banker be considered to do the appraisal for the gifting because "since they have the numbers, it would seem to be the most efficient method."[14] In court, the petitioners argued that the investment banker was qualified because he had prepared "dozens of business valuations" over the course of his 20+ year career as an investment banker. According to the court, an individual’s “mere familiarity with the type of property being valued does not by itself make him qualified.” The court further noted that the investment banker “does not have appraisal certifications and does not hold himself out as an appraiser.” The court relied on testimony at trial about appraisal experience to be instructive, as the investment banker testified that he conducted valuations "briefly" and only "on a limited basis" before starting at the investment bank the year before the appraisal. The investment banker also testified that he performed (presumably at no charge) business valuations for prospective clients "once or twice a year" in order to solicit their business. The court found the investment banker’s “uncontroverted testimony sufficient to establish that he does not regularly perform appraisals for which [he] receives compensation." The end result for the taxpayer in Hoensheid: the Tax Court found that the taxpayer failed to comply with the qualified appraisal requirements and denied the charitable deduction.Appraisal StandardsOccasionally, buy-sell agreements lay out the specific business appraisal standards to be followed by the appraiser. Standards most often cited in buy-sell agreements are the Uniform Standards of Professional Appraisal Practice (commonly referred to as “USPAP”), the ASA Business Valuation Standards, AICPA’s Statement on Standards for Valuation Services No. 1 (commonly referred to “SSVS”) and NACVA’s Professional Standards. The Connelly SPA did not reference any of these standards. Without any appraisal standards referenced, any appraiser elected to perform a valuation under the SPA who was not a member of one of the national appraisal organizations has no requirement to follow any set of standards or code of ethics.Tax Court ConclusionsConnelly was first decided by the District Court in September 2021. Having been appealed by the estate, the Eighth Circuit affirmed the District Court’s decision in June 2023. The District Court Decision The IRS had contended that the life insurance proceeds should be included in the valuation of Crown C’s equity. The estate argued that the redemption obligation was a corporate liability that offset the life insurance proceeds dollar for dollar. The District Court sided with the IRS, noting that “Because the insurance proceeds are not offset by Crown C's obligation to redeem Michael's shares, the fair market value of Crown C at the date of date of death and of Michael's shares includes all of the insurance proceeds.”[15]The Circuit Court DecisionThe Circuit Court affirmed the District Court’s decision, noting “In sum, the brothers’ arrangement had nothing to do with corporate liabilities. The proceeds were simply an asset that increased shareholders’ equity. A fair market value of Michael’s shares must account for that reality.”[16]Current StatusShareholder buyouts often occur at inconvenient times, and poor planning can have financially devastating consequences. In Connelly, a poorly drafted buy-sell agreement resulted in a notice of deficiency from the IRS in the amount of $998,155 [17] and undisclosed legal and professional fees incurred to litigate the matter. The estate has sought a refund of $1,027,042 that it views was “erroneously, illegally, and excessively assessed against and/or collected from Plaintiff as federal estate tax…”[18] In August 2023, counsel for the estate filed with the Supreme Court of the United States a petition for a writ of certiorari to the United States Court of Appeals for the Eight Circuit. On December 13, 2023, the Supreme Court granted the petition for writ of certiorari, signifying its acceptance of the case for review. As of February 2024, the case had not yet been set for argument.[1] Courts have had differing opinions on the life insurance/valuation matter. In Estate of George C. Blount, Deceased, Fred B. Aftergut, Executor, v. Commissioner, the United States Court of Appeals, Eleventh Circuit ruled that life insurance proceeds used to redeem a stockholder’s shares do not count towards the fair market value of the company when valuing those same shares.[2] The buy-sell agreement that is the subject of Connelly was challenged by the IRS as invalid for controlling the valuation of the subject company’s stock in an estate tax scenario. The district and circuit courts both agreed and deemed the buy-sell agreement invalid.[3] Crown C was sold to SRS Distribution, Inc., a portfolio company of Leonard Green & Partners and Berkshire Partners, in 2018. Terms of the deal were not disclosed. Crown C continued to serve the St. Louis market as of the publication date of this article.[4] Amended and restated stock purchase agreement by and among Michael P. Connelly, trustee U/I/T dated 8/15/90, Michael P. Connelly, grantor, and Thomas A. Connelly, executed effective August 29, 2001.[5] Sale and purchase agreement by and among Thomas A. Connelly, trustee of The Michael Connelly Irrevocable Trust dated 15 August 1990, Crown C Supply Co., Inc., a Missouri Corporation, Thomas A. Connelly, individually, Connelly Partnership/Connelly, LLC, and 5200 Manchester, LLC, executed November 13, 2013.[6] Ibid.[7]Connelly v. United States, Memorandum and Order, page 21, September 2021.[8] Appeal from the United States District Court for the Eastern District of Missouri – St. Louis, No. 21-3683, page 3, filed June 2, 2023.[9] ($3.0 million / 385.9 shares) = $7,774 / share.[10] ($3.9 million / 114.1 shares) = $34,067 per share.[11] ($6.9 million / 500 shares)[12] Mercer, Z. Christopher, Buy-Sell Agreements for Closely Held and Family Business Owners (Peabody Publishing LP, 2010).[13] American Society of Appraisers Business Valuation Standards (approved through November 2009).[14] T.C. Memo. 2023-34; Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent.[15] Connelly v. United States, Memorandum and Order, page 35, September 2021.[16] Appeal from the United States District Court for the Eastern District of Missouri – St. Louis, No. 21-3683, page 13, filed June 2, 2023[17] Complaint of Thomas A. Connelly, Executor of the Estate of Michael P. Connelly, Sr. dated May 23, 2019.[18] Ibid.Originally published in Mercer Capital's Value Matters Newsletter: Q1 2024

Will Finfluencers Replace Financial Advisors?

We think finfluencers are more likely to be a marketing opportunity than a competitive threat to financial advisors seeking business from younger investors. FAs that stress their value proposition and key points of differentiation will usually win the clients they want over their conflicted competitors. If that fails, they can always partner with one, but we highly recommend they read CFAI’s report before doing so.

Non-Operating Working Interests in Oil & Gas: Part I

Characteristics of Non-Op Working Interests, the Risks, and the Benefits

The economics between an operating interest and a non-op interest can sometimes differ significantly in certain circumstances.

Understanding the Asset Approach

What Is It and How Is It Used for Auto Dealer Valuations?

Everyone in the auto dealer industry has likely heard of Blue Sky values. Under the market approach, valuation professionals add the indicated Blue Sky value to the dealership’s tangible net asset value. This is where the asset approach comes into play.

February 2024 | Themes from AOBA and Pay vs. Performance: What’s New in Year 2

Bank Watch: February 2024

In this issue: Themes From the 2024 Acquire or Be Acquired Conference and Pay vs. Performance: What’s New in Year 2

Pay Versus Performance: What’s New in Year 2?

Financial Reporting Flash: Issue 2, 2024

The 2024 proxy season marks Year 2 under the SEC’s new Pay Versus Performance disclosure framework for public companies.

Essential Financial Documents to Gather During Divorce - Part 1

Navigating Tax Returns | Tips and Key Focus Areas for Family Law Attorneys and Divorcing Individuals/Business Owners

Documents Needed to Prepare the Marital Balance Sheet

The Tangled Path to Banking’s Garden of Earthly Delights

Hieronymus Bosch, The Garden of Earthly Delights, 1490-1510, Museo del Prado, Madrid.One of BankWatch’s favorite artists is the Dutch painter Hieronymus Bosch (1450-1516). His work is both enigmatic and fantastical, with bizarre human/animal hybrid forms and other monstrous creations of Bosch’s fecund imagination. Indicating its lasting relevance and, in a sense, modernity, centuries later Bosch’s work served as inspiration when the Surrealist movement sought to depict dreamlike scenes formed from the depths of their unconscious mind. One triptych, The Garden of Earthly Delights, depicts a utopian scene in the middle panel adjacent to a hellscape in the right panel.It serves as an apt metaphor for the banking industry’s stomach churning volatility in 2023.As in the hellscape panel on the right side of the triptych, the banking industry sunk to the depths of despair beginning in March 2023, tormented by bank failures and deposit runs.From year-end 2022 to the nadir in May 2023, the Nasdaq Bank Index sunk 34%. Bank stocks rebounded during the summer but remained under pressure through the fall as the ten year Treasury rate briefly exceeded 5%.Finally, more dovish comments from Chairman Powell lifted sentiments, causing the Nasdaq Bank index to appreciate by 12% in November 2023 and 15% in December 2023.While we have not returned to a banking utopia, the greener pastures in which Bosch’s hybrid forms graze in the triptych’s middle panel seem more representative of industry conditions at year-end 2023.2023 PerformanceFor 2023, the Nasdaq Bank Index and the KBWNasdaq Regional Bank Index depreciated by 7% and 4%, respectively (see Figure 1 ). This marks the second year of negative performance for bank stock indices. Between year-end 2021 and 2023—covering the entire period of rising rates—the Nasdaq Bank and Regional Bank indices decreased by 24% and 13%, respectively (see Figure 2).After losing 19% in 2022, the S&P recovered in 2023 with 24% appreciation, meaning that the S&P 500 at year-end 2023 returned to a level virtually identical to year-end 2021. Struggling with earnings pressure, banks lost favor with growth minded investors, thereby underperforming the broader market.Figure 1 :: Index Performance (12/31/22 - 12/31/23)Figure 2 :: Index Performance (12/31/21 - 12/31/23)Figure 3 stratifies the 328 banks and thrifts traded on the NYSE and Nasdaq by asset size. Banks in the three strata between $1 billion and $100 billion performed similarly, with the median bank’s stock price falling by about 5% in 2023. Between 30% to 40% of banks reported share price appreciation over year-end 2022. The largest banks outperformed in 2023, as several banks like J.P. Morgan Chase (NYSE: JPM) “over-earned” their long-term return on equity target. JPM and other money center banks were boosted by low-cost deposits flowing from smaller banks in the wake of the failures of SVB, Signature Bank, and First Republic Bank.JPM also recorded a bargain purchase gain from the acquisition of First Republic Bank as did First Citizens BancShares (NYSE: FCNCA) and New York Community (NYSE: NYCB), the winning bidders for SVB and Signature Bank.Figure 3Figure 4 replicates the analysis for the period between year-end 2021 and year-end 2023. Not all banks have struggled through this rising rate environment, as 28% of banks reported share price appreciation over the two-year period. Nevertheless, the largest number of banks have experienced a 10% to 20% decline in their share prices.Figure 4Catalysts for (Under)PerformanceChanges in the net interest margin have the greatest effect on profitability and share price performance in the current environment, given limited credit issues. Figure 5 includes publicly traded banks with assets between $1 billion and $10 billion, sorted into quartiles based on their NIM change between the fourth quarter of 2022 and the third quarter of 2023.Figure 5The first quartile, including banks with the most severe NIM pressure, experienced a median stock price change of negative 14% in 2023. Meanwhile, banks in the fourth quartile—with the least NIM pressure or even NIM expansion—eked out a positive 2% change in stock price.This relationship holds true if we consider the entire rising rate period between the first quarter of 2022 and the third quarter of 2023 (see Figure 6). Over this period, approximately one-half of the banks reported a higher NIM; however, the market provided a meager reward with share prices for banks in the fourth quartile appreciating by a median of 4%. This reflects the market’s focus on the more recent trend in the margin—generally downward for most banks—rather than a historical anchor in a low rate environment. Meanwhile, the banks in the first quartile that were most exposed to rising rates suffered a median -24% change in their stock prices.Figure 6Valuation ImplicationsFigure 7 illustrates the earnings pressure resulting from tighter NIMs.For 2023, analysts’ EPS estimates indicate a median EPS decline of 15% for publicly traded banks with assets between $1 and $15 billion, with 73% of the banks in the analysis expected to face lower year-over-year earnings in 2023. These estimates are based upon recent data. Measured from January 2023, the reduction in earnings estimates is much more severe, meaning analysts cut estimates as the year progressed.Figure 7The outlook is only marginally better in 2024, as the median decline in EPS is 8%. Analysts generally expect NIMs to stabilize, or at least decline at a more modest rate, in the first half of 2024, followed by some expansion in the second half of 2024. The NIM stabilization in the latter half of 2024 leads to earnings growth in 2025 for most banks, with a median EPS growth rate of 10%. However, only 28% of banks in our analysis are projected to have higher EPS in 2025 than in 2022.With the share price recovery in late 2023, publicly traded banks with assets between $1 and $15 billion reported a median price/one year forward earnings multiple of 11.5x and a price/tangible book value multiple of 1.26x. As indicated in Figure 8, these multiples are in-line with the range over the last five years. Therefore, the catalyst for further share price appreciation likely will be earnings improvement rather than P/E multiple expansion.Figure 8ConclusionThe worst has passed for banks, with slowing deposit attrition and stabilizing NIMs, unless credit performs materially worse than expected.However, conditions likely are not ripe for rapid earnings growth. First, NIMs likely will recover more slowly than they contracted due to volume of assets repricing years into the future. Second, many banks are reporting slowing loan growth, as higher rates have gradually eroded loan demand. Third, if loan demand exists, marginal funding remains difficult to obtain at a favorable cost of funds.For many publicly traded banks, returning to the garden of earthly delights remains a ways off.Orginally appeared in the January 2024 issue of Bank Watch.

5 Reasons Buyers Need a Quality of Earnings Report

After sitting on the sidelines for much of 2022 and 2023, the prospect of Fed rate cuts may lure buyers back onto the field in 2024.And when deal activity heats back up, due diligence will be as critical to buyers as ever. For many buyers, a quality of earnings (“QofE”) report is a cornerstone of their broader diligence efforts.For family businesses, an acquisition that goes sour can negatively affect family wealth for decades to come. Obtaining a thorough QofE report as part of deal diligence can help family business directors avoid such a misstep. In this week’s post, we review five reasons family business directors need a QofE report before approving an acquisition.1. Avoid overpaying for earnings that aren’t sustainable.Audited financial statements provide assurance that the past performance of the target company is faithfully represented. However, successful acquirers are focused on the future, not the past. A thorough QofE report helps buyers extract what truly sustainable performance is from the welter of the target’s historical earnings. Paying for historical earnings that don’t materialize in the future is a recipe for sinking returns on invested capital. QofE reports analyze historical earnings for adjustments that convert historical earnings to the pro forma run rate earnings that make an acquisition worthwhile.2. Identify opportunities for cost savings in the target’s expense base.The detailed analysis of cost of sales and operating expenses in a QofE report can uncover opportunities for acquirers to boost margins at the target through cost-saving initiatives. By observing trends in headcount by function, occupancy, and other components of operating expense, buyers can identify redundancies and develop strategies for enhancing post-acquisition cash flow from the target.3. Find revenue synergies with your existing business.A thorough QofE report is not just about expenses. Observing revenue trends by product and business segment, coupled with analysis of customer churn data, can help buyers better understand how the target “fits” with the existing business of the buyer, which can open up strategies for fueling revenue growth in excess of what either company could accomplish on a standalone basis. Armed with a better understanding of opportunities for revenue synergies, buyers can move to the closing table more confident of the upside to be unlocked through the transaction.4. Clarify working capital needs of the target.Incremental working capital investment is the silent killer of transaction return on investment. A thorough QofE report will move beyond the income statement to evaluate seasonal trends in the core components of net working capital. Doing so helps buyers plan adequately for the ongoing working capital requirements they will need to fund out of post-acquisition earnings. Working capital analysis in the QofE report also helps buyers negotiate appropriate working capital targets in the final purchase agreement.5. Assess capital expenditure needs at the target.Not every dollar of EBITDA is equal. EBITDA multiples are a function of risk, growth, and capital intensity. Buyers cannot afford to overlook capital intensity when evaluating targets. A thorough QofE report examines historical trends in capital expenditures and fixed asset turnover to help buyers better discern the prospective capital expenditure needs of the target and how those needs influence the transaction price and prospective returns. For family businesses contemplating an acquisition, the stakes are high. You can’t eliminate risk from an M&A transaction but obtaining a thorough QofE report on the target can help directors avoid mistakes and increase the odds of a successful deal. If you are considering an acquisition in 2024, give one of our senior professionals a call to discuss how our QofE team can generate Insights That Matter for your diligence team.WHITEPAPERQuality of Earnings AnalysisDownload WhitepaperFor buyers and sellers, the stakes in a transaction are high. A QofE report is an essential step in getting the transaction right.

5 Reasons Buyers Need a Quality of Earnings Report

For family businesses, an acquisition that goes sour can negatively affect family wealth for decades to come. Obtaining a thorough QofE report as part of deal diligence can help family business directors avoid such a misstep.

Quality of Earnings Analysis for RIAs

As we’ve often highlighted on this blog, transaction activity in the RIA space has increased dramatically over the last decade. Alongside this increase in deal activity, there have been significant developments in the supporting infrastructure for M&A. Many large consolidators now have dedicated outreach and deal teams and standardized due diligence processes. This professionalization of the buyer market combined with more recent headwinds to deal activity have led to increasing scrutiny of target earnings.

Vroom in the Tomb and Used Vehicle Gloom

What Does the Collapse of Vroom Say for Auto Dealers?

Vroom and other used-only dealerships are more squeezed because they aren’t tied to a franchise. They can only sell used vehicles whose prices have been more volatile, and they don’t have access to captive financing from their OEMs. In short, we don’t think traditional franchise dealers will be stung by the forces that took down Vroom. However, we believe Vroom shouldn’t be ignored as it can provide valuable insights. Its S-1 highlighted e-commerce penetration in the industry sits at just under 1%, compared to about 16% for total retail.

Goodwill Impairments Are on the Rise. Surprised?

Executive SummaryPreliminary results for 2023 show that the number of goodwill impairments is increasing for both large and middle-market public companies. Based on data through November, the number of impairments recorded by firms on the S&P 500 and Russell 2000 indices had already eclipsed 2021 and 2022 full-year figures. Interestingly, these trends materialized even as the indices themselves posted favorable total returns for the year of 25% and 14%, respectively. Public and private companies currently in the process of performing their annual/interim impairment tests should be on the alert if their peer group turns out to be the one recording impairment charges.Back in 2020, the stock market downturn stemming from pandemic shutdowns resulted in triggering events and impairment charges for many companies.This was especially evident among smaller publicly-traded companies (as tracked by the Russell 2000 versus the S&P 500).The number of charges dropped drastically in 2021 (even compared to 2019 results), suggesting that some of the 2020 impairment charges may have reflected a pull-forward of later charges.Since that time, the number and percentage of companies recording charges has steadily increased, with preliminary figures for 2023 already exceeding the numbers recorded in 2022.Total Goodwill Impairment Charges and % of companies with GW that recorded chargesThis trend held across sectors as well.In the Russell 2000, eight of eleven sectors reported an increase in number of charges to goodwill between 2019 and 2020.Charges in the consumer staples sector declined among S&P 500 companies, while increasing for Russell 2000 companies.Charges in the utilities sector declined for S&P 500 companies but remained stable for Russell 2000 companies.For both groups of companies, charges taken by the materials sector declined.Following 2020, impairment charges dropped below 2019 levels – sharply, in the case of many sectors over 2021 through 2022.More recently, the number of charges and the magnitude of total goodwill charges for the first eleven months of 2023 had already exceeded the full year of 2022.Additional impairments may be on the way as companies complete and file their year-end financials. Based on the preliminary figures for the Russell 2000, the sectors recording the most charges appear to be healthcare and industrials.Despite the increase in impairment charges taken in 2020, the number of small-cap companies reporting year-end goodwill balances increased in 2020 and continued to increase through 2022 and 2023.Approximately 60% of Russell 2000 companies carried goodwill in 2019, while over 63% did so in 2023.The percentage of S&P 500 companies reporting goodwill declined from 89% in 2019 to 86% in 2023.Percent of Companies Reporting GoodwillIt is impossible to attribute the rise in impairment charges to a single specific factor. However, it is likely that rising interest rates and higher inflation played a significant role in 2023 results. Impairment charges also tend to have a larger impact on smaller companies.Generally speaking, smaller companies tend to be less diversified in terms of product or service offerings, and their client bases may be more sensitive to external economic factors.Ultimately, the preliminary data for 2023 shows that impairments do not necessarily taper off when overall equity markets are rising. Company-specific factors, including financial performance relative to history, expectations, and peer performance, are critical when evaluating goodwill for potential impairment. Will the impairment trends seen in the large and middle-market public markets extend to private companies? Perhaps.The valuation specialists at Mercer Capital have experience in implementing both the qualitative and quantitative aspects of goodwill impairment testing under ASC 350. If you have questions, please contact a member of Mercer Capital’s Financial Statement Reporting Group.

2024 Oil and Gas Outlook

A Year Of Divergence

When it comes to the oil and natural gas upstream markets, it appears each commodity and their producers are heading to different places in 2024. We can see it through market sentiment, prices, production, and corporate actions such as mergers.

WHITEPAPER | Quality of Earnings Analysis

What Buyers and Sellers Need to Know About Quality of Earnings ReportsFor buyers and sellers, the stakes in a transaction are high. You only get one chance to do it right.Commissioning a quality of earnings report is an essential step in getting the transaction right.In this whitepaper, we illustrate how buyers and sellers benefit from a quality of earnings report that extracts a company’s sustainable earning power from the thicket of historical GAAP earnings. We review the most common earnings adjustments applied in QofE analyses and review the role of working capital and capital expenditures as the links between EBITDA and cash flow available to buyers.Leverage the experience of our QofE team to generate Insights That Matter in support of your next transaction.

Ownership & Succession Planning in 2024

Who knew the Green Bay Packers could be a source of inspiration for your family business’s succession planning?

Navigating the Shifting Tides

Trends Shaping the RIA Industry in 2023 and Beyond

As the financial landscape continues to evolve, the RIA industry experienced a notable shift in 2023, diverging from the challenges faced in the preceding year. Despite predictions going into 2023 that persistent inflation and elevated interest rates would lead to an economic downturn, no recession came to pass, and all sectors of the RIA industry experienced growth as markets rebounded from the 2022 slump.

2024 Automotive Trends

A Look Back to Look Forward

Following the auto industry rollercoaster of the past two and a half years, perhaps 2024 will be a return to the times before the pandemic. If not, this could be our new normal. Margins and profitability have already declined in the latter half of 2023. The buying process for vehicles has forever changed, offering online and omnichannel options to the traditional in-person experience at the dealership. While inventory supply from the OEMs continues to improve, will it level off, or will it also climb back to pre-pandemic levels in 2024?

The Chesapeake and Southwestern Merger

Reshaping U.S. Natural Gas

On January 11th, 2024, Chesapeake Energy Corporation and Southwestern Energy Company announced that they would be merging, with the resulting (currently unnamed) company becoming the largest natural gas producer in the country.

Forward Air Corporation to Acquire Omni Logistics, LLC?

Another tough call for the merger arb community – acquirer and target sue each other in Delaware Court of Chancery to respectively terminate the merger agreement or force consummation of the merger

How Does Your Family Business Think About Philanthropy?

While we’ll be the first to say there are others better suited to help you think about the existential questions (why should we give, to what causes), we think there are some considerations and strategies that you and your family board can keep in mind when determining how your family business thinks about philanthropy.

The Remarkable Resilience of RIA M&A Activity

RIA M&A activity has demonstrated remarkable resilience, defying initial expectations of a slowdown amid challenging macroeconomic conditions. As the economy entered 2023 facing high inflation, rising interest rates, and tight labor markets, many anticipated a decline in M&A activity. However, Fidelity’s November 2023 Wealth Management M&A Transaction Report listed 210 deals through November 2023, up 3% from the 203 deals executed during the same period in 2022. Notably, there was a significant uptick in total transacted AUM during 2023. Total transacted AUM through November 2023 was $336.6 billion—a 25% increase from the same period in 2022.

December 2023 SAAR

The December 2023 SAAR was 15.8 million units, up 3.2% from last month and up 16.8% compared to this time last year. After only two months of single-digit year-over-year improvements, the December SAAR returned to double-digit year-over-year growth. The December SAAR marks a strong finish to 2023, with growth in line with the double-digit percent increases seen from March to September. The December SAAR extended the streak of consecutive year-over-year improvements to 17 months.

Haynesville DUCs Buoy Production Despite Rig Count Decline

The economics of oil & gas production vary by region. This quarter, we take a closer look at the Haynesville shale.

A 2024 M&A Update

Middle-Market Deal Activity in 2023 and Thoughts on 2024 Activity

In last week’s post, Travis Harms opened the year by offering a few key questions that family business owners and directors should ask themselves in 2024. One of these questions suggests a thorough review of your family business’s M&A strategy. In this week’s post, we take a closer look at middle-market deal activity in 2023, which sank to its lowest level in a decade, and offer a few thoughts regarding the state of the middle market as we see it in 2024.

RIAs Finish 2023 with a Q4 Rally

Investor Interest Moves to Alts and Big-Name Managers

Share prices for most publicly traded asset and wealth management firms trended upward with the broader market during Q4 2023. For the second quarter in a row, alternative asset managers outperformed the market and other RIAs, ending the quarter up about 21% compared to 11% for the S&P 500. On a year-over-year basis, all sectors of RIAs experienced growth as the markets rebounded from the 2022 slump. RIAs directly benefit from improving market conditions as they result in a stronger asset base on which to collect fees.

What Is the Car Parc Makeup?

Data from Q3 2023

Initiating Coverage of the Haynesville Shale

We’re starting 2024 with coverage of the Haynesville shale. The Haynesville shale is one of the top natural gas plays in the U.S., particularly when factoring in its geographic location, pipeline and infrastructure capacity, and deliverability of gas to the Gulf Coast industrial complex and liquified natural gas (LNG) export facilities.

Evaluating Your Firm’s Margin

We start the new year with an industry-focused piece, sharing a recent article from our Investment Management blog, RIA Valuation Insights. The industry focus is intentional because we have provided family law valuation and forensic services to numerous owners (and spouses of owners) of RIAs/wealth management firms. In addition, the broader topic of understanding the role of a firm’s margin in valuation is important for family law attorneys, as well as other parties to a divorce.

5 Questions for Family Business Directors in 2024

For some family businesses, 2023 was a year to remember, while others hope it won’t be repeated. Regardless of how your family business fared last year, 2024 is here. What should you and your fellow directors be thinking about as the new year starts?

The Baltimore Bridge Collapse, One Month Later

Q1 2024

It’s been about a month since cargo ship Dali collided with the Francis Scott Key Bridge in the waters of the Chesapeake Bay. We wrote about the collapse when it occurred and wanted to revisit the topic. The bridge collapse represents another event in a string of global impacts on the supply chain and is another reminder about how unpredictable events can have a wide reach.

January 2024 | The Tangled Path to Banking’s Garden of Earthly Delights

Bank Watch: January 2024

In this issue: The Tangled Path to Banking’s Garden of Earthly Delights

Goodwill Impairments Are on the Rise. Surprised?

Financial Reporting Flash: Issue 1, 2024

Preliminary results for 2023 show that the number of goodwill impairments is increasing for both large and middle-market public companies.

Value Focus: Insurance Industry | First Quarter 2024

Brokers and P&C underwriters outperformed the broad market and other insurance sectors in Q1-2024

Medtech and Device Industry Newsletter - Q1 2024

FEATURE ARTICLE | Five Trends to Watch in the Medical Device IndustryEXECUTIVE SUMMARYThis quarterly update includes a broad outlook that divides the healthcare industry into four sectors:Biotechnology & Life SciencesMedical DevicesHealthcare TechnologyLarge, Diversified Healthcare CompaniesWe include a review of market performance, valuation multiple trends, operating metrics, and other market data. This issue also includes a review of M&A and IPO activity

E&P First Quarter 2024

Eagle Ford

Eagle Ford // Despite significant rig-count declines, Eagle Ford production declined only modestly over the twelve months ended March 2024, aided by a significant number of DUCs going into production.

Transportation & Logistics Newsletter

First Quarter 2024

Bank M&A 2023

Subdued But Potentially Explosive

Middle Market Transaction Update Winter 2023

Although middle market transaction activity remained depressed in the third quarter of 2023 compared to 2022 levels, M&A activity and possibly deal multiples could improve in 2024 given the potential for Fed rate cuts, an economy that has remained resilient in spite of 525bps of rate hikes by the Fed, and ample dry powder held by PE firms to deploy.

‘Twas the Blog Before Christmas...

2023 Mercer Capital Auto Dealer Holiday Poem

Enjoy our year-end poem.

Capital Structure in 5 Minutes

New Video Released on Family Business On Demand Resource Center

Family businesses are built on long-term capital investments. Capital structure refers to the mix of debt and equity financing used to make those investments. In this video, we explore what capital structure means for family businesses, the effect of capital structure on the weighted average cost of capital, and some qualitative considerations to consider when establishing a target capital structure.

Top 10 Energy Valuation Insights Blog Posts of 2023

Auto Dealer Insights: Best of 2023

We are about to put a bow on 2023! Our weekly posts follow the auto industry closely to keep up with market trends and gain insight into the private dealership market. We hope you have enjoyed our content in 2023, and we look forward to connecting further in 2024! Below, we have recapped four of our popular topics.Auto Industry Trends to Monitor in 2023Early in the year, we wrote a post discussing a potpourri of trends to monitor in 2023, coming off specific statistics from 2022. We discussed new vehicle pricing, used vehicle pricing, electric vehicles, connected cars, and SAAR predictions for 2023. As we close out 2023, we revisit some of these topics and predictions in hindsight.The average transaction price for new vehicles continued to rise in early 2023 before flattening out and eventually declining. As of the most recent data, the average transaction price of new vehicles stood at $45,332 in November, representing a decline ranging from 1.5-2%, depending on the source. Consistent with those trends, incentives on new vehicles have steadily risen and now comprise approximately 4.5-5%, depending on the source. Finally, the percentage of new vehicles selling above MSRP is 21.4%, compared to nearly 37.1% from this time last year, according to JD Power/LMC. All of these trends indicate that we are shifting from a seller’s market to a buyer’s market for automobile consumers.Average transaction prices for used vehicles also followed suit, posting a figure of $29,985 for November, a decline of approximately 2.9% from November 2022.Avid readers are familiar with our monthly SAAR reports. With a strong December, which is typically the strongest selling month of the year, the annual SAAR is expected to land somewhere in the area of 15.6 million units. As a point of reference, predictions for 2023 ranged from 14.1 to 15 million from industry experts such as Edmunds, Cox Automotive, NADA, and Toyota North America. After underperforming expectations in 2022, predictions were reigned in, and the rebound materialized in 2023, outstripping expectations.EV PotpourriAccording to Automotive News, EVs continued to increase market share, with estimates ranging from approximately 7% at the beginning of the year based on the total number of new vehicle registrations to 8.6% in June. This post discussed the different charging levels, various requirements automakers have for their dealers, and the expanding presence of charging stations at retailers and restaurants.Later in the year, we discussed the recent development of EV affordability, as well as a view of consumer demand measured by days’ supply of EV inventory versus all vehicles. EVs continue to be more expensive than their internal combustion engine (ICE) counterparts, with average transaction prices of $55,436 and $41,630 for new and used EVs, respectively. Only five of the twenty new EV models to be introduced in 2024 will be offered at prices below the average transaction price for all new vehicles.While production of EVs has increased, the amount of EV inventory on dealers is beginning to mount, perhaps reflecting a softening interest in these models. For all OEMs other than Chevrolet and Cadillac, the days’ supply of inventory for EVs is far more than the days’ supply of all new vehicle inventory. Stated simply, EV inventory is sitting on dealers’ lots for extended periods compared to ICE vehicles.Ford recently announced it is scaling back its $3.5 billion Michigan battery plant as EV demand has declined and labor costs have increased.United Auto Workers StrikeThe increase seen in labor costs is due to the UAW strike, which began on September 15th and ended on November 20th, when new deals were ratified. Our October 6th post chronicled the strike in real time, including insights into why the union was striking, the key players in negotiations, and how this strike differed from previous ones. Historically, the UAW only targeted one OEM at a time during a strike. But as this was the first simultaneous strike against the Big 3, it enabled the UAW to use concessions by one OEM as negotiation leverage with the others. Possibly learning from the recent supply chain constraints, the strikes also targeted specific factories that produce the most popular and profitable vehicles, allowing the UAW to inflict maximum economic pain while limiting the interim losses of its striking members.The new contract gave union workers an immediate pay increase of 11%, and union members will get a total pay increase of 25% throughout the 4½-year deal. The new contracts also reinstated cost-of-living adjustments, let workers reach top wages in three years instead of eight, and protected their right to strike over plant closures.For comparison sake, we noted reports that the UAW was seeking: As expected, the UAW gained some valuable concessions but also didn’t get everything they were seeking. Floorplan Interest Income FadingIn the post-COVID and supply chain-constrained boom, auto dealers enjoyed an unlikely profit center: floorplan interest. Floorplan loans are provided to dealers by banks, specialty lenders, and vehicle manufacturers. Interest accrued on these loans is called floorplan interest, and in the time between when the vehicle is acquired by the dealer and sold to a consumer, the dealer must pay floorplan interest expense to the lender. The longer the vehicle sits on the lot, the longer interest accrues.When dealers started selling vehicles as soon as they arrived at the dealership, floorplan credits exceeded floorplan interest expense. Normally a cost of doing business, low interest rates coupled with depressed inventories meant the sales-volume-based credits many dealers receive from their OEM exceeded the financing cost of holding vehicles on the lot.As we noted in our post this year, this began to fade in 2023 as inventories recovered and rates remained elevated. With no end in sight, they continued to rise as many Fed watchers anticipated a “higher for longer” interest rate environment.

7 Considerations for Your RIA's Buy-Sell Agreement

If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion in this post.

Worldwide Impacts on Marine Shipping

Q4 2023

We discussed reshoring and nearshoring trends a bit in the last newsletter. There’s been some developments on that front, especially as it relates to the ongoing battle between East Coast and West Coast ports.

Talking Money with the Next Gen

Communicating financial results to family shareholders is not optional, and one-size-fits-all solutions may not work for your family. Being intentional and taking the duty to communicate well with your next-gen family members today can save everyone a lot of grief tomorrow.

Assessing an RIA’s Quality of Earnings

Don’t Pay a Premium for a Project

A thorough quality of earnings assessment can go a long way to understanding why a given firm is profitable and how likely it is to remain so after a transaction.

Remembering Charlie Munger

His Investment Wisdom and Legacy

Mr. Buffet took this one step further – “I will confidently wager that no computer will ever replicate Charlie.” Unfortunately, he was probably right.

November 2023 SAAR

The November 2023 SAAR was 15.3 million units, down 0.7% from last month but up 7.4% compared to this time last year. As demonstrated by a second consecutive single-digit year-over-year improvement, the industry continues to grow slower than the double-digit percent increases seen from March to September.

Memorable Mungerisms

Our colleague Brooks Hamner wrote a great post for sister blog RIA Valuation Insights last week, marking the passing of investing legend Charlie Munger. Brooks’ post unearthed some Mungerisms we had not heard before, and we think Mr. Munger’s wisdom is just as relevant inside the family boardroom as it is for professional investment managers. Enjoy!This week, we step aside from our usual musings on valuation trends in the RIA industry to honor the late Berkshire Hathaway Vice Chairman with our thoughts on some of his famous quotes (that might be relevant to you and your clients):“I think the reason why we got into such idiocy in [personal] investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, ‘My God, they’re purple and green. Do fish really take these lures?’ And he said, ‘Mister, I don’t sell to fish.’” – 1994 speech at the University of Southern California Business School We’ve all taken the bait on a flashy investment opportunity that didn’t pan out. We knew better but couldn’t resist the prospect of doubling our money in a short amount of time. Rational investing leads to rational returns, and irrational investing leads to irrational returns (typically below 0%). Maximizing the ratio of rational investing to irrational investing for clients is easier said than done, but one of the primary responsibilities of a prudent financial advisor. Feel free to share Charlie Munger’s thoughts on crypto the next time a client asks about Bitcoin:“A cryptocurrency is not a currency, not a commodity, and not a security. Instead, it’s a gambling contract with a nearly 100% edge for the house, entered into in a country where gambling contracts are traditionally regulated only by states that compete in laxity.” – 2023 Wall Street Journal op-ed piece Charlie Munger often distinguished between investing and gambling, which, in his mind, was the same thing as “investing” in a cryptocurrency. That probably seems obvious to you (and your clients), but unfortunately, that’s not the case for much of the investing public. Interestingly, he had a similar disdain for diversification, which probably isn’t so practical for most individual investors:“A lot of people think that if they have a hundred stocks they’re investing more professionally than they are if they have four or five. I regard this as insanity.” –2021 shareholder meeting for the Daily Journal Corporation Mr. Munger called this ‘diworsification,’ and this philosophy allowed him to achieve above-market returns for several decades and become one of the most successful investors of all time. This mentality probably only applies to active managers (like he was himself) who devote much of their professional careers to investment research and analysis. His colleagues Warren Buffet and Jack Bogle would certainly not recommend this approach to most individual investors.“Usually, I don’t use formal projections. I don’t let people do them for me because I don’t like throwing up on the desk, but I see them made in a very foolish way all the time, and many people believe in them, no matter how foolish they are. It’s an effective sales technique in America to put a foolish projection on a desk.” – 2003 Herb Kay Undergraduate Lecture at the University of California, Santa Barbara Economics Department Since we often rely heavily on projections in our DCF valuation models, it’s probably best that Mr. Munger was never a client of ours (actually, I’m sure he would've been great to work with). We understand the fallacies of projections and contend that all models are wrong, but some are useful (to quote the British statistician George Box) when grounded in reason and reality.“I think you would understand any presentation using the word EBITDA, if every time you saw that you just substituted the phrase, bull**** earnings.” – 2003 Annual Berkshire Hathaway Shareholder Meeting We often utilize EBITDA metrics in our valuation models, so Mr. Munger probably wouldn’t have appreciated that aspect of our analysis either. Mr. Munger clarified this later in the meeting by stating, “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.” Fortunately, your business is the former, and you get to keep most of its EBITDA every year.“I am personally skeptical of some of the hype that has gone into artificial intelligence. I think old-fashioned intelligence works pretty well.” – 2023 Berkshire Hathaway Annual Meeting Mr. Buffet took this one step further – “I will confidently wager that no computer will ever replicate Charlie.” Unfortunately, he was probably right.

Munger Games: Charlie Munger’s Legacy

And His Common Sense Approach to Business and Investing

This week, we step aside from our usual musings on valuation trends in the RIA industry to honor the late Berkshire Hathaway Vice Chairman with our thoughts on some of his famous quotes (that might be relevant to you and your clients).

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of November 17, 2023

Bank Watch: December 2023

In this issue: Bank M&A 2023—Subdued But Potentially Explosive

Stock-Based Compensation in Volatile Markets: Employee, Management, and Investor Perspectives

Financial Reporting Flash: Issue 3, 2023

Executive SummaryOver the past decade stock-based compensation (SBC) gained widespread popularity as a way to reward employees while conserving cash.Turmoil in the stock market during 2022 resulted in employees seeing diminishing value in SBC and investors questioning its aggressive use.In this article, we discuss how market volatility can affect employee, management, and investor perspectives on SBC.

Issue No. 12 | Data as of Year-End 2023

Featured Articles: No Soup for You: Customer Lifetime Value and Brand Loyalty in the Auto Industry and Q4 2023 Earnings Calls

Portfolio Valuation: Private Equity and Credit

Fall 2023

We are generalizing here, but stocks have been supported by a soft consensus that the economy will avoid a hard landing and that the Fed may pivot to rate cuts in 2024 (i.e., the 2022 hope about 2023). Likewise, credit has benefited from the soft-landing narrative as credit spreads, especially CCC, have narrowed this year. Arguably, a lot of potential good news is already reflected in security prices.

Elon Musk on Fairness and Solvency Opinions

While portfolio valuations are driven by governance and reporting requirements, major transactions often demand fairness and solvency opinions that extend beyond financial analysis to include process, legal standards, and conflicts of interest. High-profile transactions involving Elon Musk — including Tesla–SolarCity and the acquisition of Twitter — offer timely lessons for private equity and private credit investors navigating complex deals.

Return to Status Quo or a New Normal?

Auto Leasing Trend Update

Consumers are typically faced with two options when considering their next vehicle transaction at the dealership: buying an automobile or leasing one.

It’s Getting Real(ized)

Rising rates have driven unrealized losses in bank bond portfolios, prompting some banks to restructure securities to boost yields, margins, and long-term earnings despite near-term capital impacts.

Navigating the Buffet of Investment Options

A Guide for Family Businesses

There is no “right” answer for where or how your family should invest. Ultimately, your family’s risk tolerance and return objectives will determine the right option for your family business. However, your family needs to have a process for objectively estimating expected returns and analyzing the riskiness of its options. Please give one of our professionals a call for an independent perspective on your family businesses’ investment options.

Key Takeaways for Auto Dealers from the 2023 AICPA Dealership Conference

Last month, we attended the 2023 AICPA Dealership conference and in this post present key takeaways from two sessions that are of interest to our blog readers: “Driving Success in Auto Retail” and “The Electrification of Auto Retail.”Key Takeaways: "Driving Success in Auto Retail " Session This session was presented in the form of a conversation between Alan Haig of Haig Partners and Daryl Kenningham, CEO of Group 1 Automotive. Group 1 Automotive owns approximately 205 auto dealerships in the United States and the United Kingdom and boasts approximately $16 billion in annual revenues. They specifically own 150 auto dealerships in the United States, with headquarters and a high concentration of dealerships in the Houston, Texas market. (For information on other publicly traded auto dealers, see our ongoing blog series featuring profiles on Asbury Automotive Group, Auto Nation, Sonic Automotive, and Lithia Motors.)Here are the key takeaways for our readers.The Service Experience for Tesla Consumers May Not Be OptimalWhile Tesla consumers have loved the direct sales model buying experience, they have not enjoyed the service experience. As we’ve discussed, franchised auto dealers have implemented elements of the direct sales model through digital/online platforms. Unlike Tesla, franchised auto dealers have physical locations near their customer bases and are more equipped to provide ongoing service for the life of their vehicles.There Is a Used Car ShortageWith more focus on the shortage of new vehicles produced in the last three years caused by the pandemic and microchip shortage, the shortage of used vehicles hasn’t been as widely discussed. Fewer new vehicles sold leads to fewer trade-ins, which leads to fewer used vehicles for sale. Mr. Kenningham estimated that 8 million fewer used cars are available in the system even though approximately 40 million used vehicles trade hands annually. Also contributing to the system’s shortage of used vehicles are consumers maintaining their current vehicles longer, fewer new units available, as well as affordability issues.There Is a Technician ShortageGroup 1 and other auto groups have countered the lack of skilled technicians in the workforce by gradually raising labor rates. While this strategy has been effective, it has led to costlier repairs on average and, eventually, a ceiling on these increased rates. Mr. Kenningham estimated that an empty service bay would cost the company $17,000 in gross profit each month.It Is Hard to Retain a Service Department CustomerMr. Kenningham estimated that Group 1 and other franchised auto dealers only retain approximately 2/3 of service customers from new vehicles they sell directly. The Service Department is one of the higher margin segments in the auto dealership business model; therefore, it’s important for dealers to try to retain more ongoing service work for their current customers. While oil changes and tire rotations are not very profitable to auto dealers, they provide frequent/additional opportunities for the auto dealer to service the customer.Younger Customers Are Not Loyal CustomersYounger customers are more inclined to seek out the purchase of a new automobile on a digital platform because of the comfort of making material purchases in that format. However, younger customers tend to be less loyal in the long run, so auto dealers must strike a balance in their sales offering methods to the customers.The 3 Things Dealers Should Focus OnConsistent with these trends and observations, Mr. Kenningham listed three things that auto dealers should focus on in the future:Invest in technology,Invest in customers, andDrive scale into all elements of your business model.Key Takeaways: "The Electrification of Auto Retail – 2023 Update" SessionThis presentation by Capital Automotive provided a snapshot of the current landscape for the electric vehicle (EV) market as well as a comparison of industry conditions and headwinds in 2021 versus 2023. Specifically, the headwinds in 2021 were cost parity to traditional internal combustion engine (ICE) vehicles, consumer adoption/demand, and the charging network. These headwinds primarily still exist in today’s environment.Affordability and Value Retention Are a Question MarkThe following graph from information provided by Cox Automotive details the average new and used price trends from battery electric vehicles (BEVs): Source: Cox AutomotiveClick here to expand the image aboveIn September 2023, the average transaction price for a new BEV totaled $55,436 compared to the $47,899 average transaction price for all new vehicles (Cox Automotive). For used vehicles, the average transaction price for BEVs was $41,630 compared to $28,935 for all used vehicles (Edmunds).In addition to higher transaction prices, the six BEV models in the following graph are projected to lose 25%-42% of their value five years after purchase. This may seem like a high percentage, but for comparison, Capital Automotive noted that an iPhone 11 lost ~75% of its value five years after purchase. Sources: AAA, AppleClick here to expand the image aboveFinally, Capital Automotive provided two other views of the affordability of BEVs/EVs. The first data point examined the cost of ownership of an F150 Platinum Truck (ICE) versus an F150 Lightning (BEV) comparing the cost of fuel, average insurance premiums, fees & taxes, interest financing, repairs & maintenance, and depreciation. The BEV (F150 Lightning) was 21% more expensive to own (by ~$4,000) than the ICE (F150 Platinum Truck) even though the BEV had lower fuel and repairs & maintenance costs.The second data point offered by Capital Automotive related to the cost of 2024 BEV models. According to Car & Driver, CNET, Kelly Blue Book, and U.S. News, 20 new BEV models are being introduced to the market in 2024. Only five of those models (Cadillac Celestiq, Chevy Equinox EV, Fiat 500e, Honda Prologue, and Volvo EX30) will be offered at prices below the average transaction price for all new vehicles.Consumer Demand Has Grown But ...Based on the statistics of U.S. new light vehicle sales, the EV unit’s share of the market is 8.6% as of June 2023, according to Automotive News. While this figure remains a small percentage of the overall market, it has grown from a meager 0.1% in just six and a half years.Another way to view consumer demand is in inventory levels, as seen in the graph below presented by Capital Automotive. Source: Axios, CarEdge, Seeking AlphaClick here to expand the image aboveOther than Chevrolet and Cadillac, EVs’ average days’ supply and inventory levels are higher than traditional ICE vehicles for all other manufacturers listed above. Dealers have plenty of EV inventory on their lots, but the pricier EV models are not selling as quickly and are beginning to pile up.The states with the fastest EV adopters are mostly in the west and northwest (California, Washington, Oregon, Nevada, Arizona, and Colorado). The states with the slowest EV adopters represent more of the country's rural areas (Wyoming, Iowa, Arkansas, Mississippi, South Dakota, North Dakota, and West Virginia).Charging Infrastructure Is Not SufficientThe specific needs of EVs, such as charging levels and requirements and infrastructure investments, are well-known in the industry. Additional challenges have been presented by fires caused by the combustion of lithium batteries in EVs in apartment buildings, airport parking garages, and cargo ships. According to a 2023 Electrical Safety Foundation Survey, 50% of homes in the United States do not have electrical systems capable of the continuous load required for EV charging, and 54% of all homes would require an electrical panel upgrade to facilitate EV charging.ConclusionThe recent AICPA Dealerships conference provided a great forum to discuss current trends in the auto dealer industry and predictions for the future. It’s also informative to hear how individual dealerships are confronting their own unique challenges. All of these trends/factors will continue to impact the operations of dealerships and, ultimately, their profitability and valuation.Mercer Capital provides business valuation and financial advisory services, and our auto team assists dealers, their partners, and family members to understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your auto dealership.

Review of Key 3Q 2023 Economic Indicators for Family Businesses

Before we dig into our turkey and dressing later this week, we look at Q3 2023 economic data in this week’s post.

Evaluating Your Firm’s Margin

In the investment management world, evaluating a firm’s margin isn’t as simple as “more is better.” For RIAs, margin reflects efficiency, but it also reflects the firm’s tradeoffs with compensation. Investment management is a talent business, and striking the right balance between margin and employee compensation that allows the firm to attract, retain, and incentivize talent is critical to an RIA’s success.

Themes from Q3 Energy Earnings Calls-Part 2: Oilfield Service Companies

Themes from Q3 2023 Energy Earnings Calls

Part 2: Oilfield Service (“OFS”) Companies

In our most recent earnings call blog post, Themes from Q3 2023 Earnings Calls, Part 1 Upstream, prevalent themes from E&P companies included discussions about consolidation in the industry, a focus on efficiency of operations, and strong production volumes throughout 2023. This week, we focus on the key takeaways from OFS operators’ Q3 2023 earnings call.

UPDATE: Analysis of the Spirit Fairness Opinions re the JetBlue Acquisition

Spirit-JetBlue’s stalled merger highlights regulatory risk and time erosion, as Spirit shares trade far below the $33.50 offer.

Who Eats First, the Family or the Family Business?

It’s that time of year again. The grocery list has been made, the headcount has been verified, and the dusted box with pilgrim decorations has been taken down from the top shelf of the storage closet. The table might not be set yet, but for the most part, we know who we will be eating turkey with next week on Thanksgiving Day. Aunt Cathy may or may not bring Cousin Lenny, but Cousin Lenny prefers ham and doesn’t even eat any cornbread stuffing or pumpkin pie, so we don’t need to worry about him!Traditionally, we have offered some suggestions on what not to talk about at the Thanksgiving dinner table. But this year, we decided to focus on something new. Who eats first, the family or the family business?There is no cookie-cutter recipe or fine-tuned formula one might use to answer this question. On the surface, it does not seem like a tough one. However, every family business operates differently, with different shareholder preferences, family dynamics, and investment decisions. So, before answering the most important question of who eats first on Thanksgiving Day, ponder these three topics to help guide you.The Meaning of the Family BusinessThe meaning of a family business is a function of both family and business characteristics. As shown above, the meaning of the family business, in turn, influences the company’s dividend policy, investing, and financing decisions.Family business directors must decide how to dispose of every dollar the business generates through its operations. At the most basic level, a dollar of operating cash flow can be returned to owners in the form of dividends and share redemptions or reinvested in the business.When the family business can access many investments offering high returns, reinvestment will be more attractive. However, if there aren’t many attractive investment options out there, retaining capital in a business that can’t use it well drives down returns and risks the future of the family enterprise.When discerning what the family needs, there is no substitute for asking.What are the liquidity needs of family shareholders?How much risk are family shareholders willing to bear in pursuit of capital appreciation?How important is the family’s legacy? Shareholder circumstances and attitudes are constantly evolving, so even if you had a good feel for what the family needed five years ago, you may not know what they need today. In our experience, the most successful family businesses balance the business needs with the family shareholders' needs.Dividend PolicyOnce the “meaning” has been embraced by the family, the distribution policy will more naturally follow. Answering the dividend policy question for your family business requires looking inward and outward. Looking inward, what does the business “mean” to the family? Looking outward, are attractive investment opportunities abundant or scarce?Some family businesses have shareholders who are highly dependent on distributions from the company to fund their lifestyle and are focused on the dividend-paying capacity of the family business. Other shareholders may fund their lifestyle needs from other sources and are more focused on the rate at which the value of their investment in the family business grows.Ultimately, family business directors need to remember their shareholders are just that: shareholders. While their equity may have been earned hereditarily, the family business directors owe a duty to the family shareholders — a focus on maximizing shareholder value through a mix of good reinvestment opportunities and distributions.Capital AllocationDividend policy decisions are not made in a vacuum. When operating cash flows are used to pay dividends, those cash flows cannot be reinvested to grow the business. Conversely, cash allocated for the future growth of the business is not available to provide for the liquidity needs of family shareholders.Click here to expand the image aboveSuccessful family business directors must balance the company’s needs with those of the family when making capital allocation decisions. Analyzing investment choices and understanding your family shareholder objectives is not easy, but going back to the meaning of your family business will help provide a backdrop for making these decisions.ConclusionA clear understanding of what the business means to the family is essential if decisions about dividend policy and capital allocation are to be made in a coordinated manner. Matching your family shareholders’ growth objectives with their relative risk tolerance is a key challenge for family business directors and one that is tied directly to what your family business means to you.Our professionals are eager to help your family discern what your family business currently means so that everyone has a seat at the Thanksgiving dinner table.

Themes from Q3 2023 Energy Earnings Calls

Part 1: Upstream

In Themes from Q2 2023 Energy Earnings Calls, we noted E&P operators’ search for ways to maintain production levels, expectations for low crude oil inventories, and decreased activity in the Haynesville shale region. This week, we focus on the key takeaways from Upstream Q3 2023 earnings calls.

Speed, Velocity, and Momentum

The Best Measure of RIA Success

Market performance gives you speed. Employee performance gives you velocity. Practice management gives you momentum. If you want to be successful, focus on building momentum.

October 2023 SAAR

The October 2023 SAAR was 15.5 million units, down 1.2% from last month but up 5.6% compared to this time last year. As we predicted in last month’s SAAR blog, this month officially marks the end of a seven-month streak of consecutive double-digit year-over-year improvements in the SAAR. While we do expect to see double-digit improvements pop up over the next few months, the end of this streak is a reminder that the industry has been on the path to recovery for some time now and is slowing down to a more normalized, sustainable level.

Capital Budgeting in 5 Minutes

New Video Released on Family Business On Demand Resource Center

Capital budgeting can’t be avoided — the only question is whether your family business has a consistent and disciplined process for evaluating potential investments or instead makes significant capital commitments in a more haphazard way. In this video, we describe the key elements of the capital budgeting cycle and identify some common potholes along the way.

Newly Released: Auto Dealer Video Series

In each episode of the 12-part series, you'll find practical advice, expert insights, and real-world examples created especially for any auto dealer looking to navigate the complexities of valuations and succession planning successfully. We hope you enjoy!

D CEO's 2023 Energy Awards

This past week, Mercer Capital was a part of D CEO’s 2023 Energy Awards—a fantastic event that celebrates the energy industry, transactions, and individuals that impact the Dallas Fort Worth Metroplex. Major players such as Energy Transfer Partners, Exxon, and Denbury were honored or noted. However, broader reaches of the industry were also recognized, such as private equity and royalty companies.

Can Active Management Survive a Bear Market?

Moving forward, we expect some active managers to improve their competitive positioning but aren’t ignoring what the market is telling us about the outlook for these businesses – it’s probably going to get worse before it gets better.

Bank Watch: November 2023

In this issue: It’s Getting Real(ized)

Letters From the SEC: Business Combinations Edition

Financial Reporting Flash: Issue 2, 2023

We discuss and comment upon four examples covering customer relationships, tradenames, contingent consideration, and bargain purchases.

Specialty Finance M&A

Acquiring a specialty finance company comes with a unique set of hurdles, different than acquiring a bank.

The Scariest Thing That Faces Family Business Directors

Happy Halloween! This week, we have four frightening guests who share their most terror-inducing family business challenges. It’s definitely not for the faint of heart, but if you are brave enough to face your fears, check it out!Get your preferred copy of the book, The 12 Questions That Keep Family Business Directors Awake at Night,here.The Scariest Thing That Faces Family Business Directors - Halloween 2023 from Mercer Capital on Vimeo.

Consolidation in the RIA Industry?

A Look at Record-Pace RIA Acquisition

Time will tell if the RIA industry sees the same level of consolidation as we’ve seen in the banking industry. But at least in the near term, the number of RIA firms appears poised to continue growing as the supply of new firms more than offsets a significant level of M&A activity.

Just Released | 3Q23 Exploration & Production Newsletter

Third Quarter 2023 | Regional Focus: Appalachian Basin

Mercer Capital’s Value Focus: Exploration & Production newsletter provides an overview of the industry through supply and demand analysis, commodity pricing, and public market performance. In addition, each issue of this quarterly newsletter focuses on a region, including Eagle Ford, Permian, Bakken, and Appalachia, examining general economic and industry trends. Appalachian production fared well over the last year, particularly considering the sharp decline in the Henry Hub price. Despite the Henry Hub decline, the Appalachian rig count decline was less than that of two of the three oil-rich basins presented, largely due to Appalachia’s higher production declines, which require a higher rig count to maintain production levels.Exploration & ProductionThird Quarter 2023Region Focus: Appalachian BasinDownload Newsletter

Dealership Working Capital

A Cautionary Tale Against Rigid Comparisons

Opportunities for Ownership Succession in the Beer Wholesaler Industry

For those wholesalers contemplating succession, now is the time to act.

Decisions, Decisions: 3 Questions to Start Thinking About Capital Structure

Capital structure decisions are crucial to the longevity of a family business. By addressing questions about available borrowing capacity, current capital structure, and peer comparisons, family businesses can be better equipped to make optimal capital structure decisions.

Energy Values Take Hits….And Keep Moving Forward

The famous philosopher Rocky Balboa once said: “It ain’t about how hard you can hit. It’s about how hard you can get hit and keep moving forward.”Amid mixed signals, Middle East conflict, rising inflation, rising interest rates, political and regulatory headwinds, and other factors the oil and gas industry continues to perform and cycle upwards. For the year to date, the S&P Oil and Gas Exploration & Production Select Industry Index has gone up over 7%. For the past three years, the index has had an annualized return of over 48%. TheS&P 500 has only a 7% annualized return itself over the past three years. It’s a marked change from the decade-long dry spell the industry had, particularly in 2014 and 2015. In a time where numerous things could dampen demand, prices, profits, and valuations the industry continues an upward trend. In addition, some defensive posturing that the industry has taken in recent years may pay off in ways that were not immediately obvious. Capital discipline, low debt, and improved technology have helped set the stage for the current conditions which should allow oil and gas producers to keep moving forward.Capital Discipline & DeleveragingOil prices have continued to be relatively strong for nearly two years now, rarely dropping below $70, sometimes topping $100, and averaging closer to $80. This is a far cry from the years and years of $50 oil (or less). More on that later. However, amid that strength of sustained higher commodity prices and the corresponding profitable drilling locations, rig counts have dropped year over year according to Baker HughesBHI0.0%. My Forbes colleague David Blackmon wrote about this a few weeks ago. The urge to drill with every available resource remains constrained, which is not how operators behaved in past cycles. The focus on returns and value creation appears to have overruled growth, and in addition, some of this may be coming from the continually rising costs to drill and complete wells according to the latest Dallas Fed Energy Survey, alongside a tight labor market. Additionally, technology continues to incrementally improve and increase efficiency of recovery at the well level, which helps productivity per rig.Another form of capital discipline has been the continual deleveraging trend. I have written on this before, but not in this interest rate environment. As the cost of debt capital goes up, the industry’s deleveraging will have another silver lining: directing more operating profits to shareholders instead of bankers. Operating decisions at many companies will be less immune to upward interest rate pressures or refinancing risks. On top of that – bankers often require companies to hedge large portions of their production to ensure downside protection for their debt. However, the trade-off companies make is that they also often give away some (or a lot) of upside commodity price potential. This is less of a problem when debt loads are low. Lastly, on this front, bankers are not the only capital source that has been reticent to supply new money to the industry. Equity investors have desired to do more harvesting than planting in the oil and gas sector, thus there has been less capital available to aggressively pursue drilling plans.Higher Forecasts For Commodity PricesThat’s not to say that drilling plans do not look good right now. They do. Not only are oil prices above $80 now, but the tail of the futures curve suggests prices above $60 as far out as 2029. Fed Energy Survey participants agree — prices should be buoyant into the intermediate future. This is arguably more important to management teams as they marshal resources for long-term projects. Dan Pickering of Pickering Energy Partners thinks oil will be around $80 in 2027 and that the upcycle will be continuing. Part of this is fueled by prior and continuing investments in oil and gas pipelines in the past several years and LNG infrastructure. The cheaper access to markets has helped to manage constrained or stranded supply (particularly gas). At the same time, the conceptual rationale for pricing is particularly circular. Constrained capital discipline will slow supply growth to match demand and vice versa, but there are other factors as well – more global ones on the supply-demand seesaw.Global ProductionThe global market is a little more unstable, but events more recent in Israel and in the Russian/Ukrainian war have had more muted effects on the global supply of oil than otherwise might be thought. While European sanctions on Russian gas appear to have been effective, Russian oil has found its way to other markets. This has helped to limit price shocks. (Side question: what might happen if Venezuela remounted its petroleum horse again?)However, as the shale revolution matures and Tier 1 drilling locations shrink, it will get harder to maintain and grow supply compared to demand. Now this could balance out in future years as demographics age and world population potentially slows and shifts. Nonetheless, one factor that could change the equation back to a more aggressive drilling posture is that oil will probably peak again in the next 20 years. As such, exploration will come back into the conversation as fields mature and declines increase. Even the Biden Administration relented on some offshore drilling leases, albeit minimally.What this means for energy valuations is that the upswing over the past few years does not appear to be peaking anytime soon. While there will be winners (most likely larger operators) and losers (most likely smaller operators), the sector’s overall value continues to move forward.Originally appeared on Forbes.com.

Just Released: Mid-Year 2023 Auto Dealer Industry Newsletter

We are pleased to release our latest edition of Value Focus: Auto Dealer Industry Newsletter.

Alt Managers Race Ahead

A Resurgent Year for Investment Management Firms

Alternative asset managers fared particularly well during favorable market conditions for the RIA sector. Over the past year, all categories of RIAs have experienced growth as the market has rebounded from its Q3 2022 trough. Alternative asset managers and RIA aggregators both outperformed the S&P 500 with gains of 44% and 28% over the past year. However, traditional asset managers trailed the S&P 500 with gains of 13%. RIAs have directly benefited from improved market conditions, which have boosted assets under management ("AUM").

An $80 Billion Estate & Gift Tax Valuation Update

3 Things to Do When Selecting a Business Appraiser

How would you spend $80 billion in new funding? Much politicking and articles have been written about the Inflation Reduction Act. One piece of that legislation that will impact every taxpayer is an increased IRS of roughly $80 billion over the next ten years. The Tax Foundation analyzed how the IRS plans to deploy additional funding, as shown in Figure 1.Figure 1 :: IRS Funding Increases per Inflation Reduction Act Noticing “money sent back to my bank account” didn’t make the list, one quickly notices “Enforcement” getting the largest dollar increase over the next ten years at nearly $46 billion. The IRS lists five objectives in its 2023 strategic operations plan. One of the objectives includes: “Focus expanded enforcement on taxpayers with complex tax filings and high-dollar noncompliance to address the tax gap.” Again, from the Tax Foundation: “Digging more into the specifics of enforcement, individual initiatives acknowledge some of the trade-offs in expanded enforcement operations. Within the third objective, dedicated to expanded enforcement, five of the seven initiatives involve expanded enforcement on certain types of taxpayers: large corporations, large partnerships, high-income and high-wealth individuals, other areas where IRS audit coverage has declined (including employment, excise, and estate and gift taxpayers), and developing areas such as digital assets.” A recent presentation by Stephanie Loomis-Price and Marissa Pepe Turrell at the ASA’s International Conference summarized 709 (gift) and 706 (estate) filings and audit rates, excerpted in Figure 2 below.Figure 2 :: Gift and Estate Tax Filings and Audit Rates Total gift tax audits have been just under 1% for the last decade, and estate tax audits have been around 10% on average, per Figure 2. And while audit rates have remained stable overall for gift and estate tax filings, one doesn’t have to connect too many dots to see that may be changing. Much has been written on declining audit rates, and policymakers have explicitly said they plan to audit wealthier Americans. So, with plenty of dry powder to beef up enforcement and looming changes to the estate tax horizon (including a reduction in the estate and gift tax exemption), family businesses and estate planners need to be cognizant of the changing tax landscape and increased audit scrutiny.3 Things Family Businesses Should Do When Selecting a Business AppraiserHow do business appraisers fit into this shifting gift and estate tax paradigm? If your gift tax return involves a business valuation, having a trusted and reputable valuation firm as part of your estate planning roster is more important than ever. Below are three criteria that can help you think about who you want in your corner.Insist on an appraiser with experience and credentials. Each business appraisal is unique, and experience counts. Most business valuation firms are generalists rather than industry specialists, but the experience gained in discussing operating results and industry constraints with a broad client base gives the appraisal firm substantial ability to understand the client’s specific situation. Credentials do not guarantee performance, but they do indicate a level of professionalism for having achieved and maintained them. Family businesses and their estate planning counsel should insist upon them.Involve the appraiser early on. One of the most common concerns such owners cite around long-term planning is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way. Even in seemingly straightforward gift and estate tax planning, it is helpful to seek the advice of a business appraiser as part of the planning process. Understanding the finer points around fair market value, the levels of value, discounts for lack of marketability, and ultimately estimated tax liabilities are all questions a business appraiser should be able to provide feedback and guidance upon.Expect the best. In most cases, the fee for appraisal services is nominal compared to the dollars at risk. The marginal cost of getting the best is negligible. Family businesses can help their appraiser do the best job possible by ensuring full disclosure and expecting an independent opinion of value. The best appraisers have the experience and credentials described above but recognize the delicate balance between the inherent art and science when valuing private companies. Mercer Capital has been performing business appraisals for over 40 years and has a long track record of delivering reasonable and supportable business valuations. Our team of professionals is ready to help you and your clients navigate your valuation challenges.

RIA M&A Update: 3Q 2023

Although inflation has begun to subside and the stock market has rallied after a turbulent start to 2023, elevated interest rates and macroeconomic uncertainty have contributed to a leveling off of deal volume so far in 2023.

Now Available: Mercer Capital's 2023 Energy Purchase Price Allocation Study

The 2023 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that closed and reported their purchase allocation data in calendar year 2022.

September 2023 SAAR

The September 2023 SAAR was 15.7 million units, up 2.1% from last month and up 14.9% compared to this time last year. This month’s data holds true to the ongoing trend of double-digit year-over-year improvements. Altogether, this month marks the fourteenth straight month of year-over-year improvements in the SAAR.

Twitter (X Holdings I, Inc.) Solvency

Exploring the issuance of a solvency opinion for the October 2022 acquisition of Twitter, Inc. by Elon Musk’s X Holdings I, Inc.

Should I Stay, or Should I IPO?

What kind of family business are we? Dividend policy & capital allocation decisions help define what kind of company your family business is. Matching your family shareholders' growth objectives with their relative risk tolerance is a key challenge for family business directors and one that is tied directly to what your family business means to you. Successful family businesses need to evaluate how they invest for future growth and their distribution policies in light of their family's risk tolerance, growth objectives, and business meaning.

Q3 2023: Alts Take the Lead as Other RIAs Lose Traction

Market Uncertainty and Fee Compression Trends Lead Investors to Take an Alternative Approach to RIA Investing

Share prices for most publicly traded asset and wealth management firms trended in line with the steady decrease in the broader market during Q3 2023. Alternative asset managers were a notable exception to this trend, ending the quarter up about 10%.

Leading America Toward Energy Independence

Hart Energy LIVE’s America’s Natural Gas Conference 2023

Last week, I attended Hart Energy LIVE’s second annual America’s Natural Gas conference in Houston. The speaker roster included CEOs of companies operating in the Utica (Encino Energy) and Haynesville shales (Rockcliff Energy) and Green River basin (PureWest Energy), investment bankers, private equity investors, and consultants, among others. CO2 emissions reduction, demand for LNG exports despite inadequate transportation and storage infrastructure, and the energy transition were three of the more prevalent themes discussed. Below are a few highlights I would like to share with you.

United Auto Workers Strike

What It Means for Auto Dealers

Rising wages for automakers will ultimately raise MSRP, though as noted above, this was a likely outcome regardless of the strikes due to the larger share of profit realized by auto dealers in the past few years. A drawn-out strike would reduce vehicle availability, but with relatively higher Days’ Supply, domestic dealers can weather the storm if they can successfully steer consumers toward models that are in greater supply. If not, other brands stand to benefit from increased market share.

Coming Off the COVID Wave

Q3 2023

We’re sitting most of the way through 2023 at this point, and we are continuing to live in interesting times. The shipping frenzy brought on by the COVID-19 pandemic has run its course and the industry is returning to more normal levels. At the same time though, it is important to note that a decline from never-before-seen highs does not necessarily indicate a freight recession is underway. Many of the year-over-year data points will indicated large declines, but on a quarterly or monthly basis, the data is much more stable.

Why ROIC Matters for Family Business Directors

New Video Released on Family Business On Demand Resource Center

Bank Watch: October 2023

In this issue: Specialty Finance M&A

Impending Guidance on Business Combinations

Financial Reporting Flash: Issue 1, 2023

Working Draft of The AICPA Accounting and Valuation Guide: Business Combinations

Navigating Complex Business Valuation in Litigation | Part 2: Strategies for Multiple Valuation Dates & Opposing Expert Reports

This is the second of a two-part series where we focus on navigating business valuation complexities in litigation.

Medtech and Device Industry Newsletter - Q4 2023

E&P Fourth Quarter 2023

Haynesville

Haynesville // Haynesville production held-up reasonably well during the 2023 review period, particularly considering the sharp fall-off in the basin’s rig count.

Transportation & Logistics Newsletter

Fourth Quarter 2023

A variety of pandemic-related and regulatory issues resulted in long delays at California ports, the traditional import location for the majority of goods from East Asia. Many carriers shifted their import handling to East Coast ports – with the port of Savannah being one of the biggest winners.

A Shortcut for Tax Savings

Charitable Giving Prior to a Business Sale Yields Big Results

In this week's post, we offer a quick overview of the tax strategy that charitable RIA owners ought to keep in mind when selling their firm (and don't forget RIA clients' selling businesses as well!).

This Interest Rate Environment Done Got Old

This article covers some implications of a higher-for-longer rate environment.

Appalachian Production Marches on Despite Henry Hub Plunge

The economics of oil & gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter, we take a closer look at the Marcellus and Utica shales.

5 Takeaways from the Association of Trust Organizations' (ATO) 2023 Annual Meeting

Earlier this week, ATO held its annual meeting at the Ritz Carlton in New Orleans to discuss a variety of topics relevant to independent trust companies, including the impact of AI, M&A and financial performance trends, and best practices for evaluating prospects. As a sponsor of this year's conference, here are our main takeaways from the meeting:

Fall 2023 Private Company M&A Update

In this week’s post, we take a look at recent trends in private company transaction activity up to this point in 2023.

Inside the Board Rooms of a $5.4 Billion Oil and Gas Merger

In a departure from our typical analysis and discussion of recent deals, this week’s Energy Valuation Insights blog takes a break from deal multiples and observes the negotiations of the $5.4 billion merger between Sitio Royalties Corp. (“Sitio”), a player in the Marcellus Shale, and Brigham Minerals, Inc. (“Brigham”).

What’s Driving RIA M&A?

We first wrote about borrowing costs for RIA consolidators late last year, shortly after the Fed’s aggressive hiking cycle led to an abrupt spike in interest rates for virtually all borrowers. Since then, borrowing costs for RIA acquirers have remained roughly flat but at a level significantly elevated from 18 months ago.

Do You Know How Much Your Dealership Is Worth?

Whitepaper: Understand the Value of Your Auto Dealership

You Can't Spend the Same Dollar Twice

A key element of shareholder education for such families is the concept of capital allocation. In other words, family capital is a scarce resource that can either be put to work inside the business or distributed to provide liquidity to shareholders, but not both. Or, in other simpler words: You can't spend the same dollar twice.

Harkins to Present at the ASA Philadelphia Chapter 2023 Business Valuation Conference

David W. R. Harkins, CFA, ABV is speaking at the virtual ASA Philadelphia Chapter 2023 Business Valuation Conference on September 21, 2023. David’s session will cover “Winding Road to Blue Sky Value: Important Considerations in Auto Dealer Valuations and Pitfalls to Avoid.”David is a member of the firm’s Auto Dealership Industry team, and provides valuation analyses for family law, commercial litigation, gift and estate tax planning, transactions (M&A), fairness and solvency opinions, and employee stock ownership plans (ESOP), among other valuation-related service needs of privately held businesses. He publishes research on valuation issues in the newsletter Value Focus: Auto Dealer Industry and also contributes regularly to Mercer Capital’s Auto Dealer Valuation Insights Blog.

August 2023 SAAR

The August 2023 SAAR was 15.0 million units, down 4.5% from last month but 13.6% higher than August 2022’s figure. This month’s data holds true to the ongoing trend of considerable year-over-year improvements that have remained strong throughout the year. In fact, this month marks the thirteenth straight month of year-over-year improvements in the SAAR.

Where Is RIA Dealmaking Headed?

Matt Crow Interviewed for Barron’s Advisor Podcast

Steve Sanduski sat down with Matt Crow to talk about the state of the RIA industry for Steve’s Barron’s Advisor Podcast. In the episode, Steve and Matt explore the main drivers of the recent M&A environment for RIAs, the pros and cons of consolidation, and when selling to a consolidator makes sense instead of pursuing internal succession.

Middle Market Transaction Update Fall 2023

Middle market transaction activity fell in the second quarter of 2023, continuing an ongoing decline in transaction activity in the middle market.

Five Reasons to Conduct a Shareholder Survey

New Video Released on Family Business On Demand Resource Center

In this video, Atticus Frank breaks down the top five reasons why your family business should consider conducting a shareholder survey. He emphasizes how these surveys can provide critical insights into shareholder perspectives, facilitate informed business decisions, and enhance communication among family members involved in the business. From uncovering deeply held views to promoting educated and engaged shareholders, the video offers valuable guidance for multi-generational family businesses looking to align interests and build trust.Click here to watch the video(you will be redirected to www.familybusinessondemand.com) Don't forget to check out our dedicated family business site. The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses. There, you’ll find a curated and organized diverse collection of resources from our staff of family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies. The perspectives we offer here are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses like yours. There’s nothing else like it, and we look forward to your visit.

What Can We Make of Goldman’s Brief Foray into the Mass Affluent Space?

It seems unlikely that Goldman Sachs intended to own United Capital’s mass affluent business for only four years after its $750 million purchase in 2019.

Themes from Q2 2023 Energy Earnings Calls-Part 2: Oilfield Service Companies

Themes from Q2 2023 Earnings Calls

Part 2: Oilfield Service (“OFS”) Companies

This week, we focus on the key takeaways from OFS operators’ Q2 2023 earnings call.

September 2023 | This Interest Rate Environment Done Got Old

Bank Watch: September 2023

In this issue: This Interest Rate Environment Done Got Old

Navigating Complex Business Valuation in Litigation | Part 1: Strategies for Multi-Entity, Multi-Location Businesses

Valuing a business in a litigation context is akin to navigating a complex maze.

2023 Core Deposit Intangibles Update

Although deal activity has been slow, we have seen an obvious uptick in core deposit intangible values relative to this time last year.

Review of Key 2Q 2023 Economic Indicators for Family Businesses

Now that economic data for the second quarter of 2023 has been released and made available over the last several weeks, we take a look at the tale of the tape in this week’s post.

Q2 2023 Earnings Calls

Lower New Vehicle Supply Boost Fails to Lift Profits; Used Vehicle Prices Drop Amid High Demand

Reviewing earnings calls from executives of the six publicly traded auto dealers, new vehicle gross profit declined as inventory availability improved, though the decline in profitability was less than anticipated. While unit-level profitability is anticipated to continue to decline, there are signs of strength in consumer demand. Despite affordability issues, the market is anticipated to remain structurally above pre-pandemic levels.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of August 21, 2023

Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership.Due to a variety of corporate structures (including master limited partnerships and Up-Cs) and complex capital structures (including preferred equity and non-traded common units), mineral aggregator enterprise values pulled from databases are often missing meaningful components of value, leading to skewed valuation multiples.Mercer Capital has thoughtfully analyzed the corporate and capital structures of the publicly traded mineral aggregators to derive meaningful indications of enterprise value. We have also calculated valuation multiples based on a variety of metrics, including distributions and reserves, as well as earnings and production on both a historical and forward-looking basis.Mineral Aggregator Valuation Multiples StudyMarket Data as of August 21, 2023Download Study

Unpacking Your RIA’s Income Statement

Performance Measurement Is More than Profits and Losses

The goal of this exercise should be to view the financial performance of an RIA from a strategic perspective rather than the generic and mostly unhelpful lens of GAAP. Revenue for an investment management platform is not simply a “sales” number that stands on its own merits but a function of business model efficiency, value to the market, and business mix. GAAP wants to depict every cost on an RIA’s income statement as operating expenses, but industry participants know that compensation policy carries very different implications for the growth and returns of the company than the copier lease or occupancy costs.

Navigating the Estate Tax Horizon

The Time Is Now

Looking for a golden opportunity? A recent series of articles from the Wall Street Journal suggests that one exists, but time is of the essence. There is an urgency to consider a range of estate tax strategy options in order to maximize gifting family wealth rather than family drama.

Succession Planning: RIAs Have Options

Themes from Q2 2023 Earnings Calls

Part 1: Upstream

In Part 1: Upstream themes from Q1 2023 Earnings Calls, notable themes included a divide on whether dividends or buybacks are the best means to return capital to shareholders and management’s reactions to a decline in strip prices, as well as highlighting inventory in the favorable Permian and Eagle Ford plays. This week, we focus on the key takeaways from Upstream Q2 2023 earnings calls.

Driving Value: Key Components of an Auto Dealership Valuation

Like most business owners, auto dealers are likely always curious about what their dealership might be worth. While there are many times they may want to know, there are life events that make them need to know the value, such as a transaction (including buy-sell), litigation, divorce, wealth transfer, etc. While valuations tend to be performed infrequently around these events, dealers can evaluate their business and improve its value by understanding and consistently focusing on the value drivers of their auto dealership.

Private Equity (Still) Wants to Buy Your Family Business

Private equity is inherently neither good nor bad. When a private equity buyer expresses interest in your business, you and your fellow directors have an obligation to take them seriously and determine whether it is an opportunity that merits your attention.

A Little Less Conversation, A Little More Compensation

Compensation Structures for Investment Management Firms Whitepaper

Attached is a whitepaper that we update periodically on the topic of compensation structures for RIAs.

Industry Expert vs. Valuation Expert: Which Should You Choose?

In the complex world of the oil & gas industry, a nuanced understanding of industry intricacies and valuation principles is vital. While it's common to find specialists in either industry knowledge or valuation methods, a complete solution requires a synergy of both these domains. In this article, we explore the unique benefits of both industry and valuation experts before delving into why a firm with expertise in both these areas is the best choice for oil & gas industry companies.The Case for an Industry ExpertChoosing an industry expert to value your oil & gas company has several distinct benefits that stem from a deep understanding of the sector's unique dynamics, trends, and complexities. Here's a breakdown of some of the key advantages.Long-Time Analysts of the Oil & Gas IndustryIndustry experts are veterans in analyzing the oil & gas sector, employing years of observation and insight to interpret trends and make accurate predictions. They have an intimate understanding of the factors affecting the oil & gas sector, including regulatory changes, technological advancements, market demand, geopolitical influences, and environmental considerations. Industry experts are often well-versed in current market trends, including supply and demand dynamics, price fluctuations, and competitor strategies.Understanding of Industry Concepts and TerminologyTheir grasp of specific oil & gas terminology and concepts ensures that the valuation process is more tailored and precise. They know what factors to consider and how these factors interplay within the context of the industry.Writing/Speaking about Industry TrendsWith a thorough knowledge of the industry's evolution, these experts can provide invaluable insights and analysis on emerging trends.Transaction ExperienceIndustry experts have hands-on experience in dealing with transactions within the oil & gas sector, including with upstream E&Ps, JVs, Partnerships, and LLCs.Advisory ServicesIndustry experts are often sought to provide advisory services and are attuned to the market as typical acquirers and divestors of assets, entities, and interests in the oil & gas industry.Enhanced CredibilityFinally, an industry expert's valuation may carry more weight with stakeholders and regulatory authorities due to their specialized knowledge and experience in the oil & gas field. It reflects a deep understanding of the unique attributes of the industry.The Case for a Valuation ExpertSelecting a valuation expert to assess your oil & gas company brings a distinct set of advantages rooted in their specialized training, adherence to recognized standards, and a focused approach to valuation. Here are the key benefits.Training, Professional Designations, and Valuation StandardsWith specialized training and professional certifications, valuation experts bring credibility and expertise to the valuation process, adding confidence for stakeholders, investors, and regulators. In addition, valuation experts are trained in internationally recognized standards and methodologies. This ensures that the valuation is consistent, transparent, and in compliance with legal and regulatory requirements.Objective PerspectiveValuation experts approach the market as hypothetical buyers and sellers, providing an unbiased and objective perspective. This helps in creating a fair and neutral valuation that can withstand scrutiny.Expertise in Valuing Minority InterestsValuation experts have specialized skills in valuing minority interests, ensuring a fair and comprehensive understanding of all ownership stakes within the company.Advising on Buy-Sell AgreementsValuation experts can provide critical insights into contractual agreements that dictate the buying and selling of ownership interests.Defense in Litigated MattersValuation experts have experience in defending their work in litigated matters. If the valuation were ever challenged in court, their expertise could be instrumental in upholding the assessment.Handle Recurring Tax and/or Valuation WorkValuation experts can handle regular tax and valuation work, providing consistency and continuity, and ensuring ongoing compliance with tax laws and regulations.Cross-Industry KnowledgeValuation experts often have experience across various industries, allowing them to bring a broader perspective to the valuation. They can apply lessons and insights from other sectors to the unique context of the oil & gas industry.Why You Need BothThe best solution for an oil & gas company is to employ a firm that combines the experience and insights of both an industry and valuation expert. While industry experts bring the contextual understanding and transaction experience, valuation experts provide the specialized valuation skills that ensure accuracy and compliance with legal standards.The Mercer Capital ExampleMercer Capital, organized according to industry specialization, stands as a prime example of a firm embracing both these crucial elements:Industry Specialization: Our energy team has an extensive specialty oil & gas background, experience, and training. We've worked with operating entities, assets, and joint ventures throughout all phases of commodity price cycles.Recognition: Writing and speaking regularly on industry topics through channels like Forbes.com & Hart Energy, Mercer Capital has gained a reputation as a thought leader.Expert Valuations: Our firm has provided expert valuation opinions to over 15,000 clients across the globe, upheld by court jurisdictions and regulatory bodies like the IRS & PCAOB.Leadership: Actively leading in the valuation profession, Mercer Capital offers training to other professionals within the valuation, accounting, and legal communities.Global Reach: Our international experience spans Europe, the Middle East, South America, and nearly every major domestic basin and play. Through a unique combination of industry expertise and valuation specialization, Mercer Capital offers a holistic approach that caters to the multifaceted needs of the oil & gas sector, positioning itself as a preferred partner in this dynamic industry. Contact one of our professionals to discuss your valuation issue in confidence.

July 2023 SAAR

The July 2023 SAAR was 15.7 million units, almost exactly in line with last month’s SAAR but 18.2% higher than July 2022’s figure. This month’s data holds true to the ongoing trend of considerable year-over-year improvements that have remained strong as the year goes on. In fact, this month is the twelfth straight month of year-over-year improvements in the SAAR, marking a full year of rising tides in auto sales volumes.

How to Communicate Financial Results to Family Shareholders

Whitepaper Release

How to Communicate Financial Results to Family Shareholders

Whitepaper Release

Everyone agrees that communication promotes positive shareholder engagement, but what does it look like to communicate financial results effectively? In this week's blog we introduce a whitepaper that offers practical suggestions for presenting key financial data in ways that family shareholders find useful.About Mercer Capital Mercer Capital provides valuation, financial education, and other strategic financial consulting services to family businesses.We help family ownership groups, directors, and management teams align their perspectives on the financial realities, needs, and opportunities of the business.WHITEPAPERHow to Communicate Financial Results to Family ShareholdersDownload Whitepaper

WHITEPAPER | How to Communicate Financial Results to Family Shareholders

Suppose that your exposure to the French language consists of two years of high school classes twenty-five years ago. Imagine how frustrating it would be if suddenly the only news outlet available to you was Le Monde. With no small effort on your part, there’s a good chance you would be able to discern the broad outlines of the day’s events, but the odds of misunderstanding a key part of the story would be high, and any subtleties or nuance in the writing would be totally lost on you.That is likely how many of your family shareholders feel when it comes to comprehending the financial results of your family business. Perhaps they took an accounting course at some point in their lives. Or simply by virtue of having grown up around the family business, they have developed a vague sense of the differences between revenue and equity, or assets and expenses. As a result, when they read a financial report, they are generally able to discern the broad outlines of performance for the year or quarter, but the odds of misunderstanding a key part of the story are high, and any subtleties or nuance beyond the most rudimentary data are likely to pass them by.Everyone agrees that communication promotes positive shareholder engagement, but what does it look like to communicate financial results effectively? In this whitepaper, we offer practical suggestions for presenting key financial data in ways that family shareholders find useful.

Value Focus | Exploration & Production

Second Quarter 2023 | Region Focus: Permian

Mercer Capital’s Value Focus: Exploration & Production newsletter provides an overview of the industry through supply and demand analysis, commodity pricing, and public market performance. In addition, each issue of this quarterly newsletter focuses on a region, including Eagle Ford, Permian, Bakken, and Appalachia, examining general economic and industry trends. In this quarter's newsletter we focus on the Permian. Production growth over the past year continued to run well in the Permian, ahead of growth in the Eagle Ford, Appalachian, and Bakken, as the Permian basin remains one of the most economic regions for U.S. energy production. With the decline in commodity prices over the past year, rig counts fell, with the most significant decline occurring in May. With E&P firms expecting continued cost increases through the remainder of 2023, the Permian’s existing cost advantage will contribute to its continued dominance over the major U.S. basins.Exploration & ProductionSecond Quarter 2023Region Focus: PermianDownload Newsletter

Toyota’s Steady State Battery

Breakthrough or Yet Another Long-Dated Production Target?

In early July, Financial Times reported Toyota’s solid-state battery breakthrough. According to Keiji Kaita, president of Toyota’s research and development center for carbon neutrality, the goal is to cut the size, weight, and cost of both liquid and solid-state batteries in half. In this post, we get into the details of this report, what auto dealers should know about solid-state batteries, and provide some context for realistic expectations. For consumers, we don’t recommend delaying your vehicle purchase by four years based on this news.

Compensation Structures for RIAs

Part II

A well-structured equity incentive plan is accretive to existing shareholders, not dilutive. Some of the more common equity-incentive plans are discussed in this post.

August 2023 | 2023 Core Deposit Intangibles Update

Bank Watch: August 2023

In this issue: 2023 Core Deposit Intangibles Update

Potential Forensic Services Resulting from Valuation Normalizing Adjustments

In the sometimes contentious realm of divorce proceedings, the role of forensic services becomes increasingly vital.

Dividend Policy for Family Businesses

New Video Released on Family Business On Demand Resource Center

Travis Harms provides an insightful examination into the important topic of dividend policy in family businesses. He explains how to go about the decision-making process regarding distribution and why considering various shareholder characteristics and business attributes matters.

Exxon’s Acquisition of Denbury

A Tale of Two Businesses, and Neither One Is Worth $4.9 Billion

ExxonMobil made waves in the energy M&A markets by announcing its acquisition of Denbury, Inc. Exxon paid somewhere between Denbury’s stock price and a slight premium depending on the timing and stock price fluctuations. In total, the headline value was around $4.9 billion, according to Exxon’s news release.However, while Denbury is an energy company on the whole, it is made up of two main segments that have very different economics. First, its carbon capture utilization and storage segment (CCUS). Second, its upstream enhanced oil recovery segment. These two businesses, in many ways, represent Denbury’s journey over the last several years that have one foot in the carbon future and one foot in the oily past. Neither of their business segments appears to be worth the $4.9 billion price tag. So what did Exxon buy exactly, and how might one value it?A quick look at some of the overall implied metrics related to the deal reveals some oddities compared to pure-play oil companies. As to CCUS transactions, there really have not been many to compare to, and certainly not at the scale that Denbury has achieved thus far. The table below was compiled based on figures from the announcement and Capital IQ data. Just looking at the implied values relating to upstream multiples, the flowing barrel metric jumps out as high compared to most operators, especially with an EBITDA margin below 55%. This implies a higher multiple than much larger global companies such as BP, ConocoPhillips, and Occidental Petroleum—which does not make intuitive sense. On the other side of the equation, the value per mile of pipeline appears relatively high at first glance. This is considering management’s recent earnings call comments about construction costs being between $2 to $4 million per mile, coupled with the fact that the pipelines are not fully utilized yet. There clearly is a mix of segment-made contributions that drive different elements of the overall transaction price.Denbury’s CCUS business represents the future of Denbury and embodies the key rationale for Exxon’s interest. Denbury has touted this segment, and most of its marketing, to investors centers on this aspect of its business. Its enthusiasm is apparent as its annual report spent almost all its focus on this area of the business. CCUS does represent a synergistic operational advantage for the company because Denbury has been one of the few upstream companies focusing on older, depleted fields that have lost what the industry calls “natural drive” and thus require incremental efforts to bring oil to the surface. Denbury’s solution to this challenge for a long time has been to inject its CO2 into the fields to create pressure and stimulate oil production.However, the business model for a standalone CCUS business model is still relatively nascent, requiring hundreds of millions of dollars of investment and years before it could potentially reach cash flow sustainability separate from oil production activities. There’s already much in place now with 1,300 miles of pipeline and ten onshore sequestration sites, which was attractive to Exxon. However, things like the growth of offtake agreements, Section 45Q tax incentives (which I wrote about last year), and carbon storage contracts are not expected to generate net positive income for Denbury until several years in the future. Nonetheless, this developmental potential and strategic location in the Gulf region have significantly contributed to Denbury’s stock price and Exxon’s interest. How much the CCUS is contributing to Denbury’s value is uncertain. But in an interesting article published a few days ago, Hart Energy interviewed Andrew Dittmar, a Director at Enverus, who estimated that (effectively) about 62% of Denbury’s value was based on their CCUS business. In the meantime, Denbury’s upstream enhanced oil recovery (EOR) business has been pulling the income statement’s performance along. Nearly all profits for Denbury are generated through this business line. However, compared to other public upstream companies, Denbury’s profitability is comparably lower, production is smaller, and production costs are higher. This is not a recipe for high comparative valuations, certainly not over $100 thousand per flowing barrel, which only the likes of Exxon and Chevron imply. (While we’re on the topic of segments, it is not a clean comparison either since Exxon and Chevron are two integrated companies with many segments that contribute to their values too). Denbury is primarily a regional oil producer with less than 50 thousand barrels per day of production and EBITDA margins lower than many public oil companies. To its credit, Denbury does have lower decline rates than other companies due to the maturity of the fields they produce from. However, the flip side is that it costs $35-$39 per barrel to produce. Those are expensive lease operating costs when many companies operate somewhere in the teens per barrel. All that said, Enverus’s estimate in their Hart Energy interview was that the EOR business contributed about 38% of Denbury’s value. So, if Enverus’s analysis is to be applied here, that would put an adjusted value on Denbury’s production at around $39,000 per barrel and an adjusted value per pipeline mile of around $2.3 million. Take a look at these “adjusted” figures:Under this scenario, Denbury’s upstream business would potentially be slotted in with public regional upstream producers with characteristics closer to: (i) under 200 thousand barrels per day of production and (ii) EBITDAX margins under 60%. Companies like Chord Energy (a Bakken-focused producer), Callon Petroleum (a smaller Permian operator), or maybe even Enerplus (another Bakken-focused producer) come to mind. Additionally, the value per mile of pipeline drifts down to the lower end of the construction estimate range, which also appears to be more realistic. Of course, this value depends on commodity expectations, regulatory stability, and execution of Denbury’s plan. Exxon appears to be optimistic about it. Whether or not Denbury’s shareholders will be remains to be seen.Originally appeared on Forbes.com.

Compensation Structures for RIAs

Part I

Compensation models are the subject of significant handwringing for RIA principals—and for good reason. Out of all the decisions RIA principals need to make, compensation programs often have the single biggest impact on an RIA’s P&L and the financial lives of its employees and shareholders. The effects of an RIA’s compensation model are far-reaching, determining not only how compensation is allocated amongst employees but also how a firm’s earnings are split between shareholders and employees, what financial incentives employees have to grow the business, and what financial incentives are available to attract new employees and retain existing employees.Compensation models at RIAs tend to be idiosyncratic, reflecting each firm’s business model, ownership, and culture. In an ideal world, these compensation programs evolve purposefully over time in response to changes in the firm’s size, profitability, labor market conditions, and a variety of other factors. However, inertia is a powerful force: we often encounter compensation programs that made sense in the past but haven’t adapted to serve the firm’s changing needs as the business has grown in scale and complexity.Effective compensation programs need to change with the times, and the times have certainly changed. The RIA industry has seen tremendous growth over the last decade. As a result, firms today face increasingly complex compensation decisions that affect a growing list of stakeholders: outside shareholders, multiple generations of management, retiring partners, new partners, possible minority investors, and so on. On top of that, financial and labor market conditions have evolved dramatically over the last eighteen months, leading many RIAs to scrutinize their compensation models more than ever before.Introduction to RIA Compensation ModelsIt’s important to note at the outset what compensation models do and don’t do. Compensation models determine how the firm’s earnings are allocated; they don’t (directly) determine the amount of earnings to be allocated. When it comes to determining who gets what, it’s a fixed-sum game. The objective of an effective compensation policy is to allocate returns in such a way as to increase this sum over time.Compensation for RIAs can be broken down into three basic components, each of which serves different functions with respect to incentivizing, attracting, and retaining employees:Base Salary / Benefits. This is what an employee receives every two weeks or so. It’s fixed in nature and is paid regardless of firm or employee performance over the short term. On its own, base salary provides little incentive for employees to grow the value of the business over time.Variable Compensation / Bonus. In theory, variable compensation can be tied to specific metrics that the firm chooses or may be allocated on a discretionary basis. The amount of variable compensation paid to employees varies as a function of the chosen metric(s) or management’s qualitative analysis of an employee’s Variable compensation is also called at-risk compensation because all or part of it can be forfeited if target thresholds are not met. Variable compensation is most often paid out on an annual basis.Equity Compensation. Equity incentives serve an important function by aligning the interests of employees with those of the company and its shareholders. While base salary and annual variable compensation serve as shorter-term incentives, equity incentives serve to motivate employees to grow the value of the business over a longer period and play an important role in increasing an employee’s ties to the firm and promoting retention.Variable CompensationIn this blog post, we focus our attention on the variable compensation component (we’ll address the others in subsequent posts).Variable compensation plays an important role in incentivizing employees over the relatively short term (1-3 years). The evidence suggests that such incentives work, too. According to Schwab’s 2022 RIA Compensation Report, firms using performance-based incentive pay saw 28% greater AUM growth, 34% greater net asset flows, and 31% greater client growth over five years than firms without performance-based incentives.What Do You Want to Incentivize?As the name suggests, variable compensation changes as a function of some selected metric, typically revenue, profitability, or some other firm-level metric or individual-level metric, depending on the specific aspects that management intends to incentivize. Additionally, a qualitative assessment of employee performance across various areas may factor into variable compensation.In our experience, variable compensation pools tied to firm profitability and allocated amongst employees based on a combination of individual responsibilities and performance provide an effective incentive for most firms to grow the value of the business over time. Such structures tend to work well because linking variable comp to profitability creates a durable compensation mechanism that scales with the business and aligns the financial and risk management objectives of shareholders and management. Variable comp linked to profitability also promotes a cohesive team, rather than the individual silos that can arise out of revenue-based variable comp, which further helps to build the value of the enterprise.In market downturns, compensation mechanisms that directly link employee pay to firm profitability have the additional benefit of helping to blunt the impact of market conditions on firm profitability. Consider the example below, which shows the impact of a 10% AUM increase and a 10% AUM decrease for a hypothetical firm under two comp programs, one in which all compensation is fixed and the other in which there is a variable bonus pool equal to 20% of pre-bonus profitability.Click here to expand the image aboveIn this example, both compensation programs result in $4 million in EBITDA and an EBITDA margin of 24.6% in the base case scenario. In the downside scenario, however, the fixed comp structure leads to a high degree of operating leverage, and as a result, a 10% drop in AUM leads to a decline in EBITDA of over 40% and a decline in the EBITDA margin to 16.2%. Under the variable comp structure, the variable bonus pool helps to blunt the impact of declining AUM. In this example, a 10% decline in AUM results in a 32.5% decrease in EBITDA and a decline in the EBITDA margin to 18.5% under the variable comp program. In the upside scenario, the increase in EBITDA is greater under the fixed comp structure than under the variable comp structure (an increase of 40.6% vs 32.5%).From a shareholder perspective, a variable compensation program such as the one described above effectively transfers some of the risk equity holders bear to the firm’s employees. In downside scenarios, some of the decline in profitability that would otherwise accrue to shareholders is absorbed by employees. Similarly, some of the increase in profitability is allocated to employees in upside scenarios. The logic of such a compensation program is that employees are incentivized to grow and protect the same metric the shareholders care about—the firm’s profitability.ConclusionInvestment management is a talent business, and structuring an effective compensation program that allows the firm to attract, retain, and incentivize talent is critical to an RIA’s success. In future posts, we’ll address additional compensation considerations, such as equity compensation options and allocation processes.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

Mid-Year 2023 Review of the Auto Dealer Industry by Metrics

Cooling Statistics, But Perspective Is Key

As the summer winds down and we turn the calendar to August, the first half of 2023 is fully in the rearview mirror, and mid-year statistics for the auto industry have been released. How has the industry performed, and what do the metrics tell us about the direction the industry is headed for the remainder of 2023? In this post, we discuss several key metrics that we have tracked in this space over the last several years: new vehicle profitability, the supply of new vehicles, average trade-in equity values of used vehicles, the used-to-new vehicle retail unit sales ratio, fleet sales, and vehicle miles traveled.

A Tale of Two Shoes

Is there merit to emphasizing scarcity as a product attribute for your family business? Why or why not? If so, what does scarcity look like for your brand/product? Does your family business have a “core” customer? If so, who is that core customer, and how do you pursue innovation and growth strategies without alienating that customer? We discuss in this week's post.

Trending: The Independent Trust Company

One of the most frequently ignored sectors in the wealth management industry may be its first cousin, the independent trust industry. While many still associate trust administration with banks, which still control more than 75% of the space, the growing prominence of independent trust companies is capturing the attention of many participants in the investment management community. In this post, we examine current trends impacting independent trust companies.

Managing Your Complete Family Business Balance Sheet

Having a mindset that considers not just your family business balance sheet, but your complete balance sheet, will help you and your fellow family shareholders make better decisions that align with your shareholders. A holistic view will also help foster business longevity, health, and family harmony.

Tax Planning for Auto Dealerships

Why Auto Dealers Might Not Pay “Market” Rent

RIA M&A Update: 2Q 2023

Permian Production Growth Holds

Earnings Season

As a private family business, earnings season may not look the same as it does for Elon Musk or Mark Zuckerberg, as there are fundamental differences between large public companies and family businesses. But this does not mean successful family businesses should ignore the Street’s earnings season dance. Family business leaders should use some characteristics from earnings season as an opportunity to ask their family board these questions.

June 2023 SAAR

Direct-to-Consumer Sales—Gaining Traction or Losing Their Footing?

The June SAAR was 15.7 million units, up 4.0% from last month and up 20.2% from June 2022. This June marks the 11th straight month of year-over-year improvements in the SAAR, and the magnitude of the improvements has continued to grow. As we laid out in last month’s SAAR blog, inventory levels were still dismal a year ago. The SAAR reported three straight months below 13.3 million units during June, July, and August of 2022. Inventory started to improve in August, and sales followed suit in September, sending the industry on the path to recovery. With this context in mind, we expect to see significant year-over-year increases in the SAAR for at least the next two months.

Q2 2023: RIAs Finish Strong Following June’s Bull Market

Steady Interest Rates Calm Investor Nerves, Boosting RIA Performance

Share prices for publicly traded asset and wealth management firms remained relatively stagnant for most of the first two months of Q2, tracking a broader market that struggled to find direction. In late May, however, the S&P 500 kicked off a summer rally that saw the index enter bull market territory in early June before continuing to notch an 8.3% gain for the quarter. This market uplift propelled AUM balances higher, and share prices for most categories of publicly traded asset and wealth management firms followed suit.

Fairness Opinions and Down Markets

Fairness opinions do not offer opinions about where a security will trade in the future. Instead the opinion addresses fairness from a financial point of view to all or a subset of shareholders as of a specific date. The evaluation process is trickier when markets fall sharply, but it is not unmanageable.

What We’ve Been Reading

We hope that you and your family enjoyed a relaxing Fourth of July holiday this week. To help ease you back into the routine of things, we’ve compiled a brief reading list of items we’ve found to be interesting and informative in the past couple of weeks. Think of it as your Family Business Director summer reading list. Don’t worry – next week’s post won’t include a test.Family OfficeIn this piece, Deloitte takes a look at a few ways that families can protect, preserve, and grow their wealth, even in the complex tax rate environment we currently find ourselves in.Family Business Magazine provides a set of considerations for families looking to start up a family office in this recent article. As with any worthwhile endeavor, the article stresses the importance of defining the end goals of a family office as the starting point of the process.Estate PlanningThe National Law Review gives a concise look at a few of the estate planning tools at the disposal of couples subject to the federal estate tax in this recent overview.Firm ManagementThis case study from The Family Business Consulting Group highlights the importance of alignment in family businesses with multiple generations of shareholders and the difficult, but necessary, work needed to ensure that shareholder incentives are aligned within a family business.Finally, we turn to Mercer Capital’s RIA Advisory group for a look at some considerations regarding your buy-sell agreement that should help align expectations in a triggering event. While this blog piece was written with RIA owners in mind, we think that the considerations laid out are applicable to businesses across a wide swath of industries.

Bank Watch : July 2023

Bank Impairment Testing

Valuation of a Business for Divorce

In this article, we introduce the three valuation approaches and discuss the importance of normalizing adjustments to the subject company’s income statement.

E&P Third Quarter 2023

Appalachian Basin

Appalachian Basin // Appalachian production fared well over the last year, particularly considering the sharp decline in the Henry Hub price.

Transportation & Logistics Newsletter

Third Quarter 2023

Dust Off That Buy-Sell Agreement!

An Outdated Contract Is Hazardous to Your Wealth

One of the most exciting things in the vintage car world is when a classic model is “discovered” in a barn or a forest, or a field, covered in mud or dust or worse. Special because they’re untouched for decades, usually in original condition, and often with very little wear from use, these so-called “barn-finds” can sell for extraordinary sums at auction.Forgotten and ignored buy-sell agreements are also exciting, but usually not in a good way. Buy-sells tend to favor the business’s needs and the ownership’s thinking at a particular time. Decades later, the business has changed, the owners’ perspectives have matured, and the agreement—instead of being helpful—becomes a source of contention.Few RIA owners review their buy-sell agreements until something unexpected happensOur consistent experience is that few RIA owners review their buy-sell agreements until something unexpected happens. The partners argue over the future of the business. Someone gets divorced. Someone gets in trouble with the SEC. Someone dies suddenly. At that point, the buy-sell agreement goes from being a forgotten afterthought to the only thing on everyone’s mind. And, unfortunately, that one thing may be subject to interpretation.The biggest problem we see in shareholder agreements: pricing mechanisms.If a buy-sell is triggered and a 25% shareholder is to be redeemed, what’s the transaction price?The worst situations we’ve seen involved fixed-price agreements. Second to that, we’ve seen lots of problems with formula pricing.I probably don’t have to tell you what we think of formula pricing. Formula pricing has the benefit of simplicity, but simple isn’t always better.Is the formula a multiple of trailing, current, or forward earnings? Are appropriate multiples reflective of long-term averages, current market pricing, good times, bad times? Is the formula intended to generate a change of control value? To a financial buyer or a strategic buyer? Rational buyer looking for ROI or irrational buyer making a land grab? Pricing reflective of highly synergistic deal terms (use our vendors, sell our products, adopt our brand) or on a stand-alone basis? Sale of actual equity interests or a hybrid instrument that asymmetrically shares upside but protects the buyer against downside?In one situation, the agreement called for pricing an interest based on “prevailing market value.” What does that mean? Prevailing market conditions might work something like this:RIA with reported EBITDA of $5 million and adjusted EBITDA of $7 million when the LOI was drafted and reported EBITDA of $6 million and adjusted EBITDA of $8 million at the time of closing. Assume the firm sells for upfront consideration of $40 million plus the potential to get an additional $20 million in earnout if profits grow by 25% over three years. Based on this scenario, what’s the multiple? Is it:5x (upfront consideration as a multiple of adjusted EBITDA at closing)?6x (total possible consideration as a multiple of hurdle EBITDA at the time the earnout is paid)?7x (upfront consideration as a multiple of reported EBITDA at closing)?5x (total possible consideration as a multiple of adjusted EBITDA at closing)?8x (upfront consideration as a multiple of reported EBITDA at negotiation)?9x (total possible consideration as a multiple of adjusted EBITDA at negotiation)?10x (total possible consideration as a multiple of reported EBITDA at closing)?12x (total possible consideration relative to reported EBITDA when negotiated)?When people whisper deal multiples, they use the highest number possibleNaturally, the seller wants to believe they sold for 12x, and the buyer wants to tell his capital providers he paid 5x. It does no good to ask parties what multiple was paid. We find that when people whisper deal multiples, they use the highest number possible—in most cases, the maximum transaction proceeds possible as compared to a trailing measure of reported earnings. This serves the needs of all parties to the transaction. The seller gets to brag about what he was paid—and we all value psychological rewards. The investment banker brags about what a good job she did—and she probably did do a good job. And the buyer gets a reputation for paying up, so the potential sellers will return his call. All of this is good for the deal industry but not especially revealing as to valuation.Absent some reliance on formula pricing or headline metrics, you can hire an appraiser (like us), but even that’s complicated. Do you pick a valuation specialist or an industry expert? Valuation folks characteristically rely on projection models that might be more expressive of intrinsic value than market. That’s not me engaging in professional self-loathing—it’s just reality. Then there are industry experts—usually investment bankers—whose perspective leans heavily on the best deal they’ve heard of recently with a highly-motivated and over-capitalized buyer and a pristine target company with strategic relevance.If you hire a valuation expert with ample amounts of relevant industry experience (like us), you should get a balanced approach to the pricing of your transaction. But even the best resources out there (like us) have to deal with pricing expectations set long before we are involved. A buyer who wants something akin to intrinsic value and a seller who wants the highest bid imaginable will have a hard time coming to terms with the result of any valuation exercise. That situation is more common than not.I’ll offer two closing pieces of advice on crafting the valuation mechanism in your buy-sell agreement:Get your RIA valued on some kind of regular basis. If you have a smaller firm, a valuation every few years may suffice. If you have a larger firm, you might need it more than once per year. What this process offers, more than anything, is to manage expectations. The psychological bid/ask spread I describe above is much more narrow when the parties to an agreement are accustomed to seeing particular numbers, methodologies, and metrics used to determine the value of their interest. This is the main function of regular valuations. Buy-sell valuations are five-figure Buy-sell disputes are seven-figure catastrophes.Don’t draft your pricing mechanism to intentionally privilege either the buyer or seller at the expense of the other. We’ve seen estate situations where the company was compelled to redeem a 25% stake for about 45% of the value of the business. The resulting dilution to the remaining shareholders put a significant strain on the business model, ownership transition, and sustainability of the company. We’ve seen shareholder squeeze-outs where a group of shareholders was entitled to kick out a partner for minimal consideration. There’s no virtue in democracy when two lions and one lamb vote on what’s for dinner. Regardless of what you think your RIA is worth, if you aren’t intimately familiar with the terms of your buy-sell agreement, you don’t know what your interest in your RIA will net you in a transaction. Pull your agreement out, dust it off, and read it. If it seems at all confusing as to how it will function when the buy-sell mechanism is triggered, the reality will be worse than you expect.

M&A in the Permian

Acquisition Growth Flat Ahead of Expected Surge

Transaction activity in the Permian Basin remained flat over the past 12 months. The transaction count decreased slightly to 19 deals, a decline of two from the 21 deals that occurred over the prior 12-month period.

Net Interest Margin Trends for Banks Versus Credit Unions

The change in the median NIM from 1Q22-1Q23 is greater for banks versus credit unions (31 basis point expansion vs. 25 basis point expansion).Yields on earning assets expanded to a greater degree for banks versus credit unions from 1Q22-1Q23, which likely reflects a greater proportion of fixed rate loans for credit unions versus banks.The median yield on loans increased 87 bps for banks from 1Q22-1Q23 in comparison to 61 bps for credit unions.Credit unions appear to be less sensitive (at least so far) to funding cost pressure.The median cost of earning assets for banks increased by 91 bps from 1Q22- 1Q23 in comparison to 70 bps for credit unions.The 1Q22-1Q23 change in the NIM components varies by asset size (that is larger banks/CUs generally have experienced larger upward adjustments to both asset yields and the cost of funds, relative to smaller banks/CUs).Over the course of 2022, the median NIM for banks expanded from 3.06% in 1Q22 to 3.59% in 4Q22, while the median NIM for credit unions expanded from 3.04% to 3.40%.The NIM advantage reported by banks began to dissipate in 1Q23 as banks faced more cost of funds pressure than CUs.Bank NIMs widened by 17 bps more than CU NIMs between 1Q22 and 4Q22. However, funding cost pressures in 1Q23 caused bank NIMs to tighten by 22 bps in 1Q23, while CU NIMs compressed by only 11 bps.The change in NIMs between 1Q22 and 1Q23 can be decomposed as follows:Source of data for tables: S&P Capital IQ Pro, Mercer Capital research. Includes credit unions and banks with assets > $500 Million as of 12/31/21Originally appeared in the June 2023 issue of Bank Watch.

Bank Impairment Testing

Bank stocks have underperformed in the broad market since the beginning of the year and many currently trade below book value, which begs the question, is goodwill impaired?

Economic Indicators for Family Businesses

New Video Released on Family Business On Demand Resource Center

In this video, Tripp Crews discusses a few key economic indicators that family business owners and directors would be well-served to keep an eye on as we continue to navigate through a turbulent macroeconomic environment. Having a working knowledge of these indicators can help inform decision-making processes for owners and directors both in the office and in the board room.Click here to watch the video(you will be redirected to www.familybusinessondemand.com) Don't forget to check out our dedicated family business site. The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses. There, you’ll find a curated and organized diverse collection of resources from our staff of family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies. The perspectives we offer here are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses like yours. There’s nothing else like it, and we look forward to your visit.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of June 19, 2023

Overview of Auto Finance 2023

Origination, Delinquency, and Portfolio Trends

In this blog post, we review these themes and layout new developments and changes in the state of auto finance since this time last year.

4 Considerations for Your RIA’s Buy-Sell Agreement

If the parties to a shareholder’s agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.

Demise of the Sedan

Does Recent Data Suggest the Sedan Will Follow the Station Wagon and Minivan?

While recent data from the average age of cars, production of vehicle types by class, and fuel economy by vehicle type might suggest that light trucks/SUVs/crossovers will continue to overtake market share, I’m not ready to author the eulogy for the demise of the sedan/passenger car just yet. While it’s true that a proliferation of more light trucks/SUVs/crossovers on the roads means that taller/heavier vehicles might also shift the road-safety equation, there still could be momentum shifting the popularity back to sedans. While legislation helped fuel the growth and profitability of trucks, perhaps in the coming years, legislation or government mandates regarding electric vehicles will tilt the scales back towards the sedan or passenger car.

The Hardest Thing to Do in Business

What is the hardest thing to do in business? Stand still. Businesses are either growing or shrinking.

Purchase Price Allocations for Asset and Wealth Manager Transactions

There's been a great deal of interest in RIA acquisitions in recent years from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. These acquirers have been drawn to RIA acquisitions due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer. Following these transactions, acquirers are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.

Lessons from the Oracle of Omaha

Just Released: 2023 Benchmarking Guide for Family Business Directors

Growing up playing football, the team would gather after every game to run back the tape and review film. Rewatching games where you made a big play and the team won was always a good feeling. A loss? As my college coach from East Tennessee used to say, “Katy, bar the door.”If 2021 was a comeback win for a lot of companies after the COVID-19 downturn, 2022 was like running into a stonewall defense. Rising interest rates, breakneck inflation, and the Russia-Ukraine conflict stifled offenses like the ’85 Bears. But despite some bumps and bruises, the tape was more favorable than one might have expected. While shareholder returns were down with a broad decline in equity markets, EBITDA margins held up, albeit unevenly across industries, and total distributions (distributions and share repurchases) rose considerably over 2021. Or for a coaching cliché: “The game was really a lot closer than the scoreboard would indicate.”We are happy to share the release of our 2023 Benchmarking Guide for Family Business Directors. Benchmarking helps provide valuable context to directors when making their most critical decisions: what should our dividend policy be, what investments should we make, and how should we finance our business? For our benchmarking report, we have used the Russell 3000 Index Companies, excluding financial institutions, real estate companies, and utilities. We also excluded companies with less than $10 million in revenue in 2022. We have also sorted the data into five quintiles based on company sizes and the following industries. This blog post summarizes some of our financing, operating, investing, and distribution findings. For a comprehensive and detailed report on all the above questions, download the full guide.How Much Money Do Companies Like Ours Make?Inflation may have originally been billed as transitory and only here for a short visit, but 2022 showed us CPI is not taking the hint. The 12-month percentage change in Consumer Price Index, or CPI, has run north of 2% every month since March of 2021, with 2022 exceeding 6% the entire year. Red-hot inflation does appear to have been finally shown the door, with growth peaking in June 2022, but CPI is still well above recent historical norms and Federal Reserve targets.The chart below shows the number of industry constituents who saw gross margin increases and decreases in 2022 relative to 2021. Strong results in the energy sector masked gross margin challenges across other industries as companies struggled to adapt to an inflationary environment not seen since the early 1980s. The majority of energy companies saw gross margin expansion, while the majority of companies in all other industry sectors saw gross margin decline.Gross Margin Year-Over-Year How did costs affect the bottom line? While Wall Street often looks at earnings, EBITDA is the key earnings measure for family businesses. EBITDA serves as a proxy for discretionary cash flow available to service debt, pay taxes, fund reinvestment, and provide for shareholder distributions. The table below highlights EBITDA margins by industry in 2022 and 2021.EBITDA Margin Year-Over-Year Following gross margins, EBITDA margins compressed in certain industries as pricing pressure affected industries less able to pass along price increases or reduce operating expenses. Communication services, consumer staples, and healthcare all saw year-over-year EBITDA margin declines. The energy sector saw the largest change in margin, with improving oil prices serving as a tailwind to the sector.What Is The Hurdle Rate for Companies Like Ours?The Fed aggressively took on the challenge of inflation. It increased rates precipitously in the middle and back half of 2022, with four 75 basis point increases between June and November of 2022. The Fed Funds Target range went from 0% to 0.25% in early 2022 to 4.25% to 4.50% by year-end.The weighted average cost of capital is the blended return expectation of lenders and shareholders. We calculate the cost of each capital source and the weighted average regarding the market value of total capital. WACCs are generally higher for smaller and perceived riskier companies.Companies use hurdle rates to help screen out potential investments. All family businesses face capital constraints, meaning they could invest in more investments than they should invest in. Along with a robust strategic review, using a hurdle rate (often the WACC) can help directors limit review of potential projects to those that are financially feasible.Weighted Average Cost of Capital As shown above, calculated WACCs in 2022 were over 2.0% higher than in 2021 on average. Increase in interest rates, with 20-Year Treasury rising from 1.94% to 4.14% from year-end 2021 to year-end, the main driver. Borrowing costs (as reflected in BBB Corporate Bond Yields) were also up in line with treasuries. What’s the impact? Higher WACCs mean higher hurdle rates for companies and family businesses. This changes the calculus in reviewing potential projects and determining what is financially feasible for the business, affecting capital allocation and investment decisions. The chart below tracks aggregate spending on maintenance and growth capital expenditure, as well as acquisitions for the companies in the sample. Spending on acquisitions decreased in 2022 amid higher capital spending totals. Higher hurdle rates likely influenced this spending shift, as project-specific hurdle rates tied to acquisitions became perhaps less palatable to boards of directors. With more rate hikes occurring in 2023 and potentially more in the offing, 2023 could see further shifts in capital allocation decisions as we off-ramp the low/no interest rate environment.Aggregate Investment Trends Download your complimentary copy of the 2023 Benchmarking Guide for Family Business Directors, which gives you an in-depth analysis of the topics discussed here as well as discusses additional questions, including:How much money do companies like ours distribute?How much money do companies like ours borrow?How fast should companies like ours grow?What kind of return do companies like us generate for their shareholders?For more targeted insights and observations, call one of our professionals to talk about a customized benchmarking analysis for your family business.

The Benchmarking Guide for Family Business Directors

Family business directors need the best information available when making strategic financial decisions that will help set the course of their business for years to come.

ISO: Cheap Capital

All Models Are Wrong, Some Are Useful

In the post-ZIRP environment, many RIA models are hitting a wall of market resistance, opening up space for new ideas. Some of those ideas will look a lot like the same wine in more presentable bottles—some will genuinely be new.

May 2023 SAAR

The Road Ahead: SAAR Predictions for the Rest of 2023

The May 2023 SAAR was 15.1 million units, a decrease of 6.5% from last month but an increase of 19.6% from this time last year. Last month also marks the tenth straight month of year-over-year improvements in the SAAR, highlighting almost a full year of rising tides in national auto sales. On an unadjusted basis, May 2023’s sales were up 22.8% from this time last year and are much closer to pre-pandemic levels.

Tax Court Sides with Family Business in Cecil

In a recent decision (Cecil v. Commissioner, T.C. Memo. 2023-24), the Tax Court tackled the thorny issue of how to value a minority interest in an operating business with valuable underlying assets. Although the decision does not directly address the appropriate “premise of value” in its decision, that is ultimately what the case was about. The Court’s ruling was a resounding victory for the taxpayers and will likely provide critical support for future family businesses facing similar fact patterns.

Middle Market Transaction Update Summer 2023

Middle market transaction activity, as measured by both deal value and deal volume, fell again in the first quarter of 2023.

6 Events That Warrant a Business Valuation of an Auto Dealership

What common events would require a business valuation of an auto dealership?

The Terminal Value

After years of abundant liquidity and elevated exit multiples, the valuation of portfolio companies has become more challenging in today’s bear market. With lower growth expectations, higher discount rates, and fading reliance on bull-market comparables, disciplined fair value analysis grounded in market-clearing prices is more important than ever.

June 2023 | Net Interest Margin Trends for Banks Versus Credit Unions

Bank Watch: June 2023

In this issue: Key Considerations in the Valuation of Banks and Bank Holding Companies and Net Interest Margin Trends for Banks Versus Credit Unions

What Is a “Level” of Value, and Why Does It Matter?

Business owners and their professional advisors are occasionally perplexed by the fact that their shares can have more than one value.

Issue No. 11 | Data as of Mid-Year 2023

Freature Articles: Mid-Year 2023 Review of the Auto Dealer Industry by Metrics and Q2 2023 Earnings Calls

Portfolio Valuation: Private Equity and Credit

Spring 2023

Although market conditions are difficult for venture-backed firms that require capital and PE-backed companies that need to refinance debt, the presumably imminent recession is not yet visible.

Merger Arbitrage and Valuation

We are sometimes asked to value common equity securities where the target (usually our client) has agreed to be acquired but the transaction has not yet closed.

Steps in a Business Valuation

New Video Released on Family Business On Demand Resource Center

Join Zac Lange from Mercer Capital as he guides you through the comprehensive process of business valuation. His walkthrough reveals the important steps of a valuation, from defining the engagement, gathering and analyzing relevant data, to selecting appropriate valuation approaches, and finally issuing the report. He emphasizes the importance of understanding the company's specific context, industry, and economic environment, and how different levels of control and marketability can impact a company's value.Click here to watch the video(you will be redirected to www.familybusinessondemand.com) Don't forget to check out our dedicated family business site. The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses. There, you’ll find a curated and organized diverse collection of resources from our staff of family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies. The perspectives we offer here are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses like yours. There’s nothing else like it, and we look forward to your visit.

Four To-Dos Before You Sell Your Investment Management Firm

Considerations for Every RIA Owner

Long before your eventual exit, you should begin planning for the day you will leave the business you built. There are many considerations for investment managers contemplating a sale, but we suggest you start with these four.

Themes from Q1 2023 Earnings Calls

Part 1: Upstream

Despite the strength of the Eagle Ford, attention and resources were increasingly directed towards the Permian Basin, where operators aimed to capitalize on improving well economics, flexibility in project scheduling, and cost savings to drive enhanced free cash flow.

The Oracle of Omaha: Lessons to Be Learned

Can you guess who said the following?“[M]y long-time partner, and I have the job of managing the savings of a great number of individuals. We are grateful for their enduring trust, a relationship that often spans much of their adult lifetime. It is those dedicated savers that are forefront in my mind as I write this letter.”No, that quote isn’t from some dear family member or close friend but from the opening paragraph of Mr. Warren Buffett’s 2022 Shareholder Letter for Berkshire Hathaway. Mr. Buffett’s understated demeanor and self-deprecating midwestern mannerisms have a way of making you forget he is, in fact, the fifth richest man in the world. Buffett and his business partner Charlie Munger recently held court in Omaha for Berkshire Hathaway’s annual shareholder meeting, fielding questions for over five hours. Not a bad showing for Buffett and Munger, 92 and 99, respectively.In what amounts to a near cliché for financial writing, we share a handful of lessons based on this year’s musings from the Oracle of Omaha in his 2022 Shareholder Letter.$38,000,000 vs. $250,000In the understatement of the century, Mr. Buffett offered the following assessment of his capital allocation performance:“At this point, a report card from me is appropriate: In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so.”Let’s review Berkshire’s performance: if you invested $1,000 in the S&P 500 in 1965, at the end of 2022, you would have (including dividends) $250,000, nearly a 10% return every year. Not bad. If you had invested that same amount into Berkshire Hathaway, you would now have almost $38 million, just under a 20% return annually. What does Mr. Buffett chalk that” so-so performance” to?“Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years – and a sometimes-forgotten advantage that favors long-term investors such as Berkshire.”When your family business is thinking about its next big growth endeavor or capital allocation decision, it may be helpful to remember Mr. Buffett: long-term outperformance comes from good decisions played out for a long time.It’s important to make good capital allocation decisions with a solid framework, considering both your family business’s hurdle rate and your long-term strategy.The power of good, solid decisions over months will move the needle. Done over decades, these decisions will impact your family for generations.A Family Gathering in OmahaHere is how Buffett describes what his over $700 billion market cap conglomerate does:“Charlie and I allocate your savings at Berkshire between two related forms of ownership. First, we invest in businesses that we control, usually buying 100% of each. Berkshire directs capital allocation at these subsidiaries and selects the CEOs who make day-by-day operating decisions….”“In our second category of ownership, we buy publicly-traded stocks through which we passively own pieces of businesses. Holding these investments, we have no say in management.”“Our goal in both forms of ownership is to make meaningful investments in businesses with both long-lasting favorable economic characteristics and trustworthy managers.”Simple? Yes. Insightful? Definitely. As Mr. Buffett points out, “Almost endless details of Berkshire’s 2022 operations are laid out” in the financial disclosures. This year’s letter was shorter than past years at 11 pages, and Berkshire still abstains from quarterly conference calls. However, there is no dearth of information that would be important to a Berkshire shareholder and may give you and your family business ideas on how to present financial and business results to your family shareholders.We have discussed how to effectively communicate with your family shareholders, but ultimately the frequency and detail will depend on your shareholder base. Remember that while shareholder communication is an investment of time and energy, it has an attractive return for both your company and your shareholder base.There Is No FinishYou may be a fifth-generation family business that has been around for over 100 years, or you may be in the early innings. Regardless, family business owners need to be thinking not in terms of quarters but in decades. This is how Buffett described Berkshire’s genesis.“In 1965, Berkshire was a one-trick pony, the owner of a venerable – but doomed – New England textile operation. With that business on a death march, Berkshire needed an immediate fresh start. Looking back, I was slow to recognize the severity of its problems. And then came a stroke of good luck: National Indemnity became available in 1967, and we shifted our resources toward insurance and other non-textile operations.”As we’ve noted in previous posts, family businesses need to be both long-term-minded and nimble enough to adapt to market demand.You should be asking yourself if you are meeting market demand or hoping the market will accept what you want to produce. How is market demand different today than it was five years ago? What will customer preferences look like five years from now? Ultimately you are aiming to make decisions that will impact your family business longevity many years from now.Analyze the tough decisions with a mindset to ensure your family business continuity through the next generation, even if it may be painful today. From Buffett:“At Berkshire, there will be no finish line.”Final Thoughts and “Munger-isms”Over nearly 60 years, one may describe Berkshire’s performance as better than “satisfactory.” Check out Berkshire’s 2022 Shareholder Letter, and I hope you enjoy it as I did. Below are a couple of my favorite quotes from the “artfully blunt” Munger in this year’s letter.“Don’t bail away in a sinking boat if you can swim to one that is seaworthy.”“A great company keeps working after you are not; a mediocre company won’t do that.”“All I want to know is where I’m going to die, so I’ll never go there. And a related thought: Early on, write your desired obituary – and then behave accordingly.”

The Devil in the Details

Diving into the CI US/Bain Transaction

On May 11, 2023 CI Financial announced a transaction through which it will sell a 20% interest (a convertible preferred stake) in its U.S. wealth management division (CI US) for $1.0 billion to a group of institutional investors led by Bain. The transaction offers a few takeaways for RIAs.

What Is the Value of My Auto Dealership?

It Depends on Who's Buying

In our Valentine’s Day-themed Levels of Value Blog Series, we discuss the theoretical considerations of the three distinct levels of value and how they apply to auto dealerships. In this post, we take a more practical approach to the discussion. When dealers ask themselves, “What is my auto dealership worth?” the answer is, “It depends on who’s buying.”

Book Review: The Psychology of Money

Successful family business directors recognize the role of luck and risk in success and failures, are adaptable, and make alternate operational decisions based on changing goals. Housel’s book does a nice job of expanding on these themes and can be an excellent addition to your family business library.

Is TXO's Strategy Paying Off?

The TXO Energy Partners IPO

As our colleague Bryce Erickson said in a recent post, uncertainty rules the day in the upstream world despite strong demand for oil and elevated commodity prices. The war in Ukraine has contributed to this, but there is no way of knowing when or if it will wind down. Interest rates continue to rise, and recession fears loom. We believe the recent initial public offering (IPO) of TXO Energy Partners LP offers an interesting case study of how investors are responding to these mixed signals. In the early 2010s, upstream IPOs were at a peak. In 2011, there were no fewer than 20 IPO announcements, and the average targeted capital raises for IPOs climbed to well over $550 million by 2013. Things went sour from there. Since 2015, there have only been 22 IPOs announced. Due in part to the pandemic, average IPO targets for upstream firms have sunk to $15 million. Despite the vital role of oil and gas in the US economy, the market for public equity in upstream firms can certainly be described as underweight due to few publicly available investments in the sector and, thus, fewer opportunities for investment. Despite this, 2022 featured more IPO announcements than any year since 2016. Soaring commodity prices are bringing back interest in upstream investments. Upstream managers are confronting investor uncertainty by strengthening their balance sheets, using their historically high revenue to continue ramping production, and making generous distributions to shareholders. Click here to expand the image aboveValuation ConsiderationsTXO Energy Partners LP, formerly MorningStar Partners LP, is an E&P firm that IPO’d on the New York Stock Exchange on January 26, 2023, under the ticker TXO. The Partnership is focused on plays in the Permian and San Juan Basins within Texas, New Mexico, and Colorado. TXO offered five million common shares with a target price of approximately $20 per share (which would raise about $100 million). The IPO also allowed underwriters to purchase another 750,000 common shares at the IPO price net of discounts and commissions.One of the most important factors when considering TXO’s fundamentals is its recent acquisitions. In late 2021, they purchased 24,052 leasehold acres, a CO2 plant in the Permian Basin, and additional CO2 assets in Colorado (these assets are referred to as the “Vacuum Properties”). Within just a month, they also acquired an additional 21,112 gross leasehold acres in the Permian (the “Andrew Parker Acquisition”). Finally, they increased their interest in the Vacuum Properties in August 2022. Every transaction involved proven producing wells.Further, these wells have an average decline rate of just 7% (compared to a 9% projected decline rate across all TXO’s assets). By making such acquisitions, TXO noticed a short-term impact on its income statement but has ultimately set itself up for reliable, comparatively non-risky cash flows. The table below summarizes TXO’s developed and undeveloped acreage as of December 31, 2022. One observation immediately jumps off the page: despite the recent Permian Basin acquisitions discussed above, TXO’s acreage is heavily weighted towards developed acreage in the San Juan Basin. Questions arise from this observation: Is TXO indicating a shift in priorities from the San Juan Basin to the Permian Basin? Will the company sell some of its San Juan Basin assets and use the proceeds to purchase more developed acreage in the Permian Basin after 2023? At the very least, the company’s focus is clearly on developed acreage rather than undeveloped acreage (see below for management’s immediate investment plans).In its S-1 statement, TXO reported PV-10 as of year-end 2021 of $986.6 million, compared to established firms like Diamondback Energy ($21.8 billion) and Black Stone Minerals ($972.1 million). A summary of TXO’s reserves per its most recent 10-K is shown below.Despite its comparatively small war chest of reserves (per the table above this paragraph showing the company’s reserve portfolio as of December 31, 2022), management has indicated that they anticipate most of their 2023 expenditures will go towards optimizing existing wells rather than continuing to make acquisitions to grow the wells in their portfolio.In the nine-month period ended September 30, 2022, revenues for TXO were $204.0 million, as opposed to $138.9 million for the same period in the prior year. TXO’s Vacuum and Andrews Parker acquisitions helped boost production volumes by almost 1,200 Mboe. Higher commodity prices also provided a significant boost, with realized prices for both oil and gas over 50% higher than in 2021. TXO reported net income of $14.6 million for the nine-month period ended September 30, 2022, compared to $25.2 million for the nine months ended September 30, 2021 ($0.58 per unit and $1.01 per unit for each respective year). The year-over-year decrease in net income was primarily attributable to higher production expenses in 2022 as well as transportation and tax expenses. On a year-over-year basis, production expenses climbed 105% as of September 30, 2022, while taxes and transportation expenses climbed 92%. Management stated that both items increased due to the two Vacuum and Andrews Parker property acquisitions. The higher production cost is a function of the acquired properties’ strong focus on oil production, which is typically more expensive on a Boe basis than natural gas production. The increase in taxes and transportation expenses was caused by rising commodity prices and changes in the Partnership’s production mix.In its S1, TXO portrays itself as holding a conservative balance sheet. Per Capital IQ, at the end of 4Q 2022, their largest liability was a credit facility with a balance of $113 million. Paying this debt down was the primary reason for their IPO. TXO has one of the smallest debt-to-capital ratios among its peers, as shown below. With less leverage, TXO is a comparatively less risky investment, all else being equal. This makes it particularly attractive to investors preparing for a potential downturn in the larger economy or upstream space.What is interesting about these financials is that despite tailwinds from commodity prices and growth from new acquisitions, YTD EPS shrank by 50%, yet TXO filed for an IPO anyway. Why? First, the EPS shrinkage is related to their acquisitions. Second, TXO’s stated strategy plays to the current desires of the market. As mentioned earlier, TXO is spending most of its money optimizing existing wells. Despite this, they still have plans to identify new opportunities. When describing how they are going to go about spending the portion of their capital dedicated to development, TXO stated that “over the next 24 months we anticipate that approximately half of our development activity will be focused on drilling new wells, virtually all of which we expect to be conventional, vertical wells.”Additionally, 97% of TXO’s current wells are conventional plays rather than more risky shale operations. By focusing on conventional plays, TXO can take advantage of slower production volume decline rates and earn steady cash flows to pay out dividends. The Partnership clearly had a distribution-focused plan in mind setting up their firm, as their Partnership Agreement specifies that every quarter it must pay out virtually all cash available for distributions. At one point, the S1 directly states that “our primary goal is to maximize investor returns through cash distributions and flat to low production and reserves growth over time.” At the time of this blog post, TXO has yet to make its first distribution since its IPO. How it sets its policy relative to other smaller upstream companies will be an interesting phenomenon to watch.The market does not currently seem to be valuing aggressive growth programs. Instead, investors are looking for companies like TXO with conservative balance sheets, large amounts of distributable cash, comparatively non-risky reserves, and steady, stable growth.All of this naturally begs the question of whether TXO’s strategy is paying off. Between TXO’s IPO date and May 4, the market price of the Standard and Poor’s Exploration & Production Select Industry Index has decreased by about 19%. On the other hand, TXO’s share price has only decreased by just under 2%.With such a high degree of uncertainty in the market, investors are bracing themselves for Murphy’s Law to take effect. They are seeking shelter in stable growth, safe balance sheets, and frequent dividend payments. TXO offered that, so investors have rewarded it.Mercer Capital has its finger on the pulse of the energy industry. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators comprising the upstream space. For a more targeted energy sector analysis that meets your valuation needs, please contact a member of the Mercer Capital Oil & Gas Team.

Infrastructure Investment for EVs, Data Privacy, and Dealership Buy-Back Programs

2023 NADC Conference Update

The National Association of Dealer Counsel (NADC) annual member conference was last week in Amelia Island, Florida. My colleague, Scott Womack, and I were happy to attend. In this week's post, we provide a few takeaways from the conference for readers to keep an eye on during the remainder of the year. At the end of the post is further reading about other topics presented at the conference.

Fair Market Value and the Nonexistent Marketability Discount for Controlling Interests

This article discusses the concept of fair market value and its various effects. First, we explain what fair market value means. Then, we explore the hypothetical negotiations between potential buyers and sellers when determining fair market value and the implications of these discussions.

RIA Dealmaking in a Post-ZIRP Market

Terms Bridge Seller Expectations and Market Realities

Seller expectations are sticky, but buyers who overpay will be left holding the proverbial bag. So deal terms will continue to evolve to find a way to reward sellers when things go well and protect buyers when they don’t. Our only warning to sellers—and buyers—is to look carefully at the underlying value of a transaction and not just the headline price.

A Lifelong Succession Plan

Lessons from the Arnault Family

Bernard Arnault and his children present a unique, large-scale case of clearly defined and equitable succession planning to ensure their family business’s future for generations to come. If you’d like to explore what this could look like in your own family business, please feel free to reach out to one of our seasoned family business professionals.

IRS Valuation Guidance

Mines, Oil and Gas Wells, & Other Natural Deposits

In this blog post, we discuss portions of Treasury Regulation 1.611 and its additional guidance when determining the fair market value of mineral properties.

Common Valuation Misconceptions about Your RIA

Old Rules of Thumb, Recent Headlines, and the Endowment Effect

The "endowment effect" refers to an emotional bias that causes individuals to value an object they own higher than its market value. We’ve probably all been guilty of this at various times in our life when it comes to property values or assets that have some sort of emotional or symbolic significance to us.

April 2023 SAAR

The April 2023 SAAR was 15.9 million units, up 7.2% from last month and 11.4% from April 2022. This month’s improvements are significant for the month and the year as they emphasize the story that the data has been telling for months: vehicle availability has been improving, leading to higher sales volumes and more consistency in the SAAR. In fact, the year-over-year improvement in April marks the ninth straight month that the SAAR improved from the year prior. On an unadjusted basis, total sales for April came in at 1.39 million units, an improvement of 9.4% from April 2022. See the chart below for a comparison of the last eight April’s unadjusted sales.

Corporate Finance in 5 Minutes

New Video Released on Family Business On Demand Resource Center

Family shareholders are entitled to know what long-term strategic decisions are being made on their behalf by the managers and directors of the family business and why those decisions are being made. In this video, Travis Harms discusses three fundamental corporate finance questions that will help family business shareholders understand the basics of corporate finance and will ultimately result in more engaged and valuable shareholders.Click here to watch the video(you will be redirected to www.familybusinessondemand.com) If you want to dive even deeper into the world of corporate finance, read our whitepaper "Corporate Finance in 30 Minutes." In the whitepaper, we provide more insight into the three key decisions of capital structure, capital budgeting, and dividend policy to assist family business directors and shareholders without a finance background make relevant and meaningful contributions to the most consequential financial decisions all companies must make. Our goal with this whitepaper is to give family business directors and shareholders a vocabulary and conceptual framework for thinking about strategic corporate finance decisions, allowing them to bring their perspectives and expertise to the discussion.

May 2023 | Merger Arbitrage and Valuation

Bank Watch: May 2023

In this issue: Merger Arbitrage and Valuation

Fair Market Value and the Nonexistent Marketability Discount for Controlling Interests

This article discusses the concept of fair market value and its various effects.

RIA Margins: How Does Your Firm’s Margin Affect Its Value?

First Republic Bank & The Asymmetry of Banking

First Republic Bank’s first quarter 2023 earnings release said little, yet little needed to be said.

What Are Bank Stocks Telling Investors?

What was expected to be a prosaic first quarter was anything but that.

Value Focus | Exploration & Production

First Quarter 2023 | Region Focus: Eagle Ford

Mercer Capital’s Value Focus: Exploration & Production newsletter provides an overview of the industry through supply and demand analysis, commodity pricing, and public market performance. In addition, each issue of this quarterly newsletter focuses on a region, including Eagle Ford, Permian, Bakken, and Appalachia, examining general economic and industry trends. In this quarter’s newsletter, we focus on the Eagle Ford. Strong rig-count growth spurred an Eagle Ford production increase that was second only to the Permian.However, production improvement was offset by commodity price easing in the latter half of 2022 and early 2023, resulting in Eagle Ford comp group stock price declines over the last year.Despite those dynamics, interest in the Eagle Ford remains high, with Devon doubling its presence in the basin in late 2022 and SilverBow making significant acquisitions (SandPoint and Sundance) last year.Exploration & ProductionFirst Quarter 2023Region Focus: Eagle FordDownload Newsletter

Middle Men: Family-Owned Auto Dealerships

In this 5-minute video, originally recorded in May 2022 for Mercer Capital’s Family Business On-Demand Resource Center, Scott Womack addresses the topic of auto dealership valuation. He explains the economic and financial challenges that have affected the auto dealer industry and what drives the ultimate value of your dealership.

The New 3 Circles of Family Business and How to Be a Good Owner

Recap of the Transitions 2023 Conference

We were pleased to be a sponsor of last week’s Transitions Conference organized and hosted by the publishers of Family Business Magazine. The organizing framework for this year’s conference was “The New 3 Circles.”

Challenging Year Ahead for Asset Managers

Asset Management Firms Struggle as Market Downturn and Fund Outflows Persist

Rising interest rates and inflation caused painful losses in the stock and bond markets in 2022, and market conditions have remained choppy so far in 2023. Moody’s lowered their December outlook for the global asset management industry from stable to negative in response to the current business and economic environment. Following the decline in AUM in 2022, lower starting AUM levels will likely weigh down industry-wide revenues and earnings in 2023.

Earnings Stability and Geopolitical Volatility

Two Foes Are Battling Once More

In the mire of much of the chaotic goings-on of the world energy markets over the past year, a lot of things have changed. A lot of other things have not gone according to predictions or plans. War in Ukraine remains. Interest rates have gone up. Recession questions haunt the market: are we close to one or already in one? Uncertainty has ruled the day.

EV Potpourri

Discussing Levels of Charging to OEM Requirements of Dealers

News of electric vehicles (EVs) has permeated headlines in the auto industry as much as record profitability, supply chain issues, and microchip shortages over the last three years. While environment-conscious mandates and industry projections have framed the narrative on the overall popularity and adoption of EVs, several recent metrics have emerged that measure the momentum of EV sales. According to CleanTechnica, monthly EV sales exceeded 7% of all new light-duty vehicle sales in the U.S. for the first time in September 2022. Experian reported registration data from January 2023 that 7.1% of all new light vehicle registrations were all-electric vehicles.

Toronto-Dominion Bank and First Horizon National Merger

FHN is a tough call for the merger arbitrage community: $25 per share of cash if the current deal closes; regulators reject the deal, causing FHN's shares to trade freely in a tough market for bank stocks; or the parties extend the merger agreement again, but does the price get renegotiated?

200-Year History: Family Business Lessons from an American Icon

A recent Barron’s article on the link between Elon Musk, corn, and John Deere piqued our interest. What can family businesses take away from this situation? We see two lessons: be open to seeking non-family members to run your business, and don’t be afraid to be a fast follower.

RIA M&A Update: 1Q 2023

RIA M&A activity has remained resilient through the first quarter of 2023, even as macro headwinds have emerged for the industry over the past year. Fidelity’s March 2023 Wealth Management M&A Transaction Report listed 68 deals through March 2023, up 19% from the 57 deals executed during the same period in 2022.

March 2023 SAAR

Is North American Auto Production Lagging Behind?

The March SAAR was 14.8 million units, down 1.2% from last month but up 9.3% compared to March 2022. Year-over-year improvements in the SAAR continue to persist as inventory is more available compared to this time last year. In fact, this month marks the eighth month in a row of year-over-year improvements in the SAAR and signals consistency in auto production and auto demand trends. On an unadjusted basis, industry-wide sales numbers tell the same story. March 2023’s sales significantly improved from last year but remain below the levels seen in 2016 through 2019.

Three Reminders on Gift and Estate Taxes

New Video Released on Family Business On Demand Resource Center

Estate planning may appear to be less pressing than other issues on your family business’ radar. However, the positive impact of effective planning on the long-term health of both the family and the family business is hard to overstate. In this video, Atticus Frank covers some reminders and quick to-dos to help you and your family implement your estate planning goals.

Q1 2023: The Market Rallies, RIAs Stay Behind

The RIA industry saw a tumultuous first quarter, with most categories of publicly traded investment managers underperforming the S&P 500. Alternative asset managers, however, saw a last-minute rally during the final few days of the quarter, leading to this category outperforming the S&P during the period.

(More) Lessons for Family Business Directors

From the Failure of Silicon Valley Bank

This week, we are pleased to feature a guest post from our firm’s founder, Chris Mercer. Before establishing Mercer Capital in 1982, Chris worked in the banking industry, and in its early days (during the height of the Savings & Loan crisis), many of the firm’s clients were troubled financial institutions. In this post, Chris brings his decades of experience to bear in analyzing the failure of Silicon Valley Bank and identifies four critical lessons for family business directors, regardless of industry. We hope you enjoy it!

April 2023 | What Are Bank Stocks Telling Investors?

Bank Watch: April 2023

In this issue: What Are Bank Stocks Telling Investors? and First Republic Bank & The Asymmetry of Banking

The Important Role of Personal Financial Statements in Divorce

High dollar, contested divorce litigation engagements often involve complex financial issues.

E&P Second Quarter 2023

Permian

Permian // Permian production growth over the past year continued to run well ahead of growth in the Eagle Ford, Appalachian, and Bakken, as the Permian basin remains one of the most economic regions for U.S. energy production.

Transportation & Logistics Newsletter

Second Quarter 2023

The level of domestic industrial production directly impacts demand for transportation services.

Public Auto Dealer Profiles: Asbury Automotive Group

Corporate Finance in 30 Minutes

Updated Whitepaper

In this updated whitepaper, we distill the fundamental principles of corporate finance into an accessible and non-technical primer.

An RIA’s Independence Is Valuable

Selling Control Is Losing Control

It’s more than a little ironic that many RIAs get their start because the founders want freedom from the constraints of a large corporation, only to build a successful business that ultimately gets resorbed into another large corporation. There are workarounds, like minority partners, but even then, the devil is in the details. Measure twice, cut once.

“I’m Not Broke. I’m Just Not Liquid.”

Like the Katy leaving the station, the banking industry is embarking into the unknown after the failures of SVB and Signature.

Down, But Not Necessarily Out

In this week’s post, we attempt to divert your attention from interest rates and banking crises by looking at recent private company transaction multiples and some implications of these measures.

Eagle Ford Activity and Production Grow, Despite Price Easing

The economics of oil & gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. This quarter we take a closer look at Eagle Ford.

Plan for the Unexpected

Succession Planning for Auto Dealers

Succession planning involves the transfer of value or leadership in a company or organization. For auto dealers, the dealership can represent a lifetime of efforts and relationships with key employees and customers. Hopefully, the dealership has also provided the owner wealth and income over the years. These factors make the discussion of succession more complicated for auto dealers because of the deep emotions tied to the legacy that they have created. So, let's discuss a few of the key factors involved in the succession planning process and why they are so critical.

Letters From the SEC: Business Combinations Edition

We discuss and comment upon four examples covering customer relationships, tradenames, contingent consideration, and bargain purchases.

Unpacking the Corporate Transparency Act

In this week’s post, we answer the main questions stemming from the Final Reporting Rule of the Corporate Transparency Act that will most likely affect you and your family business.

Q4 2022 Earnings Calls

Executives Anticipate a Return to Normal

Reviewing earnings calls from executives of the six publicly traded auto dealers, the consensus is that volumes will increase approximately 10% to about 15 million in 2023, but gross profit per unit (“GPU”) will decline as supply constraints are alleviated. Nobody is anticipating that record-setting unit-level profitability will continue, though most expect, or are at least hopeful, that “normalized” levels will be higher than pre-pandemic.

Eagle Ford M&A

Transaction Activity Picks Over the Past 4 Quarters

Deal activity in the Eagle Ford has increased over the past 12 months, with 13 deals closed compared to 10 that closed in the prior year. What is fueling Eagle Ford's M&A momentum?

The Relationship Between AUM Multiples and RIA Performance

Rules of thumb based on a percentage of AUM are frequently cited in the RIA industry as a back-of-the-envelope way to quickly estimate a firm’s value. One reason for the prevalence of AUM multiples is purely practical—AUM for RIAs is a publicly available metric, and it’s often the only window into a firm’s financial performance available to third parties. Another reason for the popularity is simplicity—AUM can be compared across firms without regard to fee levels, margins, compensation structure, and the like.The simplicity of AUM multiples is also the greatest pitfall. AUM multiples condense a significant amount of information into a single metric. In our experience, they’re usually better thought of as an output rather than an input to valuation. To gain insight into what drives AUM multiples, we can (using a little bit of math) decompose AUM multiples like this: From a practical standpoint, a dollar of AUM is worth more when it generates more fees, and those fees are worth more when they yield higher returns (earnings) to capital providers (all else equal). Investors will pay more for an RIA’s AUM when there’s more cash flow behind it. To illustrate, consider the sensitivity table below, which shows the implied AUM multiple for a given EBITDA multiple (in this case, 9.0x) as a function of effective realized fees and EBITDA margin. For sensitivity purposes, we’ve shown a wide range of effective realized fees (55 to 95 bps) and EBITDA margins (10% to 50%) which will encompass most, but not all, firms. A firm at the middle of both ranges (75 bps effective realized fee level and 30% EBITDA margin) transacting at a 9.0x EBITDA multiple would imply a 2.0% AUM multiple—in line with an often cited “2.0% of AUM” rule of thumb. But the range in the table is wide. A firm at the low end of profitability and effective realized fees (10% margin with fees of 55 bps) transacting at the same EBITDA multiple would imply a multiple of AUM of 0.5%. In comparison, a firm at the high end of the range (50% EBITDA margin and fees of 95 bps) would imply a multiple of AUM of 4.3%—a nearly ninefold increase in the multiple. This reality is why we see such disparity in the AUM multiples paid for investment management firms. Firms vary significantly in terms of their asset class focus or allocation, fee levels charged, client base demographics, and operational efficiency. All of these variables (and more) impact how AUM translates into profitability and thus what investors are willing to pay for a dollar of AUM. If a firm has balance sheet items such as GP interests or has non-AUM-based business lines, AUM multiples can be further skewed. When assessing AUM multiples from transactions, it’s important to keep these caveats in mind. If you’re an RIA principal looking to improve the value of your assets under management, the levers to pull are the effective realized fee, EBITDA margin (profitability), and the EBITDA multiple. Since the EBITDA multiple is primarily a function of risk, growth, and market conditions that are largely outside your control, the path of least resistance is probably fee discipline and margin improvement. (Though we acknowledge the difficulties of enhancing your bottom line when markets and AUM are falling while inflation swells your compensation costs and overhead expenses.) The takeaway is to focus on what you CAN control: hiring practices, new business development, incentive compensation structure, operating efficiencies, fee discipline, and cost controls. As the last year has proven, you can’t always rely on a market tailwind to lift AUM and revenue. Developing new business in a cost-efficient manner will increase margins and profitability in almost any market environment. It will also improve your AUM multiple and value by extension.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

Middle Market Transaction Update Spring 2023

Transaction activity in the middle market, measured both in terms of deal value and deal volume, fell in the fourth quarter of 2022, continuing a year-long skid in deal activity realized in 2022 against the backdrop of rising interest rates and looming economic threats.

SVB and Three Family Business Lessons

California (Bank) Dreamin’

In case you have been on an exotic vacation in a remote location, Silicon Valley Bank (SVB) imploded last week in a "gradually, then suddenly" fashion. You’ve likely read more about this California bank than you cared to over the last few days, so this post from Family Business Director aims to highlight three relevant family business lessons we can take from this: diversification, succession planning, and keeping a long-term focus.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of March 3, 2023

Preparing for the Unknown Unknowns

The Importance of Sell-Side Due Diligence

I do not think it’s fair to say Focus’s foray into the public space was a failure. Over the years, I’ve blogged that the IPO was richly priced (it was). I thought some of their disclosures on things like organic growth were less than helpful (they were not). I wondered if they were overleveraged (and I wasn’t the only one). I noted that they had lots of competition in the acquisition space (as time went on, they did). It’s absolutely true that most of the total return on Focus was earned on the initial day of trading and the speculation over going private.

February 2023 SAAR

The February SAAR was 14.9 million units, down 6.3% from last month but up 8.6% from February 2022. Year-over-year increases in the SAAR have been a theme throughout the last several months. In fact, February 2023 marks the seventh month in a row that the SAAR improved from the year prior. Looking ahead, we believe that it is likely that year-over-year improvements will continue for several more months as nationwide inventory balances continue to recover.

A Little Planning—A Lot of Tax Savings

Charitable Giving Prior to a Business Sale

Over the last few weeks, I’ve had both professional and personal conversations with family business owners who utilized a business transaction to maximize their charitable giving and minimize their tax burden. While taxes are not generally the primary driver in making large gifts to charity, a little foresight and planning can create flexibility in your giving, yield more bang for your buck, and result in fewer taxes owed to Uncle Sam. In this week’s post, we discuss the tax strategy that charitable family business owners should keep in mind when selling their business.Charitable Gifts and Business TransactionFor many family businesses, the original cost basis of their business ownership interest is extremely low, if not zero. If you have received stock via gifting, your stock’s basis is "carried over" from the original donor (or was the stock's fair market value at the time of the gift). In short, for many family businesses, any sale likely has quite a large built-in capital gains tax, especially if your family business has generated solid returns over generations.So, where’s the beef? A donation of some portion of your family’s business ownership in its business prior to a sale provides two benefits:A charitable tax deduction for the fair market value of the interest at the time the gift is made.Minimized capital gains exposure for the portion donated and sold by the charity rather than the family. Below we provide an example and some thoughts on this strategy.Utilizing a Donor Advised FundA donor-advised fund, or "DAF," is a flexible and tax-efficient way to give to charities. A DAF operates like a charitable investment account for the sole purpose of supporting charitable organizations. When taxpayers contribute assets, such as cash, stock, or other (read: private business stock) assets to a DAF, they can take an immediate tax deduction, avoid capital gains recognition, and grow the donation tax-free.A primary benefit of using a DAF to implement this gifting strategy is a practical one. Many charities are not structured to take stock of privately held companies, whereas organizations that support DAFs are able to handle the complexities around private family-owned stock gifts.Gift TimingAs the saying goes, "Pigs get fat, hogs get slaughtered." If you already have a legally-binding transaction agreement in place, this strategy is less useful, and the IRS is not likely to allow recognition of the gift. However, a non-binding letter of intent ("LOI"), where each side can leave the table, meets the bill. For the gift, a qualified appraisal would likely give significant weight to the pro rata offer on the table in measuring fair market value. The likelihood of a near-term transaction would also limit the typical discounts for lack of marketability or control. This would maximize the value of the ownership interest for gifting purposes.This works for donating stock to charity broadly, not just in a business transaction context. However, if a path to liquidity is not on the horizon, discounts for lack of control and marketability are likely to be more significant. This lowers the total fair market value of your gift, reducing tax savings at the time of the gift. On the flip side, if the gift is made to a DAF, as discussed, the ownership interest may be held and grow as the business value grows. At a business exit, your DAF reaps the benefits of the sale and avoids the capital gains tax on that portion of ownership, maximizing future charitable gifts from the DAF.Qualified AppraisalIf you’re reading this blog, you may have guessed this already; Gifts of private family ownership interests require qualified appraisals per the IRS. We talk about what amounts to a "qualified appraisal" and how to pick a qualified business appraiser here.Tax Benefits of PlanningTo illustrate the benefits of this strategy, consider two alternative scenarios: (1) the business owner contributes to charity using funds after a sale of the business (“post-sale”), or (2) the business owner contributes stock to charity prior to the deal closing ("prior-to-sale"). We’ll briefly summarize Figure 1 below.In both scenarios, the value of the gift is assumed at $3.5 million. This represents the pro rata cash proceeds in the post-sale scenario and the value of the privately held stock based on a qualified appraisal (which referenced the non-binding LOI purchase price in developing the conclusion of fair market value) in the prior-to-sale scenario.In the post-sale scenario, the business owner pays a capital gains tax on the appreciation in the stock, or $700,000 (20% of $3.5 million, assuming a $0 basis). In the prior-to-sale scenario, the business owner avoids the capital gains tax because the stock was gifted to a DAF.Under both scenarios, the business owner is entitled to a charitable deduction of $1.295 million for income tax purposes.The total tax benefit in the post-sale scenario is $595,000 ($1.295 million less the capital gains tax paid of $700,000). The prior-to-sale scenario’s total tax benefit is $1.295 million, or $700,000 higher.Final ThoughtsAs we said in the beginning, tax considerations are generally on the back burner when considering major gifts. While gifts of family business stock can be complex, the benefits of the strategy and the impact it can have are too significant to ignore. We’ve worked with business owners to provide qualified appraisals for gifting purposes in both a charitable and estate planning context. Give us a call if you want to discuss a gifting strategy you are contemplating in confidence.Note: The example here and tax ramifications are for illustration only. This article does not consider state, AMT, or other complex tax situations. The value of stock in your situation may not equal post-sale pro rata proceeds. Please consult your independent appraiser and tax advisor regarding your situation and potential tax consequences.

When a Buyer Offers You Stock

Fairness Considerations in Equity Financed Transactions

Stock consideration is rarely discussed in RIA transactions, but it is a common financing feature in other industries. We expect to see more stock-for-stock deals in RIAs. How can a seller decide whether or not to accept a suitor’s stock?

2022 Auto Dealer Industry Metrics Review

Has Profitability Peaked?

2022 marked another very successful year for auto dealers. Most of the metrics discussed in this post seem to have peaked at some point during 2022 and are shifting in the other direction. Does this signal that profitability has peaked? Will increasing volumes compensate for declining unit economics? Only time will tell.

Themes from Q4 2022 Earnings Calls

Part 2: Oilfield Service Companies

The common themes among E&P operators and mineral aggregators’ in the Q3 2022 upstream earning calls included expanding business segments internationally, long-term sustainable growth for OFS, and production growth plans. In our most recent blog post, Themes from Q4 2022 Earnings Calls, Part 1 Upstream, prevalent themes from E&P companies included dividend distribution, organic growth, and management optimism regardless of upcoming economic challenges. This week we focus on the key takeaways from oilfield service operators’ Q4 2022 earnings call.

March 2023 | I’m Not Broke. I’m Just Not Liquid

Bank Watch: March 2023

In this issue: “I’m Not Broke. I’m Just Not Liquid.”

Understand the Discount Rate Used in a Business Valuation

What Comprises the Discount Rate and What’s a Reasonable Range?

Mercer Capital’s Value Matters^® 2023-03

Navigating the Estate Tax Horizon

Out to the Public and Back Again

The Weber Grill Case Study

A recent Wall Street Journal article highlighted the trend of newly-public companies reverting back to private ownership after a very short time in public hands. Among the boomerang IPOs mentioned in the article was that of backyard grill maker Weber. With the advent of grilling season, we were curious about Weber’s experience in the public markets and any lessons that family business directors might be able to draw from the tale.

Themes from Bank Director’s 2023 Acquire or Be Acquired Conference

The 2023 version of AOBA felt bigger than ever.

Themes from Q4 2022 Earnings Calls

Part 1: Upstream

The common themes among E&P operators and mineral aggregators' in the Q3 2022 upstream earning calls included continued share buybacks, growth in production levels, and inflation’s impact on limiting growth. This week we focus on the key takeaways from the Upstream Q4 2022 earnings calls.

Analysis of the Spirit Fairness Opinions re the JetBlue Acquisition

As participants and observers in transactions, the pending acquisition of Spirit Airlines, Inc. (NYSE: SAVE) by JetBlue Airways Corporation (NASDAQGS: JBLU) offers a lot of fodder for us to comment on.

The Relationship Between Revenue Multiples and EBITDA Margins

Revenue multiples are cited perhaps as much as any other valuation metric in the RIA industry. In this week’s post, we focus on their key drivers and ways to improve the value of your management fees.

LOV(E): Why Getting the Level of Value Right Is So Important to Auto Dealers

Part II

In this two-part series (the first post dropped on Valentine’s Day), we are covering a topic near and dear to the hearts of business valuation analysts. LOV – or the “Levels of Value” – refers to the idea that while “price” and “value” may be synonymous, they don’t quite mean the same thing. A nonmarketable minority interest level of value is very different from a strategic control interest level of value.

Review of Key 4Q 2023 Economic Indicators for Family Businesses

In this week’s Family Business Director post, we look at a few key macroeconomic trends that developed in the fourth quarter of 2022 and early 2023 and their impact on family businesses.

NAPE 2023: Europe’s Post-Russian Energy Strategy & A 2023 Merger Outlook

Earlier this month, the NAPE Expo in Houston, TX, was once again at the center of the oil and gas industry. Every February, NAPE’s Global Business Conference provides insight from multiple perspectives in the industry. This year it included, among other topics, discussions of energy policy around the globe. Additionally, TPH&Co. provided a review of 2022 and an outlook on the merger and acquisition market in 2023.

As Deal Momentum Slows, What’s Next for Wealth Management Consolidation?

Is the slowdown here to stay? What does this mean for the future of deal activity? Here are a few predictions for the year ahead.

LOV(E): What Are the “Levels of Value" and Why Does It Matter to Auto Dealers?

Part I

Shareholders are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.

From Unfriended to Best Friends Again?

Attaining Efficiency Through Restructuring

This post discusses Meta's long-term planning.

Mailbox Money: Mineral Rights & Other Alternative Assets

In this 5-minute video, originally recorded for Mercer Capital’s Family Business On-Demand Resource Center, Bryce Erickson addresses the topic of oil and gas mineral/royalty rights. He explains what they are and what they aren’t, the basic framework and investment processes, and key drivers and risks associated with value.Click here to watch the video (you will be redirected to www.familybusinessondemand.com) In addition to the video, we have included additional resources on this topic that might be helpful to you.The Family Business On Demand Resource Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family businesses. While not specific to the oil and gas industry, there you’ll find a curated and organized diverse collection of resources from Mercer Capital’s family business professionals, including more 5-minute videos, articles, whitepapers, books, and research studies.The perspectives offered on the Family Business On Demand Resource Center are rooted in our experiences at Mercer Capital, working with hundreds of enterprising families in thousands of engagements over the past forty years. Our main focus is on the financial challenges faced by family businesses. There’s nothing else like it, and we hope you will visit the site. We plan to feature additional videos from our oil and gas industry team in the near future.

Investment Management Is a People Business

Who’s in the Driver’s Seat?

There is no conclusion to my ramble other than an admonition that investment management is a people business and that there are aspects to a people business that do not yield to financial modeling. It’s kind of frustrating for our team at Mercer Capital, but it also keeps work interesting.

January 2023 SAAR

The January 2022 SAAR was 15.7 million units, which is 18% higher than December 2022 and 4% higher than this time last year. This month’s data release revealed the fifth straight month of year-over-year improvements in the SAAR, supporting that inventory levels are actually recovering from the throws of persistent supply chain disruptions.

6 Valuation Principles You Should Know

New Video Released on Family Business On Demand Resource Center

Family business directors and shareholders do not need to be valuation experts. However, there are six basic valuation principles that can help directors and shareholders make better long-term financial decisions for their family businesses. In this video, we identify and explain these six principles, which are great additions to your family business toolbox.

Understanding Oilfield Services Companies & How to Value Them

This whitepaper provides invaluable guidance in regard to these aspects of the OFS industry. If you haven’t already, take a look.

Whitepaper Release: Compensation Structures for Investment Management Firms

For this week’s post we’re introducing our whitepaper on compensation structures for investment management firms. Since roughly 75% of an investment management firm’s expenses are compensation costs, figuring out the right balance of salary, performance pay, and equity incentives is always front of mind for RIA principals. This whitepaper is designed to help you navigate the various compensation models to optimize firm growth and employee retention.

WHITEPAPER | Compensation Structures for Investment Management Firms

Should You Conduct a Shareholder Survey?

Five Reasons Why It's a Good Idea

This week’s post outlines a few reasons why boards and management teams should consider a shareholder survey as part of their strategy to keep the incentives of all a company’s stakeholders aligned.

February 2023 | Themes 2023 Acquire or Be Acquired Conference and Pay vs. Performance

Bank Watch: February 2023

Themes from Bank Director’s 2023 Acquire or Be Acquired Conference

Meet the Team – Timothy R. Lee, ASA

In each “Meet the Team” segment, we highlight a different professional on our Family Law team.

Mercer Capital’s Value Matters^® 2023-02

Estate Tax Exemption Uncertainty

2022 Bank Stock Performance Recap

As in 2022, no doubt some newfound concerns will emerge in 2023 to drive bank stock performance.

Are You Ready for the Next Recession?

What 2023 Might Have in Store

This post offers a few practical steps business owners, directors, and their advisors can take to ensure their business continues to thrive.

Floorplan Interest Income Fading

Part 1: Rising Interest Rates and Increasing Inventories Are Anticipated to Remove the Unlikely Profit Center

Interest rates and inventory levels remain top of mind for auto dealers. Compared to last year, interest rates have significantly increased since the Federal Reserve began raising rates in March 2022. Inventories have also improved as the industry works through its supply chain issues. These shifts in economic trends are expected to have an impact on many aspects of auto dealer operations. In this week’s post, we talk about floorplan interest income and pose some important questions: What is floorplan interest expense, and what are floorplan credits? How have floorplan credits turned into an unlikely profit center for dealers? Can we expect this trend to continue amid changing conditions?

What Does the FTC’s Proposed Non-Compete Ban Mean for RIAs?

Earlier this month, the Federal Trade Commission (FTC) announced a proposed ban on non-compete agreements in employment contracts. If enacted, the proposed ban would prohibit a common provision of employment agreements that employers use to limit employees’ ability to compete.

WHITEPAPER | Buy-Side Considerations for Middle-Market Companies Looking to Enter the Acquisition Market

The 84 Lumber King

Succession Planning and How to Find Your Next Leader

“Money won’t make you happy… but everybody wants to find out for themselves.” – Zig Ziglar

Wealth Management in Turbulent Times

Navigating the Challenges Ahead

With the prospect of a potential recession in 2023, the worst may still be ahead. While facing uncertainty heading into 2023, it will be important for wealth management firms to have a strategy in place to navigate these challenges and capitalize on opportunities that may arise.

Auto Industry Trends to Monitor in 2023

An Automotive Potpourri

January is a month to review statistics from the prior year and to make predictions for the new year. The automobile industry is no different. In this post, we tackle a potpourri of trends to monitor in 2023, including new and used vehicle prices, electric vehicles, connected cars, and SAAR predictions.

Value Focus | Exploration & Production

Fourth Quarter 2022 | Region Focus: Appalachian Basin

In this quarter’s newsletter, we focus on the Appalachian. Notable topics include Russia-Ukraine War’s effect on the demand for LNG exports to Europe in the face of winter, tight valuations between major operators, flat production levels in the region despite a high commodity price environment, as well as increased M&A activity in 2022 highlighted by Sitio Royalties and Brigham Minerals merger — creating the largest public minerals owner.

Estate Tax Exemption Uncertainty

And Other Takeaways from the Heckerling Estate Planning Conference

This year’s week-long conference was the first to be held in person in a few years, and the exhibit hall and education sessions were full of good information and details on the estate, gift, and tax planning fronts. Below we share just a few topics of conversation and tidbits we picked up from the sessions and conference last week.

Six Things to Consider When Working with a Business Appraiser

In this post, we discuss six things that attorneys or auto dealers should consider when selecting or working with a business appraiser.

RIA M&A Update: 4Q 2023

RIA M&A activity set new records in 2022, even as macro headwinds for the industry emerged throughout the year. Fidelity’s December 2022 Wealth Management M&A Transaction Report listed 229 deals through December 2022, up from 215 in 2021. However, deal volume was most significant in the first half of 2022 and began to cool in the second half of the year, particularly in the fourth quarter.

All in the Family Limited Partnership

In this week’s Energy Valuation Insights post, we share a recent piece from our Family Business Director blog on the topic of Family Limited Partnerships. While the post speaks directly to family-owned businesses, the content is applicable to many because the individual estate tax exemption reverts to $6 million in 2026 from its current level of $12 million. As a result, many estates are beginning to plan now.

Dividends, Shareholder Signals & Present Value

As market and financial data for 2022 continue to roll in, we are beginning to prepare for our annual benchmarking study. One early finding is that investors clearly distinguished between companies that pay dividends and those that don’t. Across the size spectrum, investors favored dividend-paying stocks in 2022, as illustrated in Table 1.Table 1 :: Average Returns by Dividend Status While it was a down year across the board, the average return for companies that paid dividends was less negative than those that did not. In this post, we explore two potential reasons for this outcome and the lessons for family business directors.Lesson #1 – Dividends are a powerful signal to shareholdersActions speak louder than words, and dividends speak louder than slide decks. Dividends tell shareholders what time it is and what the future looks like.Paying a dividend—or not—tells shareholders whether it is planting time or harvesting time. The implicit signal from non-dividend payers is that the company has more attractive investment alternatives than available capital (i.e., it’s planting time). However, dividend payers are communicating to shareholders that they are generating more cash flow than can be responsibly reinvested (i.e., it’s harvesting time).We can confirm this in general terms by looking at the prevalence of dividend payers among the small-cap (S&P 600), mid-cap (S&P 400), and large-cap (S&P 500) indices. As shown in Table 2, nearly 80% of the large-cap companies in the S&P 500 paid dividends in 2022, compared to just over half of the small-cap companies in the S&P 600.Table 2 :: Prevalence of Dividend Payers by IndexAs companies grow and mature, they often use dividend payments to signal to shareholders what time it is.Second, companies can use dividends to signal to shareholders what they believe the future holds. Stock prices are all about expectations for the future, not what has happened in the past. Companies tend to only change dividends when they believe the new level will be sustainable, so investors interpret dividend changes as powerful signals regarding management’s confidence in the company’s performance going forward.Table 3 :: 2022 Return by Dividend ChangeAs shown in Table 3, those dividend payers that increased dividends during the year outperformed those that maintained or reduced their dividends during 2022.So what is your family business’s dividend policy telling your family shareholders about what time it is and what the future holds for your family business? As we have often remarked, shareholder letters may or may not get read, but dividend checks always get cashed. Are your dividend actions aligning with your words about the family business’s circumstances and future prospects? If not, there is a good chance you are eroding credibility and trust with your family shareholders, and credibility and trust are the lifeblood of successful and sustainable family businesses.Lesson #2 – Dividends reduce shareholder riskMarkets are complicated, and returns are influenced by many factors. However, at the risk of oversimplifying, stock prices fell in 2022 because higher interest rates increased the cost of capital for businesses. As the Wall Street adage says: “Don’t fight the Fed.”Rising interest rates do not affect all investments equally, however. The longer investors have to wait to receive cash, the more sensitive an investment is to interest rates. A steady dividend stream shortens the “duration” of investments in dividend-paying shares relative to non-dividend-paying shares. So, in a rising rate environment like 2022, basic present value math suggests that dividend-paying stocks will outperform.But one shouldn’t expect that what worked in 2022 will not always work going forward. Table 4 summarizes average annualized returns for the same group of companies for four years ending December 31, 2021. Over this period, during which the federal fund’s effective rate fell from 1.42% to 0.08%, returns for dividend payers lagged those of their non-dividend paying peers.Table 4 :: Annualized 2017-2021 Returns by Dividend Status Dividends reduce risk (and upside potential) for public company investors. What about your family shareholders? What role do dividends play in managing the investment risk of your family shareholders? We’ve written previously about how your family business has more than one value. Of the three “values” of your family business at any given time, the lowest is the value of a minority (non-controlling) position in shares that is not readily liquid, as depicted in Table 5.Table 5 :: The Levels of Value The “marketability discount” in Table 5 measures the economic burden of illiquidity commonly borne by family shareholders. The magnitude of that discount is not the same for all family businesses. Rather, it is a function of several factors, prominent among which is the amount of expected future dividends. As markets demonstrated in 2022, dividend payments mean that investors don’t have to wait as long to receive a return on their investment. For family shareholders facing an uncertain but potentially lengthy holding period, regular dividend payments ease the burden of illiquidity.ConclusionYour family business’s dividend policy is sending a signal to and is affecting your family shareholders' risk (and potential return). Are you and your fellow directors being intentional about the signals sent by your dividend? Are you incorporating the risk-return tradeoff for your family shareholders in your dividend policy deliberations? Intentionally crafted or not, all family businesses have a dividend policy: is yours sending the right signals?Mercer Capital has worked with family businesses in crafting their dividend policy. Let us know if you have questions about your dividend policy and the message it is sending your family shareholders.

December 2022 SAAR

The December SAAR was 13.3 million units, down 5.3% from last month but up 4.7% from this time last year. This month’s SAAR data is a bit concerning for the auto industry, as supply chain improvements do not seem to be translating to improvements in vehicle sales pace as quickly as the last couple months have indicated. Over the past month, it has seemed more and more likely that plummeting trade-in equity, persistently-high interest rates, and growing fears of an economic recession are keeping the sale of automobiles low, which could spell trouble for auto dealers that have thrived in a high-price environment over the past eighteen months.

Appalachian Gas Valuations: A Beautiful Future Emerges From An Ugly Past

Today’s solid earnings and strong balance sheets are a far cry from what they were then. Stock prices have risen alongside a fresh confidence that $4 and $5 gas prices will be sustainable for a while. Mercer Capital’s sector statistics tell the story.

The Eye of the Storm

RIAs Outperform the S&P 500 in Q4 2022

The value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with closely held RIAs should be made with caution. Many smaller publics are focused on active asset management, which has been particularly vulnerable to headwinds such as fee pressure and asset outflows to passive products. Many sectors of closely-held RIAs, particularly wealth managers and larger public asset managers, have been less impacted by these trends and have seen more resilient multiples as a result. In the case of wealth management firms, strong demand from aggregators has also helped to bolster pricing in recent years.

Middle Market Transaction Update Winter 2022

Overall deal activity at $45 billion in the third quarter of 2022 was roughly unchanged from the second quarter but down sharply from $63 billion in the third quarter of 2021.

Southwest Airlines Meltdown and Your Investment Decision

Come Fly With Me (Soon?)

So how do you make rational investment and capital expenditure decisions? Do you acquire a new business or modernize? What is a good investment? In this post, we discuss two key areas to address these questions: identify investments available to your business and evaluate your available investment opportunities.

January 2023 | 2022 Bank Stock Performance Recap

Bank Watch: January 2023

In this issue: 2022 Bank Stock Performance Recap

Understanding the Importance of Defining the Assignment in a Business Valuation

To celebrate a new year and everything that comes with new beginnings, the Mercer Capital Litigation Support Services Team has decided to start the year with a blog emphasizing the importance of the beginning of a family law engagement, defining the assignment.

Mercer Capital’s Value Matters^® 2023-01

Estate Tax Exemption Uncertainty

E&P First Quarter 2023

Eagle Ford

Eagle Ford // Strong rig-count growth spurred an Eagle Ford production increase that was second only to the Permian.

Transportation & Logistics Newsletter

First Quarter 2023

Domestic industrial production directly impacts demand for transportation services.

Bank M&A 2022 — Turbulence

At this time last year, we thought bank M&A would be described as a second year of “gaining altitude” after 2020 was spent on the tarmac following the short, but deep recession in the spring of 2020. Our one caveat was that bank stocks would have to avoid a bear market following a strong performance in 2021 because bear markets are not conducive to bank M&A.The caveat was correct. Bear markets developed in both bank stocks and fixed income that included the most deeply inverted U.S. Treasury curve since the early 1980s. Among the data points:The NASDAQ Bank Index declined 19% through December 28;The Fed raised the Fed Funds target rate 425bps to 4.25% to 4.50%;The yield on the 10-year US Treasury rose 236bps to 3.88%; andCredit spreads widened, including 150bps of option adjusted spread (OAS) on the ICE BofA High Yield Index to 4.55% from 3.05%.The outlook for deal making in 2023 is challenged by significant interest rate marks (i.e., unrealized losses in fixed-rate assets), credit marks given a potential recession, soft real estate values, and the bear market for bank stocks that has depressed public market multiples. For larger deals, an additional headwind is the significant amount of time required to obtain regulatory approval.However, core deposits are more attractive for acquirers than in a typical year given rising loan-to-deposit ratios, the high cost of wholesale borrowings and an inability to sell bonds to generate liquidity given sizable unrealized losses. A rebound in bank stocks and even a modest rally in the bond market that lessens interest rate marks could be the catalysts for an acceleration of activity in 2023 provided any recession is shallow.A Recap of 2022As of December 28, 2022, there have been 167 announced bank and thrift deals compared to 216 in 2021 and 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.As a percentage of charters, acquisition activity in 2022 accounted for 3.5% of the number of banks and thrifts as of January 1. Since 1990, the range is about 2% to 4%, although during 2014 to 2019 the number of banks absorbed each year exceeded 4% and topped 5% in 2019. As of September 30, there were 4,746 bank and thrift charters compared to 4,839 as of year-end 2021 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.Also notable was the lack of many large deals. Toronto-Dominion’s (NYSE: TD)pending $13.7 billion cash acquisition of First Horizon (NYSE: FHN) represents 61% of the $23 billion of announced acquisitions this year compared to $78 billion in 2021 when divestitures of U.S. operations by MUFG and BNP and several larger transactions inflated the aggregate value.Pricing—as measured by the average price/tangible book value (P/TBV) multiple—was unchanged compared to 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.The median P/TBV multiple was 154% in 2022. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 134% in 2020 due to the impact of the short but deep recession on economic activity and markets.The median P/E in 2022 eased slightly to 14.6x from 15.3x in 2021; however, buyers focus on pro forma earnings with fully phased-in expense saves that often are on the order of 7x to 8x unless there are unusual circumstances. Accretion in EPS is required by buyers to offset day one dilution to TBVPS and to recoup the increase in TBVPS that would be realized on a stand-alone basis as investors expect TBVPS payback periods not to exceed three years.Figure 1 :: 1990-2022 National Bank M&A MultiplesClick here to expand the image abovePublic Market Multiples vs Acquisition MultiplesFigure 2 compares the annual average P/TBV and P/E for banks that were acquired for $50 million to $250 million since 2000 with the average daily public market multiple each year for the SNL Small Cap Bank Index.1Among the takeaways are the following:Acquisition pricing prior to the GFC as measured by P/TBV multiples approximated 300% except for the recession years of 2001 and 2002 when the average multiples were 248% and 267%.Since 2014, average P/TBV multiples have been in the approximate range of 160% to 180% except for 2020.The reduction in both the public and acquisition P/TBV multiples since the GFC reflects a reduction in ROEs for the industry since the Fed adopted a zero-interest rate policy (ZIRP) other than 2017-2019 and 2022.Since pooling of interest accounting ended in 2001, the “pay-to-trade” multiple as measured by the average acquisition multiple relative to the average index multiple has remained in a relatively narrow range of roughly 0.9 to 1.15 other than during 2009 and 2010.P/E multiples based upon unadjusted LTM earnings have approximated or exceeded 20x prior to 2019 compared to 14-18x since then.Acquisition P/Es have tended to reflect a pay-to-trade multiple of 1.25 since the GFC but the pay-to-trade multiples are comfortably below 1.0x to the extent the pro forma earnings multiple is 7-8x, the result being EPS accretion for the buyer.Figure 2 :: 2000-2022 Acquisition Multiples vs Public Market MultiplesClick here to expand the image aboveFigure 3 :: 2000-2022 M&A TBV Multiples vs. Index TBV MultiplesClick here to expand the image abovePremium Trends SubduedInvestors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to public market prices. Investors tend to talk about acquisition premiums as an alpha generator, but long-term performance (or lack thereof) of the target is what drives shareholder returns.As shown in Figure 4, the average five-day premium for transactions announced in 2022 that exceeded $100 million in which the buyer and usually the seller were publicly traded was about 20%, a level that is comparable to recent years other than 2020. For buyers, the average reduction in price compared to five days prior to announcement was 2.5%. There are exceptions, of course, when investors question the pricing (actually, the exchange ratio), day one dilution to TBVPS and earn-back period. For instance, Provident Financial (NASDAQ: PFS) saw its shares drop 12.5% after it announced it would acquire Lakeland Bancorp (NASDAQ: LBAI) for $1.3 billion on September 27, 2022.Figure 4About Mercer CapitalM&A entails a lot of moving parts of which “price” is only one. It is especially important for would be sellers to have a level-headed assessment of the investment attributes of the acquirer’s shares to the extent merger consideration will include the buyer’s common shares. Mercer Capital has 40 years of experience in assessing mergers, the investment merits of the buyer’s shares and the like. Please call if we can help your board in 2023 assess a potential strategic transaction.

MedTech & Device - Industry Scan 2022

For this quarterly update, we bring together a couple of strands of our medtech and device industry practice.First, as long-term observers, public market developments in 2022 were interesting and perhaps marked an inflection point for the short to medium term.Second, in October, we attended a medtech industry conference, where we were able to gather a rich set of perspectives.The implications for some of the larger companies in the space are probably clear-cut.The downstream reverberations to private, development stage companies may be less straightforward.Nevertheless, since development stage companies are typically constrained by currently available funds and continually contemplating the next funding round, these developments are of critical importance.2022: A Brief ReviewA tumultuous year in the public markets is coming to a close.By the end of the third quarter 2022, the S&P 500 was down nearly 25%, marking a near-bottom for the year.The broader medtech and devices industry largely followed suit.On the brighter side, established large, diversified companies, while lagging their own previous benchmarks, outperformed the broader market.As a group, some biotech and life sciences companies (see next section) also seemed to fare relatively well.A closer look reveals that within the group some of the larger companies with more diversified revenue bases and, perhaps more importantly, profitable operations performed much better than smaller companies promising higher growth but deferred profits.Current profitability also appeared to differentiate better stock price performers among the medical device and healthcare technology companies.At the same time, negative sentiment was more apparent for wide swathes of these two groups compared to the broader industry.It is obvious in hindsight but over the course of 2022, as interest rates rose and remained high, markets seemed to prefer existing earnings and nearer-term cash flows over future (rosier) prospects.The shift towards more caution also manifested in other measures of market sentiment and activity.Wholesale downward revisions of earnings (growth) estimates have not occurred so far (this may yet come to pass), so much of the price decline reflects compressing valuation multiples.The pace of M&A transactions, which had gone from strength to strength during 2020 and 2021 despite myriad disruptions and distractions, decelerated significantly in 2022.By our measure, total transactions volume in the industry through the first three quarters of 2022 was roughly equal to that of just the fourth quarter of 2021.The number of IPOs also slowed to a trickle.Looking Ahead to 2023 and Beyond: A Few Notes for Development Stage CompaniesNo industry is an island but as we and others have pointed out, several long-term trends, demographic and otherwise, suggest a favorable overall outlook for the medtech and device space. Even against the seemingly dour recent market backdrop, a multitude of attendees at the medtech conference agreed on the relative merits of the industry compared to the broader economy and market. We work with a number of development stage medtech and device companies over the course of a typical year. From that perspective, we find the long-term trends interesting because of the structural emphasis on continual innovation that improve outcomes for patients and clinicians.A defining feature of medtech innovation funding is that it occurs over multiple tranches as the technologies and companies achieve various developmental milestones.In this context, some observations for development stage companies:An obvious first order effect of the recent public market developments over the past year is that development stage companies should expect generally lower valuations for funding rounds (at least) over the next couple of years.Lackluster exit activity, via either M&A or IPO, delays and/or reduces deployable capital for venture capital funds, which will make them more cautious in considering investment decisions.The sentiment shift towards more caution is shared by all investors, although the degrees will differ.Accordingly, in addition to valuation compression, some types of companies (for example, those at the pre-clinical stage) will find fundraising to be extremely difficult.As a corollary, investors are likely to prize clean clinical data. Companies focused on demonstrating good clinical outcomes will be better prepared for future funding rounds.Similarly, companies that can stretch their existing funds until they can achieve a good (clinical) milestone will be better rewarded in the next funding round.Commercial traction after hurdling regulatory approval remains an important structural consideration, especially for the non-corporate investors.Wrap-upBeyond the near-term market dynamics, a key conference takeaway for us was that the medtech funding eco-system is deep and diverse.We met and heard from traditional venture capital investors, corporate investors, and folks who operate in the continuum between them.The goals for the various investors differ to some degree, with some focused on financial attributes while others (like corporate VCs) include strategic considerations in the mix.Investors with broader goals and considerations are, to an extent, less sensitive to the prevailing market conditions and can afford to take a longer-term view.Even among these investors, financial terms and preferred deal structures vary considerably.For development stage companies contemplating fundraising efforts, a deep and diverse investor eco-system can provide plenty of optionality.In keeping with a recurring theme of this update, a note of caution – evaluating a potential funding round requires both an examination of the financial terms and an understanding of the structural features and their longer-term implications.Mercer Capital has broad experience in providing valuation services to medtech and device start-ups, larger public and private companies, and private equity and venture capital funds involved in the sector.Please contact us to discuss how we may be of help.For a more in-depth review of the industry, take a look at our most recent newsletter.

Portfolio Valuation: Private Equity and Credit

Fourth Quarter 2022

Fairness Opinions for GP-Led Secondaries

‘Twas the Blog Before Christmas…

2022 Mercer Capital Auto Dealer Holiday Poem

‘Twas the Night before Christmas, when all through the lot No vehicle was stirring, no customer ‘Bot All service lanes and lifts were empty and bare In hopes that the technicians soon would be there.Our analysts report yet another great year Despite a war in Ukraine and other big fears Record profits and operations in fixed Here we go again with allocations nixed.When most in the industry can boast of success Let’s tip our glasses in hopes ‘chips be in excess Now it’s time to ponder, look back and review To our past Blog topics that interested you.Is the industry shifting to directly sell? Will Ford follow Tesla, or only time will tell? The dealership model protected by state law; Turns out different than anyone foresaw?Many market disruptors appear on the scene How will they perform? and what does it all mean? From ride share to tall machines, ready to vend Will they be successful, or come to an end?EVs continue to dominate headlines By 2030 ICE vehicles may draw fines And will there be enough stations to charge Or will constraints on the power grid be too large.Cars are ever changing, some may even call smart Connecting infotainment and data by part Then there are vehicles and sports of power Gaining popularity hour by hour.Now Penske! Now Sonic! Auto Nation, Group 1! Gupta, Smoke, other researchers join in the fun To listen by quarter to each earnings call Will Q4 be the one where revenues fall?Each passing month reports production by the SAAR Wondering where have we been; where we currently are How it all translates to multiples so high Best to be explained by metric called Blue Sky.Then events bring industry and sport together Just as the calendar, ever changing weather From the recent World Cup to upcoming ‘Bowl Advertisers, teams will be ready to roll.Wishing you joyful season with merry and glee We will be blogging again in 2023 Mercer Auto Team will now fade out of sight Merry Christmas to all, and to all good night!

What Is on Your Family Business Box Score?

Back in the day when not all sporting events were shown on TV, reading the box score in the newspaper the next day was sometimes the only way to know the story of the game.A box score is a structured summary of results from a competition. The box score lists the game score as well as individual and team achievements. Here’s an example of a baseball box score—a savvy baseball fan might remember this game as it was especially memorable.As you see, the box score can tell the story of the game through key statistics—innings represent the primary measurement period, and runs, hits, and errors summarize the main takeaways from the game. Here's another example of a box score—personally, one of my favorites as I was born and raised in New Orleans.A question for you and your board, what is on your family business box score?When the lights are still on and things are stable, it can be easy to continue with business as usual and not look too closely at key return metrics. Creating a box score, and maybe more importantly, updating it consistently, can help prevent complacency. Establishing fundamental metrics important to your business and benchmarking your performance to peers or "opponents" can help quickly convey to you and your shareholders how the family business is doing.Consider these three metrics for your family business box score.Return on Invested CapitalReturn on Invested Capital—ROIC—is one of the best comprehensive measures of financial performance for family businesses. In its simplest form, ROIC is the ratio of NOPAT (net operating profit after tax) to invested capital (the sum of equity and debt capital invested in the business). It describes how much NOPAT the business generates per dollar of invested capital. ROIC depends on both the income generated by the business and the amount of capital invested. It is a great metric for the family business box score as it facilitates comparison to the performance of alternative investments that may be available to the family. As we have discussed previously, companies with higher ROIC display positive attributes for businesses: faster growth, more cash distributions, reduced risk, increased shareholder returns, and increased worth of the company as a whole. Paying attention to ROIC today is a reliable way to improve shareholder returns tomorrow. It is a powerful metric for evaluating how your family business has performed in the past and creating a strategy for future improvement.Shareholder ReturnsInvestment returns have two components: dividend yield and capital appreciation. The yield measures the current income a business generates, while capital appreciation measures the increase in value during the period. As depicted below, total return is the sum of yield and capital appreciation. These two components have an inherent tradeoff—greater current income limits future upside, and increased growth usually comes at the expense of current income. Investors choose from a menu of different investment alternatives, including short-term treasury notes, small-cap public stocks, private equity, and/or venture capital. Uniformly, investors desire higher returns; however, the greater the expected return correlates with the increased potential risk. Think of it like a football team: are we a run-first, ball-control offense, or do we sling the ball up and down the field? The two represent a tradeoff—but ultimately aim to achieve the same goal: a win. Or, in your family’s case: a return. Just like a team’s "identity" aims to play to its strengths, your total shareholder return profile likely reflects what your business means to you. Analyzing where the total return comes from (in the form of appreciation or yield) can help you see how you are doing relative to shareholder objectives and desired business meaning.Capital Structure & Financial LeverageUtilizing capital structure & financial leverage on your family business box score can lead to a plethora of important strategy discussions. Conversations with family shareholders that include: What is the appropriate mix of debt and equity? What is the current capital structure? How does the capital structure compare to our peers? What effect would different financing decisions have on the overall cost of capital? What is the target capital structure?Capital structure decisions are inevitably linked to family business meaning and shareholder objectives. Are you seeking to leverage current assets to achieve growth into the future (growth engine), heightening risk, or do you avoid debt to reduce volatility and shore up dividends? Financial leverage can be measured by comparing total debt to invested capital (book values of debt and equity), market values, or relative to cash flow. Ratios like debt-to-equity, debt-to-EBITDA, and debt-to-assets can be useful for your family business box score, especially when used to benchmark to peers in direct competition within your industry.ConclusionThe sports and business worlds are increasingly data-driven, and access to relevant data is essential to making the right decisions. The best performance metrics address not just “what” performance has been in the past, but reveal the “why” behind it and give direction for “how” to improve operations in the future. We believe that the individual statistics discussed above qualify as the best performance measures to help depict the “why” and guide the “how” in the future.Creating a process for your family business and understanding which key metrics to utilize for a box score can be challenging. But rather than stress about the exact measures, aim for consistent measurement and understand the drivers and outputs of your selected metrics. Our family business advisory professionals help family management teams develop their box score and align their perspectives on the financial realities, needs, and opportunities of the business.We’ll be taking next week off from the Family Business Director Blog. Enjoy the holiday, and we will see you in the new year!

Appalachian Production Holds True Despite Market Disruptions

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Marcellus and Utica shales.Production and Activity LevelsEstimated Appalachian production (on a barrels of oil equivalent, or “boe” basis) decreased approximately 1% year-over-year through late December. Production in the Eagle Ford, Permian, and Bakken increased 16%, 11%, and 5% year-over-year. Despite a much-improved year-over-year commodity price environment, Appalachian production was fairly stable, largely due to high price volatility over the year, which left the markets uncertain as to where prices would be going forward. Rig counts continued to climb in all four basins over the last year. Growth rates in the Appalachian and Permian basins were more modest, while rates for the Bakken and Eagle Ford basins were notably higher. The Appalachian rig count rose 30% from 40 to 52 rigs. Among the oil-focused basins, the Eagle Ford led with a 71% increase from 42 to 72 rigs. The Bakken followed with a 56% increase (27 to 42 rigs), while the Permian had the lowest increase with a 24% increase (283 to 350 rigs). As is typical, Appalachian production has been relatively flat despite its rig count growth. That’s due to the basin’s higher production declines which necessitate a higher rig count to maintain production levels.Commodity Price VolatilityHenry Hub natural gas front-month futures prices have experienced significant volatility over the latest year. Prices began 2022 on a general upswing before rising sharply as the market reacted to Russia’s invasion of Ukraine in late February. As Russia subsequently began leveraging its natural gas supplies against Europe in retaliation of Europe’s response to the war in Ukraine, natural gas prices became notably more volatile. They rose from an early March low of $4.56 to an early June high of $9.29 — only to drop back to $5.39 in late June and then hit a 2022 high of $9.42 in late August. By mid-December, Henry Hub had declined, albeit with only lightly reduced volatility, to $5.79.Oil prices, as benchmarked by West Texas Intermediate (WTI) and Brent Crude (Brent), also began 2022 on a steady upward trend that took the WTI from $76/bbl to $88/bbl and the Brent from $79/bbl to $91/bbl, prior to the Russian invasion. As the reality of the Russian-Ukraine war took hold, the oil benchmarks showed a marked uptick in volatility that lasted into mid-May, with prices hitting highs of $120/bbl and $128/bbl, and lows of $93/bbl and $96/bbl. Since then, WTI and Brent prices have trended downward, exhibiting more typical volatility other than modest rallies in August and October. As of mid-December, WTI sat at $73/bbl and Brent at $78/bbl.Financial PerformanceThe Appalachian public comp group saw markedly strong stock price performance over the past year (through December 12th), led by Antero and EQT with price increases of 90% and 77% as of December 12th. The remaining members of the comp group showed more modest 1-year price increases of 12% to 38%. Prices peaked in early June for all members, except EQT, with year-to-date increases of 71% to 171%. EQT’s stock price peaked in mid-September at a year-to-date increase of 143%. Stock prices fell sharply beginning in mid-September but reversed direction immediately following the sabotage of the Nord Stream pipelines in the Baltic Sea that transport Russian natural gas to northern Europe.Antero and EQT led the way among this group for several reasons. For Antero, one reason appears to have been its lack of hedging for 2023, which has allowed it greater exposure to the uptick in gas prices and has allowed Antero to be aggressive in paying down debt. EQT, on the other hand, does have more near-term hedging ceilings to deal with. However, its strength is in its operational efficiencies, whereby their recent literature demonstrates breakeven operating expenses at $1.37 per mcf. This is among the lowest in the industry and allows them to accumulate cash flow.ConclusionAppalachian production held steady in 2022 despite historically high commodity price volatility driven by the Russian-Ukraine war, the sabotage of the Nord Stream pipelines, and rising LNG exports to Europe to stave-off potential winter heating shortages. The Q4 Appalachian rig count is at a level beyond that needed for production volume maintenance, so there would seem to be at least some potential for Henry Hub price reductions going into 2023. However, the demand for new natural gas supplies to Europe provides a countervailing wind to any potential downward movement in natural gas prices. In the end, the natural gas markets seem to be in the midst of a series of events that promise continued supply and demand shifts with no certainty as to where the market will go in 2023.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

‘Twas the Blog Before Christmas…

The 2022 Mercer Capital RIA Holiday Poem

It has become a tradition for the RIA team at Mercer Capital to end the blog year with a “unique” annual summary of industry events, riffing off Clement Clark Moore’s classic “A Visit from St. Nicholas.” We hope all of you in the investment management community are enjoying the holiday season and looking forward to the many opportunities of the new year. We look forward to hearing from you in 2023. For now, please enjoy the finest only holiday poem written about money management.Happy Holidays from Mercer Capital’s RIA Team!‘Twas the night before Christmas, when all through our firm, We looked back on a year that was filled with concern; The stockings were hung by the chimney with care, In hopes ’23 wouldn’t be such a bear.Our analysts diligenced, scratching their heads, O’re down-sloping yield curves that offered no spreads; And tech stocks deflated, and rates out of sight - Each glance at the Bloomberg made anxious with fright.When out in the hall there arose such a clatter, I set down my coffee to check on the matter; Away to the lobby I flew like a flash, As good bankers do when they fear for their cash.When what to my wondering eyes should appear, But the ghost of Paul Volcker, looking quite debonair; A phantom in grey flannel, the Fed superstar, Who floated in haze from his giant cigar.“Good sir!” I addressed this strange apparition “Is it you: the inflation-fighting magician?” “The same” said the ghost, “and I sense from your query, That interest-rate changes have made your life dreary.”I told him our clients, ‘cross the RIA spectrum, Had found this past year quite a pain in the rectum; Business down, costs up, was the theme of my story, A punch to the gut that was not transitory:“First they killed crypto, then housing, then bonds! Every asset we held faced a flock of black swans! I blame the Fed board for all of this rot, My life was all good, ‘til they changed the Dot Plot!”“Relax!” cried the ghost, “don’t show your stupidity, There is such a thing as too much liquidity; Preserving your wealth is no justification, For letting the world suffer global stagflation.“When I was named Chair, we were on the back foot, But we didn’t give markets an endless Fed put! Your stocks will recover, your bonds will be fine, As soon as Jay Powell makes inflation decline.”He said plenty more, as is such with his work, He answered my questions; then turned with a jerk. A heav’nly elevator appeared there before us, And he boarded to hymns of the central bank chorus.Adjusting his glasses, perched high on his nose, He gave me a nod just before the doors closed. But I heard him exclaim, as he rose out of sight – “Don’t fight what we do, and your bets will go right!”

Is Your Family Business Ready for the Next Recession?

A Look Ahead to 2023

Allow us to interrupt the usual glad tidings enjoyed in December with a dousing of cold water. No, we aren’t about to embark on a full-on airing of grievances a la the great 20th-century philosopher Frank Constanza. Rather, the intent of our post this week is to wave a cautionary flag one last time this year before we enter the Christmas season over the next several weeks. As we begin to put a bow on 2022 and turn our attention to 2023, we suspect that the dreaded “R word” is on the mind of many of our readers as they contemplate the myriad challenges and obstacles their businesses will face in 2023.While we are not professional economists and have no illusions of being so, those that have chosen to make their living by predicting the timing of fluctuations in the business cycle are in near unanimous agreement that the U.S. economy will enter a recession in 2023 if it has not done so already. Recent readings of The Conference Board Leading Economic Index® (LEI) for the United States suggest as much: “Indeed, given the LEI’s recent performance, The Conference Board projects that economic weakness will intensify and spread more broadly throughout the U.S. economy over the coming months with a recession to begin around the end of 2022 or early 2023.”As a family business owner or director, now is the time to think critically about how your family business is positioned for a potential economic slowdown. This post offers a few practical steps family business owners and directors can take to ensure their business continues to thrive even if Santa brings us a recession this year.Operating EfficiencyOne of our family business clients told us a long time ago that making good decisions is a lot easier when you don’t need the money. There’s a lot of wisdom in that maxim, given that sustained revenue and profit growth can mask inefficiencies in the day-to-day operations of your family business. When business is going well, it’s often easy to put off hard decisions regarding expense management. When you don’t feel like you “need” the money is typically the best time to make decisions in support of the long-term sustainability of the family business. If you wait until you feel the pressure in the heat of a downturn, making appropriate expense management decisions will be much more painful.Balance Sheet StrengthManaging the balance sheet is a constant trade-off between efficiency and flexibility. We often write about the perils of “lazy” capital in family businesses, yet some financial flexibility can help sustain family businesses during economic slowdowns. Balance sheets can be fortified in advance of a recession by shedding underperforming or non-operating assets and using all or some of the proceeds to reduce outstanding indebtedness and build up a war chest of cash to sustain operations in the event of a downturn. Bankers prefer to lend money to those who don’t need it, so now could still be an optimal time to expand borrowing limits on lines of credit or re-negotiate loan covenants.Competitive DynamicsOne oft-touted benefit of family businesses is the ability to maintain a long-term focus and avoid the short-termism that can afflict non-family public companies. Taking the long view, an economic disruption may present opportunities for patient family businesses to take advantage of industry dislocations by increasing market share or consolidating industry capacity. You don’t have to outrun the bear as long as you can outrun the other hunters. Now is the time for management teams and boards to carefully assess competitive and industry dynamics to identify what opportunities might arise for the family business to solidify its long-run competitive position during a recession.Revenue CyclicalityThe cyclicality of revenue refers to the sensitivity of a family business’s revenue stream to overall economic growth. Companies that sell non-discretionary goods or services exhibit less revenue sensitivity since customers need such products and services regardless of the economic environment. Demand for food, personal care products, healthcare, and similarly situated industries can soften during a recession as consumers trim budgets, but the sensitivity is muted relative to that for discretionary goods and services (automobiles, home renovations, leisure goods, etc.) that consumers can more readily forego or defer when belts need to be tightened. Examining the cyclicality of your family business’ revenue and employing strategies to manage this cyclicality is one practical step owners and directors can take to limit the company’s revenue exposure in the event of an economic slowdown.ConclusionWe sincerely hope the next recession doesn’t start for a long time. You need to be prepared whenever it does start, whether in 2023 or later. As a family business director, you will probably never be able to make your business “recession-proof,” but now is the time to evaluate the prudent steps to prepare for the next downturn. Our family business advisory professionals have lived and worked through several recessions (and have the scars to prove it). Give us a call to discuss positioning your family business for the next one today.

November 2022 SAAR

The November 2022 SAAR was 14.1 million units, down 6.5% from last month but up 7.9% from November 2021. Compared to this time last year, vehicle availability has significantly improved, and there seems to be hope around the industry that the auto inventory crunch is in its final act. If true, this would be good news for auto dealers and consumers alike, as more units on dealer lots seem to be the first step in a “return to normal” for the industry. While it’s clear that a year-over-year improvement is present, a dip from last month’s SAAR figure may raise red flags for some of our readers. However, an additional selling weekend in October and a marginal uptick in sales due to natural disasters in the Gulf of Mexico were both tailwinds that supported a surprising improvement in the SAAR last month. Given this perspective, November 2022’s SAAR seems to return to the larger trend of improving conditions.On a full-year basis, this month’s SAAR moved the 2022 average from 13.76 million units at the end of last month to 13.79 million units, a relative drop in the bucket. Even if another improvement in the industry’s sales pace follows suit in December, it’s clear that a full-year SAAR of fewer than 14 million units is almost inevitable. Unadjusted sales trends on a relative basis are in line with the last several months. November 2022 unadjusted sales are noticeably better than November 2021 but remain depressed compared to November 2015 through 2020. It’s likely that the gap between the pre-pandemic sales pace and the current sales pace will continue to narrow in 2023, but the rate at which improvements are expected throughout the next year remains unclear. As we have learned over the past two and a half years, no one truly knows what to expect regarding geopolitical events and OEM decision-making that impact inventory availability and consumers’ demand for automobiles. Simply put, expectations for the next year of selling should be cautiously optimistic.InventoryAs we mentioned earlier in this blog, it’s clear that inventory conditions are improving. According to the NADA, inventory on the ground reached 1.65 million units in November, which is up 6.5% from last month and 57% from last year. We believe it’s likely that nationwide auto inventories will remain roughly flat through the end of 2022, with continuing marginal improvements expected throughout 2023. The industry’s inventory-to-sales ratio, a metric released with a one-month lag, actually fell in October 2022 due to a significant improvement in last month’s sales pace (as elevated sales outran inventory production over the month). Going forward, we believe that a return to the long-run average inventory-to-sales ratio of 2.41x is very unlikely in the near term or throughout 2023. Given how auto dealer profitability has thrived in the low-inventory environment, we find it increasingly likely that a fundamental shift in the industry has already occurred. What if auto dealers never return to the days of 2-3x monthly sales worth of inventory on the lot? The last two years have informed us that dealers can thrive in this environment, but only time will tell us how sustainable this success may or may not be, particularly considering how profits are split between dealers and OEMs.Transaction Prices, Monthly Payments, and Incentive SpendingAccording to J.D. Power, November 2022’s average transaction price is expected to reach $45,872, 3.1% higher than this time last year. While 3.1% doesn’t seem egregiously high in this period of high inflation, we’d note that this is in addition to much higher prices from two years ago with no signs of meaningful price declines. The only way to know if prices will contract will be to wait for a complete recovery of nationwide inventory levels and the satisfaction of any pent-up demand that may still be lingering in the industry.Alongside sticker prices, another affordability metric is the industry’s average monthly payment. In November 2022, the average monthly payment is expected to be $712, an increase of $48 from last year. A few factors determine the average monthly payment made by consumers: 1.) the transaction price, 2.) the agreed-upon interest rate, and 3.) the term of the loan.While we have already made it clear that transaction prices continue to increase, it is notable that interest rates continue to grow as well. The Federal Reserve raised the federal funds rate for the fourth consecutive time in November 2022, bringing the overnight lending rate to its highest point since 2008 and elevating all interest rates throughout the economy. According to Experian’s State of the Automotive Finance Market Q3 2022 Report, the average auto loan rate in Q3 2022 was 5.16% (compared to 4.09% last year and 4.23% in 2020). Term lengths on auto loans, the final piece of the monthly payment puzzle, typically range from 12 to 84 months. According to Experian’s report, the average term of auto loans originated in Q3 2022 was 69.73 months, trending toward the 72-month mark and largely in line with the past two years (69.51 in 2021 and 69.64 in 2020). According to Edmunds, the share of auto loans exceeding 73-month terms increased from 27% in October 2017 to 34% in October 2022.Average incentive spending per unit is expected to total $1,009 in November 2022, down 35% from this time last year. Despite being down year over year, this month marks the end of a six-month streak where average incentive spending per unit remained below $1,000. Perhaps OEMs are beginning to relent and offer more incentives as spending across the economy cools off.December 2022 OutlookMercer Capital’s outlook for the December 2022 SAAR is optimistic. Industry supply chain conditions are improving. However, sales volumes will likely continue to be closely tied to production volumes, although less so than a few months ago. High profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Consumer activity may begin to cool off as affordability becomes an issue for many prospective buyers, but at this point, we have to see it to believe it.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Shifting Gears to 2023: Six Trend Changes for RIAs

Don’t Let Your Clutch Slip!

As the RIA team at Mercer Capital looks back on 2022 and ahead to next year, we’ve noticed a few themes emerge in discussions with clients that we expect to hear more about in the new year. Don’t think of these as predictions but simply the current state of market behavior—the implications of which will soon be evident.1. Dynamic Markets Favor Providers of DiversificationAfter a decade when do-it-yourself investing in a narrow band of large-cap domestic stocks was all you needed to be successful, we see a dramatic shift to dynamic markets which require analysis and judgment. Time will tell if FAANG has gone the way of the Nifty-Fifty, Dot-Coms, and other can’t-lose equity fads. What we know is large-cap U.S. stocks are among the priciest investments available (crypto is another story), and the dollar is punching above its weight. Having lived through the worst year for 60/40 in anyone’s career memory, we now have good opportunities across a broad swath of investment classes. All of a sudden, diversification matters.We think this bodes well for those who traffic in diversification, whether it’s OCIOs, multi-family offices, wealth managers, independent trust companies, or managers in niche asset classes that play a unique role in portfolio strategies. Anyone who suffered by comparison to the S&P 500 is being set up for vindication and possibly some healthy client inflows.2. Compensation Plans Are Being Tailored to Business ModelsHistorically, many RIAs were a variable-revenue, fixed-cost business. That works when markets are steadily rising, but not in times like this. Margin of profitability is also a margin of safety.Volatile markets have wreaked havoc on industry profitability this year, both because of downward pressure on AUM and because institutional investors are increasingly asking to pay lower base fees plus performance fees. In an effort to match expenses with revenues, RIAs are responding by increasing variable pay: bonus structures and equity compensation that directly share in the profitability of the business. In many firms, leaning more on variable compensation can be a smart risk management tool both for bad markets (mitigating margin impact when revenues sag) as well as good markets (paying to retain key staff when money is plentiful).3. Borrowing Costs to Affect M&AFor most of this year, we’ve been writing that Fed behavior was going to rein in transaction activity. Like many market prognosticators, so far, we’re “not wrong, just early.” Historically, transaction activity in the RIA space is a lagging indicator, and the steep rise in rates this year is starting to have an impact.Last week, both Focus Financial and CI Financial announced debt refinancing at higher rates than they’ve had to pay in a long time. Focus closed term financing at SOFR plus 250 bps and SOFR plus 325 bps for maturities between 5 and 5.5 years. If SOFR peaks at 5% or a little higher, Focus will have term borrowing costs on the order of 8%. CI Financial is paying a fixed rate of 7% over the next three years and wants to deleverage. Focus isn’t looking to increase its leverage ratios. Our read on private acquirers aligns with these two publics. We don’t see as much dry powder available to fund M&A in 2023, and that which is available will be deployed more judiciously.4. Minority Transactions Provide the Opportunity to Wait and SeeAs M&A slows, minority transactions are being viewed by many as a way to kick the can down the road. Rather than cede control in an atmosphere of lower AUM, revenue, margin, multiples, and—therefore—value, minority sellers can take some money off the table, satisfy a near-term liquidity need, cash out one or a handful of retiring partners, or otherwise satisfy their basic ownership requirements. Key players can stay in the saddle for markets to recover and sell more in a few years.Regardless of the present conditions, we’ve heard investors in the RIA space make a compelling argument that minority investments work better anyway. Financial buyers don’t want to run RIAs, they just want to own a piece of the success brought about by committed and talented management. If management owns a meaningful stake in the business, outside investors can rest easy. We anticipate an increase in merchant banking over the next few years, especially if markets remain unsettled and interest costs are meaningfully higher.5. Fortune Favors the Bold…and So Do EarnoutsJust as we see institutional investors wanting pay-for-performance relationships and firms using variable compensation, volatile markets and higher borrowing costs favor pushing more transaction consideration toward contingent payments. It gives buyers comfort and sellers opportunity, and we think the prominence of earnout consideration will only increase.6. Buy-Sell Pricing to Mimic Transaction BehaviorBuy-sell agreements provide ownership structures with a contractual mechanism to determine how ownership interests in closely-held businesses will transact. They are a must-have for RIAs with multiple owners, and in our experience, most have some form of buy-sell agreement in place. Unfortunately, many buy-sells are not well-engineered. We get more work than we should helping disentangle disputes involving internal transactions which were supposed to happen smoothly.One recurring issue involves buy-sells that price ownership interests using formulas. Formula pricing promises simplicity, but life is rarely simple. It’s common to see formulas using industry multiples derived from rules of thumb, which might work fine under “normal” conditions.Buy-sells are usually triggered under abnormal conditions, though, when such rules of thumb could dramatically undervalue or overvalue a business. RIAs usually transact with some money paid upfront and the rest contingent on the post-transaction performance of the firm. We wonder why buy-sell pricing isn’t structured the same way.

M&A in Marcellus & Utica Basins

Shareholder Value Creation Abounds; ESG Interest Waning

Through November 2021, there were three M&A deals in the Marcellus and Utica shales. Compared to the 16 deals in the same period in 2020, companies looking to get into or out of the Appalachian basins effectively did so in 2020. The following table summarizes transaction activity in the Marcellus and Utica shales in 2021:Click here to expand the image aboveAs shown in the following table, M&A activity picked up in 2022 year-to-date, with twice as many transactions announced.Click here to expand the image aboveWhat has caused the slight rebound in M&A activity in the Marcellus and Utica shales? Companies are focusing on asset quality, strong balance sheets, prudent capital structures, and free cash flow growth. Below we examine the two largest transactions that occurred in but were not limited to the Marcellus and Utica shales in 2022.Sitio Royalties and Brigham Minerals, Inc. Merge to Create the Largest Public Minerals OwnerOn September 6, Sitio Royalties Corp. (NYSE: STR) (“Sitio”) and Brigham Minerals, Inc. (NYSE: MNRL) (“Brigham”) announced a definitive agreement to combine in an all-stock merger, with an aggregate enterprise value of approximately $4.8 billion based on the closing share prices of Sitio and Brigham on September 2, 2022. The combination brings together two of the largest public companies in the oil and gas mineral and royalty sector. Upon completion of the merger, the combined entity will retain the name Sitio Royalties Corp.Under the merger agreement's terms, Brigham shareholders will receive a fixed exchange ratio of 1.133 shares of common stock in the combined company for each share of Brigham common stock owned. Sitio’s shareholders will receive one share of common stock in the combined company for each share of Sitio common stock, based on ownership on the closing date. Brigham’s and Sitio’s Class A shareholders will receive shares of Class A common stock in the combined company, and Brigham’s Class B and Sitio’s Class C shareholders will receive shares of Class C common stock in the combined company. Upon completion of the transaction, the former Sitio shareholders will own approximately 54%, and the former Brigham shareholders will own about 46% of the combined entity on a fully diluted basis.Robert Rosa, CEO of Brigham, commented,“Our merger with Sitio creates the industry-leading powerhouse in the minerals space … with approximately 100 rigs running across all of our operating basins and greater than 50 activity wells to continue to drive production and cash flow growth.”The Sitio-Brigham deal press release discusses operational cash cost synergies, a balanced capital allocation framework that aligns with shareholder interests to drive long-term returns, enhanced margins, and increased access to capital. But, as a recent Forbes article points out, despite Kimmeridge Energy, which owns approximately 43.5% of Sitio, being a heavy promoter of ESG in the shale business, the press release has only a slight mention of ESG. The only direct mention of ESG is in the last bullet point of the strategic rationale behind the deal.EQT Corporation Continues to Add to Core Marcellus Asset BaseOn September 8, EQT Corporation (NYSE: EQT) (“EQT”) announced that it entered into a purchase agreement with THQ Appalachia I, LLC (“Tug Hill”) and THQ-XcL Holdings I, LLC (“XcL Midstream”) whereby EQT agreed to acquire Tug Hill’s upstream assets and XcL Midstream’s gathering and processing assets for total consideration of $5.2 billion. The purchase price consists of cash of $2.6 billion and 55 million shares of EQT common stock worth $2.6 billion. The transaction is expected to close in the fourth quarter of 2022, with an effective date of July 1, 2022. Transaction highlights include:~90,000 core net mineral acres offsetting EQT’s existing core leasehold in West Virginia95 miles of owned and operated midstream gathering systems connected to every major long-haul interstate pipeline in southwest AppalachiaCombined upstream and midstream assets at 2.7x next-twelve-month (“NTM”) EBITDAUpstream-only valuation of 2.3x NTM EBITDA300 untapped drilling locations in the Marcellus and Utica shales The deal is the largest U.S. upstream deal since Conoco Phillips purchased Shell’s Permian Basin assets for $9.5 billion in September 2021. EQT President and CEO Toby Rice commented, “The acquisition of Tug Hill and XcL Midstream checks all the boxes of our guiding principles around M&A, including accretion on free cash flow per share, NAV per share, lowering our cost structure and reducing business risk, while maintaining an investment grade balance sheet.” The Tug Hill/XcL Midstream transaction piggybacks EQT’s May 2021 $2.93 billion acquisition of all of the membership interests in Alta Resources Development, LLC’s (“Alta’) upstream and midstream subsidiaries. Consistent with his comments on the Tug Hill/Xcl Midstream deal, Mr. Rice commented that the Alta deal would provide attractive free cash flow per share accretion to EQT shareholders. As with the Sitio-Brigham deal, Forbes points out that the EQT-Tug Hill-XcL Midstream press release provides only a token reference to ESG in a quote by the CEO of Quantum Energy Partners, the private equity backers of Tug Hill and XcL Midstream.ConclusionM&A transaction activity in the Marcellus & Utica shales increased in 2022 relative to 2021, with large industry players motivated by free cash flow growth and creating shareholder value and less motivated by championing the ESG cause.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We can leverage our historical valuation and investment banking experience to help you navigate a critical transaction in the oil and gas industry, providing timely, accurate, and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

The Top 2022 Blog Posts from Auto Dealer Valuation Insights

Despite existing operational and new economic headwinds in 2022, auto dealers continued to produce record profits. As we wind down the year and look towards next year, we look back to see what was popular with you—our loyal readers. These are your favorite posts of 2022, which all highlight opportunities or threats to the traditional auto dealership.Future of Auto Dealerships In this blog post, David Harkins discussed the inventory challenges dealers continued to face in 2022. David also posed the question: would prevailing supply conditions fundamentally change the franchise dealer model? After reviewing the history of the franchised dealer network in the United States, David highlighted the concept of direct selling. We have definitely seen some shift to direct selling with some manufacturers more so than others, mostly with their Electric Vehicles (EVs).Succession Planning Just as our recent World Cup post paired an auto dealer topic to sports, Scott Womack paired auto dealer succession planning to the NCAA March Madness tournament. This post explained some of the key considerations for business valuations in connection with succession planning in a March Madness-style bracket. Succession planning continues to be top of mind for aging dealers as they identify the next generation of owners within their immediate or extended families.Rideshare: Friend or Foe to Auto Dealers and Manufacturers The current batch of threats to the auto dealerships' success seemed to center around the adoption of EVs and the continued development of autonomous vehicles. A few short years ago, the newest/biggest threat to auto dealers was thought to be rideshare. In this post, Harrison Holt presented the anticipated effects of ridesharing on the auto industry, along with the resulting shift from the pandemic. While we expect rideshare to continue coexisting with auto dealers, the industry has proven that it can survive and flourish despite these outside threats.SmartConnected Cars, OTAs, and Their Impact on Auto Dealers No, we weren’t commenting on the compact, fuel-efficient design models resulting from the discontinued venture between Swatch and Mercedes-Benz. We were referring to connected cars that operate like smartphones or smart appliances. In this post, Scott Womack discussed the size of the connected car market and informed our readers about Over the Air Updates (OTAs) and their ongoing connection with auto dealership service departments. Despite having disadvantages, OTAs provide some advantages and opportunities for auto dealers with new service department revenue sources.Carvana Is Looking More Like Icarus Another market disrupter to auto dealers has been Carvana. With its iconic car vending machines, Carvana attempted to reduce its real estate footprint compared to traditional auto dealerships. The company initially stood out with its online-first presence to capture digital sales. In this post, David Harkins discussed Carvana’s strategies to scale its business platform and its most recent challenges and struggles. Along the way, the Carvana narrative provided several key takeaways for auto dealers to capitalize on consumer-centric shifts in the car buying space.Powersports: Alternative Growth Opportunity for Auto Dealers Another emerging opportunity for auto dealers with excess cash from continued profits or remaining PPP funds is an investment in powersports. Powersports franchises operate similarly to traditional auto dealerships. Auto dealers with the skills and experience to sell high volumes of automobiles would also possess the necessary skills to succeed in the powersports industry. In this post, Scott Womack educates readers on the powersports industry, including the similarities and differences to traditional auto dealerships. More of our dealership clients continue to add alternative investments in powersports franchises adjacent to their existing markets.ConclusionWe look forward to 2023 and appreciate your interest in our Valuation Insights blog. We will round out the year with the final SAAR blog post and another installment of our ‘Twas the Blog Before Christmas,” highlighting the past year in the auto dealer industry. May you and your family enjoy a happy holiday season and a prosperous new year!

All in the Family Limited Partnership

Many enterprising families have January 1, 2026, circled on their calendars. Why? Because the individual estate tax exemption reverts to $6 million (give or take, depending on inflation) in 2026 from its current level of $12 million. As a result, many estates that are not currently large enough to be taxable will become so, and the effective tax rate for all estates will increase.A recent Wall Street Journal article highlighted the benefits, and potential downsides, of family limited partnerships, or FLPs (and their close cousin, the family limited liability company).The “magic” of the FLP is the ability to transfer assets to heirs, and out of taxable estates, at discounted values. The WSJ article points out that the IRS is skeptical of many FLP planning strategies, noting that audit challenges may become more frequent as the IRS puts its new $80 billion enforcement budget to work.While the valuation discounts applicable to FLPs may seem like estate planning magic, there really is no sleight-of-hand involved. Instead, valuation discounts reflect economic reality.Fair Market Value Is an Arm’s-Length StandardEstate planning transfers must be accounted for using the “fair market value” of the subject interest. Revenue Ruling 59-60 offers the following definition for fair market value: “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”Fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant factsThere’s a lot there, but for this post, we will simply highlight that fair market value is not determined with respect to a specific buyer or seller and therefore does not consider any familial relationship between the transferor and transferee in an exchange. Rather, fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant facts.Under this standard of value, business appraisers typically value interests in FLPs using a three-step approach.The Market Value Balance SheetThe first step is to compile a listing of all assets owned by the FLP, reduced by any liabilities. FLPs hold all kinds of assets, some of which have more readily ascertainable values than others. So, for some FLPs, the market value balance sheet can be constructed simply by referring to a brokerage statement, while other assets, like shares in a family business, will require a separate valuation process. Once the market values of the assets and liabilities have been determined, the difference between the two, referred to as “net asset value” or “NAV,” provides the starting point of the valuation analysis.It's Nice to Be in ChargeIf the subject interest possessed sole discretion over the operations of the FLP, net asset value would be an appropriate proxy for fair market value. After all, rather than sell the interest at a discount, the holder of such an interest would instead liquidate the underlying assets and settle the liabilities of the FLP, thereby realizing the net asset value.However, the FLP interests used in estate planning transfers rarely have such authority (as would be possessed by a sole general partner). Small, limited partner interests lack the ability to direct the operations of the FLP or force the liquidation or distribution of the underlying assets. Willing buyers operating under the fair market value standard are wary of such investments. All else equal, they prefer to be the ones making the key investment and operational decisions. When submitting to someone else’s decisions, they demand a higher return on their investment by applying a discount to the pro rata share of net asset value.This reflects a simple economic reality: minority interests in asset portfolios are worth less than the corresponding share of net asset value. There is ample real-world evidence supporting this conclusion in the market for shares in closed-end funds, which regularly trade at discounts to NAV.It’s Even Better to Be LiquidThat is where the similarities between FLP interests and shares in closed-end funds end, however. Unlike investors in closed-end funds who can quickly convert their shares to cash, there is little to no liquidity for most interests in FLPs. All else equal, investors tend to prefer liquid assets to illiquid ones. As a result, our “willing buyer” from the fair market value definition requires an additional discount to be convinced to buy a minority interest in an FLP.The discount appropriate to your family limited partnership interest will be a function of four primary economic characteristicsOnce more, this discount is no mere valuation parlor trick but instead reflects economic reality. The discount appropriate to your family limited partnership interest will be a function of four primary economic characteristics:Duration of the expected holding period. Since investors prefer liquidity, the longer a willing buyer would expect to be stuck holding the FLP interest, the larger the discount.Magnitude of expected distributions. Even when not readily marketable, some FLP interests receive regular distributions (beyond those needed to pay pass-through tax liabilities), while others receive none. The greater the magnitude of the expected interim distributions, the lower the discount.Expected capital appreciation of underlying assets. For the willing buyer, returns can only come from two sources: distributions (accounted for above) and capital appreciation. All else equal, the faster the underlying FLP assets are expected to grow in value, the smaller the discount.Holding period risks. Return follows risk, and owning the subject FLP interest is riskier than owning the underlying assets outright. The more incremental risk associated with the subject FLP interest, the greater the return required by the willing buyer, resulting in a larger discount.Be Sure the FLP Structure Is Right for Your FamilyValuation discounts for FLPs are not convoluted mirror tricks on the part of appraisers but rather reflect the straightforward economic reality of FLP interests. However, for these discounts to withstand IRS scrutiny, the economic reality we’ve described in this post must match, well, reality. As noted in the WSJ article, families forming FLPs should be prepared to live with the economic reality of having an FLP, including identifying and adhering to a clear business purpose, formal meetings, and pass-through taxes.We have valued minority interests in well over 1,000 FLPs over the past forty years. We don’t know if an FLP is right for your family, but if you and your tax and legal advisors conclude that it is, give one of our valuation professionals a call to see how we can help you.

Westwood Looks to Replace Lost AUM and Revenue with Salient Partners Acquisition

Two weeks ago, Westwood Holdings Group (ticker: WHG) completed its acquisition of Salient Partners’ asset management business. The purchase price consisted of $35 million in cash at closing plus a potential $25 million in earn-out payments (in WHG stock and cash) contingent upon hitting specific revenue retention and growth rates over the next 2-3 years. The deal is expected to add $4 billion in AUM and $31 million in annual revenue to WHG, pricing the total consideration (cash up front plus earn-out payments) at 1.5% of AUM and just under 2x revenue, which is right in line with WHG’s public peers.Click here to expand the image aboveThis valuation seems reasonable, especially considering 42% ($25 million) of the $60 million purchase price is contingent upon hitting specific revenue retention and growth objectives after closing. These metrics support WHG management’s assertion that the deal represents an “attractive valuation, structured with back-end protection through prudent growth and revenue retention hurdles.”Another (unstated) rationale for the deal is AUM and revenue replenishment. WHG assets under management and revenue peaked in 2017 at $24 billion and $134 million, respectively, and have since fallen to $11.5 billion and $68 million, respectively (prior to this acquisition). Westwood’s stock price has followed a similar trajectory, peaking at $70.84 in October 2017 and currently sitting at $11.27. This acquisition added 33% in AUM and 47% in revenue and should be immediately accretive to earnings. The Street agreed, and WHG’s stock price increased 6% on the day of the announcement.Masking losses through acquisitions is typically a risky proposition, but this may be an instance where it actually makes sense. WHG had some excess cash and investments on its balance sheet, which it employed to purchase a sizeable asset management business at a reasonable price. By acquiring an asset manager with distinct energy infrastructure, private investment, tactical equity, and real estate strategies, WHG will be able to diversify its predominantly U.S. value product offering while earning a higher effective fee on total client assets. As part of the transaction, Westwood will also acquire a 47% stake in Broadmark Asset Management, which subadvises a liquid alternative strategy on the Morgan Stanley platform.In a year where most investment management firms have endured a precipitous drop in AUM, revenue, and earnings, this acquisition could be a blueprint for future transactions. Asset manager values are down significantly over the last year, so there’s ample opportunity to add client assets and revenue for a reasonable price. These deals also tend to accrete immediately, and earn-out consideration provides downside protection against adverse market events or client losses. We’re still seeing strong deal flow for wealth management firms without the corresponding gains for asset manager M&A. If this deal goes well, we could finally see a year where asset management dealmaking outpaces RIA M&A. As always, we’ll keep an eye on it and report back.

Themes from Q3 2022 Earnings Calls-Part II

Themes from Q3 2022 Energy Earnings Calls

Part 2: Oilfield Service Companies

In a previous post, we highlighted common themes from OFS companies’ Q2 earnings calls, which included the role of OFS in energy security, OFS operators’ focus on margins rather than market share, and industry optimism. In last week’s post, we noted common themes from E&P companies, including a continued focus on share buybacks, moderate production growth, and the effects of inflation. This week we focus on the key takeaways from the OFS operators’ Q3 2022 earnings calls.Expanding Role of International Business SegmentsA common theme among OFS operators included the prevalence of quarterly growth in international segments and expectations of continued optimism among international segments. Executives noted that this growth is primarily driven by the need for updated oilfield equipment and technology outside the U.S. Their optimism is further enhanced by the surging U.S. dollar’s effect on overseas freight costs and labor. As broad-based activity increases tighten equipment availability, this will further drive price increases within global business segments.“Over the last few months, we booked orders for equipment into the Middle East and Africa. We’ll continue to selectively target international markets as we progress plans for more meaningful growth abroad. On the supply chain front, transit times and overseas freight costs are improving…while a strengthening dollar further supports improving margins.” – Scott Bender, CEO, Cactus Inc.“Our third quarter performance demonstrates the strength of our strategy to deliver profitable international growth through improved pricing… International revenue in the third quarter for the C&P [Completion and Production] and D&E [Drilling and Evaluation] divisions grew year-over-year from a percentage standpoint in the high teens and mid-20s, respectively, which outpaced international rig count growth and reflects our competitiveness in all markets. Our year-over-year growth and the margin expansion demonstrated by both divisions give me confidence in the earnings power of our international business.” – Jeff Miller, Chairman & CEO, Halliburton Company“I think international markets, in particular, have a long way to go in stepping up their technology that they apply in… in their drilling operations.” – Clay Williams, Chairman, President & CEO, NOV Inc.The Suspected Result of Near-Term Market Tightness — Long-term Sustainable Growth for Oilfield Service CompaniesOFS operators attributed expectations of steady and sustainable growth in their business to near-term tightness in the hydrocarbon commodity market. Without an immediate fix to the current supply and demand imbalances, equilibrium in the global oil and gas commodity marketplace will require years of investment to level. The imbalance may be further prolonged by E&P companies focusing on returning cash to shareholders.“While broader market volatility is clear, what we see in our business is strong and growing demand for equipment and services. There is no immediate solution to balance the world’s demand for secure and reliable oil and gas against its limited supply. I believe that only multiple years of increased investment in existing and new sources of production will solve the short supply… [E&P operators’] commitments to investor returns require a measured approach to growth and investment. Service companies follow the same discipline, delivering on their commitments to investor returns and taking a measured approach to growth and investment. What I think is underappreciated is how this results in more sustainable growth and returns over a longer period of time.” – Jeff Miller, Chairman & CEO, Halliburton Company“There’s very little used equipment that really can be refurbished economically, and what we’ve seen over the past year is more and more pressure pumpers in North America are pivoting towards buying new and the longevity and sort of the overall value offered by going to new versus used, I think, is a lot stronger.” – Clay Williams, Chairman, President & CEO, NOV Inc.“And there’s some drill out rigs that, again, what a couple of our customers have said is that they wanted to --they were out of budget, they were out of wells to complete. They wanted to stop that in kind of mid-Q4 and then pick them back up in Q1. Now we’ve had demand that’s kind of been building up behind, and so most of those rigs have already been redeployed… We’re now in a situation where even though there was some budget exhaustion, those rigs are now being put to work. And we know we have demand coming on the backside and 2023.” – Melissa Cougle, CFO, Ranger Energy Services Inc.E&P Production Growth Plans Concentrated Amid Strict BudgetsAs highlighted in a theme from last week’s post, domestic E&P production is expected to rise, albeit modestly. This growth is concentrated among certain large contracts; though the top lines may indicate relatively gradual and steady growth across the board, production growth is more concentrated among certain E&P operator plans. More generally, a limitation on broader growth for oilfield services companies in the near term is attributable to the E&P’s limited budgets. Considering the fragmentation in domestic production plans, some OFS companies have sought growth through acquisitions.“In terms of concentration, I’m going to guess that two-thirds — maybe a half to two-thirds — have to do with additions from our existing customers, which would be the publics and the other would be new logos. So, I guess the short answer is, [plans for production growth are] certainly concentrated with the large publicly traded E&Ps, at least ours.” – Scott Bender, CEO, Cactus Inc.“For the fourth quarter, we expect growing opportunities associated with our Completion & Production Solutions segment’s backlog to be mostly offset by certain projects that were pulled forward into the third quarter and supply chains that remain elongated, resulting in revenues that should be relatively flat.” – Jose Bayardo, SVP & CFO, NOV Inc.“It is clear that our acquisitions executed last year are now delivering strong returns, demonstrating the value of our consolidation strategy for Ranger and for the sector more broadly. The Ranger management team and board believe that consolidation remains an essential and ongoing process for the company within both existing and adjacent product lines. And we continue to be actively engaged on this front.” – Stuart Bodden, CEO, Ranger Energy Services Inc.Mercer Capital has its finger on the pulse of the OFS operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the ancillary service companies that help start and keep the stream flowing. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

5 Things to Know About the SEC’s New Pay Versus Performance Rules

In August 2022, the SEC adopted final rules implementing the Pay Versus Performance Disclosure required by Section 953(a) of the Dodd-Frank Act. These rules go into effect for the 2023 proxy season and introduce significant new valuation requirements related to equity-based compensation paid to company executives. What does this mean, and how does it apply to you? What are the requirements, and why might there be significant valuation challenges involved? We discuss all that and more below.Executive SummaryThe new SEC proxy disclosure rules introduce several new requirements, including that registrants calculate and disclose a new figure (Compensation Actually Paid), alongside existing executive compensation information. For most registrants, the rules will apply to upcoming 2023 proxy season.A new Pay Versus Performance table will detail the relationship between the Compensation Actually Paid, the financial performance of the registrant over the time horizon of the disclosure, and comparisons of total shareholder return.The newly introduced concept of Compensation Actually Paid will require companies to measure the period-to-period change in the fair value of all equity-based compensation awarded to named executive officers.The type of equity awards that have been granted will determine the complexity of the valuation process. Equity-based awards such as stock options might require updated Black Scholes or lattice modeling, while awards with performance or market conditions may require more complex Monte Carlo simulations.Registrants should understand that if equity awards have been granted on a consistent basis for a period of years, the new rules could require a large number of historical valuations for this initial proxy season and a significant amount of disclosure complexity.Advance planning and processes will be needed to establish the scope and complexity of complying with the new rules, including identifying how many equity-based awards will require updated valuations to measure the period-to-period changes.1. Overview and BackgroundThe new disclosures were mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act and were originally proposed by the SEC in 2015. These rules will add a new item 402(v) to Regulation S-K and are intended to provide investors with more transparent, readily comparable, and understandable disclosure of a registrant’s executive compensation. The new provisions apply to all reporting companies other than (i) foreign private issuers, (ii) registered investment companies, and (iii) emerging growth companies.The rules apply to any proxy and information statement where shareholders are voting on directors or executive compensation that is filed in respect of a fiscal year ending on or after December 16, 2022. As such, the vast majority of registrants will be required to include related disclosure for their 2023 proxy statements, though there are relaxed requirements for smaller reporting companies.The new SEC proxy disclosure rules introduce several new requirements, including that registrants calculate and disclose a new figure (Compensation Actually Paid), alongside existing executive compensation information. For most registrants, the rules will apply to upcoming 2023 proxy season.2. The Pay Versus Performance TableThe new rules require registrants to describe the relationship between the Executive Compensation Actually Paid (“CAP”) and the financial performance of the registrant over the time horizon of the disclosure. Additional items include disclosure of the cumulative Total Shareholder Return (“TSR”) of the registrant, the TSR of the registrant’s peer group, the registrant’s net income, and a company-selected measure chosen by the registrant as a measure of financial performance. These items are to be disclosed in tabular form (based on an example included in the final rule), which is replicated below.Click here to expand the table aboveThe table includes the following components:Year. The form applies to the five most recent fiscal years (or three years for smaller reporting companies)Summary Compensation Table Total for Primary Executive Officer (PEO). These are the same total compensation figures as reported under existing SEC proxy disclosure requirements. However, additional columns may need to be added if there was PEO turnover in the relevant periods.Compensation Actually Paid to PEO. For each fiscal year, registrants are required to make adjustments to the total PEO compensation reported in Item (b) for pension and equity awards that are calculated in accordance with US GAAP. This item is potentially complex and is discussed in detail below.Average Summary Compensation Table Total for Non-PEO Named Executive Officers (NEOs). These average figures would be calculated using the same compensation figures as reported under existing SEC proxy disclosure requirements for NEOs. Different individuals may be included in the average throughout the five (or three) year period. Footnote disclosure is required to list the individual NEOs.Average Compensation Actually Paid to Non-PEO NEOs. These amounts would be calculated using the same methodology as in Item (c), but then averaging the amounts in each year.Total Shareholder Return. The registrant’s TSR is to be determined in the same manner as is required by existing Regulation S-K guidance. TSR is calculated as the sum of (1) cumulative dividends (assuming dividend reinvestment) and (2) the increase or decrease in the company’s stock price for the year, divided by the share price at the beginning of the year.Peer Group Total Shareholder Return. This is calculated consistently with the methodology used for Item (f). Registrants are required to use the same peer group they use for existing performance graph disclosures or compensation discussion and analysis.Net Income. This is simply GAAP net income for the relevant period.Company Selected Measure. This item is intended to represent the most important financial performance measure the registrant uses to link compensation paid to its PEOs and other NEOs to company performance. The registrant can select a GAAP or non-GAAP financial measure.The remainder of this article focuses on the two shaded columns (c) and (e) which address Compensation Actually Paid and the valuation inputs that support these disclosures.A new Pay Versus Performance table will detail the relationship between the Compensation Actually Paid, the financial performance of the registrant over the time horizon of the disclosure, and comparisons of total shareholder return.3. What Is Compensation Actually Paid?For each fiscal year, registrants are required to adjust the total compensation reported in Columns (b) and (d) for pension and equity awards that are calculated in accordance with US GAAP. The following table describes these adjustments in detail. The pension-related adjustments should be calculated using the principles in ASC 715, Compensation – Retirement Benefits. The equity-based compensation adjustments will require registrants to disclose the fair value of equity awards in the year granted and report changes in the fair value of the awards until they vest. This means that it will be necessary to measure the year-end fair value of all outstanding and unvested equity awards for the PEO and other NEOs under a methodology consistent with what the registrant uses in its financial statements. For most registrants, this will be ASC 718, Compensation – Stock Compensation. Appropriate footnote disclosure may also be required to identify the amount of each adjustment and any valuation assumptions that materially differ from those disclosed at the time of the equity grant.The newly introduced concept of Compensation Actually Paid will require companies to measure the period-to-period change in the fair value of all equity-based compensation awarded to named executive officers.4. What Are the Different Types of Equity Awards?The procedures used to calculate fair value will vary depending on the type of equity award.For restricted stock and restricted stock units (RSUs), fair value can be calculated using observed share prices at the grant date, fiscal year-end, and the vesting date. The change in fair value would simply be the difference between these dates.For stock options and stock appreciation rights (SARs), fair value at the grant date is often calculated using a Black-Scholes or lattice model. Therefore, updated fair values at year-end and at the vesting date should be based on updated assumptions in those models, including current stock price, volatility, expected term, risk-free rate, dividend yield, and consideration of a sub-optimal exercise factor (in a lattice model). Care should be taken to ensure that expected term appropriately considers moneyness of the options at the new date. The use of historical and/or option-implied volatility should be evaluated for consistency and continued applicability.For performance shares and performance share units (PSUs), the fair value calculations may be more complex due to the presence of a performance condition (e.g., the award vests if revenues increase by 15% and EBITDA margin is at least 20%) or a market condition (e.g., the award vests if the registrant’s total shareholder return over a three-year period exceeds its peer group by at least 5%). The performance condition will require updated probability estimates at year-end and at the vesting date. Awards with market conditions are typically valued at their grant date using Monte Carlo simulation and so a reassessment at subsequent dates using a consistent simulation model with updated assumptions will be necessary.The type of equity awards that have been granted will determine the complexity of the valuation process. Equity-based awards such as stock options might require updated Black Scholes or lattice modeling, while awards with performance or market conditions may require more complex Monte Carlo simulations.5. Special Considerations for Market Condition Awards Using Monte Carlo SimulationMarket condition awards come in many different flavors. Three of the most common types of plans include:Market condition based upon performance in the registrant’s own stock. In this plan, vesting might be achieved if the registrant’s share price exceeds a certain level for a defined number of trading days or reaches an agreed-upon measure of total shareholder return.Market condition based upon relative total shareholder return. In this plan, the award vests based upon the registrant’s TSR in comparison to a similarly calculated TSR for a broad market benchmark index, an industry index, a peer company, or group of peer companies. Some plans employ a modification factor that adjusts the size of the award based upon varying levels of relative TSR performance.Market condition based upon ranked total shareholder return. In these plans, award vesting is based upon a numerical ranking of the registrant’s TSR against the TSRs of a group of peer companies or all of the companies on a particular broad market or industry index. The numerical or percentile ranking then determines the modification factor that adjusts the size of the award.Each of the above plans has inputs and assumptions that drive the Monte Carlo simulation. When performing a subsequent year-end or vesting date fair value analysis, each of the grant-date assumptions will need to be reevaluated. For example, for a relative TSR plan with a three-year term, the subsequent year-end valuations will necessarily have shorter terms (2-year and 1-year), which will require new inputs for volatility and correlation factors. Shorter terms may make the use of option-implied volatility more relevant if sufficient market data is available. For relative TSR plans that reference a group of companies or an index, some of the peers may have been acquired or merged in the subsequent periods. The plan documentation will often describe the steps to be taken when the composition of the peer group changes or there is a change in the benchmark index. A different group (or number) of companies will affect the correlation assumption as well as the percentile calculations in a ranked plan. Regardless of the type of plan, it is important for registrants to understand how even a relatively simple award, if granted consistently for a period of years, can lead to a large number of Monte Carlo simulations for this initial proxy season and a significant amount of disclosure complexity. As shown in Figure 3 below, if a company has made annual PSU grants (with a market condition) for each of the last five years, then up to eight Monte Carlo valuations could be required to calculate the CAP in each period.Click here to expand the example aboveIn the example above, the blue boxes indicate when a valuation of prior grants would be necessary to calculate the change in fair value for each period of the CAP disclosure. For the final period of a relative TSR market condition plan, the company could use the actual market performance of its stock (and the comparative index) to calculate the expected value of the award.Registrants should understand that if equity awards have been granted on a consistent basis for a period of years, the new rules could require a large number of historical valuations for this initial proxy season and a significant amount of disclosure complexity.Summary and Next StepsWhile the new SEC Pay Versus Performance disclosure rules can seem daunting, they can be managed with proper planning and a systematic approach. For the CAP disclosures, registrants need to understand the details of all equity awards that have been awarded to named executive officers (how many and what type of award). The award characteristics will determine which valuation method is most appropriate and how many valuations need to be performed.If you have questions about the valuation techniques used for the various types of equity compensation awards or would like to discuss the process, please contact a Mercer Capital professional.

December 2022

In this issue: Bank M&A 2022 — TurbulenceThe outlook for deal making in 2023 is challenged by significant interest rate marks, uncertain credit marks given a potential recession and soft real estate values, and the bear market for bank stocks that has depressed public market multiples. However, core deposits and excess liquidity of potential sellers is highly prized today given tight balance sheet liquidity and an inability to sell bonds to generate liquidity given sizable unrealized losses. A rebound in bank stocks and even a modest rally in the bond market that lessens interest rate marks could be the catalysts for an acceleration of activity in 2022 provided any recession is shallow.

Bond Portfolio Update

The U.S. bond market is undergoing its worst bear market in decades. Barclays U.S. Aggregate Bond Market Index produced a total return of negative 14.5% through September 30, 2022 and negative 16.0% through November 8, 2022. Excluding coupon income, the year-to-date loss was 17.2% which speaks to how low coupon income is given the nominal difference between price change and total return.Click here to expand the image aboveAs shown in the figure below, U.S. commercial banks have suffered unrealized losses in their bond portfolios equal to roughly 10% of the cost basis of both AFS and HTM classified portfolios as of September 30, which compares to a price reduction of 15.6% in the Barclay’s index as of quarter end.The less-worse performance by U.S. banks likely reflects less duration than the index, which has an effective duration of 6.25 years and weighted average maturity of 8.25 years. Our observation is that for the most part outsized losses among U.S. banks reflect an outsized position in municipals and/or MBS. The index composition is heavily skewed to U.S. Treasuries and U.S. Agency obligations given the heavy issuance of government backed debt the past 15 years or so.While management and directors at most banks are unhappy with their bond portfolios, institutional investors have taken a more nuanced view of the impact of rising rates based upon the tenor of third quarter earnings calls and the reaction of most stocks upon the release of earnings. Rising rates have supported bank earnings even though fixed-rate loan and bond portfolios are slow to reprice as floating-rate loans have repriced and banks have lagged deposit rates.Investor concern is more focused on liquidity risks. Some (or many) banks eventually may have to raise deposit rates sharply to stem outflows and/or fund loan growth because selling bonds is not a viable option given the magnitude of unrealized losses that if realized will reduce regulatory capital.Our prior commentary on bank bond portfolios following the release of the first and second quarter Call Reports can be found here and here.

Community Bank Loan Portfolios Have Unrealized Losses Too

Fixed income is undergoing one of the deepest bear markets in decades this year.There has been a lot of discussion surrounding the impact of rising rates on bank bond portfolios and bank stocks as rising rates have resulted in large unrealized losses in bank bond portfolios. My colleague, Jeff Davis, provides an update to his previous commentary on the topic based on third quarter Call Report data here.If subjected to mark-to-market accounting like the AFS securities portfolio, most bank loan portfolios would have sizable losses too given higher interest rates and wider credit spreads; however, unrealized “losses” in loan portfolios do not receive much attention because there is not an active market for most loans unlike most bonds that populate bank portfolios. Further, accounting standards do not mandate mark-to-market for loans other than those held-for-sale.While the trend in loan portfolio fair values is harder to examine given the lack of data, the following charts provide some perspective based on a survey of periodic loan portfolio valuations by Mercer Capital. To properly evaluate a subject loan portfolio, the portfolio should be evaluated on its own merits, but markets do provide perspective on where the cycle is and how this compares to historical levels.Fair value is guided by ASC 820 and defines value as the price received/paid by market participants in orderly transactions. It is a process that involves a number of assumptions about market conditions, loan portfolio segment cash flows inclusive of assumptions related to expected prepayments and expected credit losses, appropriate discount rates, and the like.The fair value mark on a subject loan portfolio includes two components – an interest rate mark and a credit mark. The interest rate mark is driven by the difference in the weighted average discount rate and weighted average interest rate of the subject portfolio. The discount rate that is applied to a subject loan should reflect a rate consistent with the expectations of market participants for cash flows with similar risk characteristics. The credit mark captures the risk that the borrower will default on payments and not all contractual cash flows will be collected.Since the end of 2021, rising market interest rates have been the predominant factor driving the change (i.e., reduction) in loan portfolio fair values. As shown in Figure 1, the median interest rate mark for our data sample has fallen from a modest 0.55% premium at December 31, 2021 to a 5.65% discount as of September 30, 2022. While bank earnings benefit from a higher rate environment and net interest margin expansion, it takes time for the increase in market rates to be passed on to customers via higher loan rates and for lower, fixed-rate loans to roll out of the portfolio. In talking with Mercer Capital clients and in our loan portfolio valuation practice, so far it seems that banks have been unable to fully pass on the increase in rates to loan customers.Figure 1: Trends in Interest Rate MarksClick here to expand the image aboveThe shift in the valuation adjustment attributable to interest rates reflects an increase in market interest rates.Figure 2 depicts the LIBOR forward curve at December 31, 2021, March 31, 2022, June 30, 2022, and September 30, 2022.Relative to December 31, 2021, forward LIBOR rates have increased 66 bps to 394 bps on average with the largest increases occurring for periods ranging from 1 to 12 months following the valuation date.Figure 2: LIBOR Forward CurveFigure 3 depicts the trend in the credit mark for our data sample relative to credit spreads. Credit spreads provide perspective on a number of factors, including where the credit cycle has been and where we may be headed.Figure 3: Trends in Credit MarksClick here to expand the image aboveOver the period shown in Figure 3, credit marks peaked at the start of the pandemic given the uncertainty and expectation of higher losses on loan portfolios. Credit marks trended down from the March 31, 2020 peak through the first quarter of 2022, as did banks’ loan loss provisions, as credit quality remained stable. While credit quality continues to remain strong, both credit spreads and credit marks have ticked up in 2022 with the weakening economic outlook and concerns that the Federal Reserve’s tightening interest rate policy may trigger a sharper downturn in economic activity.Mercer Capital has extensive experience in valuing loan portfolios and other financial assets and liabilities including depositor intangible assets, time deposits, and trust preferred securities. Please contact us if we can be of assistance.

Auto Brands and the 2022 World Cup

Who Are the Top Ranked Countries?

After failing to qualify in 2018, the United States Men’s National Soccer Team went over 3,000 days between World Cup matches. After returning to the World Cup stage this year, the U.S. team notched draws against Wales and England, meaning that the U.S. will advance to the knockout stages if they win against Iran.In the spirit of the Cup, we compare the FIFA rankings of the world’s largest vehicle-producing countries. Spoiler alert: there is no correlation. But in our research, we found plenty of interesting nuggets. We also discuss top vehicle-producing nations that did not qualify for the World Cup and nations that did but do not have a significant presence in auto production. We also get into brand presence and Blue Sky multiples of these nations’ vehicle brands.FIFA Rankings, World Cup Groups, and Vehicle Production DataAs the industry’s supply chain issues have shown us in 2022, the world economy is interconnected. Both the World Cup and personal vehicles demonstrate a wide variety of cultures and consumer preferences. Vehicle production data in this piece is based on depressed 2022 levels reported by the International Organization of Motor Vehicle Manufacturers, or "OICA." We note this data may not perfectly illustrate nuances between manufacturing vs. assembly. For example, none of the top 10 most popular vehicle brands in Brazil in 2021 were actually Brazilian, which ranks 6th globally in population as well as car production.The table below shows all 32 countries in the World Cup that are also captured in the reported 37 largest global auto producers for 2022. Only Brazil and Spain are ranked in the top 10 of both categories, with reigning World Cup champion France producing the 12th most cars in 2022 according to OICA. Germany is also ranked highly in soccer and car production, coming in 5th in cars produced and 11th in the World FIFA Rankings.The “Group of Death”In world soccer, the "Group of Death" refers to which group looks to be the most difficult to advance to the knockout stages. With the expanded tournament and group determination based on FIFA rankings, the odds of a prohibitive favorite being in the same group as two other favorites are significantly reduced. However, the Russian invasion of Ukraine meant the last three spots had not been determined at the time of the drawing. These three spots, eventually won by Wales, Australia, and Costa Rica, were placed into Pot 4 despite their FIFA rankings. This led to Group B having teams currently ranked 5, 16, 19, and 20, or a sum of 60. The next toughest World Cup group in terms of combined FIFA ranking is Group E with Spain, Germany, Japan, and Costa Rica. In terms of vehicle production, this would certainly be the Group of Death with three of the top seven vehicle-producing countries. When you consider that China (FIFA 79) and India (FIFA 106) are two of these, that’s some heavy concentration in Group E. Group A is the only group that does not have one of the world’s largest auto-producing countries.Top Vehicle Producers That Missed Out on the World Cup Now that we have looked at World Cup participant nations’ auto production industries let’s look at nations that did not qualify. While China and India have no significant soccer history, some high-level soccer teams are also top car producers, including Russia, the Czech Republic, Slovakia, Turkey, and Italy. See the table "Other Top Car Producers" for the OICA rankings of the nations that missed out on this year’s contest in Qatar. Russia hosted the 2018 World Cup and advanced to the knockout stages but was disqualified from the 2022 tournament given the ongoing conflict with Ukraine, who failed to qualify after a 0-1 loss to Wales (which was delayed due to the war). Perhaps the biggest shock to the casual observer is the omission of Italy, who won the World Cup in 2006 and the European Championships in 2020. A poor showing in the notoriously difficult European qualifying process ended for Italy after a shocking loss to tiny North Macedonia, who went on to lose to Portugal in the playoff.World Cup Teams That Do Not Produce Many AutomobilesAs noted previously, no teams from Group A are considered top auto producers. Based on geography, each of the six World Cup confederations has at least one World Cup participant without significant auto production. Costa Rica is the only country from CONCACAF (North and Central America) omitted from the OICA list though it is a relatively short distance from Mexico. Conversely, Morocco is the only African team on the top producer list. Strictly by these rankings, both Spain (7) and Morocco (22) are equally capable of playing professional soccer and producing vehicles.Auto Brands by CountryShifting away from production, there are four countries with brands that have a significant presence in the U.S.: Japan, the U.S., Germany, and South Korea. While German vehicles are associated with luxury, Japanese vehicles are viewed as more durable. German dealerships tend to fetch higher Blue Sky multiples in the U.S., but there’s an interesting comparison with their soccer teams here. While Germany is a favored high performer, Japan is viewed as more durable. Perhaps this is how Japan came from behind in the 2-1 upset when it looked like Germany might run away with it at halftime last Wednesday.Brands by country are shown below. Other major brands in the U.S. are Jaguar/Land Rover and Volvo, which are from the U.K. and Sweden, respectively.Auto Brands by OEM and Blue SkyBelow, we’ve tabulated major brands in the U.S. market, sorted by Blue Sky value according to the Q3 Haig report. We’ve included the OEM for each brand and their home country. While Acura is Honda’s luxury brand, it was first launched in the U.S. and Canada in 1986 and is primarily based in North America today. In 1989, Toyota and Nissan responded by launching Lexus and Infiniti, respectively. Other OEMs with multiple dealerships brands in the U.S. market include:VW (Audi is a luxury offering acquired in the 1960s)GM (Cadillac is a luxury offering acquired in 1908)Hyundai (also owns Kia; neither of which are considered luxury)Ford (Lincoln is a luxury offering acquired in 1922) While Toyota has become one of the most desirable dealership brands, they are still deemed less valuable than Lexus dealerships. Audis have declined from their runup in popularity about ten years ago, but they remain considerably more valuable than their VW counterpart, who continues to climb out of its emissions scandal. While Blue Sky multiples are positively correlated to luxury brands compared to the domestic/mass market, Cadillac, Infiniti, and Lincoln are all less valuable than the mass market version offered by their OEMs. According to Haig’s Blue Sky multiples, Cadillac is below all GM brands (Chevy and Buick-GMC), Infiniti is below Nissan, and Lincoln is below Ford. Whether it’s an issue of product mix or lack of attention/investment compared to core brands, there’s a clear dichotomy in performance compared to Lexus and Audi.ConclusionWhile we would have liked to run a statistical model based on brand desirability or production, we know the correlation would be spurious at best. But that won’t stop us from cheering on the boys in red, white, and blue!Mercer Capital follows key trends in the auto industry to stay current with the operating environment of our privately held auto dealer clients. To see how prevailing trends may impact your dealership, contact a Mercer Capital professional today.

Double Down or Cash Out: The Reinvestment or Distribution Decision

I recently got back from the AICPA’s Forensic and Valuation Services conference in Las Vegas. While I came back richer in experience and CPE credit, the green felt of the blackjack table was less kind to my wallet.I had the opportunity to present at the conference on implied market multiples. To save you 75 minutes, multiples in public or private markets represent composite expectations regarding two variables affecting business cash flow: expectations of growth in cash flow and the risk associated with achieving those cash flows. Pricing power, industry position, proprietary processes, and management depth funnel down to risk and growth and, ultimately, your business value.Matching your family shareholders’ growth objectives with their relative risk tolerance is a key directive for family business directors and one that is tied directly to what your family business means to you. We highlight two corollary questions relating to growth, risk, and business meaning: investing decisions and distribution policy.Before We Hit the TablesBefore we look at investment and distributions, we have observed that families tend to assign one of four basic meanings to their family business: Readers of Family Business Director will be familiar with these concepts, but in short, the idea is that your family business’ appetite for growth and risk depends on what meaning your family assigns to the business. As shown below, the meaning of the family business, in turn, influences the company’s dividend policy and investing (as well as financing) decisions. All on Red?How your family business thinks about investment is tied to how you and the family think about risk and growth. In principle, families make investment decisions from a large menu of potential alternatives (both inside their business and through diversification). The image below illustrates some of the more common risk-return combinations available to investors. To achieve a higher expected return, investors must be willing to accept greater risk. This concept of accepting higher risk to achieve greater investment returns affects both the family business operator and gambler alike: no risk, no blue chips! For more on risk and return, see our “Corporate Finance in 30 Minutes” whitepaper. But how do family business directors approach the risk-return question? Going back to the meaning of your family business provides a backdrop for making that decision. For example, if your family business serves as a “Source of Lifestyle,” you are less likely to invest in higher return (higher risk) projects or diversification efforts that could jeopardize current dividends and harm business predictability. Alternatively, suppose your family views the business as the “Economic Growth Engine” meant to grow with your family. In that case, you will likely aim to make investment decisions that maximize the expected return (thus increasing risk) to drive the economic growth of your business for future generations. Ultimately, your goal as a family business operator is to match your family’s risk-return objectives and elucidate your business’s growth and risk profile with family shareholders.Taking Some Chips Off the TableThe flip side of reinvestment in your family business is distributions. Net operating cash flows can either be reinvested into your business or paid out to shareholders. Companies that understand what the business means to them can make distribution decisions that reflect shareholder objectives and needs. Suppose shareholders see the company as a growth engine; they will accept lower distributions to generate higher growth, just as shareholders seeking consistent distribution checks will (or should) accept muted long-term growth. As we have observed in a previous post, some family businesses appear to avoid paying significant distributions out of earnings on principle: owning shares in the family business should not provide one with disposable income. This “principle” is generally animated by a belief that the family shareholders cannot be trusted with financial resources, “father knows best,” as well as empire building. Ultimately, family business directors need to remember their shareholders are just that: shareholders. While their equity may have been earned through their bloodline, family business owners deserve the same considerations paid to public company shareholders, i.e., a focus on maximizing shareholder value through a mix of good reinvestment opportunities and distributions.Know When to Hold ’Em and When to Fold ’EmBoth a process of analyzing investment choices (we discuss in detail here) and understanding your family shareholder objectives will help ease the burden of deciding when it’s time to pull some chips off the table and hit the buffet. All family businesses need to evaluate how they invest for future growth and their distribution policies in light of their family’s risk tolerance, growth objectives, and business meaning. If you need help analyzing some of these decisions for your business, give one of our professionals a call.

Themes from Q3 2022 Earnings Calls-Part I

Themes from Q3 2022 Energy Earnings Calls

Part 1: Upstream

In Part 1: Themes from Q2 2022 Earnings Calls, the common themes among E&P operators and mineral aggregators calls included the strengthening of balance sheets to offset price volatility, the increasing role of share buybacks, and the persistence of supply and demand imbalances. This week we focus on the key takeaways from the Upstream Q3 2022 earnings calls.Continued Focus on Share BuybacksAs we noted in our analysis of last quarter’s earnings calls, E&P operators and mineral aggregators have seen exceptional profitability since the start of the upcycle in late 2021; companies accentuated paying down their debt and distributing to shareholders. With the continuance of stable cash flows, the role of share buybacks has increased as a source of returns in lieu of bolt-on acquisitions or other investment opportunities.“Look, we've seen the volatility in the market that every quarter, we've had the opportunity to buy shares back, and when that opportunity presents itself, we'll do so aggressively. I think the key to any of those questions is the ability to generate free cash flow. And that's certainly what our focus is… [as well as] maintaining the flexibility on how the return of that free cash flow gets prosecuted. I will say that in conversations with our long-only shareholders, a lot of those guys prefer to get the cash back. But again, we believe that we'll have opportunities to repurchase shares back.” – Travis Stice, CEO & Chairman, Diamondback Energy Inc.“While we had guided third quarter return of capital to at least 50% of our CFO due to strong operating and financial performance, our financial strength, including our replenished cash balance and favorable market conditions, [and] including clear value in our stock price, we saw an opportunity to materially step-up the pace of repurchases. We bought back $1.1 billion of stock during the third quarter.” – Dane Whitehead, Executive Vice President and CFO, Marathon Oil Corp.“On the capital allocation side… we continue to take advantage of current equity market conditions by repurchasing 8.4 million shares in the quarter and another 3.2 million shares after the close of the quarter through October 21. Said differently, we bought back another 4% of our total shares outstanding. And over the last eight quarters, we have repurchased approximately 20% of the outstanding shares of the company. We continue to see this as a remarkable low-risk capital allocation opportunity moving forward. And although we have not given an explicit capital allocation framework, if you extrapolate these levels of buybacks moving forward, you can see that we will continue to dramatically reduce our denominator and thereby meaningfully grow our free cash flow per share.” – Alan Shepard, CFO, CNX Resources Corp.Moderate Production GrowthAs a consequence of a favorable pricing environment and continued tightness on the supply side, industry operators are increasing production in order to capitalize on strong market conditions. Ultimately, firms may not be able to fully capitalize on high prices due to increased labor and equipment costs as well as other miscellaneous supply-side challenges.“We generated total production volumes for the quarter of 40,000 Boe per day, an increase of 19% over our second quarter volumes. All that increase was from royalty volumes, which were up 23% to 37,300 Boe per day. Our base production is trending up as development activity remains robust across our acreage and as our target development programs with operators in the Shelby Trough, Haynesville and East Texas, Austin Chalk continue taking shape, while growing and moving forward. Production from the quarter exceeded expectations due to certain operators, particularly in Louisiana Haynesville, bringing new wells on line at more aggressive initial flow rates to take advantage of higher natural gas prices.” – Tom Carter, Chairman and CEO, Black Stone Minerals, L.P.“We posted strong results this quarter that were underpinned by sequential production growth of 7% on a BOE basis and 8% on an oil-only basis, exceeding both our guidance and consensus estimates. These gains were driven by well performance that was above expectations and consistent execution in the field, particularly on the completions front with reduced cycle times in the Permian and Eagle Ford. At a bigger picture level, our commitment to a life of field development philosophy of our multi-zone resource base, paired with continuous improvements in drilling and completion designs, has resulted in year-over-year improvements in Callon's well performance at a time when concerns around inventory degradation are increasingly becoming a focal point of the industry.” – Joe Gatto, President & CEO, Callon Petroleum“I think there is asset maturation. I think certainly, supply chain constraints are also limiting growth... I think all of those factors weigh into more of a muted production growth from US shale going forward. That said, out here in the Permian, I think we're still continuing to hit production records every month, somewhere close to 5.3 million to 5.5 million barrels a day. But that's going to be challenged to continue to grow that into the future. Do we have the assets out here? Yes, we do. But some of those other topical constraints that I mentioned are going to be impediments to efficient growth.” – Travis Stice, CEO & Chairman, Diamondback Energy Inc.“I think, just generally we see some large pads coming on [in] Q2 and beyond… The Diamondback piece, which we have 100% visibility on, will grow 10%. It's just going to start growing in Q2 and Q3… the way we see it right now is basically flat oil from Q3, which was an all-time high into Q4 and Q1 and then the ramp starts to begin again in… Q2 of next year.” – Kaes Van’t Hof, President, Viper Energy Partners, L.P.Inflation Continues To Limit GrowthThe current high-price environment incentivizes operators to grow rapidly. While most industry participants certainly would like to increase the scale of their output, multiple executives discussed how high inflation has constrained their efforts. The impact from inflation is evident in multiple areas, but especially in the cost of raw materials and labor.“One of the major topics of the year continues to be the inflation story. The price pressure we are seeing on steel, fuel and labor continues to be persistent. Our employees are maintaining their focus on finding ways to mitigate inflation through innovation and efficiencies in our operations. Through their efforts, we now expect our average well cost to increase a modest 7% as compared to last year.” – Billy Helms, President, and COO, EOG Resources Inc.“The biggest concern we've got is not so much labor inflation or service inflation outside the company as much as it is… the quality of the available labor set or the quality of the available service skill set. And that's where we spent most of our time. So it's not just the easy question of will the individuals and the service provider be available. It's more a question of can we get the best of the individuals and the best of the service providers available.” – Nicholas Deluliis, President, CEO & Director, CNX Resources Corp.“Casing has been a massive headwind for us and for the industry. Midland Basin casing is now $110 a foot, that is a huge number of… fixed cost that we can't really control here.” – Kaes Van’t Hof, President & CFO, Diamondback Energy Inc.“I think on the labor inflation side, that's subject to kind of more of the macro environment. I mean you could potentially paint a scenario where if the company slips -- or the country slips into recession, some of those pressures ease. And conversely, if we avoid that, you can continue to see pressure on those fronts. So again, this just goes back to kind of the wider guidance we provided on this call, and then we'll have some more color as we move forward. I think we'll know a lot more a quarter from now about where things are headed.” – Alan Shepard, CFO, CNX Resources Corp.Mercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators comprising the upstream space. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

Something to Chew on This Thanksgiving

We have traditionally advised you about what not to talk about at the Thanksgiving dinner table, but this year, we thought we would highlight a more positive family business conversation that you might want to have with your family shareholders—if not this weekend, then sometime soon.The question is: What is the economic meaning of the family business for our family? Is it an economic growth engine for the benefit of future generations or a source of lifestyle for shareholders today? Is it a “safe haven” store of value or a source of wealth accumulation allowing shareholders to diversify away from their economic dependence on the business? Gaining consensus on this question can help make the many other questions family businesses ask about dividend policy, capital structure, and capital budgeting easier to answer.Check out this brief five-minute video about the meaning of your family business from our recently launched Family Business On Demand Resource Center.The Four Meanings of Family Business from Mercer Capital on Vimeo.

Buyer’s Remorse? CI Financial’s M&A Binge

On the earnings call last week, CI Financial reiterated intentions to separate its U.S. wealth management business and Canadian asset management business through an IPO of its U.S. wealth management business.CI’s CEO Kurt MacAlpine reported continued progress toward the IPO and announced an anticipated S-1 filing later this month. After the transaction, the U.S. wealth management business will trade on the U.S. exchange, while the legacy Canadian asset management business will be delisted from the NYSE and traded exclusively on the Toronto Stock Exchange.Since MacAlpine took the helm as CEO in 2019, CI has quickly made a name for itself as one of the more prolific acquirors of U.S. wealth management businesses. Driven by a rapid succession of deals, CI increased its U.S. wealth management AUM more than tenfold in just two years—from C$15.5 billion on October 31, 2020, to C$171.9 billion on October 31, 2022.CI’s share price has fallen over 40% this yearWhile CI has had apparent success at completing deals, investors have not been on board with the strategy. CI’s share price has fallen over 40% this year, and many have publicly speculated that CI’s substantial deal volume is at least partially attributable to its willingness to overpay. While the pricing of CI Financial’s acquisitions is generally not disclosed, the volume of deals that CI has strung together during intense competition from buyers and record high multiples suggests it’s not accustomed to being the low bidder.This year, souring market conditions have thrown cold water on CI’s M&A binge. The firm’s deal pace is slowing, and the focus has shifted to deleveraging and attempting to unlock the value of the U.S. wealth management business built through the planned spinoff. By selling off a portion of the wealth management business via IPO, CI will raise funds that it can use to pay down its debt balance. The spinoff will also present a stand-alone, pure-play wealth management business to the public markets that (CI’s management hopes) will be valued more like a private wealth manager and less like a public asset manager.DeleveragingAfter the transaction, the existing debt and guaranteed payment obligations related to CI’s wealth management acquisition spree will be retained by the Canadian asset management business, while the U.S. business will retain the contingent consideration obligations related to prior acquisitions. The Canadian asset management business will then use the proceeds from the spinoff to pay down its debt balance, which stood at C$3.9 billion on September 30, 2022. After the IPO, CI’s management expects that the Canadian business will not fund any future U.S. acquisitions, nor will it pursue large M&A opportunities in Canada. Future inorganic growth of the U.S. business will be funded by cash flow, partnership units, and public company stock.The focus on deleveraging comes at a time when debt costs have been soaring, putting additional strain on leveraged consolidator models beyond declining revenue and rising costs for component firms. Amidst this environment, early warning signs for CI have started to emerge; in April this year, CI Financial’s issuer credit rating was downgraded by S&P from BBB to BBB- (the lowest investment grade rating). In early November, CI’s credit facility was amended to increase the maximum leverage ratio (funded debt to annualized EBITDA) to 4.5x (previously 4.0x). On September 30, CI’s leverage ratio stood at 4.0x—exactly in line with the covenant prior to amendment.While CI initially targeted a 20% spinoff of the U.S. wealth management business, CI’s CFO hinted that the amount could now be higher. A larger spinoff would presumably allow for greater deleveraging.Unlocking Value?Beyond deleveraging, CI hopes that a pure play U.S. wealth management business will be valued differently from the combined asset and wealth management business. CI’s Enterprise Value / LTM EBITDA multiple peaked at close to 12x late last year, and today CI trades at roughly 7.7x trailing twelve-month EBITDA. Back in February, MacAlpine remarked on CI’s fourth-quarter earnings call that he felt the company was “criminally undervalued” based on where it was trading at the time. “We’re not getting credit for the shift of our business to the U.S. nor the rapid growth of our wealth management business,” MacAlpine added.The disparity between publicly traded asset manager valuations and privately transacted wealth manager valuations has become more pronouncedWhile we doubt CI’s valuation is a criminal offense, MacAlpine may be on to something. The disparity between publicly traded asset manager valuations and privately transacted wealth manager valuations has become more pronounced in recent years. EBITDA multiples for most smaller publicly traded asset managers have trended downwards, reflecting adverse trends like pricing pressure and asset outflows that have plagued the asset management industry. On the other hand, wealth management firms have been less exposed to these pressures and have seen multiples trend up (at least through the end of last year) as a proliferation of capital and acquiror models have competed for deals.We suspect that CI has paid a higher multiple for many of its wealth management acquisitions than it trades at itself. Undoing that reverse multiple arbitrage is something that CI’s management hopes will happen with the spinout, but the current market environment will likely make this an uphill battle. Along with almost everything else, multiples for publicly traded asset/wealth managers have declined this year. According to MacAlpine himself, private market valuations have declined “in lockstep” with public markets. All of this suggests that achieving an attractive valuation for the U.S. wealth management business may prove difficult.

Meet the Team

Harrison Holt

In each “Meet the Team” segment, we highlight a different professional on our Auto Dealer Industry team. This week we highlight Harrison Holt, Financial Analyst.Harrison Holt began his valuation career at Mercer Capital as an intern in the summer of 2019. After finishing his degree at Rhodes College in 2020, Harrison joined Mercer Capital as a financial analyst in the Memphis office. In 2022, he moved to Mercer Capital’s Nashville office.What influenced you to pursue a career at Mercer Capital?Harrison Holt: I have always been very intrigued and excited by math, problem-solving, and storytelling. Luckily for me, valuation work is the intersection of the underlying story behind a business's performance and the value indications that established financial models imply for that business. These two forces have to reconcile with one another, and I really enjoy telling the stories of numerous businesses through my valuation work. Each valuation engagement is unique and offers many specific research and learning opportunities. My work with auto dealerships has been the most rewarding, as I have the opportunity to consistently study the auto dealer industry for market insights that pertain to various valuations. Location is also a huge benefit of working for Mercer Capital. As a native Tennessean hailing from Jackson, starting my career in West Tennessee was a great way to stay close to family and challenge myself professionally. After my recent move from the Memphis office to the Nashville office, I feel grateful that I can do the type of work that I love in a part of the country that I love.What types of auto engagements have you worked on?Harrison Holt: There are many reasons an auto dealership would need a valuation from Mercer. For example, divorce proceedings, estate planning, and buy-sell issues are a few of the reasons why an auto dealership has crossed my desk. In my valuation work, I have valued dealer operations, entities that own the underlying dealership real estate, and powersports dealerships.Tell me about any interesting takeaways from your experience writing the monthly SAAR blog.Harrison Holt: Starting my career at the beginning of the COVID-19 pandemic came with its fair share of challenges, and this was especially true for the automotive industry. I have followed the monthly Bureau of Economic Analysis (BEA) SAAR data releases for two consecutive years now. When I first started studying the SAAR, I became very comfortable with the data set as a whole. I started by reviewing the industry's history so that I could draw relevant conclusions about where automotive retail stands today. As most of our readers know, the last two years have been a roller coaster for auto dealers and the broader economy. When I first began covering the industry, high inventory volumes and low selling activity were the auto dealerships' challenges. Mere months later, low inventory balances and red-hot demand pushed sticker prices and profitability through the roof. Supply chain issues, pent-up demand, and a volatile affordability environment have made following the industry exciting. While it's been challenging to keep up, I am grateful that it's an intriguing story to tell.What has surprised you the most about valuing auto dealerships compared to businesses in other industries?Harrison Holt: From time to time, I have found myself asking questions like “How can a dealership with only twenty units on the lot sustain record profitability over so many consecutive months?” and “Does it make sense to sell this dealership at elevated earnings and elevated blue sky multiples when the business itself is a premier cash flowing asset?”. These questions come from observing the situation in which most of our clients find themselves. It has been nice to see how well these clients are doing, especially when many other industries are struggling to adapt to a rapidly changing economic environment. While client success is always good to see, valuing auto dealerships in the current environment does not come without challenges. One challenge I have encountered while valuing auto dealerships has been estimating ongoing performance, which is a crucial step in the valuation process. Dealership performance over the past two years has been encouraging for our clients, but estimating the ongoing earning power of their dealerships into the future requires us to temper our expectations from currently elevated levels. The industry as a whole has addressed this issue by changing the standard for calculating ongoing earnings used in deal pricing. Prior to the pandemic, trailing twelve-month earnings were the standard. Since then, industry participants such as Haig Partners have suggested multiple iterations of how to calculate ongoing earnings in an attempt to:Exclude the initially uncertain COVID-19 impact,Partially consider elevated earnings but place more weight pre-COVID performance, andPlace more reliance on recent outperformance due to COVID and the chip shortage. Now approaching three years since the pandemic began, it is increasingly difficult to derive a one-size-fits-all formula for how to determine ongoing earnings for all the 16,000+ dealerships across the country.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of November 14, 2022

Review of Key Economic Indicators for Family Businesses in Q3 2022

With economic data for 3Q22 beginning to trickle in, we look at a few key trends that developed during the quarter. The tale of the tape in the third quarter was the same as it has been for virtually all of 2022—volatile equity markets, ongoing inflationary concerns, and rising interest rates.The sections below provide a concise and unbiased look at some of the manifested trends. We sourced data and commentary from Mercer Capital’s National Economic Review (subscription required), which is published quarterly and summarizes macroeconomic trends in the U.S. economy.GDPAccording to advance estimates released by the Bureau of Economic Analysis, GDP increased at an annualized rate of 2.6% during the third quarter of 2022. The increase in annualized GDP growth during the third quarter follows declines of 1.6% in the first quarter of 2022 and 0.6% in the second quarter. The increase was driven by gains in exports, personal consumption expenditures, nonresidential fixed investment, and government spending. Decreasing imports also boosted GDP (imports are deducted in the calculation of GDP). Mitigating factors to the increase in GDP were declines in residential fixed and private inventory investments.Economists expect GDP growth to stagnate in the next two quarters. A survey of economists conducted by TheWall Street Journal reflects an average GDP forecast of 0.4% annualized growth in the fourth quarter of 2022, followed by an annualized decline of 0.2% in the first quarter of 2023.Click here to expand the image above.InflationEstimates from the Bureau of Labor Statistics released last week reveal that the Consumer Price Index (“CPI”) increased 0.4% in October 2022 on a seasonally adjusted basis after rising 0.4% in September as well. On a year-over-year basis, the CPI increased 7.7% from October 2021 to October 2022, a slower pace than in recent months, which generally appreciated. The Wall Street Journal survey reveals that respondents expect inflation to remain persistent throughout 2022, as they predicted, on average, an annual rate of 7.2% in December 2022 before falling back to 4.1% by June 2023. The Producer Price Index (“PPI”) is generally recognized as predictive of near-term consumer inflation. The PPI increased 0.4% month-over-month in September 2022 and increased 8.5% in the twelve months ended September 2022.Monetary Policy and Interest RatesDuring the third quarter of 2022, the FOMC met in late July and September, raising rates by 0.75% at both meetings. At the July meeting, FOMC members voted unanimously to raise the benchmark federal-funds rates to a range between 2.25% and 2.50%. Equity markets rallied in the week of the meeting because Chairman Powell offered few specifics regarding the magnitude of future rate increases and signaled an eventual slowdown in the pace and magnitude of future rate increases. Still, the FOMC raised the benchmark rate again by another 0.75% at its September meeting, leaving the benchmark rate between 3.0% and 3.25%. Projections released after the September meeting revealed that FOMC officials nearly unanimously expected to raise rates to a range of 4.0% and 4.5% by year-end 2022, which would require sizeable increases again at the November and December meetings of the FOMC.The Fed continued its rate-raising march at its recent November meeting, increasing the benchmark rate by another 75 basis points to a range between 3.75% and 4.0%. After the November meeting, Chairman Powell indicated that FOMC members could contemplate a smaller hike at the FOMC’s final meeting of 2022 in December but cautioned observers that borrowing costs could be higher in 2023 than previously projected. Chairman Powell also indicated that potentially reducing the size of rate increases would not necessarily equate to the FOMC pivoting away from its current monetary tightening policies.The FOMC’s decision to raise rates again in November came against the backdrop of conflicting economic signals. The job market remains strong amid elevated inflationary pressures and despite domestic demand and housing market downturns. Widespread price increases in retail goods and services have not stifled consumer demand, likely due to generous savings cushions boosted by pandemic relief and elevated gains in asset prices over the past few years. With these conflicting signals in mind, keen Fed observers have posited that Chairman Powell is forced to choose between promoting growth and taming inflation.Powell and the FOMC have decided to fight inflation head-on with historically significant rate increases, even at the expense of potentially curbing economic growth. Perhaps the tide will turn in 2023, but it has become increasingly evident that this won’t happen until inflation cools off. With pandemic dollars still percolating throughout the economy and contributing to inflation, the Fed will continue to make difficult decisions regarding interest rates. Some observers see the fed-funds rate topping out at 5.25% to 5.50%, which could trigger a U.S. recession. Adept and adroit family business owners and directors would be wise to begin planning now for this near inevitability in 2023. We’re reminded of the adage attributed to Benjamin Franklin: “By failing to prepare, you are preparing to fail.”

Rough Quarter in a Rough Year

Q3 RIA Performance Was Mostly Bad, But in Lots of Different Ways

Most of the 9/30 quarterly results are in, and public RIA performance was all over the map. Mostly, it was a rough quarter in a rough year. Sagging AUM led to revenue cuts which dropped straight to the bottom line. Some firms mitigated their downside by cutting bonus compensation and marking down earnout payments for acquisitions. We did a survey of a cross-section of asset and wealth management firms. Ultimately, it appears some business models are working better than others.Click to View Full Screen

45Q Tax Credit Boosts Values Of Carbon Sequestration Projects, Yet Most Still In Development

Approximately half of the Inflation Reduction Act’s budget ($369 billion) has been authorized for spending on energy and climate change. One of the components buried in that act was the supercharging of an existing tax credit—45Q. This tax credit expanded from $50 per ton of sequestered CO2 to $85 per ton. What does this mean for potential carbon capture sequestration projects around the country? Perhaps a lot. However, it is too early to tell. According to Robert Birdsey of Greenfront Energy Partners, it would be like asking the pilgrims what they thought of America as they stepped off the boat.That has hardly kept interest and activity from moving forward. A few weeks ago, Exxon and EnLink announced a largest-of-its-kind commercial deal in Louisiana to capture emissions from CF Industries’ Ascension Parish and transport it on EnLink’s transportation network to store it underground on Exxon property. Start-up is expected in 2025 and will sequester up to two million metric tons of CO2 annually. At $85 per ton, that’s a commercially significant tax credit—$170 million. It won’t be the last one. There are dozens of projects at various points in the development pipeline for this space. In addition, capital has been flowing freely into the broader “sustainability” space. According to Morningstar, in the first half of 2022 alone, there was approximately $33 billion of net cash inflow into that sector, along with 245 new funds launched.Last week, I attended the Hart Energy Capital Conference, whereby Mr. Birdsey gave a presentation. I also spent some time with Mike Cain of U.S. Carbon Capture Solutionsto find out more. Some interesting facts and issues arose.IncentivesThe White House has placed a value on the social cost of carbon at $51 per ton, which is partly why the tax credit was included in the Inflation Reduction Act (“IRA”). This effect helps remove financing bottlenecks for a number of these green projects. It can be, in effect, like the government financing approximately 30% of one’s equity in a project. In a space where being the low-cost producer is the name of the game, this puts a lot more players in the game. In fact, Carbon Capture Sequestration (“CCS”) volume could reach 200 million tons by the year 2030, a 13-fold increase relative to pre-IRA estimates, according to Net Zero Labs. Ironically, the upstream industry is the most qualified to capitalize on this incentive, giving traditional E&P players more opportunities to execute projects.IssuesEven so, most of the potential projects in the CCS pipeline remain in development, where memorandums of understanding and letters of intent abound. However, binding contracts are fewer and far between, and there are reasons for this. First, from the standpoint of the 45Q credit itself, there is a potential time-matching issue here. Projects like this are multi-year—even over a decade if permits get held up. If a small government congress comes along and abolishes the incentive, it would almost certainly submarine the economics of the project. At this point, the 45Q credit is at the heart of the project’s economic viability, so if it goes, the project goes. There could be a lot of elections between now and 2030, which makes some investors nervous.However, that’s less of an issue compared to others. There are three main elements to a successful CCS project: (i) an emitter, (ii) transportation, and (iii) a sequestration site. There are issues with all three. Emitters have been cagey about these projects because they are reticent about third parties adding infrastructure to an expensive asset such as a power plant. In addition, the long take-or-pay contracts that have been proposed for a lot of these projects are risky themselves. From the transportation aspect comes most of the same issues as other pipelines. Just ask the Keystone or Atlantic Coast Pipeline proponents. In addition, CO2 has to be transported at high pressures (say 1,100 PSI) in semi-liquid, low-temperature form. That makes the infrastructure potentially different than a conventional natural gas pipeline. Then, there are sequestration site issues. The injection sites for CO2 are known as Class VI wells. To date, there are only two active Class VI wells in the U.S., so permitting is a big unknown and presents a binary risk profile. Get your well approved, then move forward. If it gets rejected, your project could be finished. Oh, and did I forget to mention that these projects can be in the hundreds of millions of dollars of capital? That’s a lot of money that could wait a long time for a return.Because of this, many investors look for emitter and sequestration sites that are proximate to each other, which is not always easy to find. Emission concentration economics, issues with monetization of 45Q credits (there is not currently a robust trading market for these), and other issues can sideline a project.The Future?Nobody really knows, yet optimism remains. It’s an emerging market. U.S. Carbon Capture Solutions is pushing forward with its Wyoming project, even though it may be 2030 before it comes online. The 45Q appears to have given this space a shot in the arm; we’ll see in five or more years from now what that turns into.Originally appeared on Forbes.com.

Fairness Opinions for GP-Led Secondaries

A Good Practice Regardless of SEC Rulemaking

Although not mandated by law, fairness opinions for significant corporate transactions effectively have been required since 1985 when the Delaware Supreme Court ruled in Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985) that directors were grossly negligent for approving a merger without sufficient inquiry. The Court suggested directors could have addressed their duty of care (informed decision making) by obtaining a fairness opinion.

October 2022 SAAR

The October 2022 SAAR was 14.9 million units, up 12.7% from October 2021 and up 9.8% from last month. This month’s SAAR comes as a bit of a surprise, as the last three months’ sales pace settled at around 13.4 million units and seemed to have stabilized at a short-term equilibrium. However, meaningful improvements in inventory balances and other tailwinds like natural disaster-related demand contributed to the second-highest monthly SAAR total this year. For perspective, from 2014-2019, there were zero months where SAAR was below this recent high in the inventory-constrained 2022.On a full-year basis, this month’s SAAR moved the 2022 average SAAR from 13.6 million units at the end of last month to 13.73 million units. Despite this turning of the tide, it remains unlikely that the full-year 2022 SAAR will exceed 14 million units, as there is not much time left in the year to pull the average up above that threshold. For perspective, the November and December SAAR would need to average 15.4 million units for the full-year average to arrive at 14 million units. Furthermore, as auto sales are a function of both supply and demand, it will also be interesting to keep an eye on the demand side of the auto sales equation as recessionary fears intensify. Stay tuned over the next two months to see if the national sales pace continues to improve.Unadjusted sales trends on a relative basis are mainly in line with the last several months. October 2022 unadjusted sales are markedly better than October 2021 but remain depressed when compared to October 2015 through 2020. However, the gap between current sales and what was observed prior to the auto inventory crunch seems to be shrinking as the months go by, which is also an interesting trend to keep an eye on as 2022 winds down.Total Sales - Not Seasonally AdjustedInventoryAccording to the NADA, ground and transit inventory totaled 1.54 million units at the end of October 2022. The industry has not seen this magnitude of inventory flow since May 2021, which is right around when the industry’s inventory crunch began to take hold. In our opinion, we should hesitate before assuming that vehicle availability has fully recovered, as the September 2022 industry inventory-to-sales ratio (0.64x) remains well below its long-run average (2.4x). We will get a better idea of this month’s inventory levels when October 2022 I/S ratio data is released next month. Nevertheless, improved inventory balances are a good sign for consumers and dealers alike, as it seems like it has been ages since the days of full car lots and numerous options for consumers to test drive and choose from.Inventory/SalesTransaction Prices, Incentive Spending, and Monthly PaymentsAccording to J.D. Power, the average transaction price of a new vehicle is expected to be $45,599 in October 2022. After numerous months of increasing transaction prices and new record highs each month, this month’s average transaction price is roughly flat compared to September 2022. Rising interest rates and recessionary fears have cooled transaction activity in many areas of the economy, like the housing market and the mergers and acquisitions market, and we believe it is likely that the same trend will occur with respect to new vehicle purchases over the next several months. Keep in mind that these activities heavily rely on interest rates to support affordable pricing. For dealers, new vehicle prices are still so elevated that profitability can still be achieved at lower volumes. Still, many dealers should expect sticker prices to begin to slip modestly in an effort to keep monthly payments in a reasonable range for consumers. According to J.D. Power, average incentive spending per unit is expected to total $882, down 44.7% from this time last year and marking the sixth straight month below $1,000. It is clear that OEMs are sticking to their guns and keeping incentives low, and we believe that this is likely to continue as long as GPUs remain historically high. However, incentives could creep back up for OEMs and dealers to keep transaction prices higher as consumers have become increasingly accustomed to these rising prices.Hurricane Ian’s Effect On the Automotive IndustryHurricane Ian raked a path of destruction across the southeast United States on September 28, 2022, devastating the state of Florida and its Gulf Coast before making final landfall in South Carolina two days later. The hurricane is now considered the second-deadliest storm to strike the continental United States since Hurricane Katrina in 2005.While the total damage done to the Gulf Coast and its people goes far beyond its effects on the automotive industry, some interesting auto-related effects are worth mentioning to our blog readers.According to Cox Automotive, it has been estimated that the total number of severely damaged vehicles in need of replacement range anywhere from 30,000 to 70,000 as a result of Hurricane Ian. Considering the region’s significant demand for replacement vehicles, retail sales in the affected area are expected to increase in the fourth quarter of 2022. Perhaps the uptick in sales that the entire industry experienced in October has something to do with this acute regional demand.Cox Automotive also posits that about 80% of replacement vehicles will come from the used vehicle market due to difficulties acquiring new vehicles from dealerships. This demand for used vehicles is likely to apply upward pressure on regional pricing and make it more likely that flood-damaged vehicles appear for sale. Generally, totaled cars and trucks are given a “salvage title” and cannot be legally driven in the United States. However, some states allow buyers to repair totaled vehicles and issue a “rebuilt title,” making them legal to drive. This process will likely produce fraudulently “title-washed” vehicles as opportunists can purchase a totaled car or truck at auction, move them to a state where re-titling is legal, and return the car to the Gulf to resell.In any case, filling the void that Hurricane Ian left in the vehicle market should prove difficult in a time of inventory restrictions. While inventory balances seem to be improving on a macro level, a concentrated need in Florida and South Carolina will likely be challenging to fill. Dealers in the region should conduct thorough due diligence on used vehicles they purchase for resale and expect demand to remain elevated throughout the hurricane recovery process.November 2022 OutlookMercer Capital’s outlook for the November 2022 SAAR is cautiously optimistic. Industry supply chain conditions are beginning to improve. However, sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving despite recent signs of improvement. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps the November SAAR can continue to approach 15 million units and signal a true turning of the tide, but we predict that a 14 million unit SAAR for 2022 is unlikely in the current landscape.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a Mercer Capital auto dealer team member today to learn more about the value of your dealership.

What Do the Midterm Elections Mean for You & Your Family Business?

The 2022 midterm elections are here, and, as usual, one of the most significant differences between Democrats and Republicans is tax policy. While voters are contemplating significant issues ranging from inflation, immigration, abortion, and gun control, the election outcome will also influence which tax priorities Democratic and Republican lawmakers will pursue over the next few years.These tax issues could involve tax deductions and other incentives that directly impact your finances. The party controlling the House and Senate will dictate which tax policies are proposed and potentially passed into law. In this post, we focus on three main tax dilemmas that will be most important to your family business this midterm election season.Individual Tax RatesThere are a number of tax provisions set to expire in 2025 that were passed as part of the Republican’s Tax Cuts and Jobs Act (TCJA). This 2017 legislation significantly reduced the corporate tax rate and temporarily cut individual rates. If Republicans take control of Congress, protecting previously passed policies will be among the party’s top priorities, despite the potential impact on inflation. One of the tax breaks set to revert to the pre-2017 levels if the TCJA is not extended is the individual income tax rate, which would return the top marginal rate to 39.6% from the current 37%.Below are the current single-filer and married filing jointly tax brackets, as well as the changes if the TCJA does expire in 2025. In an interview on C-Span, Nebraska Rep. Adrian Smith said that if the GOP regains Congress, advancing legislation for permanent individual tax rate cuts would be his first priority. However, many economists have debated that the GOP tax plan goes against the promise to combat inflation and reduce the federal deficit. Howard Gleckman, a senior fellow at the Tax Policy Center, states that extending these tax cuts promulgated from the TCJA may further fuel inflation by stimulating consumer spending. What if Congress remains Democrat-controlled? While Democrats campaigned on rolling back provisions from the TCJA, actually doing so has proven politically more difficult. Earlier this year, Democrats tried to increase the corporate tax rate and raise taxes on the wealthy to pay for the Inflation Reduction Act but failed. Meanwhile, President Biden’s 2023 Budget Proposal calls for reducing the federal deficit by $1 trillion over the next year in part by raising the corporate tax rate from 21% to 28%. The proposal also contains a new 20% minimum tax on households worth more than $100 million, which accounts for the top 0.01% of earners.Estate TaxesOn October 28, 2021, President Biden announced a framework for the Build Back Better Act. This Act invests in family care, health care, and combatting the climate crisis. It will also implement key reforms to make the tax system more equitable by ensuring that the wealthiest Americans and most profitable corporations shoulder a more significant portion of the overall tax burden. Specifically, these proposals included a reduction of the federal estate tax exemption (amount of assets that can transfer to an heir free of estate tax) to $3.5 million per person, as well as eliminating the tax basis step-up at death. These proposals were dropped from the legislation as the Build Back Better Act stalled in the Senate.Regardless of the fate of these specific proposals, effective January 1, 2026, under current law, the estate tax exemption will be reduced to $5 million per person or $10 million for a married couple – subject to inflation increases. Currently, each U.S. citizen has a $10 million exemption from estate taxes, and for a married couple, that amount is doubled. As the exemption is indexed for inflation, in 2022, the exemption is $12.06 million per person. Persons whose estates may be subject to estate tax under the projected 2026 exemption levels should consult with legal counsel and advisors to review their current estate plans and evaluate possible strategies for preserving their wealth and planning for future generations.Qualified Business Income (QBI) DeductionThe IRS defines Qualified Business Income (QBI) as the net amount of qualified income, gains, deductions, and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts. The Tax Cuts and Jobs Act introduced a new deduction taking effect in 2018 for noncorporate taxpayers in respect of their qualified business income. This deduction is up to 20% of their QBI, plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. Income earned by a C corporation or from providing services as an employee is not eligible for the deduction.Prior to the TCJA, the corporate income tax rate was 35%, and dividends were taxed at a top rate of 23.8%, resulting in an aggregate tax rate of about 50% on distributed corporate business income. Contrast this to a pass-through entity, for which earnings are passed through and taxed in the hands of the owners. Before 2018 the top ordinary income tax rate was 39.6%, and thus, there was an approximate 10% tax rate advantage operating a pass-through entity rather than a corporation. The TCJA included a permanent reduction to the corporate tax rate from 35% to 21% and reduced the top individual rate to 37%. Without any further changes, the tax rate advantage in operating a business as a pass-through entity would have decreased from roughly 10% to less than 3%. The 20% QBI deduction was the TCJA’s answer, as only 80% of certain pass-through entity income is subject to tax for qualifying taxpayers.With the control of Congress up in the air and general gridlock in Washington, it is uncertain if the 20% QBI deduction will be a tax advantage for much longer, as the deduction would ultimately expire if the TCJA is not extended past 2025.ConclusionVoters are weighing many different policy questions at the ballot box this November, and the election results will set the stage for determining which major concerns are addressed first, as well as determine which tax priorities Democratic and Republican lawmakers will pursue over the subsequent few congressional sessions. The topics mentioned above highlight some of the most important individual, estate, and business owner tax implications that family business owners need to be aware of and evaluate as the election returns roll in.

The Truck Is Slowing

Are We Running Out of Gas or Just Coasting?

Most experts agree that rates and demand for transportation services have been trending downward. There has been more disagreement about what that means, though – are we headed for a trucking recession, or are we simply coming down off our COVID-19 induced highs?

Rising Interest Rates Will Likely Affect More Than Just RIA Stock Prices

Higher RIA Aggregator Bond Yields Could Portend Lower M&A and Transaction Multiples in 2023

We haven’t blogged about the bond yields of RIA aggregator firms in the past because there hasn’t been much to report. Before this year, yields didn’t move much and generally stayed between 2% and 8%, depending on the term and credit quality of the issuer. That all changed last November when the Federal Reserve and other central banks began raising interest rates to fight mounting inflationary pressures in the global economy. Now RIA aggregator bond yields are in the 6% to 14% range after fairly steady gains throughout this year.Click here to expand the image above.Corresponding bond prices have fallen over this time, and we use a recent Hightower issuance to demonstrate the inverse relationship between bond yields and prices.Rising interest rates have also affected equity prices, particularly in the RIA sector, which has doubled the market’s loss over the last year.The driving forces behind the sharp decline in RIA stocks are relatively straightforward. Stock prices are strictly a function of earnings and a multiple (E x P/E = P). Earnings are lower because revenue and AUM have declined in the capital markets, with inflationary pressures driving costs up and margins down. Rising interest rates have pushed up the costs of debt and equity capital resulting in higher discount rates and lower multiples. The cumulative effect of these forces is a ~50% decline in RIA aggregator and investment manager stock pricing since last November.We haven’t seen these pressures play out in the M&A market for investment management firms.That could change in the coming quarters as M&A activity is often a lagging economic indicator, as deals can take months or even years to close after their announcement. The adverse effects of rising interest rates, higher inflation, and lower earnings also impact closely held RIAs, so they’re also vulnerable to reduced valuations and transaction multiples as prospective buyers anticipate lower cash flows on a diminished AUM base.Deal volume could also suffer in 2023 as much of it is driven by RIA aggregators, who are reeling from higher financing costs and lower valuations. CI Financials CEO Kurt McAlpine noted that their pace of acquisitions has “absolutely slowed down” in a recent earnings call. The combination of rising debt costs and lower expected returns in the RIA space could cause the other aggregator firms to follow suit, which would likely curtail deal-making in the sector until markets recover. The M&A market for RIA firms tends to be resilient, so we’ll continue following these trends and report back.

Market Insights on Auto Dealer M&A Activity

A few weeks ago, I sat down with Kevin Nill of Haig Partners to discuss the current state of the M&A market and other timely trends in the auto dealer industry. Specifically, I wanted to discuss some of the movements in Blue Sky multiples for various franchises and interpret the range of multiples that Haig Partners recently published with the release of their Second Quarter 2022 Haig Report (subscription required).What is the current state of the M&A market for auto dealerships? Any signs of transactions slowing down? Are you seeing earnings or multiples start to plateau or revert?Kevin: The market continues to be quite active, with a nice balance of buyers focused on strategic growth opportunities and sellers who see valuations still at or near peak levels. The pandemic accelerated the need for scale to effectively compete in a changing retail environment—consumers are ever more focused on a seamless buying experience and are embracing a digital world for researching, negotiating, and transacting the retail purchase. Couple that with the benefits of marketing a broad and large selection of inventory and dealers recognize they need more franchises and locations to effectively compete.Our analysis indicates there may be over 8 million units of pent-up demand in the marketplaceNADA has suspended the publication of data on the performance of the total dealer body, but public company financial results do indicate we may have seen a plateau in earnings. Based on our analysis, the average public dealership earned $7.0M through the Last Twelve Months (LTM) ended 2Q 2022, down just slightly from $7.1M for the quarter ended 1Q 2022. However, that’s still up approximately $5M from 2019’s average of $2.1M!! From the data and research we are seeing, inventory constraints should continue for the next several years and ensure the dealer enjoys strong gross margins for some time. Our analysis indicates there may be over 8 million units of pent-up demand in the marketplace. Additionally, the high gross F&I and service departments continue to see an upward trajectory in results.As for multiples, our firm tracks this very closely by monitoring transactions we represent alongside ongoing discussions with industry leaders in finance, accounting, and the legal communities. In summary, multiples overall have changed little since the pandemic: it’s the underlying earnings that have contributed to the elevated valuations. That said, some franchises are gaining traction and are more appealing to buyers. These include Toyota, Hyundai/Kia, and Stellantis.Scott: With NADA’s suspension of dealership performance data, Mercer Capital has also pivoted to supplying information and trends from public companies in our recently published Mid-Year 2022 newsletter. Despite positive revenue growth in the last twelve and six months, revenue growth in the more recent period is less in all six public companies showing signs of slowing down. Additionally, public companies have continued to enjoy heightened gross profit from new and used vehicle departments compared to historical averages.Any new trends in buy/sell negotiations in the last few months? Any sticking points?Kevin: There really haven’t been any “new” issues that have arisen in buy/sell negotiations, but one trend we are seeing both in the industry and our practice is a willingness of sellers to entertain either a sale of just some of their dealerships or a minority/majority ownership stake in the entire enterprise.The willingness of sellers to entertain either a sale of just some of their dealerships or a minority/majority ownership stake in the entire enterprise is a recent trendSellers are seeing these alternatives as additional strategic options for their families and organizations. In some cases, a seller may choose to take some proverbial chips off the table by exiting a market or selling a couple of stores. Further, as outside capital investors continue to target auto retail due to strong and consistent returns, some dealers are selling a percentage of the business, which allows them to stay on and operate the business. Our recent publications have gone into greater detail on this subject if readers want to know more about this trend.Scott: The trend for dealers to sell a small minority stake in their entire group (or perhaps only divest of a rooftop or two) seems to be a new and interesting phenomenon. This trend appears to be a shift from dealers selling the entire enterprise or a majority stake in the dealership holdings. Auto dealers clearly value maintaining control and not having to answer to a family office group, private equity holders, or a third-party controlling stakeholder.Operating an auto dealership is very much a day-to-day and month-to-month business. Auto dealers are usually heavily invested in their communities and care deeply about their legacies.Selling a minority interest gives the auto dealer some liquidity. While dealerships have become very valuable and have generated record profits, often those profits are reinvested in the business or are leveraged against other assets, while the heightened value of the dealership only represents value on paper until a transaction or liquidation event occurs.Mercer Capital provides estate planning valuation services that may benefit owners who take some chips off the table once a firm like Haig Partners has helped them negotiate a minority investment.The latest Haig Report mentions Toyota is the most desirable brand. Is there any reason it would not obtain the same multiple as luxury brands?Kevin: It’s no surprise to anyone active in the auto retail space that Toyota dealerships are in high demand. Manufacturer relations are best in class, and the underlying product continues to resonate with consumers. Our firm has sold 33 Toyota dealerships, including the 2nd highest-valued dealership ever in August 2022 (John Elway’s Crown Toyota). Buyer interest is always substantial. In most cases, Toyota stores will bring better multiples than some of the smaller luxury makes like Jaguar, Land Rover, and Audi. But in general, the high-profile luxury nameplates still command a higher multiple. There are a number of reasons, but the most impactful cause is there are far fewer Lexus, Mercedes-Benz, or BMW dealerships in the market and even fewer for sale. So “Economics 101” is in play—limited supply and high demand bring higher multiples. Scott: Kevin’s comparison of a Toyota dealership investment to a luxury brand is equivalent to the allure of owning a professional sports franchise. Interested investors in luxury brands covet the exclusivity and market appeal of owning one of these franchises. There may only be a few luxury brands in each market, and if one becomes available, it may be a long time until another luxury franchise becomes available. To Kevin’s point, the approximate number of Toyota and various luxury brand franchises in the United States are as follows: Will the shift for Cadillac, Infiniti, and Lincoln blue sky from a dollar amount to a multiple materially shift the value of these franchises?Kevin: Over the past several years, several weaker franchises traded for a hard dollar amount rather than a multiple of earnings, given the lack of repeatable earnings. Buyers placed a value on the “shingle” and looked at used cars and fixed operations as their way to make money from these stores. However, as some of these brands have seen a resurgence in performance, partially from the post-pandemic bump but also from developing more appealing products, we have seen buyers take a more bullish approach. So, yes, these franchises have definitely seen an improvement in value. Nissan is another brand we have seen improve in the eyes of buyers. The franchise still has a way to go, but many believe the worst is behind Nissan — their products are solid, and the OEM has learned from its “volume at all costs” approach.Are there any new threats to the auto industry?Kevin: Open any automotive periodical, and you will see discussions about the potential impact of EVs. One consequence of the forecasted shift away from ICE to EV is the desire of some OEMs to modify their retail strategies. Tesla and other EV startups have gone the direct selling route, foregoing the traditional franchise model, and some major manufacturers are eyeing this strategy with jealousy. All despite historically failed attempts to replicate the proven ability of the franchise retailer to best serve the consumer’s needs. Ford, Hyundai, Mercedes-Benz, Volvo, and Polestar are examples of manufacturers who are overtly or quietly trying to change the retail model more toward the agency model seen in Europe. Haig Partners encourages dealers to be active participants with their state dealer associations to ensure franchise laws remain robust and protective of retailers. Scott: Despite the news and headlines dominated by EVs, the implications of EVs can vary drastically by brand. In other words, some OEMs are further along in producing EV models, while others do not anticipate producing EVs before 2024 and 2025. Additionally, the requirements of the various OEMs to auto dealers are also quite different. Some brands do not require any additional dealer commitments, while others, such as Ford, are forcing auto dealers to declare at what level they want to opt-in for selling EVs. Ford’s financial requirements can range from $0 for dealers that do not opt-in to selling EVs (only selling ICE vehicles) to $1,200,000 for dealers that opt-in to selling EVs at the premium level.What are the typical adjustments seen in negotiations for buy/sells?Kevin: One of the most important aspects of representing a seller is ensuring the buyer has a solid understanding of the historic and expected cash flows generated by the dealership. Just looking at the dealership’s financial statement doesn’t accurately depict the earnings opportunity of the store.Just looking at the dealership financial statement doesn’t accurately depict the earnings opportunity of the storeWe extensively analyze the dealership to understand what add-backs and deducts should be applied to reflect recurring cash flow. Some are non-cash entries; others are one-time expenses or income that should be adjusted.Some common add-backs are LIFO expenses, owner’s compensation (if excessive and/or not to be recurring for a future owner), owner’s perks that run through the statement (travel, airplane, etc.), and F&I over-remits/mailbox money that is generated outside the dealer statement.Deductions to earnings include PPP funds and one-time settlement funds or gains from asset sales.Scott: Similarly, Mercer Capital reviews the balance sheets of auto dealers for potential adjustments to inventories, fixed assets, working capital, goodwill, non-operating assets, and owner accounts receivable. Some typical areas for potential adjustments on the income statement include inventories, owner compensation, rent, other income, owner perquisites, and remittance, to which Kevin refers.Remittance is related to the service contract and other warranty-related products the dealership offers in connection with the purchase of a vehicle. A dealer can act as an agent in this process by offering products from multiple third-party vendors or acting as the principal, whereby they own a reinsurance company that offers those products to their customers. In either case, the dealership retains a portion of the service contract or warranty product and remits the other portion to the obligor or administrator of the contract. In an example where a vehicle service contract is $800, the dealership might retain $400, report that as income, and remit $400 to the obligor/administrator.In some cases, the dealer may have an “overpayment” arrangement in place with the third-party administrator or their reinsurance company, whereby the dealer might retain $250 in the previous example and then remit $550 to the obligor/administrator. The “overpayment” arrangement allows the dealership to determine the amount of the overpayment and designate a beneficiary outside the dealership to receive the overpayment amount. These arrangements effectively reduce or shift income out of the dealership. The presence and amounts of overpayments or over remittances should be considered as potential normalization adjustments to earnings when determining the value of a dealership.We thank Kevin Nill and Haig Partners for their insightful perspectives on the auto dealer industry. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

November 2022

In this issue: Community Bank Loan Portfolios Have Unrealized Losses Too and Bond Portfolio Update

2022 Family Law Team Conference Wrap-Up

In-person conferences are back in 2022 and so are we.

Unfriended? Long-Term Planning and Facebook's Stock Collapse

Meta Platforms (NASDAQ: META), formerly known as "Facebook," recently released its third-quarter earnings and guidance for 2023. Let's just say the market was less than pleased. Meta's stock fell over 20% in after-hours trading, which is down over 65% year-to-date. Per Figures 1 and 2, the stock is currently sitting at its lowest level since 2016, with a corresponding decline in implied valuation multiples.Figure 1 :: Meta (Facebook) Stock PerformanceFigure 2 :: Meta (Facebook) Variation Multiples A quote from Yahoo Finance piqued our interest: "Investors in Meta stock wanted to hear one thing on the embattled company's earnings call late Wednesday: an acknowledgment by founder Mark Zuckerberg that leaner spending times were ahead as margins have been squeezed by an ill-timed metaverse build out and a slowing ad market…They heard the opposite." Reading between the lines, it appears the market responded negatively to Facebook's continued commitment to high spending and capital expenditure into the metaverse, artificial intelligence ("AI"), and virtual reality ("VR") offerings, despite a contraction in margin and a potential slowdown in the U.S. economy. But so what? We think the current sell-off presents two lessons to family businesses: Maintain a long-term perspective even in rough weather, and understand the season your business is in.Next Quarter or Next Generation?Mr. Zuckerberg appears to be rebuffing the Street's next-quarter-ism and focusing on the long term. A snapshot of Meta's performance highlights this "horizon" difference in Figure 3.Click here to expand the image aboveAs shown in Figure 3, despite slowing revenues, Meta's capital expenditure increased nearly 50% from year-end 2021, and R&D expenses increased by over 32%. While the markets looked for belt-tightening, Mr. Zuckerberg went back for seconds.Readers of the Family Business Director will know that one of the strengths of family businesses is their ability to make tough decisions for the long-term health of their businesses despite possible negative, near-term impacts. Publicly traded companies often lack this advantage (or grace), as Facebook is acutely highlighting. While we don't know how Meta's strategy will turn out, Meta's current strategy appears forward-looking for better or for worse.Plant or Harvest?Mr. Zuckerberg on Meta's near-term challenges:"I think we're going to resolve each of these things over different periods of time," Zuckerberg said. "And I appreciate patience and I think that those who are patient and invest with us will end up being rewarded."Patience. When was the last time you or your family board asked for patience? Knowing what time, or season, it is for your family business will help you gauge how patient (or impatient) you need to be. Is it "planting" season or "harvesting" time? Planters are family businesses that are currently investing more cash flow in future growth than their existing operations generate. In contrast, harvesters generate more cash flow from current operations than they invest for future growth.The goal of planting is to promise a future harvest. But as any farmer knows, it is a promise, not a known fact. You have to plant before you harvest. As a result, the principal peril of planting time is the risk that the harvest will turn out less attractive than expected. In contrast, harvest time promises you will finally reap the benefits of the risks and investments but potentially starve the business of needed investment.It would appear Mr. Zuckerberg will continue planting despite the market's scream to harvest before more storms arrive. As highlighted in Figure 3, Meta's adjusted EBITDA fell nearly 21% from the end of 2021, but capital expenditure continues to climb, and guidance expects operating expenses (including research and development) to climb further in 2023. With the most recent quarter's performance and macroeconomic woes, one could argue that Meta should ease off the gas and focus on core operations. However, failing to plant could let complacency set in and starve the company of future growth opportunities. Family businesses should take a step back and check what time it is for their family business and if a change of posture is in order.Next Frontier or Next Flop?Palmer Luckey, who sold Oculus VR to Facebook for $3 billion, had this to say on the metaverse in a recent interview: "It's hard for me to really wholeheartedly say, 'Oh, Horizon Worlds, what an absolute disaster,' because I look at it and I see something that's being developed in the open, developed in public. It is terrible today, but it could be amazing in the future. I think Mark will put in the money to do that." Will the metaverse be a winner? Digital real estate? AI technology? Meta's fourth-quarter earnings? We won't pretend to know what the future holds or how much patience investors ought to have. But we continue to think a competitive advantage of family businesses is the ability to be patient. Meta is refusing to stop investing in a number of new markets and opportunities despite near-term compressions on cash flow. Does your family business have to make some tough decisions to ensure you are around for another 100 years? There generally are no shortcuts to achieving long-term wealth, and there will be tough plant-or-harvest decisions along the way. Is your family business at a turning point and needs some direction? Give one of our professionals a call today to help you think about your next move.

How Are Tech-Forward Banks Performing?

In the year-to-date period, the KBW Nasdaq Bank Index has declined 22%, compared to a decline of 20% in the S&P 500 through October 27.Tech-forward banks have underperformed the broader banking sector, down 60% in the year-to-date period.1This is a reversal of the trend in 2021 when tech-forward banks outperformed the broader banking sector, logging a 70% increase compared to an increase of 35% in the KBW Nasdaq Bank Index.Figure 1 :: Year-To-Date Performance (Through October 27, 2022)Source: S&P Capital IQ Pro. Figure 2 :: 2021 PerformanceSource: S&P Capital IQ Pro. The tech-forward bank landscape encompasses a variety of business models but generally refers to banks utilizing technology or partnering with fintechs to deliver financial products or services.Banks that partner with fintechs are often referred to as providing “banking as a service (BaaS)”.This model involves an FDIC member bank offering bank products to fintech customers, for example, credit and debit cards or personal loans.The bank holds the deposits associated with the accounts and earns a fee based on a percentage of interchange income specified in an agreement negotiated with the fintech partner.Other models are focused on facilitating payments or providing financial services to a specific niche, such as cryptocurrency.While the largest banks have the resources to be at the forefront of technology adoption, many smaller banks have partnered with fintechs in recent years. This is due in part to the Durbin Amendment which places limits on interchange income for banks above $10 billion in assets.In many cases, the partnerships have accelerated growth and created new income streams for the bank partners.However, bank partners also face unique risks.As displayed in the market performance, tech-forward banks have been more volatile than traditional banks.Tech-forward bank performance has been moored, to some degree, to more volatile technology stocks, which explains the stock market outperformance in 2021 followed by a larger retrenchment in 2022.For a community bank pursuing a fintech partnership strategy, there are multiple considerations, including the following.Deposit GrowthMany fintech partner banks have continued growing deposits this year even though most banks have seen deposit growth stagnate or turn negative in the rising rate environment.An analysis performed by S&P Global Market Intelligence showed that fintech partner banks with assets between $1 billion and $3 billion experienced deposit growth of 15% (annualized) in the first half of 2022.This compares to deposit growth of 3% for commercial banks in the same asset size range.The deposits generated from fintech partnerships are often noninterest bearing accounts, which are especially valuable in the currentrising rate environment. Bank partners earn spread income from the deposits, often holding them at the Federal Reserve due to their volatility and uncertain duration. Balances at the Fed reprice immediately with changes to the Fed’s benchmark rate.Noninterest IncomeThe largest impact on the revenue side typically shows up in noninterest income.Fintech partner banks tend to have a higher ratio of noninterest income to total income relative to traditional banks as they earn a share of the interchange income.In a period of flat or declining interest rates, this diversification of revenue can help to offset net interest margin compression.For the tech-forward banks included in Figure 1 and 2, the median ratio of noninterest income to operating revenue was 29% in the trailing twelve month period.Concentration RiskWhile fintech partnerships can be a source of growth, bank partners should be cautious about revenue or deposit concentrations. Fintechs can grow rapidly, and, as a result, a bank partner may develop a concentration within their deposit base or revenues.Banks must periodically renegotiate contracts with fintech partners, and there is a risk that the fintech will find another bank partner or demand more favorable terms.This single event could eliminate a major source of deposits or reduce noninterest income, causing a much greater impact than the ordinary loss of traditional bank customers.For example, Green Dot Corporation (GDOT) provides the Walmart MoneyCard product and offers other deposit account products at Walmart. Green Dot’s second quarter 10-Q discloses that approximately 21% of its operating revenue in the year-to-date period was derived from products and services sold at Walmart locations.Regulatory RiskRegulators have stepped up their scrutiny of bank-fintech partnerships this year, focusing on risk management controls.Many banks partnering with fintechs have less than $10 billion in assets, and banks that do not currently serve fintechs may not have the necessary compliance infrastructure to effectively manage potential fintech relationships. Compliance capability must be built over a long period of time and serves as somewhat of a barrier to entry for banks desiring to pursue this strategy.Additionally, certain fintech partnerships may present an added element of risk as the bank could be impacted by the regulatory and compliance practices of the fintechs or the evolving regulatory/compliance landscape.One recent example of this risk arose in the crypto fintech niche as the FDIC released an order to a crypto brokerage firm demanding that it cease and desist from making false and misleading statements about its deposit insurance status, while the FDIC contemporaneously issued an advisory to insured institutions regarding FDIC deposit insurance and dealings with crypto companies.2Valuation & PerformanceBank stocks’ underperformance in 2022 has largely been attributed to economic uncertainty and the potential for recession brought on by the Fed’s aggressive rate hikes. Fintech partner banks have been more volatile than the broader banking market.The business models entail certain risks, as detailed above, that do not pertain to traditional banks to the same degree.In addition, the earnings from fintech partnerships are less predictable and potentially further out in the future.As seen in figure 3, the range of valuation multiples observed for tech forward banks is wide, with forward P/Es ranging from 6.6x to 16.1x but most trade at 7x to 9x estimated 2023 earnings.It is important to note that the banks included in the table above represent a variety of sizes, strategies and niches, so comparability may be somewhat limited.Tangible book multiples likewise exhibit a wide range, but in general are high relative to the broader banking sector.In valuing fintech partner banks, investors weigh the growth potential provided by the partnership versus the risk that earnings growth does not materialize.Figure 3 :: Multiples and Price Change of Tech-Forward BanksClick here to expand the image aboveConclusionMercer Capital has experience valuing and advising both banks and fintechs.If you are considering partnership opportunities or have questions regarding their valuation implications, please contact us.1Tech-forward banks include AX, CCB, GDOT, LC, LOB, MVBF, CASH, SI, SIVB, TBBK, and TBK.Year-to-date performance through 10/27/222https://www.arnoldporter.com/en/perspectives/advisories/2022/08/regulators-crack-down-on-fintechs

Takeaways from Two Recent Energy Events in Dallas

Strong Industry Fundamentals, Capital Markets Showing Signs of Resurgence, and Energy Security

In the past week, several energy-related gatherings have been held in the Dallas area. We attended two of them: the D-CEO Energy Awards and Hart Energy’s Energy Capital Conference. We had numerous discussions with company representatives, dealmakers, and service providers. The marketplace appears excited about the potential for the upcoming year amid challenges. At both events, several industry themes were evident including: the energy industry has strong fundamentals, capital markets are showing signs of a resurgence in needed capital, and energy security is returning to the lexicon.Strong FundamentalsSeveral speakers and panelists at both events expressed optimism and confidence in the important role that the sector is playing both today and in the future. “This will be the golden decade for hydrocarbon production,” said Kyle Bass of Hayman Capital at the D-CEO Energy Awards. In this inflationary environment, the best place to be in energy, according to Mr. Bass, is royalties because they capture all the cost issues beneath them.This will be the golden decade for hydrocarbon productionAt the Hart Energy Capital Conference, Tim Perry of Credit Suisse said that returns are very strong considering high profits coupled with lower than historical valuations. Upstream companies that used to trade at 6-8 times EBITDA now trade between 3-5 times. IPOs are coming out at higher discounts to these multiples, and as such, returns expected are higher. Mr. Perry pointed out that energy occupies only about 5.1% of the S&P market capitalization, whereas historically, it has typically been between 8 - 13%.Which upstream area (oil vs. gas) was a better place to be right now has been a big boardroom discussion, with oil producers getting higher margins but gas producers facing a bright future with the major energy transition fuel.Capital Resurgence?Another theme was the prospect of capital returning to the space. Considering the deleveraging trend that has been happening for several years now, it was interesting to hear from multiple panelists that capital sources are coming back to the space. Banks are starting to return and borrowing bases, which were hard to come by, are now becoming more available to upstream producers. Over the past five years or so, so-called “casual” investors have left the space. The smaller landscape is now populated with sophisticated investors who are interested in energy’s strong tenets.Due to the fundamentals, private capital has also been responsive to filling the void with more unconventional sources, such as private placements and even family offices offering debt and equity capital. The space has become more attractive as what was described on one panel as the 3 “R”s – returns; realization of the industry’s importance; and regulatory framework to allow more investing.These trends have also begun to creep into the institutional space as well. It has become less polarizing in the past year, and more people are willing to listen to energy-oriented investment theses. One panelist remarked that some larger institutional shops are quietly “repurposing’ some of their internal talent to the oil and gas space, with some even planning to hire energy industry teams.Energy SecurityPart of the optimism for the space is the realization that the geopolitical landscape is not as stable as it has been. Both conferences referenced the likelihood of food and energy shortages in the next decade. “There are going to be riots in Europe this winter,” said Jim Wicklund of Wicklund & Associates. With issues ranging from wars to fertilizer to pipelines; the focus in the U.S. on energy transition in the longer term may have overlooked energy security in the shorter term.Part of the optimism for the space is the realization that the geopolitical landscape is not as stable as it has beenWe can export 12 BCF a day now, but will that be enough for Europe’s needs this winter? Mohit Singh, Chesapeake’s new CFO said that 75% of future demand growth in gas will come from LNG. The key will be takeaway, and the next wave of LNG completions are supposed to be in 2025 or 2026, where we may be able to export closer to 28 BCF per day. However, in the meantime, there may be more turmoil as energy markets attempt to get energy where it is needed now in both Europe and Asia.Multiple speakers and panelists lamented the overreach of the idea of energy transition to renewables at the expense of potentially available energy today. Some expressed optimism that the Inflation Reduction Act would help remove bottlenecks on a lot of renewable projects; however, they conceded that it still won’t change the situation in the shorter term. In addition, most panelists agreed that disincentivizing and demonizing the oil and gas industry during this energy transition has been a mistake.Jay Allison of Comstock Resources, who received the Energy Executive of the Year award at the D-CEO Awards Dinner, put it this way: “When Henry Ford invented the Model T, he didn’t kill all the horses.”Thanks again to everyone we connected with this week. The conversations were terrific, and we enjoyed seeing all of you.

Multiple Contraction Drives Returns for Publicly Traded Asset/Wealth Managers

So far this year, many publicly traded investment managers have seen their stock prices decline by 30% or more. This decrease is not surprising, given most firms’ broader market decline and declining fee base. With AUM for many firms down significantly from year-end, trailing twelve-month multiples have declined, reflecting the market’s expectation for lower profitability in the future. For more insight into what’s driving the decrease in stock prices, we’ve decomposed the decrease to show the relative impact of the various factors driving returns between December 31, 2021, and October 25, 2022 (see table below).Click here to expand the image aboveFor publicly traded investment managers with less than $100 billion in AUM, the last twelve-month (LTM) revenue for the most recent available twelve-month period increased about 2% relative to year-end. Due to the operating leverage in the RIA business model, the decline in revenue also resulted in a higher EBITDA margin. The net effect is that LTM EBITDA increased about 5% on average year-over-year for these firms. The fundamentals for the larger group (firms with AUM above $100 billion) fared worse, with profitability generally decreasing due to modest revenue declines and margin compression.While the sub-$100B group generally saw better actual performance than the larger group, both groups saw significant declines in the LTM EBITDA multiple, which was the primary driver of the stock price decreases. Year-to-date, the median multiple for the larger group (AUM above $100 billion) has been cut by nearly a third. In comparison, the smaller group (AUM below $100 billion) saw the median multiple decrease by about 12%.The multiple compression relative to year-end is not surprising, given the market’s trajectory this year. While LTM EBITDA declines have been modest for the larger group and performance has increased for the smaller group, market participants value these businesses based on expectations for the future, not on LTM performance.What’s Your Firm’s Run Rate?The multiple contraction seen in the publicly traded investment managers over the last year illustrates the importance of expected future performance on RIA valuations. The market decline and inflationary pressures that have manifested this year have yet to be fully reflected in LTM performance metrics. But as AUM has declined for most RIAs, so too has the run-rate revenue and profitability. The decline in run-rate revenue and profitability (and expectations for the same) is a driving factor behind the multiple compression observed over the last year in public companies.Market participants tend to focus on the run-rate level of profitability because it’s the most up-to-date indication of a firm’s revenue and profitability and the baseline from which future performance is assessed. This is increasingly true in today’s volatile market as buyers seek to determine a firm’s ongoing profitability after giving effect to the market movements and inflationary pressures that have impacted firms this year.Consider the financial results for a hypothetical firm (ABC Investment Management) shown below. While illustrative, the AUM trajectory and cost structure of this firm since year-end are not unusual relative to those exhibited by publicly traded investment managers and many of our privately held RIA clients.Click here to expand the image aboveIn the example, we assume that ABC began the fourth quarter last year with $2.0 billion in AUM. Market movement is estimated using the market performance of VBIAX (a rough proxy for a traditional 60/40 portfolio). Assuming zero net inflows over the last year, ABC would have ended the third quarter of 2022 with a little over $1.6 billion in AUM, down nearly 20% from a year prior. Given the operating leverage of the business, ABC’s EBITDA in the third quarter declined by over 40% relative to the fourth quarter of last year.On an LTM basis, ABC generated revenue of about $12.4 million and EBITDA of $3.3 million (representing a 27% EBITDA margin). On a run-rate basis, however, the performance is markedly different. Given current levels of AUM and operating expenses, ABC’s run-rate revenue is $10.6 million, and run-rate EBITDA is just $2.1 million—a nearly 40% decline relative to LTM EBITDA. This example illustrates the differing perspectives that emerge in down markets: While sellers focus on LTM metrics, buyers focus on the run rate.Implications for Your RIAWhile multiples for publicly traded asset and wealth managers have been hit hard this year, RIA valuations in the private market have been more resilient as a proliferation of professional buyers and capital in the space have supported deal activity and multiples. Nevertheless, market conditions are beginning to have an effect. Run rate performance for most firms is down significantly, and borrowing costs for leveraged consolidators are rising. The upward momentum in multiples that persisted throughout last year has stalled, and deal structures have started to shift more of the purchase price into contingent consideration to bridge increasingly divergent buyer and seller expectations.

Fall 2022 Middle Market M&A Update

For this week’s post, we take a look at recent trends in middle market M&A. Despite turbulent economic and geopolitical conditions in the first half of the year, valuations in the middle market continued to hold their ground.Still, whether looking to buy or sell, family business owners would be wise to act sooner rather than later, as declines in volume and value thus far in 2022 suggest tightening conditions in the middle market.Overall deal activity in the second quarter of 2022 fell from levels seen in the first quarter of the year and the second quarter of 2021. In aggregate, deal activity in the first half of 2022 also fell from aggregate deal activity in the first half of 2021.Despite the decline in U.S. deal value and volume, multiples on deals completed in the first half of the year remained in line with levels observed in 2020 and 2021, suggesting a potential “flight to quality” in the middle market in the first half of the year.U.S. Deal Value and Volume: Q1-2020 to Q2-20222U.S. Deal Volume by Industry: Q1-2020 to Q2-2022Click here to expand the image aboveBroader economic conditions in the U.S. negatively influenced deal value and volume in the first half of 2022 but did not stifle overall deal activity. In the second quarter of 2022, U.S. GDP declined for the second straight quarter, and annual and monthly inflation measures continued to hit record levels.In response to the rampant inflation in the U.S. economy, the Fed executed two sizable rate increases in the second quarter, including enacting the largest rate increase since 1994 at its June meeting. While the U.S. economy has not yet officially fallen into a recession (despite the two straight quarters of decline in GDP), most Fed watchers agree that Jay Powell and the FOMC won’t relent in their fight to bring down inflation even if it does cause a recession. In short, the Fed appears to be willing to take a cool down in inflation in exchange for a weaker short-term outlook in terms of GDP and overall economic growth.TEV/EBITDA Multiples: Financial BuyersYet despite these challenging macroeconomic conditions, deal activity did not come to a screeching halt in the first half of 2022, as seen in the middle of 2020. We believe this is a good sign for the overall health of the middle market, particularly when coupled with the fact that multiples on PE deals were relatively unchanged in the second quarter, as seen in the chart above. The prolonged “sellers’ market” of the past several years appears to be holding up to this point in 2022, as buyers continue to be willing to pay elevated multiples for well-positioned businesses coming to market. Deals in the $50-$100 million tranche of the middle market realized multiple expansions in the second quarter, growing from an average multiple of 8.5x to 9.2x. Multiples in other tranches were either unchanged or slightly down.EBITDA Multiples by Buyer Type: 2020 to 1H 2022Number of Deals by Buyer Type: Q1-2020 to Q2-2022Click here to expand the image aboveDebt multiples on PE deals fell in the second quarter of 2022. The drop in debt utilization in deal activity is likely a sign that rising interest rates are beginning to weigh on deal activity and financing terms. Rising interest rates equate to an increased cost of borrowing and overall cost of capital for businesses, increasing the discount rates used in buyers’ valuations of potential targets. While elevated discount rates, in theory, should lead to valuations (and hence multiples) coming down from levels seen over the past several years, corporate balance sheets and PE firms still appear to be flush with cash. We believe there is still a great deal of readily deployable capital on the sidelines that should continue to support elevated multiples and valuations in the middle market in the foreseeable future.Debt Multiples: Financial BuyersIn conclusion, while deal volume was down in the second quarter of 2022 (and in the first half of the year in general), activity did not come to a screeching halt despite a challenging economic environment in the U.S. and geopolitical strife abroad.In our opinion, there has been a “flight to quality” in the middle market, which has supported valuations and multiples despite reduced deal volume. This has created heavy competition among strategic and financial buyers for well-positioned businesses coming to market and, in the process, has helped maintain the elevated multiples and deal values seen in the middle market over the past year or so.While observed multiples remain elevated, owners looking to transact their business would be advised to begin the process sooner rather than later, given the prospects of further interest rate hikes, continued volatility in the public markets, ongoing geopolitical tensions globally, and the upcoming midterm elections.While the state of the middle market remained relatively placid in the first half of 2022, these and other factors will likely hamper deal activity in the middle market in the coming quarters and years.

Mid-Year 2022 Auto Dealer Industry Newsletter Release

We are pleased to release our Mid-Year 2022 Auto Dealer Industry Newsletter after taking a brief hiatus.Beginning in the fall of last year, NADA suspended publication of its Dealership Profile data which was a helpful resource to industry participants and to our industry newsletter. We have pivoted by providing additional data from the public auto dealer groups, which we hope you will find insightful.Recurring Trends and What They Mean to YouThe first half of 2022 continued to present challenges to auto dealers. Once again, auto dealers have proven their resilience and adaptability to continue operating at heightened profitability.Recurring trends such as a lack of new vehicle supply and a shortage of microchips persist, while new challenges such as inflation, rising interest rates, and increasing gas prices began to emerge. We highlight and discuss these trends and provide key industry metrics, including total retailer profit per unit on new vehicles, supply of new vehicles on dealer’s lots, the average age of new cars, average trade-in equity on used vehicles, and fleet sales.Additionally, we recap the second quarter earnings calls of public auto companies, which further touch on these trends.Blue Sky Multiples Have Jumped for SomeAlso included in this newsletter is a discussion of blue sky multiples across various franchise segments, including luxury dealerships, mid-line dealerships, and domestic dealerships.While most blue sky multiples have remained flat for the last several quarters, there are interesting discussions on their application between buyers and sellers during continued periods of heightened earnings. Several franchises have seen their blue sky multiples jump after a period of stagnant value.What the Publics Can Tell UsFinally, this newsletter provides financial data and metrics from public auto companies that we believe are informative to single-point or smaller private auto dealers. Specifically, we analyze the market capitalization, dealership count, gross profit by segment, and the implied blue sky multiples from public earnings data for the second quarter of 2022 and the prior year-end 2021.What Other Topics Would You Like to Know More About?We hope you find this newsletter to be a helpful resource and appreciate any feedback along with way. Please send suggested content topics or ideas that you’d like to see in future editions to Mercer Capital’s Auto Dealer Industry Group Leader, Scott A. Womack, ASA, MAFF, at womacks@mercercapital.com. Click the link below to download this latest issueValue Focus: Auto Dealer IndustryDownload the Mid-Year 2022 Newsletter

One Step Forward, Two Steps Back: RIA Stocks Finish the Quarter Down 10% after a Fast Start

Most RIA Stocks Have Lost Nearly Half Their Value Since Peaking Last November

The RIA industry extended its losing streak last quarter with all classes underperforming the S&P, which also continued its decline. The market itself is part of the problem as this industry is mostly invested in stocks and bonds, which have been down considerably since the first of the year. The additional underperformance for asset and wealth managers is likely attributable to lower industry margins as AUM and revenue fall with the market while labor costs continue to rise. Rising interest rates have exacerbated this decline for alternative asset managers and RIA aggregators, who frequently employ leverage to make investments. The one bright spot for the industry is the group of smaller (under $10 billion in AUM) publicly traded RIAs, which is the only segment to outperform the market over the last year. This group is still down over this time but holding up relatively well due to the lack of aggregator firms in its composition. These smaller firms have also tended to trade at more modest multiples with higher dividend yields, so these lower-duration stocks have held up reasonably well in a rising interest rate environment. As valuation analysts, we are often interested in how earnings multiples have evolved over time since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and throughout 2021, LTM earnings multiples for publicly traded asset and wealth managers have dropped nearly 40% this year, reflecting investor anticipation of lower revenue and earnings from the recent market decline and rising cost structure. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with closely held RIAs should be made with caution. Many smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Also, most closely held RIAs are smaller than their public counterparts and often transact at lower multiples because of the heightened risk profile associated with smaller businesses.Despite industry headwinds, the M&A market for the RIA industry has remained strong though valuations have started to level off a bit. M&A is often viewed as a lagging economic indicator since deals take several months or even quarters to complete, so we may not see multiples start to come down for a few more months. As always, we’ll keep an eye on it and report back next quarter.

Now Available: Mercer Capital's 2022 Energy Purchase Price Allocation Study

Mercer Capital is pleased to announce the release of the 2022 Energy Purchase Price Allocation Study.This study researches and observes publicly available purchase price allocation data for four sub-sectors of the energy industry: (i) exploration & production; (ii) oilfield services; (iii) midstream; and (iv) downstream. This study is unlike any other in terms of energy industry specificity and depth.The 2022 Energy Purchase Price Allocation Study provides a detailed analysis and overview of valuation and accounting trends in these sub-sectors of the energy space. This study also enables key users and preparers of financial statements to better understand the asset mix, valuation methods, and useful life trends in the energy space as they pertain to business combinations under ASC 805 and GAAP fair value standards under ASC 820. We utilized transactions that closed and reported their purchase allocation data in calendar year 2021.This study is a useful tool for management teams, investors, auditors, and even insurance underwriters as market participants grapple with ever-increasing market complexity. It provides data and analytics for readers seeking to understand undergirding economics and deal rationale for individual transactions. The study also assists in risk assessment and underwriting of assets involved in these sectors. Further, it helps readers to better comprehend financial statement impacts of business combinations.>> DOWNLOAD THE STUDY <<

Five Trends to Watch in the Medical Device Industry: 2022 Update

Medical Devices OverviewThe medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems.Medical devices range from simple tongue depressors and bandages to complex programmable pacemakers and sophisticated imaging systems.Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices.The U.S. elderly population (persons aged 65 and above) totaled 40.3 million in 2021 (13% of the population). The U.S. Census Bureau estimates that the elderly will more than double by 2060 to 95 million, representing 23% of the total population.The elderly account for nearly one third of total healthcare consumption in the U.S.Personal healthcare spending for the population segment was approximately $19,000 per person in 2014, five times the spending per child (about $3,700) and almost triple the spending per working-age person (about $7,200).According to United Nations projections, the global elderly population will rise from approximately 608 million (8.2% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060.Europe’s elderly are projected to reach approximately 29% of the population by 2060, making it the world’s oldest region.While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from approximately 8% in 2015 to more than 21% of the total population by 2060.2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $4.1 trillion in 2020 to $6.2 trillion in 2028, an average annual growth rate of 5.4%.This projected average annual growth rate is faster than the observed rate of 3.9% between 2009 and 2018. Projected growth in annual spending for Medicare (4.3%) and Medicaid (5.6%) is expected to contribute substantially to the increase in national health expenditure over the coming decade.However, growth in national healthcare spendinghas slowed in 2021 to 4.2%, down from 9.7% in 2020. Healthcare spending as a percentage of GDP is expected to remain virtually unchanged from 19.7% in 2020 to 19.6% by 2030.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures.Medicare currently provides healthcare benefits for an estimated 60 million elderly and disabled people, constituting approximately 15% of the federal budget in 2018 and is expected to rise to 18% by 2028.Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2020.Medicare also accounts for 25% of hospital spending, 30% of retail prescription drugs sales, and 23% of physician services.Due to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services.Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $776 billion in 2020 and are expected to reach $1.5 trillion by 2030.The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs.While political debate centered around altering the ACA has been a continuous fixture in American politics since its passing, it is unlikely that material reform to the ACA occurs in the near future under the Biden Administration.Total Medicare spending is projected to grow at 5.6% annually between 2025 and 2030, compared to year over year growth of 11.3% in 2021 and 3.5% in 2020.3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients).In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices.Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used).Accordingly, medical device purchasing decisions tend to be largely disconnected from price. Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs.Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices.Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance.The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency.In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively.A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 35.8% of payments were tied to Category 3 and 4 APMs in 2018, compared to 32.8% in 2017.In 2020, CMS released guidance for states on how to advance value-based care across their healthcare systems, emphasizing Medicaid populations, and to share pathways for adoption of such approaches. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face similar increasing healthcare costs.A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices.Industry participants are required to report manufacturing costs, and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil.Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.4. Competitive Factors and Regulatory RegimeHistorically, much of the growth of medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients.Successful product development usually requires significant R&D outlays and a measure of luck.If viable, new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments.First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period.Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations.Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the US without prior authorization.For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S.The 510(k) clearance process may occasionally require clinical data and generally takes between 90 days and one year for completion.In November 2018, the FDA announced plans to change elements of the 510(k) clearance process.Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 10 years.In early 2019, the FDA announced an alternative 510(k) program to allow medical devices an easier approval process for manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria. The plans materialized as the Abbreviated 510(k) Program later in the year.The premarket approval (“PMA”) process is more stringent, time-consuming, and expensive.A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical, and manufacturing data.Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days.However, the process typically takes significantly longer and may require several years to complete.Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval.The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017. Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022. Intended to begin in 2020, negotiations for MDUFA V were delayed due to the COVID-19 pandemic. The FDA and industry groups reached a deal for MDUFA V, slated to go into effect beginning fiscal 2023, which would generate up to $1.9 billion in fees to the agency over five years. The U.S. House of Representatives passed MDUFA V in June 2022 and the Senate is expected to follow suit by September 2022.Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations.Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the EU. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive.Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market.This CE marking verifies that a device meets all regulatory requirements, including EU safety standards.A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. According to the WHO, middle income countries, such as Russia, China, Turkey, and Peru, among others, are rapidly converging towards outsized levels of spending as their incomes increase.When countries grow richer, the demand for health care increases along with people’s expectation for government financed healthcare.Middle income country share, the fastest growing economic sector, increased from 15% to 19% of global spending between 2000 and 2017.As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies.According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades.Global medical device sales are estimated to increase 5.4% annually from 2021 to 2028, reaching nearly $658 billion according to data from Fortune Business Insights.While the Americas are projected to remain the world’s largest medical device market, the Asia Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years.SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers.While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base.Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy.However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.

Regulatory Update: Amendments to FTC Safeguards Rule

Impacts to Auto Dealerships

Over the last month, the Mercer Capital Auto Team attended several October meetings with the Tennessee Automotive Association. The featured presentation by ComplyAuto discussed the features of the Federal Trade Commission’s (“FTC”) Safeguard Rule (“Safeguards Rule” or “Rule”) and the amendments with which must be complied by early December 2022. In previous posts, we have discussed advancements in auto retailing and vehicles and how added technology brings added risks to cybersecurity and the protection of customer information. This post discusses the FTC Safeguards Rule and what auto dealers and their advisors need to know.What Is the FTC’s Safeguards Rule?The official title of the Safeguards Rule is “Standards for Safeguarding Customer Information.” The original Rule took effect in 2003 and was intended to ensure that entities covered under the Rule maintained safeguards to protect the security of customer information. Few changes were made to the Rule since 2003 until the FTC’s proposed amendments in December 2021. These amendments sought to make changes to the original Rule to keep up with advancements and changes in technology. More importantly, qualified businesses must comply with the FTC’s Safeguards Rule by December 9, 2022.Why Does the FTC Safeguards Rule Impact Auto Dealerships?The Safeguards Rule applies to financial institutions subject to the FTC’s jurisdiction that are not subject to the enforcement of a separate authority or regulator under Section 505 of the Graham-Leach-Bliley Act. Further, the Rule defines a financial institution as “any institution of business of which is engaging in an activity that is financial in nature or incidental to such financial activities.” While on the face, this appears to be speaking primarily about banks or other similar financial institutions, Section 314.2(h) explicitly cites auto dealerships as an example of a financial institution given the nature of its leased and purchased transactions and participation in the financing activities of the transactions.NADA estimates that auto dealerships could face up-front costs of up to $294,000 per rooftop to comply with the Safeguards RuleNADA estimates that auto dealerships could face up-front costs of up to $294,000 per rooftop to comply with the Safeguards Rule, with additional ongoing costs in the neighborhood of $277,000 annually. These numbers may seem staggering at first, but what are the costs of not complying? The NADA estimates the average fine for a violation under the Rule is $47,000. While this number appears steep, it is also unclear how the FTC would view a security breach. In other words, if a security breach compromised the personal/financial information of multiple consumers, would that be one violation, or would each consumer breached be a separate violation? If the latter occurs, fines could quickly escalate into the high six digits for a more significant volume breach. This ambiguity makes it more impactful for dealerships that might otherwise “risk” the possibility of a $47,000 fine compared to annual costs of $277,000, not to mention the upfront costs.The Safeguards Rule is meant to work in tandem with consumer privacy rights and policies enforced by state attorneys general and the FTC. All 50 states have enacted some state cybersecurity requirements to protect data breach laws, with some instituting specific cybersecurity laws.What Are the Guidelines Under the FTC Safeguards Rule?Rule 1 – Four Written PoliciesAuto dealers are required to adopt, maintain, and adhere to four written policies: data retention plan, incident response plan, information security plan, and IT change management procedures. These policies must be written and the appropriate size as it relates to the complexity of your auto dealership business, the nature and scope of your business activities, and the sensitivity of the information in issue. These written policies should aim to ensure the security and confidentiality of customer information, protect against anticipated threats or hazards to the security and integrity of that information, and protect against unauthorized access to information that could lead to substantial harm or inconvenience to any customer. To comply with the information security plan, auto dealerships should have a designated/qualified individual to implement and supervise the company’s information security program.Rule 2 – Annual Risk Assessment On an annual basis, auto dealerships must complete a formal risk assessment to determine foreseeable risks and threats – both internally and externally – to protect customers’ information security, confidentiality, and integrity. Compliant assessments will also document attempts to mitigate these threats and any updates to the four written policies in Rule #1 resulting from items discovered during the annual risk assessment.Rule 3 – Annual Employee Security Awareness TrainingAn auto dealership’s security program is only as effective as its least vigilant staff member. All employees must be trained on overall awareness as well as the specific components of your information security program, policies, procedures, and safeguards. Further, the Rule insists on specialized training for those employees, affiliates, and providers with hands-on responsibility for carrying out your dealership’s information security program.Rule 4 – Phishing and Social Engineering SimulationsAs part of the new amendments, the FTC Rule requires dealerships to test their employee’s susceptibility to social engineering and phishing scams. In other words, how likely are your employees to fall for these phishing scams? Would regular testing and simulations give the dealer principal an idea of how easily or frequently these threats could become reality? Hopefully, regular simulations would also raise employees’ awareness that such threats exist daily.Rule 5 – Service Provider ContractsDuring a lease or purchase transaction, auto dealerships may require service providers that access non-public personal information (“NPI”) to sign a specific contract whereby they also promise to adopt and adhere to reasonable safeguards. Dealers will want to establish or work with pre-vetted contracts signed by their vendors and must be mindful of built-in e-sign functionality to increase efficiency with vendors.Rule 6 – Annual Service Provider and Risk AssessmentsDealers must select service providers with the skills and experience to maintain appropriate safeguards. Under the Rule, dealers are actually required to assess and monitor their service providers for continued adequacy of safeguards, even when that can often be accomplished through a security questionnaire or checklist. Dealers should consider periodic reassessments of their service providers to ensure safeguards are maintained.Rule 7 – Annual Penetration Test and Bi-Annual Vulnerability ScansDealers are required to perform annual internal penetration testing of their networks to simulate internal and external hacking. To comply with the Rule, they must also perform biannual vulnerability assessments for known exploits. As part of the total ongoing costs estimated earlier in this blog, NADA estimates that the average cost of an annual penetration test is $23,000. This cost could be increased by the number of individual rooftops that a particular dealer owns, which could rise significantly for bigger private auto groups. In addition, dealers should test whenever there are material changes to their operations or business arrangements or when they know circumstances may have occurred that could have a material impact on their information security system.Rule 8 – Device, Data & Systems InventoryDealers are required to perform a regular inventory of their data and systems. Inventory procedures would include identifying all data in their possession, tracking where the data is collected and by which vendor and system, and understanding how the data is stored and transmitted. Has your dealership added a new server? Because systems, networks, and operations like this constantly change, an auto dealer’s safeguards cannot remain static.Rule 9 – Annual Report to the Board of DirectorsAuto dealers must submit a regular written report to the Board of Directors or governing body. If your dealership does not have a Board of Directors, the report must go to a senior officer responsible for the information security program. Ideally, the report would be written and delivered by the qualified individual established to run your information security program in Rule #1. The report should include the overall assessment of your dealership’s compliance with its information security program and would discuss test results and responses to threats, including any amendments or changes to the dealership’s written policies.What Additional Guidelines Does the Rule Require Concerning Advanced Cybersecurity and Device Protection?Rule 10 – Intrusion and Attack DetectionFTC Safeguards Rule, along with most OEMs and cybersecurity insurance carriers, will require that dealers have an established system to detect intrusions and attacks on your network.Rule 11 – User and Employee Monitoring and LoggingDealers must have a security system that restricts how users and employees log into and use their information security system. Dealers must be able to detect who is on the system at all times while detecting and preventing unauthorized access, sharing, use of, and tampering with customer information.Rule 12 – Device EncryptionThroughout auto dealerships’ operations, employees utilize devices such as laptops, tablets, and mobile devices–all of which contain customer information. The Rule requires that the hard drives of each of these devices be encrypted. However, compliance with these terms can become complicated with the increase of remote employees and remotely-enabled devices.Rule 13 – Multi-Factor Authentication (“MFAs”)Dealers must implement multi-factor authentication on any system used to access customer information, including device-level MFAs. Specifically, the Rule requires at least two of these authentication factors: a knowledge factor (such as a password) and an inherence factor (such as biometric characteristics like a fingerprint, facial features, face recognition, etc.).ConclusionsThe clock is ticking for auto dealers unaware of the FTC's new amendments to the Safeguards Rule and the compliance deadline of December 9, 2022. With changes to existing and emerging technology, protecting private/confidential consumer information becomes more critical. Cybersecurity and hacking threats seem to multiply every day. Could your dealership be next? Have you taken the necessary steps to bolster your information security programs? If your auto dealership is not compliant with the FTC's Safeguards Rule, seek a professional vendor to assist you in this area.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Storms Ahead? Best Practices for Forecasting Performance

Having transplanted from Tennessee to Florida, I’ve just now gotten up to speed on the weather. In the summer, afternoon showers can pop up without warning, and the low 80s is “cool” for the locals. I am not there yet.Hurricane Ian blew through southwest Florida in late September, which had my family and Floridians keener to forecast models, storm tracking, and cone watching. We were quite lucky in my neck of the woods, but the unpredictability of the storm’s ultimate landfall led to a lot of consternation.After the dust settled, the forecast models got me thinking about the difficulty in "forecasting" business performance. How do you approach your family business budget? Do you ask your managers to "reach" or to create targets you expect to meet? Do you measure your forecasting accuracy? What is your process?We’ve written previously on how to make your forecasts more useful with your P&L and cash flow statements, and below, we share three forecast reminders that may help you make better budgets: Measure yourself regularly, remember the law of averages, and adapt your roadmaps when needed.“If you can’t measure it, you can’t improve it.” – Peter DruckerWorking with clients year after year has given us perspective on forecasting styles. Some family businesses leave ample cushion for their teams to beat, while the aspirational others point to where management is heading.Some consistently hit their targets while others chronically "over-promise-and-under-deliver." British statistician George Box famously said, "All models are wrong; some are useful." To make your budget models useful, you should consistently evaluate your process relative to actual performance. Where are your blind spots? Where are we over/under-allocating expenses? What were the biggest surprises we had last year? Understanding where the forecast process went wrong, and right, will help you make better-informed budgets and forecasts in the future.“You are not special.” – Tyler DurdenWell, perhaps that’s harsh. Likely your family business is indeed unique and has a special story, but not that special.Remember the power of mean reversion and the law of averages when thinking about your family business forecastYour family business operates in a competitive market, and any competitors are always looking to lay siege over the moat you have dug around market share and profits. Abnormally high-profit margins have a way of drifting towards industry averages, and super-charged growth generally tampers to a steady state.A recent study of Wall Street analysts’ forecasts from 1997 to 2021 by Verdad, an asset management firm, found 3-year median forecast overestimation errors for revenue at 4.6%, EBITDA at 19.4%, and pre-tax earnings of 36.8% (!). From the piece:"Across the board […] estimated growth rates systematically overshoot the actual outcomes. Importantly, analysts’ forecast errors seem to be bigger precisely in the areas that should matter most for stock prices: earnings further down the income statement that go to equity investors, and earnings further out in time."Remember the power of mean reversion and the law of averages when thinking about your family business forecast. Working with entrepreneurial families, we see success manifest in optimistic innovators and business owners. Remember to splash just a little bit of cold water on next year’s view to maintain a margin of safety.“When the facts change, I change my mind. What do you do?” – Winston ChurchillThink about the last few years. The genesis of the COVID-19 pandemic, runaway inflation, and a war in Ukraine have all rattled financial markets and upturned how many companies operate. A forecast is a tool; to be a good tool, it must be adaptable to changing facts.A good budget process does not lend to blind adherence to well-laid plans made six months hence. For example, a capital expenditure project you previously forecasted to complete with debt financing may make a lot less sense with borrowing rates up considerably in 2022. Supply chain issues and inflation may lead you to reassess your projected gross profit for the year, as well as your working capital needs.Being able to pivot when needed keeps you dry in stormy weather and allows you to execute when opportunities arise.Cloudy with a Chance of Recession?As the public markets continue to reel and the chance of a recession "landfall" increases, now is the perfect time to review your budget process and prepare for what lies ahead.Learning from past budgeting mistakes (and victories), remembering the law of averages, and maintaining an adaptive forecast process can help develop actionable plans that your directors can rely on. But when an outside perspective can be helpful in your forecast process, give one of our family business advisory professionals a call to confidentially discuss your challenges.

Asset Management Without a Net

This Time, There Is No Fed “Put”

When the economic mood soured in 2008, I called an older friend to get his thoughts on the credit crisis and what it would mean. “Jerry” had spent his career running a large heavy truck distributor, and he had visceral experience in more than a few economic cycles. Jerry told me two things on that phone call that have stuck with me.“My manufacturer’s rep called last week and asked me ‘what would I have to give you to put some of my trucks on your lot.’ I answered: A lobotomy.” Jerry then explained that most people are blinded by their own optimistic leanings to underestimate how bad things can get in a recession, and how long they can last.As September of 2022 came to a close, asset management is experiencing one of the most challenging years in history.As September of 2022 came to a close, asset management is experiencing one of the most challenging years in history. Losses are both deep and widespread. The consequence is a tough quarterly letter to pen to investors, a hit to revenue, and an even bigger impact on profitability.A few notes on where things stand:U.S. equities experienced their third straight quarterly loss, which hasn’t happened since 2008.The S&P 500 has lost a quarter of its value this year. The Nasdaq is down a third.Many indexes hit new lows on September 30.Bonds are having their worst year since 1976, with the U.S. Core Bond index falling 16% through September 30.Asset correlations are high, leaving no path for escape through diversification. The classic 60/40 portfolio is said to be having its worst year since 1980. Even TIPS (Treasury Inflation Protected Securities) are down YTD.30-year U.S. mortgage rates are hovering around 7% for the first time since before the credit crisis.The U.S. dollar has surged against other major currencies, eclipsing parity with the euro and threatening parity with the British pound. The dollar has also blasted through previous resistance levels with the Japanese Yen and the Chinese Yuan.Currency fluctuations are straining economies and asset prices globally. The breadth of the financial market strain is not without precedent, but you have to look far back to find a market as bad or worse for so many investors. Asset correlation was a tremendous issue in the credit crisis, and this bear market is seeing deep drawdowns across most asset classes. This doesn’t bode well for industry margins, as AUM declines coupled with fee pressure hit revenues, and inflationary increases in RIA expenses don’t offer a cushion for profitability.According to Morningstar, U.S. fund flows have been net negative so far in 2022, after a reasonably strong performance in 2021. Risk asset flows like equity and high yield have been hit particularly hard, both domestic and foreign. With a few exceptions active funds continued to lose AUM to passive funds, after better performance in 2021. Fixed income has lately been attracting more AUM than we’ve seen in recent memory, as the risk-off mood of the market manifested in asset rotation. Also for the first time in recent memory, there appears to be a pivot from growth to value.One bright spot for asset managers in 2022 is that many more active managers are beating passives. So far in 2022, Morningstar reports that nearly two-thirds of large cap value PMs are beating the Russell 1000 value index, and just over half of large blend managers are beating the S&P 500. Unfortunately, this “beat” means being less down than the index, and despite the win passive strategies are having more success in attracting funds.Perhaps the best metaphor for the moment is a video of Cathie Wood, CEO of Ark Invest, offering an open letter to the Federal Reserve. Wood accused the Fed of misappropriating data to rationalize policy errors which she believes will over-correct and cause damaging deflation. Wood has personal experience with asset deflation; her Ark Innovation Fund (ARKK) ended the third quarter with a year-to-date loss of more than 60%.Unfortunately for Wood and others who worry the Fed is moving too far, too fast, Fed Chair Jerome Powell has repeatedly stated that the Federal Reserve understands the damage potentially caused by their rapid increase in short term interest rates, but that they think it’s worth it to contain inflation. In other words, no matter how far asset prices fall, this time there will be no Fed “put.”

How Waves Of Reality Are Swelling Upstream Returns

Upstream and oilfield service companies have bucked trends most of this year.While other industries have had stagnant to negative returns, the oil patch has outperformed them all, as I highlighted earlier this summer. Since then, market capitalizations have stagnated. Yet, the reality is that equity returns are soaring on a wave of cash flow right now.Operational cash flow for the sector was at its highest in the five year period since 2017 at $203 billion, according to the EIAs’ Financial Review of the Global Oil and Natural Gas Industry: Second Quarter 2022 report.This led to a 22% return on equity which was notable not only because it was the highest recorded return in the survey period, but also because it usurped U.S. manufacturing companies' returns on equity for the first time in the survey period.It has been a long time coming, but several realities have been coming to the forefront to build this wave: world realities, production realities, and capital realities.World RealitiesThe energy industry’s reality is one tethered to the zeitgeist. Few if any other industries are as sensitive to the volatility of politics, regulation, and events. A year ago, longer-term supply and demand trends were pushing tailwinds for upstream producers, but those winds blew up into a storm when Russia invaded Ukraine. Several of my contributing colleagues here at Forbes.com have done good work covering these developments. That has Russian oil production likely dropping around 20%, with an accompanying impact to prices. In addition, OPEC+ has reduced oil production quotas for October.The energy industry’s reality is that some unintended consequences regarding the scramble for energy transition away from fossil fuels have collided with “contingencies.” Aramco’s CEO Amin Nasser was very blunt about this in Switzerland last Tuesday (before the Nord Stream incident).Perhaps most damaging of all was the idea that contingency planning could be safely ignored“Perhaps most damaging of all was the idea that contingency planning could be safely ignored,” said Nasser, “Because when you shame oil and gas investors, dismantle oil- and coal-fired power plants, fail to diversify energy supplies (especially gas), oppose LNG receiving terminals, and reject nuclear power, your transition plan had better be right.”“Instead, as this crisis has shown, the plan was just a chain of sandcastles that waves of reality have washed away.And billions around the world now face the energy access and cost of living consequences that are likely to be severe and prolonged,” said Nasser.There has been a flurry of speculation as to who is responsible for the explosions emanating from the Nord Stream pipeline, but what is now concerning is Europe’s ability to keep warm this winter. The U.K. reversed its fracking ban to help secure its energy supply. It may be too little too late this winter for the Brits.In the meantime, Europe’s eyes look to the U.S. to stand in the growing energy gap, particularly gas. The U.S. has skyrocketed to become the top exporter of LNG in the world this year. This won’t change any time soon and is expected to continue to expand and grow.At the same time, U.S. domestic demand has been growing too, thus multiplying natural gas prices compared to two years ago.Production RealitiesWhile demand has resurged domestically and abroad, upstream production has not been keeping up the same way it has in the past. The good news is that production is growing and will continue to. However, there are several things limiting growth. As I have written before, producers have been cautious for a myriad of reasons and as such, new major investments in development and drilling have been stalled. According to the EIA Financial Review, Capex of the companies surveyed was $59 billion in the 2Q of 2022, only 8% higher than the 2Q of 2021.Rig counts are growing, but not at the same pace as they did the last time commodity prices were this high.DUC wells are at the lowest level in almost a decade, so drilling inventories continue to shrink.Another reality is that productivity at the individual rig level is waning. This comes in two ways: 1) the form of productivity for new wells drilled, and 2) existing legacy production is declining faster than before.Explanations for this are not entirely clear. Perhaps it is the exhaustion of top-tier PUD well locations, continued permitting problems that Joe Manchin could not fix, or the flight of talent from the oilfield in the last few cycles. Costs increased for the seventh straight quarter in the Fed Survey – near historical index highs. Nonetheless – it is happening and fueling a bevy of comments like this from the Dallas Fed Survey: “Uncertainty on the political front continues to be a major concern. The withdrawal of leases that have already been issued is an example. Inflationary pressure is eating significantly into discretionary cash flow, limiting the amount of money allocated to new projects.” 85% of survey participants expected to see a significant tightening in the oil market by the end of 2024 given the underinvestment in exploration.Capital RealitiesIn the past several years there simply has not been enough capital deployed in the sector to defray some of the shorter-term event volatility such as Ukraine’s war with Russia.79% in the Fed Survey expect to see some investors return to the spaceWith the spike in prices, 79% in the Fed Survey expect to see some investors return to the space, attracted by superior returns. However, it may be some time for that to matter. In this business, measured in years and decades, investments that can move the world needle take time to come to fruition. In the meantime, 69% of respondents in the Fed Survey expect to see the age of inexpensive gas ending by 2025. Existing capital remains focused on paying off debt and dividends, not drilling. Cash flows from Operations of $203 billion and Capex of $59 billion clearly communicates this reality.In the long run, prices ultimately communicate reality in a commodity business, so the expectations of higher prices should be the instigator to change behavior to a more balanced energy policy for much of the developed world.In the short run, oil and gas investors are getting exceptional returns. That should not change any time soon.Originally appeared on Forbes.com.

September 2022 SAAR

The September SAAR was 13.5 million units, up 2.3% from last month and up 9.6% from September 2021, when the industry had less than one million vehicles available for sale. While this month’s SAAR highlights a year-over-year improvement and gives us context around how low inventory managed to fall in 2021, this month’s data release does not indicate a “return to normal” by any means. The Q3 2022 SAAR averaged 13.3 million units, roughly flat with Q2 2022’s average and consistent with the last three months of the industry’s sales pace, indicating no fundamental changes. Looking at the 2022 SAAR as a whole, the previous three months of this year have displayed stability at around 13.0 million units, while the first six months of the year were significantly more volatile.Looking at unadjusted sales numbers, September 2022 also showed a real improvement from this time last year. While this month’s unadjusted sales (1.16 million units) were certainly still limited by supply-side inventory issues and much lower than sales levels observed from 2015-2020, it is clear that September 2021 (1.05 million units) was a low point that makes the last month look good by comparison. See the chart below for unadjusted sales numbers from the previous eight September releases:InventoryOn the supply side of the vehicle sales equation, inventories have remained low but seem to be marginally improving. The industry inventory to sales (“I/S”) ratio was 0.67x in August, the most recently available month of data. August’s I/S ratio compares to 0.51x in July and an average of 0.47x from January 2022 to July 2022. For the remainder of the year, we expect industry-wide inventory levels to slowly improve. However, it is unclear how long auto manufacturers will take to bring the industry I/S ratio up to the long-run average of 2.4x. As this recovery unfolds, it will be important to keep an eye on efforts to bring more domestic semiconductor facilities online, the ongoing status of the war in eastern Europe, and the availability of key inputs from Asian markets like China. These underlying factors are key levers that would allow the domestic production of vehicles to improve in a meaningful way.Transaction Prices, Incentive Spending, and Monthly PaymentsTransaction prices remained at near-record levels in September. According to J.D. Power, the average new vehicle transaction price is projected to reach $45,622 this month, a 10.3% increase from this time last year and the fourth highest average transaction price ever. In terms of monthly payments made by consumers, rising interest rates on elevated sticker prices drive monthly payments up to an average of $667 per consumer. Incentive spending by OEMs has remained low in September. The average incentive spending per unit was $936 this month, down 47.8% from this time last year and the fifth straight month of sub-$1000 spending per unit.Is Pent-Up Demand Still Present in the Auto Industry?The sales pace of any industry is a function of a two-sided equation that includes both demand and supply. The first major factor in this equation is demand, which has been considered very high, even “pent-up,” over the last year and a half in most of the industry’s analytical publications (including some of our blogs). We recently tried to quantify pent-up demand in our June 2022 SAAR blog. In this June publication, we wanted to start a conversation around pent-up demand by challenging the idea that sales would suddenly return to 17 million units once the supply side of the equation normalizes. The idea that sales may not return to a 17 million unit SAAR right away is centered around the idea of cyclicality.When supply is so restricted, it’s not a high bar for demand to be above supplyThe auto industry has always been cyclical, with more vehicles sold during the “good times” and fewer vehicles sold during recessionary periods and times of general economic uncertainty. Cyclicality makes sense, as consumers are less likely to make a large purchase like a home or a vehicle during uncertain times when debt is expensive, and recessionary fears are present. Put simply, we are starting to wonder if the industry as a whole has overestimated the level of pent-up demand. When supply is so restricted, it’s not a high bar for demand to be above supply. And over the past two years, with rising vehicle prices, we’ve learned that consumer demand for personal vehicles was more inelastic than previously thought. Even accepting these two premises, we believe the cyclicality of auto sales may mean that by the time inventory issues are alleviated, consumers may be less confident in purchasing new vehicles.Over the last month, the country has found itself anticipating a down cycle of the entire economy as interest rates and other measures of risk increase at a rapid pace. The housing market has cooled off, wage growth has also decelerated, and the market for new and used vehicles is likely cooling off as well. It doesn’t help that near-record transaction prices and the expensive cost of debt are making vehicle purchases more and more difficult to afford. On the Mercer Capital Auto Dealer team, we tend toward the idea that pent-up demand is dissipating or perhaps overstated. We believe that rising transaction prices are more of a function of supply-side constraints than high levels of consumer competition for available vehicles.October 2022 OutlookMercer Capital’s outlook for the October 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps the October SAAR can eclipse 14 million units and signal a turning of the tide, but we predict that a 14 million unit SAAR for 2022 is unlikely in the current landscape. Stability at around 13.0 million units is a much more realistic expectation.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

From Antler Motel to the House of Representatives

The Wall Street Journal recently published an article on the life of entrepreneur Clarene Law. Clarene was a mother and a hotel bookkeeper in Wyoming’s Jackson Hole valley in the 1960s. Which led to a problem – who would take care of the kids? This question led her down the path of starting a family business. After hearing the Antler Motel was for sale, she borrowed money from her parents and put a down payment on the $125,000 asking price. Problem solved – Clarene switched hats from hotel bookkeeper to motel owner and innkeeper, and her family could live at the motel.Fast forward some years later and what started as a little-known town blossomed into a luxurious year-round hiking and skiing destination for visitors all over the country. While right place, right time played a part, it does not tell the whole story of how Clarene Law became one of the best-known entrepreneurs in Jackson Hole. Clarene expanded her reputation further as she served n the Wyoming House of Representatives for 14 years. Inspired by her story and the family business she built, we highlight three themes that can help build your family business: growth, diversification, and family business leverage.GrowthSteady, natural growth is a long-term commitment. Clarene realized early on there was no get-rich-quick formula – how could there be when rooms cost less than $10 a night? She understood that growth could be individually affected through her own efforts. Her energy was infectious, and her personal interactions with customers made them feel special. This feeling grew into loyalty, creating 30+ year relationships with customers as well as hotel employees. Clarene’s daughter, Teresa, shared why they kept coming back, “because mom’s here…just to be with her.” In 1973 Clarene married Creed Law, and while finding the right business partner doesn’t normally start with “I do,” Mr. Law helped Clarene take a step forward in growth. Mr. Law was a great builder, and together, they expanded the family business to include several more properties with a total of 477 rooms, now known as the Elk Country Inn.Growth in your family business may seem distant and slow-paced, but consistent, day-to-day efforts play a huge part in long-term growth. Clarene presents an example of someone who steadily influenced growth through her personality, decision making, and reliable hard work.DiversificationWe have written on asset diversification in the past, but Clarene’s story teaches us a good lesson on how the degree of diversification matters. Diversification is simply investing in multiple assets as a means of reducing risk. Warren Buffett states, “Diversification may preserve wealth, but concentration builds wealth.” As far as concentration goes, Clarene doubled down on hospitality, buying several inns around the area to add to the growing family business. Later, Clarene began to transition from building wealth to preserving it. She diversified into non-hospitality investments with a couple of farms and a dude ranch. Unfortunately, her other investments reportedly did not work out. Regardless of why the investments failed to deliver, we question whether Clarene’s approach to diversification was radical enough. Investing in multiple assets yields diversification benefits only if the assets behave differently; if the correlation between the assets is high, the diversification benefits will be negligible. We suspect that the correlation between Jackson Hole motels and other real estate investments in the same area was too high to generate significant diversification benefits.Diversification is simply investing in multiple assets as a means of reducing riskThis illustration is an important reminder for family businesses that diversification is important, but how you diversify your assets matters just as much. Understanding the degree of correlation among assets in the family business portfolio is essential to achieving real diversification.Leverage the Benefit of Being a Family BusinessHad it not been for family, Clarene might never have purchased the Antler Motel. Our colleague Atticus Frank reminded readers in a post earlier this year to distinguish a family business from a business family. Clarene involved her family in the business early on and gradually began passing the management of the business to her children as they grew older. Until earlier this year, she still came to work and was the first person customers would see. Clarene told The Jackson Hole News, “Whatever success I have, I owe to my family – my hardworking children, my husband, and a very loyal staff.” Loyalty, hard work, and focus on the best service are common hallmarks of successful family businesses.ConclusionClarene knew when to have the talk with her children so that when the day came, they would be ready to continue the business in her honor. Her concentration on steady, long-term growth allowed the business to develop naturally as a family business. While her diversification efforts may have fallen short of the ideal, her legacy of success is a valuable example to other enterprising families.

Transportation & Logistics Newsletter

Fourth Quarter 2022

Mineral Interest Owners: How to Know What You Own

Because of the popularity of this post, we revisit it this week. Originally published in 2019, this post is as a guide for mineral owners who are seeking to learn more about what they own.As we’ve discussed, there are plenty of factors to consider when determining the value of mineral interests. While some mineral owners may be very well attuned to decline curves and local pricing dynamics, others may only casually monitor the price of oil and gas to get a general sense of the trend in the industry. This post is geared towards those mineral interest owners who have less knowledge on the subject and should serve as a guide for those seeking to learn more about what they own. We frequently receive calls from mineral interest owners who know little about what they own other than the operator’s name on the check and the amount they receive each month. Besides just the amount paid by the operator, royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.How to Read a Royalty CheckThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment. The problem is that companies may issue checks with differing formats (see two examples below) and they can be hard to read. However, with a trained eye, mineral interest owners can learn to read these checks and glean valuable insight into what is driving the value of their interests.The first example is a check one might actually receive in the mail. The second is a sample check provided by an operator to help owners understand what it means. Regardless of the operator, there are a few key items that appear on every check:Ownership PercentageProduct CodeCountyOwnership PercentageA lease arrangement is designed to be a mutually beneficial agreement. Mineral owners own the rights to a valuable commodity, but they lack the ability to harvest it themselves. Operators come in with the equipment and requisite knowledge necessary to extract minerals from the ground. In exchange for the right to drill on the property, operators pay mineral owners a fraction of the revenue generated from the production. This fraction can appear on a check as a string of numbers like 0.0234375. You may be wondering, where does this number come from? This is the product of the net mineral acreage owned multiplied by the royalty percentage negotiated.Most of the United States uses the Public Land Survey System which is divided into townships and further into sections. A township is 36 sections and a section is 640 acres (or one square mile).[1] Sections are further broken down into quadrants, or some other division as the land is passed down over time. For instance, a lease could specify “all of the mineral interest under the E ½ SE ¼ of 11-2N.” This is read “The east half of the southeast quarter of Section 11, township 2 North.” As depicted below, this would be the rectangle in the bottom right quarter, and would represent 80 net mineral acres. That is: 640 acres per section times ¼ times ½. The lease would go on to specify the royalty percentage to be paid, like 3/16. This will frequently be presented in some form similar to the follow: “To pay Lessor for gas (including casinghead gas) and all other substance covered hereby, a royalty of 3/16 of the proceeds realized by Lessee from the sale thereof.” This simply means the operator will pay a royalty of 3/16 of revenue generated from production on the property. Multiplied by the 80 net mineral acres that make up the 640 acre section, we arrive at:80/640 x 3/16 = 0.0234375Owners will note much larger dollar figures on their checks which represent the gross revenue the operator receives from production of the minerals. This gross value is multiplied by the ownership percentage, which determines the amount actually received by the owner on their check. Knowing the net mineral acreage owned (not determined by the operator) can help determine the royalty rate the mineral owner is being paid, which helps to understand the value ultimately being paid for their interests.Product CodeThe information on royalty checks is beneficial because it gives mineral interest owners plenty of granular detail on how the operator calculates their monthly payment.The revenue received by both the operator and ultimately the owner depends on both the quantity produced and the price achieved. As of the writing of this article, crude oil prices are trading around $53 per barrel for West Texas Intermediate (WTI), the most commonly tracked figure for U.S. crude oil. By comparison, natural gas is trading around $3.04 per Mcf at the Henry Hub, the most common benchmark for natural gas in the country. Knowing what is being produced: oil, gas, NGL, or a combination of these is crucial to understanding the value of the interests. Owners can figure this out by looking at the product code on their checks, which can be expressed as either a letter or number. Our first example lists the product code as 204, and the legend at the bottom of the check indicates that gas is being produced. Even less clearly, our second example shows the letter “G” under the “P” column, and which, according to the legend, means gas is being produced. This can be far from intuitive without some sort of key describing each item.When oil prices decline, as they have since the beginning of October, mineral owners who receive royalty checks based on oil production can expect to see smaller figures on their checks. But the price isn’t purely based on the value listed on an exchange. It also depends on location and infrastructure to bring the commodity to market.CountyThe county where the minerals are produced is another common feature of royalty checks. However, it is not clearly stated as “Gaines County” for example. In our first example, we see the check says /TX/ Gaines which tells us the mineral interests are in Gaines County, Texas, which is located in the prolific Permian Basin. Again, this isn’t very clear just from looking at the check, and someone not from the region may not automatically know the names of counties in different states.Knowing the county where the minerals are located can go a long way to understanding their value. For instance, oil production in the Permian Basin has increased significantly in recent years and has been a very attractive place for industry players. However, a lack of pipeline infrastructure has led to oversupply, meaning operators were forced to take a discount to the WTI price. Mineral owners have no control over where and when operators choose to produce, and current production leads to more upfront revenue, but taking a discounted price to get the revenue upfront could ultimately be detrimental to mineral owners in the long term, given the way production tends to decline significantly.Other Sources of InformationWhile royalty checks are tangible pieces of information sent frequently to mineral owners, there’s more information out there that owners can turn to. The lease agreement itself can be the primary source for determining what you own. While many may look the same, lease agreements are ultimately an economic agreement between two parties and can have a variety of different clauses. However, there are frequently instances where our clients do not have access to these key documents. In the case of interests being passed down or donated, clients are usually dealing with legacy arrangements with operators and may not have all the documents that spell out the specific rights with their particular lease.Royalty checks provide valuable information to mineral owners that can help determine the value of their minerals.There are other potential sources of information published online that owners can access free of charge. For instance, in Texas, there’s the Texas General Land Office and Texas Railroad Commission where mineral owners can, among other things, zoom in on plots of land and see well locations. Mineral owners can also learn about historical drilling permits and activity by region. The FDIC also publishes sales of oil and gas interests which can be helpful to see actual sales prices for mineral interests observed in the market.ConclusionRoyalty checks are hardly intuitive, and not everyone would bother asking too many questions when they regularly receive a check in the mail. However, without putting in some research, it can be hard to know if the next check will be higher or lower, or if there will even be one next month. That’s where it becomes crucial to understand what drives the value for mineral interests and what are the relevant risk factors. For those looking to sell their interests, or simply looking to understand the value of what they own, an appraisal can be a helpful tool in understanding both the value of mineral interests, and what drives this value. It is important to seek advice from someone who has experience valuing mineral interests and is well-versed in all potential sources of information.Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both national and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil and Gas team to discuss your royalty interest valuation questions in confidence.[1] Exampled based on a presentation at the National Association of Royalty Owners (NARO) 2018 Conference in Denver, CO

RIA M&A Update - Through August 2022

Year-to-date RIA M&A activity has surpassed last year’s record levels in 2022, even as macro headwinds for the industry continue to mount. Fidelity’s August 2022 Wealth Management M&A Transaction Report listed 155 deals through August of 2022, up from 112 during the same period in 2021. These transactions represented $212 billion in AUM, up 16% from 2021 levels. The continued strength of RIA M&A activity amidst the current environment dominated by inflation, rising interest rates, and a tight labor market is noteworthy, given that all these factors could strain the supply and demand dynamics that have driven deal activity in recent years. Rising costs and interest rates coupled with a declining fee base will put pressure on highly leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. But despite these pressures, the market has proven robust (at least so far). Demand for RIAs has remained strong, with professionalization of the buyer market continuing to be a theme driving M&A activity. Serial acquirers and aggregators increasingly drive deal volume with dedicated deal teams and access to capital. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the first eight months of the year. While the current market environment has prompted some serial acquirers to temper their pace of acquisition activity (CI Financial’s CEO Kurt McAlpine remarked on the company’s first-quarter earnings call that their pace of acquisitions has “absolutely slowed down”), we’ve not yet seen that borne out in reported deal volume. Multiples in the industry remain high, although the upward trend in multiples has reportedly leveled off. On the supply side, the current market environment is likely to have a mixed impact on bringing sellers to market. On one hand, some sellers may be reluctant to sell when the markets (and their firm’s financial performance) are down significantly from their peak. On the other hand, a concern that multiples may decline if the current market environment persists may prompt some sellers to seek an exit while multiples remain relatively robust.The current market environment is likely to have a mixed impact on bringing sellers to marketWhile market conditions play a role in exit timing, the motives for sellers often encompass more than purely financial considerations. Sellers are often looking to solve for succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment and will likely continue to fuel the M&A pipeline even in a downturn. And despite years of record-setting M&A activity, the number of RIAs continues to grow—which suggests the uptick in M&A activity is far from played out.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has trended upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquirer models will likely continue to support higher multiples than the industry has in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions. For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions, as in most transactions. But how the deal is financed is often a crucial secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and, in some instances, may still be the best option). Still, there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling: Whatever the market conditions when you go to sell, it is essential to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a broad spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for varying levels of autonomy post-transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision that can significantly impact personal and career satisfaction after the transaction closes.

Middle Market Transaction Update Fall 2022

Overall deal activity in the second quarter of 2022 fell from levels seen in the first quarter of the year and the second quarter of 2021.

Book Review: The Future of Automotive Retail (Part 2)

Discussions and Predictions of Changes to Auto Dealers in the Next 30 Years

In this week’s blog, we continue our review of the excellent book, The Future of Automotive Retail by Steve Greenfield. It covers the changing trends of consumer behavior and technology that will likely continue to shape the automotive retailing experience for decades to come.In part one of this two-part series, we discussed the first part of the book, the “convenience economy,” including predictions of changes to power sources and vehicle production.This post continues to march through the book and focuses on vehicle ownership, autonomous vehicles, connected cars, service and repairs, and the proposed future of the auto dealership.Vehicle OwnershipAs the book's author notes, trends in vehicle ownership have changed several times in the last few years alone. Historically, traditional car ownership dominated the industry, with each household directly owning one or two vehicles. Leasing has continued to provide an alternative form of access to personal vehicles, even with common pitfalls such as mileage restrictions, down payments, expensive insurance, extensive fees, and difficulty exiting the lease. In some instances, these disadvantages have made leasing more complicated and costly than traditional ownership.The proliferation of upstart rideshares such as Uber and Lyft provided additional alternatives to vehicle ownership. Rideshares were supposed to reduce the number of vehicles on the road, reducing traffic as consumers could be paired up with strangers heading in the same direction. While rideshares have disrupted taxis, not enough people are willing or interested in taking a taxi to work every day. The pandemic also caused the pendulum to shift back to direct ownership as fewer people were traveling and commuting, public events were limited, and fears of germs and contamination led consumers to prefer the safety of their own vehicles.Through both undercurrents, subscription services have always existed. The book notes that many experts believe a shift to subscription services could soon be a permanent replacement for vehicle ownership. In fact, a study by McKinsey predicts that at least 20% of all new and used car retail sales will be in the form of a subscription as soon as 2025.Many experts believe a shift to subscription services could soon be a permanent replacement for vehicle ownershipWhat is a car subscription service? Car subscription services contain similar elements as long-term rentals or short-term leases. Subscription services offer the use of the vehicle for one all-inclusive monthly fee that typically includes repair & maintenance, insurance, taxes, licenses, and registration, leaving owners/drivers responsible for gas. One limitation with subscription services is that most packages have mileage limits, much like traditional car leases.What is the value proposition of a car subscription? A vehicle subscription allows consumers to switch vehicles easily and frequently with varying minimum periods, some as short as one month. Are you in a market where it would be appealing to have an SUV for winter conditions but a sedan for commuting during the other moderate seasons throughout the year? The myth behind this value proposition is that most customers retain their current vehicle for an average of 10 - 18 months, according to the CPO for Faaren, an upstart subscription company.However, consumers value the ability to bundle car insurance, service, and occasionally finance in certain subscription packages. The convenience economy is also a factor here, as consumers can experience different vehicle features while enjoying affordable subscription services for around $300 to $500 for small to mid-sized cars. While the upfront monthly cost is likely higher than direct ownership, it comes with more price assurances. Consumers with a subscription service wouldn’t have surprise maintenance bills when their car stops working, and some consumers will likely value not having to worry about such repairs.Another challenge to car subscription services is the demographic of likely consumers. As we discussed last week, the prevalence of the convenience economy is primarily attributed to millennials. Younger consumers are dissuaded from car subscription services because they are unable to find insurance at affordable rates. In contrast, baby boomers, who can obtain car insurance for reasonable rates, are more comfortable with the traditional vehicle ownership market, which might explain why car subscriptions have struggled to gain momentum.Another final challenge to subscription services is depreciation. Most readers understand that a vehicle loses value immediately after driving off the dealership lot. On average, a vehicle depreciates approximately 20% in the first year of ownership, and by the end of year five, a vehicle is generally worth about 40% of its initial value, according to Edmunds. With car subscriptions being shorter in duration, how do companies price in the lost value due to depreciation in the first three years of a car’s life span? Hertz is attempting to bridge this gap by pricing subscriptions in the $999 - $1,399 range to account for depreciation. Only time will tell if consumers will have an appetite for subscription packages at these higher prices.AutonomyJust as the Jetsons and Back to the Future 2 predicted, autonomous vehicles are on the horizon for the auto industry. Perhaps, autonomous taxis will gain popularity before individuals own autonomous vehicles. The auto industry believed autonomous vehicles would come sooner than what has actually materialized. Why have consumers been slower to adopt autonomous vehicles? One primary value proposition for autonomous vehicles is safety. Based on average statistics in the United States, a collision occurs every 500,000 miles, with a fatality occurring every 60 million miles. While that may seem remote, these statistics translate to approximately 1.5 million fatalities on roadways each year worldwide.A large percentage of consumers are not comfortable riding in autonomous vehicles and prefer to continue driving their own cars. They would like to see increased safety precautions and widely support a congressional mandate requiring the installation of manual brakes in self-driving cars.Let’s examine the levels of autonomous vehicles per the book:Level 0 – No Automation – Human driver fully operates the vehicle; added features such as backup cameras or blind spot indicators; this level represents most of the vehicles currently on the road;Level 1 – Driver Assistance – Characterized as having at least one driver-support system involving either braking, steering, or acceleration;Level 2 – Partial Automation – The vehicle can take over steering, acceleration, or braking, but the driver must remain behind the wheel and ready to take action;Level 3 – Conditional-DrivingAutomation – Drivers don’t have to actively steer or brake in certain situations such as a traffic jam; Vehicles monitor the driver’s state if/when they have to jump back behind the wheel;Level 4 – High-Driving Automation – No human interaction; many of these vehicles don’t have a steering wheel or pedals; This level may not work during severe weather conditions or limited visibility; currently limited in testing to specific low-speed geographies and areas;Level 5 – Full-Driving Automation – These vehicles travel anywhere and do anything; Passengers have full autonomy to enjoy entertainment, take a nap, perform work, etc.; Vehicles do not have steering wheels, pedals, or brakes; Interiors are designed more like “smart cabins”; There are currently only 1,400 autonomous vehicles on the road in the U.S.; While the timing and full adoption of Level 5 vehicles is unknown, most experts predict there will be a hybrid mix of autonomous and human drivers for at least the next thirty years. Once fully automated vehicles are integrated into the mainstream market, experts predict that dealers will sell far fewer vehicles. The sale and ownership of autonomous vehicles will be shared or part of the subscription models previously mentioned. Why subscription and shared models? Current vehicle utilization (the percentage or amount of time your car is actually in use) is somewhere in the neighborhood of only 4%. This means that 96% of the time, your car is either sitting idle at your house or in the parking garage at your office. Turo is an example of a service that allows you to list your vehicle on their platform when you’re not using it, like an “Airbnb of Cars.” Autonomous vehicles would improve upon a car-sharing model because they reduce the friction of handing off the car and the deliverer not having a ride back to where they came from. Autonomous vehicles will provide more opportunities to be fully utilized and shared by multiple individuals through subscription-based ownership. Subscription models could take on the form of monthly fees or a price-per-trip basis, like current forms of rideshare or taxi.Connected CarsWe previously wrote a post analyzing the impact of connected cars on auto dealerships. What are connected cars? In short, connected cars can communicate with other systems outside the car, allowing the car to share internet access with other devices inside and outside the car. Just as smartphones are mini-computers, smart/connected cars are also becoming mobile computers with infotainment options. The added connectivity that comes with connected cars can potentially engage the millennial generation, who has a strong affinity for smartphones. As cars morph into smartphone-like electronics, they could become a competitor for the attention of younger generations.Like smartphones and appliances, the connectivity features of cars can be controlled and updated through a technology referred to as Over the Air Updates (“OTA”s). An OTA is a software improvement or upgrade sent directly to the vehicle from the vehicle manufacturers (or “OEM”) or industry software company through a wireless internet connection. Examples of OTAs include heated beam lights during inclement weather, changes to suspension systems, or alerts to the driver if windows, doors, or trunks have been left open.The current struggle between OEMs and auto dealers is who controls the OTAs and, more importantly, who retains the revenue. McKinsey reports that the size of the OTA revenue pool could reach $750 billion by 2030, which equates to $310 of revenue per vehicle and $180 of cost savings per vehicle. Not only could auto dealers be left out of this revenue pool, but OTA updates that occur directly will forgo/reduce the need for vehicle servicing at the dealership.ABI research estimates that 203 million OTA or connected cars will ship in the U.S. by 2022ABI research estimates that 203 million OTA or connected cars will ship in the U.S. by 2022. That figure represents 91% of new, connected vehicles in the U.S. compared to only 51% in Asia-Pacific countries and 37% in Latin American countries. Perhaps dealers can join in the OTA revenue sharing by offering an “AppleCare” subscription for cars. Current examples are GM’s OnStar or NissanConnect, which provide services such as remote door locking, vehicle health reports, maintenance notifications, and others.Two unintended consequences of smart/connected cars will be data collection, privacy, and protection, much like smartphones. What types of data will be collected, and will the data collection be limited? The additional connectivity allows data collectors to track where the vehicle has been or even predict where the vehicle is going next. Smart or connected cars could risk being hacked, not only for customer information but also to automatically unlock a vehicle from a wireless keychain or disable the operation of a connected car. How will this be prevented, and will liability rest with the OEM or the dealer?Service and RepairsHow will all these technological and behavioral shifts impact the fixed operations of a dealership, more precisely, its parts and service department? Recall that the fixed operations department has historically represented the highest margin segment of an auto dealership’s operations. On the surface, electric vehicles, OTA updates, and autonomous vehicles could decimate a dealer’s service department. For example, electric vehicles have approximately 20 moving parts, compared to 2,000 moving parts in a traditional ICE vehicle. Fewer parts mean fewer opportunities for repairs and servicing, not to mention EVs don’t run on oil and will eliminate the need for oil changes.Fewer parts mean fewer opportunities for repairs and servicingThe book describes the onset of EVs as the “Blockbuster” moment for Jiffy Lube, whose core operations have revolved around oil changes. Jiffy Lube’s shift to potentially adding charging stations and other services should serve as an example to auto dealers to avoid their “Blockbuster” moment. The stark reality is that the shift to EVs would eliminate approximately 41% of Jiffy Lube’s core services and render another 18% to a lower level of importance.How can auto dealerships respond to these challenges, and what other opportunities might present themselves? EVs are not all doom and gloom, as previously described. One underreported characteristic of EVs is that they are much heavier than their ICE counterparts. The additional weight provides two opportunities for auto dealers: EVs will wear out tires 30% faster than ICE vehicles, leading to higher purchases of tires, and collisions involving EVs will cause more significant damage, leading to higher-priced repairs at the body shop. Simple parts, like windshields, are much more complicated in EVs, and consumers will be more apt to trust a reliable service department at a dealership to reinstall a smart windshield than a local repair shop. In the future, dealers could leverage that consumer trust to add options like battery swaps and sensor calibrations.As autonomous vehicles become more prominent, dealers could provide other services like late-night cleaning, car washes, or middle-of-the-night repairs. These added services could help dealers get a higher market share of fixed operation work while reducing the need for loaner vehicles if the car could transport itself to the dealership for these maintenance items. Until then, dealers can also offer remote or driveway repair services, including delivery and pick-up services, to compete with Lithia and others. Dealers could participate in the increased tire sales and potentially offer tire subscriptions to EV owners.Finally, revenue from EV recalls may be more lucrative than initially reported. EV recalls will involve more expensive parts such as batteries, which can comprise nearly 40% of the EVs total cost. According to the U.S. National Highway Traffic Safety Administration, about one out of every four vehicles on the road are open to a recall. Higher EV recalls provide auto dealers with two revenue-boosting opportunities: 1) OEMs generally pay for the recall work, and 2) service technicians can diagnose problems and recommend additional service items when the vehicle is in the shop.Future of the Auto DealershipAuto dealers have navigated numerous challenges throughout their history and the last few years. The next five, ten, twenty, and thirty years appear to be continual challenges brought about by technology and shifting behavioral trends. Historically, auto dealers have focused on day-to-day operations: how many cars have I sold today, this week, this month? A majority of the systems and processes have also been manual, as certain functions don’t directly communicate with each other. Auto dealers must also fight the stigma that they are among the least trusted professionals among consumers, with nurses and medical doctors ranking on the other end of the spectrum.The central perspective to point out from the book is that the future of auto dealers is not all doom and gloom. There are plenty of growth opportunities on the horizon, but the key is to adapt and plan for those shifts in advance to avoid their own “Blockbuster” moments. At a recent auto presentation, I heard a motivational speaker use a quote that I think is fitting for today’s auto dealers: “so what, now what…”. Dealers should adopt this attitude while facing a growing market of EVs, autonomous vehicles, OTA updates, etc., and seek service offerings and solutions that will appeal to consumers in the coming years.We highly recommend The Future of Automotive Retail to anyone in the auto dealer space. You will both enjoy the book and learn from it.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Reach out to a Mercer Capital auto dealer team member to learn more about the value of your dealership.

Private Equity Wants Your Family Business

For many family business leaders we talk with, “private equity” is a four-letter word. However, a September Wall Street Journal article highlights a recent thaw in the historically icy relationship between family businesses and private equity investors. In 2021, we predicted that non-family equity capital would grow increasingly common in family businesses. This WSJ piece confirms that our prediction is on point.Of course, family business suspicions of private equity were never completely ill-founded. There are some elements of the standard private equity playbook that don’t sit well with the ethos of many enterprising families. But the WSJ article shows that it’s more complicated than the longstanding caricatures would suggest. In this post, we identify a couple of potential “pros” for private equity that family business directors should be aware of and also confirm a couple of the well-known “cons” to accepting private equity investment.Pro: Access to Growth CapitalThere’s a large body of research literature documenting how family ownership correlates with superior business performance. While this is obviously great, it highlights a more subtle threat: family ownership can actually inhibit the growth of high-performing family businesses. We’ve written before about how family businesses are either “planting” or “harvesting.” For family businesses in “planting” season, the market opportunity may outstrip the family’s capital resources and/or willingness to use debt financing. In such cases, the family business may be prevented from reaching its potential (to the detriment of its employees, customers, suppliers, and other stakeholders) because of the capital constraints of the family. Bringing in a private equity partner can provide access to the growth capital needed to unlock the true potential of your family business.Pro: Ability to Retain Ownership & InfluenceMany private equity investors are willing to purchase less than 100% of the family business and may even want family members to remain in key management roles. Retaining ownership alongside a private equity investor allows the family to take some economic chips off the table but still benefit from the foundation for future growth laid by the family. When private equity investors grow the family business successfully, the value of the interest retained by the family can eventually exceed the value of the entire business at the time of the private equity investment. The WSJ article we linked above highlights an outlier case in which a founding family benefited from four successive private equity transactions; the family’s proceeds from the most recent transaction (for less than 5% of the company) exceeded that from the initial sale of a controlling interest in 2006.Con: MBAs Really Don’t Know It AllMoney buys influence. Private equity investors providing capital to your family business will, of course, want to make important decisions regarding your family business. The professionals tapped by private equity firms to manage portfolio companies often have great business acumen. However, being an expert about business, in general, does not necessarily translate into being an expert about your business. Greater capital resources – coupled with the hubris that often accompanies large pools of capital – create the opportunity for bigger mistakes.The WSJ article includes the cautionary tale of Sun & Skin Care Research, Inc., whose new PE-installed CEO promptly made a few key decisions that led swiftly to the demise of the once-stable family business. We suspect that one of the reasons all those academic studies find outperformance on the part of family businesses is that the company and industry-specific knowledge that accumulates and is retained in the business over the course of decades and generations is hard to match, no matter how fancy a newcomer’s degree (or pedigree) may be.Con: It’s All About the (Portfolio) ReturnWhile private equity firms have become more enlightened in recent years compared to the slash-and-burn attitudes of the early corporate raiders of the 80s and 90s, generating outsized returns is still the goal of PE investors. Doubtless, successful enterprising families are also profit-conscious. But private equity returns are not just about being profitable. Many private equity investors like to tout operational savvy as the key ingredient to their returns, but the real secret sauce continues to be the use of OPM: Other People’s Money.PE firms use financial leverage to generate a multiplicative return on their equity. So long as the operating reality matches the excel model, it all works out. Throw in an unexpected recession or another hiccup, and that debt load can quickly raise existential questions for the business. A family manages a business like its fortune depends on its continued existence (because it generally does); a private equity firm manages a business like it is one part of a diversified portfolio of winners and losers (which it is).Conclusion: What to Do When Private Equity Knocks On Your DoorPrivate equity is inherently neither good nor bad. When a private equity buyer expresses interest in your business, you and your fellow directors have an obligation to take them seriously and determine whether it is an opportunity that merits your attention.Perhaps the most important thing to keep in mind is the natural imbalance in the family-private equity relationship: they buy and sell businesses all the time, and you probably don’t. That is why it's essential that you have a trusted team of professional advisors to help you engage with potential investors. If you have received – or expect to receive – an investment proposal from a private equity firm, give one of our professionals a call for an independent, outside perspective.

October 2022

In this issue: How Are Tech-Forward Banks Performing?

The Importance of Normalizing Financial Statements for a Business Valuation

When it comes to making sense of the “normal” in this new day and age, we cannot offer any advice there. But we can speak on the process and importance of normalizing financial statements for a business valuation.

Medtech and Device Industry Newsletter - Q4 2022

E&P Fourth Quarter 2022

Appalachian Basin

Appalachian Basin // Production in the Marcellus & Utica held steady in 2022 despite historically high commodity price volatility driven by the Russian-Ukraine war, the sabotage of the Nord Stream pipelines, and rising LNG exports to Europe to stave-off potential winter heating shortages.

2022 Core Deposit Intangibles Update

On September 21, 2022, the Federal Reserve increased the target federal funds rate by 75 basis points, capping off a collective increase of 300 basis points since March 2022. With the expectation of additional rate increases this year, it’s a good time to evaluate recent trends in core deposit values and discuss expectations for deposit valuations in the coming months.Mercer Capital previously published articles on core deposit trends in August 2020 during the early stages of the pandemic and again in August 2021. In those articles, we described a decreasing trend in core deposit intangible asset values. In response to the pandemic, the Fed cut rates effectively to zero, and the yield on the benchmark 10-year Treasury reached a record low. While many factors are pertinent to analyzing a deposit base, a significant driver of value is market interest rates. As shown below, we find ourselves in a very different interest rate environment today.Figure 1 :: U.S. Treasury Yield CurveTrends In CDI ValuesUsing data compiled by S&P Capital IQ Pro, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through mid-September 2022. CDI values represent the value of the depository customer relationships recorded by acquirers as an intangible asset. CDI values are driven by many factors, including the “stickiness” of a customer base, the types of deposit accounts assumed, the level of noninterest income generated, and the cost of the acquired deposit base compared to alternative sources of funding. For our analysis of industry trends in CDI values, we relied on S&P Capital IQ Pro’s definition of core deposits.1In analyzing core deposit intangible assets for individual acquisitions, however, a more detailed analysis of the deposit base would consider the relative stability of various account types. In general, CDI assets derive most of their value from lower-cost demand deposit accounts, while often significantly less (if not zero) value is ascribed to more rate-sensitive time deposits and public funds. Non-retail funding sources such as listing service or brokered deposits are excluded from core deposits when determining the value of a CDI.Figure 2 summarizes the trend in CDI values since the start of the 2008 recession, compared with rates on 5-year FHLB advances. Over the post-recession period, CDI values have largely followed the general trend in interest rates—as alternative funding recorded by acquirers became more costly in 2017 and 2018, CDI values generally ticked up as well, relative to post-recession average levels. Throughout 2019, CDI values exhibited a declining trend in light of yield curve inversion and Fed cuts to the target federal funds rate during the back half of 2019. This trend accelerated in March 2020 when rates were effectively cut to zero.Figure 2 :: CDI as % of Acquired Core DepositsClick here to expand the image aboveCDI values have showed some recovery in the past few quarters (with an average CDI value of 93 basis points year-to-date in 2022 as compared to 64 basis points for all of 2021). Despite the recent uptick, CDI values remain below the post-recession average of 1.29% in the period presented in the chart and meaningfully lower than long-term historical levels which averaged closer to 2.5% to 3.0% in the early 2000s. They are also markedly lower than one might expect, given the current cost of wholesale funding.As shown above, reported CDI values have not increased in tandem with the recent increase in FHLB rates. The average CDI value increased just 25 basis points from September 2021 to September 2022, while the five-year FHLB advance increased a dramatic 228 basis points over the same period. In late-2018 the 5-year FHLB rate approximated the current, mid-September 2022 level, but the average CDI value at that time was 2.42% (compared to the third quarter 2022 average value of 0.75%). The CDI values in recent quarters are somewhat counterintuitive. There are likely three drivers for the relationship between recently reported CDI values and market interest rates:Reporting time lag. The increase in the 5-year FHLB rate has occurred rapidly over the past few months. The deals that closed in the second and third quarters of 2022 were announced in an extremely low interest rate environment. Following third quarter 2022 filings, we expect some upward migration in CDI values to occur as recently announced deals are completed, which reflect the Federal Reserve’s recent rate actions.Deposit levels. Since the beginning of the pandemic, banks have been inundated with deposits. It was initially expected that the increase in deposits would be transient in nature as the economy re-opened, PPP funds were spent or invested, and consumer confidence improved. However, deposit growth continued through 2021 for nearly all banks and into 2022 for some banks. The growth rate in deposit balances is slowing, and September 2022 balances ($17.95 trillion) were lower than August 2022 balances ($18.0 trillion). Given the low average loan-to-deposit ratios, banks have not been in a hurry to increase deposit rates. With the excess of deposits, there may have been a tendency for bank acquirers to discount core deposit value given the lack of immediate funding needs or concern that, with higher market rates, the long anticipated reversal of the pandemic-related deposit influx may finally occur.Uncertain Rate Outlook. While rates are expected to continue rising in the near-term, some market participants may remain concerned that a zero rate environment will remain the long-term norm. If this view is correct, which implicitly assumes that the Federal Reserve can choke inflation, CDI values will remain constrained. Nineteen deals were announced in August and September 2022, and five of those deals provided either investor presentations or earnings calls containing CDI estimates. These CDI estimates ranged from 1.5% to 2.0%, which is more in line with the numbers we have observed in our valuation analyses. We expect CDI values to continue rising in concert with market interest rates. However, market interest rates are not the only driver of CDI value, and there are some potentially mitigating factors to CDI values in the near term.Deposit levels. Over the past year, consumers were likely hesitant to go to the trouble of seeking higher interest rates as the marginal benefit of a rate enhancement would have been low in comparison to the necessary expenditure of effort. This inertia is not expected to last indefinitely. There is already evidence that excess deposit balances are beginning to exit the system. Higher attrition rates, all else equal, translate into a lower CDI value.Deposit mix. Over the past decade, nationwide average deposit mix has shifted in favor of noninterest bearing deposits. In 2007, retail time deposits constituted an average of 31% of financial institution deposits with noninterest bearing deposits comprising 16%. In 2022, this mix is nearly reversed (28% of balances in noninterest-bearing accounts and 15% in retail time deposits). As banks face increasing interest rate pressure, the deposit mix is likely to begin shifting in favor of interest-bearing deposits that have lower CDI values. Figure 3 :: Deposit Mix OvertimeService charge income. The industry is facing pressure from regulators and the public to reduce overdraft charges and other fees. Lower service charge income produces lower CDI values, all else equal.Deposit interest rate betas. Historical average deposit betas may be insufficient to forecast future deposit interest rates over the life of an acquired deposit base. For example, deposit betas for money market accounts have historically averaged approximately 50%. At September 23, 2022 the national average money market rate was 0.15%. A 50% beta may not be aggressive enough to yield a reasonable ongoing interest rate for an acquired deposit base with a starting interest rate of 0.15%. Using an inappropriately low beta would artificially enhance core deposit value by understating future interest rates on the acquired deposit base.Trends In Deposit Premiums Relative To CDI Asset ValuesCore deposit intangible assets are related to, but not identical to, deposit premiums paid in acquisitions. While CDI assets are an intangible asset recorded in acquisitions to capture the value of the customer relationships the deposits represent, deposit premiums paid are a function of the purchase price of an acquisition.Deposit premiums in whole bank acquisitions are computed based on the excess of the purchase price over the target’s tangible book value, as a percentage of the core deposit base. While deposit premiums often capture the value to the acquirer of assuming the established funding source of the core deposit base (that is, the value of the deposit franchise), the purchase price also reflects factors unrelated to the deposit base, such as the quality of the acquired loan portfolio, unique synergy opportunities anticipated by the acquirer, etc. As shown in Figure 4, deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values. Deposit premiums in the range of 6% to 10% remain well below the pre-Great Recession levels when premiums for whole bank acquisitions averaged closer to 20%.Additional factors may influence the purchase price to an extent that the calculated deposit premium doesn’t necessarily bear a strong relationship to the value of the core deposit base to the acquirer. This influence is often less relevant in branch transactions where the deposit base is the primary driver of the transaction and the relationship between the purchase price and the deposit base is more direct. Figure 5 (on the next page) presents deposit premiums paid in whole bank acquisitions as compared to premiums paid in branch transactions.Deposit premiums paid in branch transactions have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Branch transaction deposit premiums averaged in the 3.0% to 7.5% range during 2020, up from the 2.0% to 4.0% range observed in the financial crisis. During 2021 and the first quarter of 2022, branch transaction deposit premiums averaged 2.5% to 5.25%. Unfortunately, none of the branch transactions completed in the second or third quarters of 2022 reported franchise premium data.Figure 4 :: CDI Recorded vs. Deposit Premiums PaidFigure 5 :: Average Deposit Premiums PaidClick here to expand the image aboveSome disconnect appears to exist between the prices paid in branch transactions and the CDI values recorded in bank M&A transactions. Beyond the relatively small sample size of branch transactions, one explanation might be the excess capital that continues to accumulate in the banking industry, resulting in strong bidding activity for the M&A opportunities that arise–even in situations where the potential buyers have ample deposits.Accounting For CDI AssetsBased on the data for acquisitions for which core deposit intangible detail was reported, a majority of banks selected a ten-year amortization term for the CDI values booked. Less than 10% of transactions for which data was available selected amortization terms longer than ten years. Amortization methods were somewhat more varied, but an accelerated amortization method was selected in approximately half of these transactions.Figure 6 :: Selected Amortization Term (Years)Transactions Completed 2008 - September 25, 2022Figure 7 :: Selected Amortization Method For more information about Mercer Capital’s core deposit valuation services, please contact a member of our Depository Institution Services Team. 1 S&P Capital IQ Pro defines core deposits as, “Deposits in U.S. offices excluding time deposits over $250,000 and brokered deposits of $250,000 or less.”

Five Takeaways from the Association of Trust Organizations (ATO) 2022 Annual Meeting

Last week, ATO held its annual meeting at the JW Marriott in Las Vegas to discuss industry trends, practice management, and recruitment during the Great Resignation. As a sponsor and panelist, here are our main takeaways from the meeting:1. Your Capital Requirements Might Be Going DownTom Blank of Shumaker, Loop & Kendrick, noted in his regulatory update presentation that Peak Trust Company received conditional approval earlier this year from The Office of the Comptroller of the Currency (OCC) for its national charter, which required a lower-than-anticipated capital base of $7 million. This reduction could mean lower capital requirements for other OCC regulated TrustCos and possibly state-regulated firms moving forward. If industry capital requirements are ultimately reduced, more cash reserves would be available for distributions and acquisitions, but it would also lower the barrier to entry for prospective competitors.2. Service is the New SalesDavid Lincoln of Wise Insights presented on trust company performance trends and reported that a substantial portion of the industry’s new business in 2021 came from net additions from existing clients rather than acquisitions. He recommended maintaining elevated levels of client engagement with existing customers and noted that many firms were developing a more structured approach to client service and outreach strategies. Gaining new business from existing clients is generally much less expensive than revenue gained by acquisition, so retention efforts are typically more accretive to earnings.3. The Best Time to Start Thinking About Succession Planning is YesterdayPaul Lesser of Cannon Financial Institute and I participated in a discussion panel on recruitment, retention, and disruption in the TrustCo space during the Great Resignation. We both acknowledged an increased utilization of equity compensation and more deliberate succession planning to recruit and retain key staff members. It’s never too early for TrustCo owners to start planning for their eventual retirement and identifying future successors for their ownership and managerial responsibilities. Best practices typically involve a mechanism for transitioning equity and client relationships over time, which is more of an ongoing process than an eventual outcome.4. Special Assets Require Special Resources and Special FeesMelody Martinez of Farmers National, Chris Procise of CIBC National Trust Company, Brooks Campany of Argent Financial, and Mike Tropeano of Broadridge Financial Solutions discussed best practices in administering and feeing special assets held in trusts. These closely held assets require increased due diligence with less available information and a specialized skill set to manage, which poses unique challenges to trust administrators with fiduciary responsibilities. These presenters recommended a careful cost-benefit analysis to ensure the fees are commensurate with the risks associated with administering real estate and private equity assets.5. 2022 is Poised to be a Rough Year for TrustCo EarningsAlmost every attendee I spoke to about their business lamented that year-to-date earnings have declined from peak 2021 levels. AUA and revenue are down with the capital markets and costs are rising with elevated inflation levels, so industry margins are feeling the pressure. Many TrustCo principals have responded by reining in new hires and encouraging the next generation of management to buy equity that has suddenly become affordable.The conference was well attended, and there were other great topics and presentations were not referenced in this blog (see meeting slides). We would certainly recommend it for trust company officers seeking intel on the state of the industry and hope to see you at next year’s meeting in New Orleans.

Bakken Regains Its Footing

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Bakken.Production and Activity LevelsEstimated Bakken production (on a barrels of oil equivalent, or “boe” basis) increased by 5% year-over-year in September. Bakken production, relative to the September 2021 level, plunged nearly 20% in April due to the impact of back-to-back blizzards but had recovered to the September 2021 level by June 2022. Production in the Eagle Ford and Permian were 13% and 8% higher, respectively than in September 2021, without the short-lived plunge seen in the Bakken. The gas-focused Appalachia region production relative to September 2021 levels was more stable than the oil-focused regions, with relative production only varying within a band of -1% to 4%, ending at a year-over-year 3% increase in September 2022. As of September 16, 2022, 40 rigs were operating in the Bakken, marking a 74% increase from September 10, 2021. Eagle Ford, Permian, and Appalachia rig counts were significantly higher than year-earlier levels at 112%, 35%, and 24% increases, respectively. The Permian continued to command the largest number of rigs at 343, with the Eagle Ford and Appalachia closer in-line with the Bakken at 72 and 47 rigs, respectively. Oil Climbs While Gas Shows Heightened VolatilityOil prices, as benchmarked by West Texas Intermediate (WTI) and the Brent Crude (Brent), rose from $72/bbl and $75/bbl, respectively, in September 2021 to $85/bbl and $90/bbl, respectively, as of September 16, 2022. While the rise in pricing was fairly steady through mid-February 2022, the Russian invasion of Ukraine spurred a series of ups and downs, with prices spiking to a high of $120/bbl (WTI) and $128/bbl (Brent) in early March, immediately followed by a plunge to $94/bbl and $96/bbl in mid-March. Subsequent spikes and dips were somewhat more muted, but prices remained volatile through early June. A general price decline during the third quarter resulted in prices at the $85/bbl and $90/bbl level.Henry Hub natural gas front-month futures prices dipped from a late 2021 high of $5.48/mmbtu to a low of $3.44/mmbtu near 2021 year-end as commodity markets incorporated indications of rising production levels and ebbing weather-driven demand. Pricing subsequently rose to as high as $9.29/mmbtu in June on weather-driven demand and lacking supplies due to a reduction in Russian exports. In mid-June Henry Hub pricing began a sharp decline on the announcement that prices recovered over the remaining two months of the September LTM period, albeit with some volatility, to end at $7.81/mmbtu.Financial PerformanceThe Bakken public comp group's latest twelve-month financial performance (stock price) analysis was reduced to two subject companies and the XOP SPDR, as a result of the Whiting and Oasis merger in March 2022. The combined Whiting/Oasis company, Chord Energy, appears in our analysis as CHRD.The Bakken comp group showed strong price performance from year-end 2021 through early June, with increases ranging from 63% to 83%, largely reflective of oil prices. The subsequent decline in commodity prices, which ran nearly un-checked for two months, slashed the analysis period performance to increases of only 3% and 46%, with Chord posting a decline that nearly wiped out its post September 2021 gains. Prices have recovered since July with one-year gains of 42% (Chord) to 61% (Continental).ConclusionThe Bakken showed a general increase in activity over the last year, albeit with a large winter storm disruption and subsequent production recovery along the way. Rig counts have risen on strong commodity pricing, despite the oil price decline in Q3 2022. Share prices generally increased early in the latest twelve-month period, with a sharp decline in Q3 tied to oil prices slipping. Share prices recovered enough in late Q3 to show reasonably strong year-over-year growth as of September.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Book Review: The Future of Automotive Retail (Part 1)

Discussions and Predictions of Changes to Auto Dealers in the Next 30 Years

As fall approaches and school is back in swing, the Auto Team has completed our summer reading. Over the next two posts, we review the book The Future of Automotive Retail by Steve Greenfield. This book discusses changes in trends of consumer behavior and technology that will likely continue to shape the auto dealer retailing experience for decades to come. Additionally, the book makes numerous predictions about when and how those changes can pose both opportunities and challenges for auto dealerships. In our review, we discuss the content, trends, and predictions found in the book (and add a few of our own upon occasion).The auto industry has adapted to numerous changes just in the last few years alone: the introduction/proliferation of electric vehicles, online or partially online transactions of new and used vehicles, shortages in new vehicle production caused by the pandemic and microchip crisis, and threats of direct sales from the manufacturer to the consumer directly, to name a few. Moving forward, the auto industry seems to be on the precipice of change as it relates to these shifts and also evolving technology that will impact the ownership of automobiles in the future.Regarding predictions of changes to technology impacting the auto industry, we can look to the big and small screen, specifically, the Jetsons and Back to the Future 2. This iconic cartoon and movie gave us a glimpse of life in the 21st century. The Jetson’s debuted in the 1960s, and while no specific year was ever referenced, trailers for the original series mention that the setting is 100 years in the future, or approximately 2060. In fact, George Jetson’s birthday was just a couple of months ago, according to some fans. Avid viewers of the show will recall that the cartoon correctly predicted many technological advances that have already occurred today or are just on the horizon – video calls, robotic vacuums, tablet computers, robots, flying cars, smart watches, drones, 3D printed food, and flat screen TVs. In Back to the Future 2, Marty McFly travels into the future to the year 2015 where we see technological advances such as drones, tablet computers with mobile payment options, waste fueled cars, flying cars, and robotic/autonomous taxis to name a few.In part one of this blog series, we review the discussions and predictions caused by the “convenience economy,” including changes to power sources and vehicle production. In next week’s post, we will discuss vehicle ownership, autonomous vehicles, connected cars, service and repairs, and the overall future of the auto dealership.Just as auto dealers have proven their resiliency and adaptability to challenges over the last two years caused by the pandemic, they must continue to be aware of oncoming changes to technology and the retail model to stay competitive and not get left behind.Convenience EconomyWhat is the convenience economy? Per the book, the convenience economy is all about consumer empowerment and control. Today’s consumers expect to be able to purchase and receive whatever they want, whenever they want, and however they want. Some credit (or blame) the shift to a convenience economy to millennials. However, the lion’s share of the shift can be traced back to market disruption. Market disruption, in this sense, refers to new service offerings or companies that cause a profound change in the existing business landscape in a particular industry that forces existing businesses to undergo significant transformation to stay competitive. Common examples of market disruption include:Netflix’s impact on video consumption and the shift to streaming services that forced Blockbuster out of business.Uber/Lyft’s impact on getting a ride displacing taxis if not car ownership altogether as initially proffered.Amazon’s impact on ordering and delivering consumer products online. Amazon is most cited for the shift to a convenience economy and referred to as the “Amazon effect.” The auto industry is also not immune to market disruption. Examples include Tesla’s impact on the introduction and popularity of electric cars as well as a shift to direct sales to customers, Carvana and Vroom’s impact on the way vehicles are purchased and delivered, and Lithia’s Driveway impact to mobile servicing and repair.In the convenience economy, today’s consumer places value on convenience over priceIn the convenience economy, today’s consumer places value on convenience over price. Historically, the convenience economy affected lower priced consumer goods. In recent years, the convenience economy is also shifting to higher priced goods, such as the purchase of an automobile. According to the book, research predicts that 80% of all car deals in urban markets will include some components of digital retail elements in the next five years, eschewing the old-school haggling process at a dealership.Auto dealers have responded by adding digital elements to the transaction process to meet the demands of today’s consumer. According to Cox Automotive, this short list of digital changes also allows for dealers to operate more efficiently:Reducing the time that customers spend at the dealershipReducing the number of steps to complete a transactionReduction of time dealership staff spend on completing a transactionFewer staff required to complete a transaction The shift to the digital retail experience doesn’t totally eliminate the physical dealership experience. A study by Deloitte indicates the following reasons why some consumers would not want to completely shift to an online purchase:Ability to see the vehicle before purchaseAbility to test drive the vehiclePreference to negotiate in personDon’t feel comfortable purchasing online In contrast, the same study lists the following as advantages listed by consumers for online components to an auto transaction:ConvenienceSpeedEase of UseNecessityAbility to avoid going to a dealershipHow Should Auto Dealers React to the Convenience Economy?Auto dealers should recognize that they are in another period of market disruption. In an effort to meet consumer demands, auto dealers should continue to offer and improve digital elements to the transaction process. This shift could also present downsizing opportunities for the auto dealership facilities and footprint, as the need for over-the-top showrooms may be less desired by the consumer. Of course, the latter will continue to be a debate and negotiation between an auto dealer and their manufacturer.Power SourcesOf all the headlines in the auto industry in recent years, electric vehicles (EVs) continue to dominate. As discussed earlier, Tesla was an early market disrupter in this area, along with other recent start-ups like Rivian and NIO that have also joined the trend. Additionally, the legacy manufacturers of internal combustion engine (“ICE”) automobiles have also been producing electric vehicles with more models on the way. Auto manufacturers are also seeking to restore the balance of power regarding the profit margins on new vehicle sales, which have shifted to the dealers in the last year and a half or so. Several manufacturers such as Ford, Buick, and Volkswagen have expressed a desire to alter the traditional state franchise law system of the dealer network and explore direct sales models to consumers. We will discuss this trend in more detail in next week’s blog.E&Y estimates that 30% of the group born between the years 1981 and 1997 express a desire to drive electric vehiclesMcKinsey & Company estimates that EVs will comprise more than half of all U.S. passenger car transactions by 2030 if the early adoption momentum continues. Recently, California passed a mandate requiring all new car sales by 2035 to be free of greenhouse gas, aka a mandate pushing EVs.Like the convenience economy, millennials are also being credited with driving the EV movement. E&Y estimates that 30% of the group born between the years 1981 and 1997 express a desire to drive electric vehicles. A study by OC&C Strategy cited the four main concerns that consumers are apprehensive about choosing an EV:RangePriceCharging AvailabilitySpeed of Charging Earlier, we discussed a theme in the book stating that millennials valued convenience over price in the emerging convenience economy. Apparently, there is a limit to the perceived value of convenience with regard to purchasing an EV. The same study by OC&C Strategy discovered that only 16% of consumers polled would be willing to pay $2,500 more for an EV over an ICE vehicle, while 70% would not pay more than a $500 premium for an EV. It’s important to remember that convenience works both ways. While consumers may prefer quicker buying transactions, which many have associated with EVs, they may give back that time and then some awaiting their vehicle to charge as compared to refilling a gas tank.What Alternatives are Being Developed to Relieve Consumer Anxiety Related to Charging Availability?In addition to other federal and state mandates calling for the build-out and development of charging station infrastructure, NIO is also developing a battery swap technology in other countries that might eventually lead to adoption in the U.S. NIO has sold approximately 120,000 EVs to date and has erected 300 battery swapping stations across China. These stations completed 500,000 battery swaps in 2020, and NIO is currently expanding the operation to Norway. Why Norway? Norway has enacted some of the most aggressive legislation against ICE vehicles, charging a 20% carbon tax on those vehicles. The results speak for themselves: 65% of all new cars sold in Norway in 2021 were EVs, up from 54% in 2020 and 42% in 2019.We will discuss the disruptive nature of EVs on an auto dealer’s parts and service operation in next week’s blog.While EVs have fewer moving parts than their ICE counterparts, there are a couple of underreported qualities of EVs that could present opportunities for a dealer’s fixed operations.Another unintended consequence of the EV movement is the further reliance on China for various components in the EV supply chain. We have covered some of this topic in a prior blog. According to Benchmark Mineral Intelligence, China comprises the following in the EV supply chain:80% of the world’s total output of raw materials for advanced batteries90% of rare metals, alloys, and magnets8 out of 14 of the largest cobalt mines are located in the Congo, all of which are Chinese controlled>60% of the world’s graphite, an essential raw material in electric batteries Another important consideration is infrastructure. If the adoption of EVs continues, can the existing power grid support the added demand for charging these vehicles? While most believe utility companies have plenty of bandwidth to handle the extra load, some prognosticators point to the winter storm that besieged Texas in 2021 as evidence to the contrary. If nothing else, that storm and the resulting fallout should serve as a cautionary reminder that upgrades to existing grid infrastructure will be necessary and will not come cheaply. We further note that consumers in California have been urged to not charge their vehicles amid a heat wave. Other items to consider with EVs are as follows:Charging Time – currently, most battery ranges top out at approximately 300 miles; the fastest charging technology takes 40 minutes to charge to an approximate 80% level.Pollution – Part of the value proposition of EVs is to reduce the greenhouse gas effect of ICE vehicles. One unanswered question is how/where will the disposal of batteries take place at scale, and will there be environmental harm caused by that disposal? Some experts just see it as a shift of pollution in urban areas where ICE vehicles are currently operated to battery production/disposal sites in more rural areas.Used EVs transparency – As the EV movement continues to evolve and more used EVs hit the market, how will the consumer be able to discern how much battery life is remaining on the current battery before it will need to be replaced, which is a material ongoing cost with EVs?Margin Compression – If dealers will be allowed to sell and participate in the margins on new EV transactions, how will compressed margins impact the dealers' bottom line (especially in lieu of heightened margins in the last couple of years)? Many of the legacy auto manufacturers are currently selling EVs at a loss which does not provide much incentive to auto dealers.Vehicle ProductionThe vehicle production model has changed dramatically in the last three years because of the impact of the pandemic, followed by the microchip shortage and resulting supply chain issues. As a result, auto manufacturers and auto dealers have grown accustomed to operating with less inventory. Both have thrived in the short term, but how will vehicle production be impacted in the future as ICE and EVs continue to coexist for at least another few decades?The convenience economy shows up again with vehicle production. Consumers want total choice over the trim package, color, features, engine size, infotainment, and other components of their vehicles. This priority has been a struggle for consumers with lower levels of production and inventory over the last few years. As the book highlights, American consumers are not willing to wait weeks/months for customized vehicles in the convenience economy, sacrificing choice for convenience and showing that preferences can be dynamic.How will manufacturers handle vehicle production going forward in a system that most believe will maintain lower inventory levels? Historically, auto manufacturers have relied on crude data to form production decisions. If the manufacturers could anticipate the wishes of their consumers, they could save money by not overproducing the wrong model of cars or by shipping a preset number of vehicles/models to the wrong market. According to Cox Automotive, auto manufacturers and auto dealers need to focus on 12% of vehicle combinations that ultimately comprise 75% of the sales. Further, JD Power estimates that approximately 88% of manufacturers’ combinations sell fewer than fifty units each and account for only 25% of net sales. The consumer and the statistics say it all….give the people what they want.According to Intel, microchips will comprise nearly 20% of the components in premium vehicles by 2030Another technology advancement that could impact vehicle production is 3D printing. Just as the Jetsons predicted 3D printed food, 3D technology is now capable of printing an entire vehicle. Local Motors has focused on a project to 3D print an autonomous electric shuttle called Olli. With current technology, the Olli takes nearly 10 hours to 3D print and is not cost efficient. Perhaps the shorter-term adaptation for 3D printing in the auto industry will be on replacement parts, particularly for later date models where it becomes less economically viable for dealers to hold a significant inventory of these parts.Finally, how will the ongoing impact of the microchip shortage affect the auto industry? We all learned just how important and how many microchips are involved in new vehicle parts and production in the last two years. According to Intel, microchips will comprise nearly 20% of the components in premium vehicles by 2030, representing a 5X increase in their proportion in 2019. EVs will only add to the demand for microchips in the years to come. In a previous blog, we highlighted the timeline and costs involved with building new microchip plants in the U.S. to attempt to relieve some of the ongoing demand.ConclusionAuto dealers have proven that they are an adaptive, resilient bunch; able to navigate the challenges in the economy and consumer behavior in the last few years. Today we seem to be at a crossroads of emerging technology and continual changes to consumer behavior that will impact the future of auto retail. Just as past market disruptions have proven, auto dealers that are resistant to change might be left behind.I attended an auto meeting this week, and one participant made the remark that the auto industry has seen more change in the last five years than the previous 25 and more change in the last two years than the previous five. In part two of the blog next week, we will continue to explore these changes and the potential challenges and opportunities facing auto deals in the coming years.In the meantime, we highly recommend The Future of Automotive Retail for anyone in the auto dealer industry. Readers will be both educated and entertained.Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze key drivers of value. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Bakken M&A

Increased Transaction Volume Continues into 2022

Deal flow in the Bakken has been steady over the last twelve months, with 14 transactions announced since October 2021, up from nine deals during the same period in 2020-2021. Devon Energy’s $5.6 billion acquisition of assets from WPX Energy was the only deal in the twelve months prior to September 2021 that exceeded $1.0 billion in value. In comparison, five deals exceeded $1.0 billion during the twelve-month time period ended September 2022, led by the Oasis Petroleum – Whiting Petroleum merger, at $6.0 billion.Recent Transactions In the BakkenA table detailing transaction activity in the Bakken over the last twelve months is shown below. Despite an increase in the number of deals, relative to 2020 – 2021, the median deal size decreased by roughly $215 million, with five deals valued at less than $200 million. The median value per acre and value per Boepd, however, increased over 300% and 100%, respectively.Oasis and Whiting Combine In a $6.0 Billion MergerOn March 7, 2022, Oasis Petroleum and Whiting Petroleum announced a $6.0 billion merger, renaming the combined entity Chord Energy. The deal closed on July 5, 2022. Under the terms of the agreement, Whiting shareholders received 0.5774 shares of Oasis common stock and $6.25 in cash for each share of Whiting common stock owned. Oasis shareholders received a special dividend of $15.00 per share. At closing, Whiting and Oasis shareholders owned approximately 53% and 47%, respectively, of the combined entity on a fully diluted basis. Transaction highlights include:Production (2022 Q1) – 92,000 BoepdAcreage – 480,000 net acres in Montana and North DakotaThe deal creates the Bakken’s second-largest producer and the largest pure-play E&P A pro forma table of the transaction is shown below:Devon Energy - RimRock Oil and Gas DealThe next largest deal exclusive to the Bakken is Devon Energy’s $865 million acquisition of a working interest and related assets from RimRock Oil and Gas (seven of the 14 deals analyzed included acreage or midstream assets in areas in addition to the Bakken, including the $4.8 billion Sitio Royalties – Brigham Minerals transaction and the $1.8 billion Crestwood Equity Partners – Oasis Midstream Partners transaction). The deal was announced on June 8, 2022 and closed on July 21, 2022. Deal highlights include:38,000 net acres in Dunn County, North Dakota15,000 Boep/d as of Q1 2022 (78% oil)88% working interestOver 100 drilling locations Characterized by Devon Energy as a bolt-on acquisition, the 38,000 net acres are contiguous to Devon Energy’s existing position in the Bakken. Production from the acquired assets is expected to increase to approximately 20,000 Boep/d over the next twelve months. RimRock Oil and Gas is backed by private equity sponsor Warburg Pincus, which has held a stake in RimRock Oil and Gas since 2016.ConclusionM&A transaction activity in the Bakken increased through year-to-date 2022 relative to the same time period in 2021 and consisted of a handful of large deals and numerous small deals. Deal activity in the Bakken will be important to monitor as companies continue to find significant opportunities to grow their Bakken positions.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Market Indications of RIA Value are Mixed, To Say the Least

Unicorn or Glue Horse?

Imagine you manufacture luxury products. You've recently had to raise prices substantially, despite your primary markets being headed into recession. Your buyers use leverage to purchase your products, and interest rates are the highest in a decade and are headed up. On the production side, your supply chain is compromised, skilled workers are scarce, and the cost of powering your factories has skyrocketed because your home currency has devalued. Public market investors shun legacy participants like you because your industry subsector is in the midst of technological upheaval, and the cost of retooling is viewed as greater than starting from scratch. Equity markets are sagging, and the IPO market is dormant. To top it off, there's a major war with an uncertain outcome that has already worsened your supply chain issues, and fighting could spill over into nations adjacent to your home country.Does that sound like an "open window" to list as a public company?Next week, Porsche AG is going public for the first time in ten years. Parent company Volkswagen announced the complex restructure and IPO a few weeks ago, and recently confirmed that Porsche would be organized into 911 million shares (a nod to their most iconic model), half of which will be voting, common shares and the other half will be non-voting preferred shares (not preferred in a sense we're accustomed to in the U.S.). Post IPO, the public will own one-eighth of the company (25% of the preferred shares), while the Porsche family will effectively have a controlling stake.The IPO was initially criticized for its complexity, governance plan, and pricing (at $75 billion, Porsche would trade about 10% lower than VW, which sells more than 30x as many cars per year). By Wednesday evening of this week, the order books were full, eight days early. No marathon for the book runners – more of a 5K.It's a Strange MarketLast week, Zach Milam wrote about some of the conundrums we encounter in valuing RIAs. Fair market value pricing has a tendency to lean in the direction of intrinsic value. The reality is, though, sometimes markets have a mind of their own and don't really care what thoughtful, educated securities analysts think. Fundamental analysis suggests many factors working against the value of investment management firms, and trading in public RIAs confirms that view. Transaction activity tells a very different story.Fair market value pricing has a tendency to lean in the direction of intrinsic valueWe're about to close the third quarter of a record number of transactions in the RIA space. In spite of plenty of headwinds: inflation-challenged margins, sagging AUM, and higher leverage costs, the pace of M&A continues and could equal last year. I say could because, even though we'll head into the fourth quarter of 2022 with a strong lead over 2021, the Q4 2021 comp is a tough one. Last year, fear of change in tax law and the breadth of the bull market drove a ridiculous volume of transactions.Nevertheless, momentum is strong. Even though buyers are getting picky, deal terms are less generous, and consideration is starting to shift more to earnouts; pricing is steady.What's Not to Like? One thing that's different than 2021 is that public market activity is anemic. Public RIAs aren't benefiting from any of this private market pricing activity, and the IPO window is – despite what some people have suggested – nailed shut.It’s difficult to reconcile public market pricing with private market sentimentIt's difficult to reconcile public market pricing with private market sentiment. Public RIAs are commonly trading at mid-single-digit multiples of EBITDA. Private company owners scoff at those metrics, and for good reason. Even though transactions may not always be as generous as some think, they're still better than going public. On the private side, consolidators are lauded for building wealth management empires – all while Focus trades just above its IPO price from four years ago, and CI Financial gets criticized for building a wealth management empire. The doublespeak is staggering. One wonders why more public RIAs don't throw in the towel and go private like Pzena.Who wants to go public in this market? In the first quarter of 2022, we heard about Dynasty Financial and Gladstone Companies going public and CI Financial offering shares in its U.S. wealth management business. None of that has happened, and until market conditions change, none of that is going to happen.Your Mileage May VaryI've heard lots of explanations of the private/public discrepancy in valuation, but nothing yet that's altogether satisfying. Depending on who you talk to, one man's unicorn is another man's glue horse.What we can say with certainty is that the differential in interest in public investment management businesses and private investment management businesses isn't sustainable. What we don't know is when or how. Will higher interest rates eventually wear down leveraged acquirers, as they have in other growth-and-income sectors (real estate, anyone?)? Will PE investors start to question the merits of trading companies from fund to fund instead of testing valuations in the open market? Will the public RIA group follow Pzena's lead and go private? Or will public investors' newfound interest in dividend stocks lead them to RIAs?It's tough to forecast a public RIA resurgence but never say never. Investors may not be pricing Porsche like Tesla, but they're giving it a valuation more like Ferrari (RACE) than Ford (F). In a market full of both prancing horses and mustangs, the public companies may yet win by a nose.

Blue Sky Multiples Remain Flat as Earnings Plateau

Dealers Continue to Perform through Negative Economic Indicators

The first half of 2022 was tumultuous, which Haig Partners succinctly summarized in their Q2 Haig Report. Negative headlines and headwinds aplenty:Inflation driving up costs for dealers and reducing affordability for customersInterest rates rising also drives up dealer costs and reduces affordabilityGas prices spiked (and are receding) which also reduces affordability (though this has only indirect impact on dealer costs)The stock market (as measured by the S&P 500) is down 18.2% year to date and GDP growth has been negative for two consecutive quartersThere is geopolitical uncertainty surrounding China-Taiwan and Russia's invasion of UkraineSupply chain issues have plagued the industry for over a year and a half and consumers are well aware of the high transaction prices of vehicles Available monthly data for these economic indicators are displayed since December 2019 in the following graphs below. In spite of these conditions, dealers have navigated this environment to deliver record profits. However, Haig points to the public dealers' earnings in Q2 as an indication that dealer earnings may have plateaued. The future direction of profitability is hard to predict, but with all the historical indicators for the industry flashing red, eventually, even the supply-demand imbalance cannot overcome all of these challenges. Whenever supply starts to rebound, the key question will be the degree to which gross profitability reverts as well.Blue Sky Multiples – Luxury BrandsAfter three straight quarters of changes in 2020, not a single luxury dealership saw a change in its multiple range in the next seven quarters. However, after years of only reporting a value range due to a lack of profitability, Cadillac dealerships reported at a range of 3x-4x in Q4 2021. Similarly, Infiniti and Lincoln reported a multiple range of 3x-4x in the Q2 2022. Value ranges are used instead of multiples when many of the brands' dealers are not profitable, but with improved earnings performance industry-wide, Haig is now reporting a multiple range for every brand covered in its report for the first time since at least Diesel Gate in 2014. We note the 3x-4x range for Cadillac, Infiniti, and Lincoln matches the 3x-4x range of Acura dealerships, which have consistently reported a multiple range at the low end for luxury dealerships.Blue Sky Multiples – Mid-Line Import BrandsDuring the first half of 2022, Hyundai and Kia saw another 0.25x improvement in multiple to a range of 4x-5x, building on a 0.5x improvement in Q3 2021. There are now three distinct tiers of mid-line brands: Toyota paces the top group (followed by Honda and Subaru), Hyundai and Kia, despite improvements, are still 2.0x below the top three, followed by VW, Nissan, and Mazda, which are about 1.0x below Hyundai and Kia and in line with the lowest multiples of the luxury brands.Toyota dealerships still fetch higher valuations than Audi and Jaguar-Land Rover dealerships. While they don't sell luxury vehicles, Toyotas are viewed as dependable vehicles. Potentially more important to dealers, Toyota has indicated it has no plans to replace dealerships with an agency model and is committed to a phased transition into EVs while also offering ICE vehicles and hybrids. Haig declared that Toyota might be the most desired brand in the industry. We find this interesting as Toyota dealerships remain a bargain in terms of Blue Sky's multiple range as compared to the top-of-the-line luxury dealerships. Desirability may also be factoring in cost, and the supply of luxury dealerships for sale may have an impact on the higher multiples for Porsche, Lexus, etc., particularly considering Toyota Motor Corporation owns Lexus.Blue Sky Multiples - Domestic BrandsDomestic franchise multiples have not changed since Q3 2020. With the rise of Hyundai and Kia's multiples over the past year, domestic brands' multiples are now generally in between the second and third tier of mid-line imports, where they once held a slight advantage over some of those brands. One would think that supply chain constraints would more negatively impact import brands than their domestic counterparts. However, the past two years have demonstrated that even domestic brands rely heavily on the global supply chain for their inputs, particularly microchips.In the last four years, domestic brands Ford, Chevrolet and Buick-GMC are the only brands across all of the published Haig multiples that have decreased. In Q2 2018, these brands' multiples were half a turn higher than they are in Q2 2022. Stellantis actually increased over that same period but only by 0.25x.It is important to note that the published blue-sky multiple ranges, while certainly reasonable, do not imply that dealerships are actually transacting at these multiples. With the performance of most dealerships remaining elevated, owners on the lower end of Blue Sky multiples are less likely to transact when the payback period on an investment is so short unless they need liquidity or are approaching retirement without an identified succession plan.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don't directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple, and if a dealer feels they are being reasonably compensated, they may choose to sell.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

What’s Lurking on Your Family’s Balance Sheet?

If a cursory reading of the financial press is an accurate judge, it would appear those most bullish on the crypto and digital asset space are eating at least a small helping of crow before their quest to upend the global financial system. Bitcoin (BTC) is down over 65% from its all-time highs, and that’s relatively outperforming some more exotic holdings. Nonfungible tokens (NFTs) have fallen even more precipitously, with many NFTs, such as the “Bored Ape Yacht Club,” needing a downgrade to a dinghy.Compare that to the record-breaking sale of Andy Warhol’s ‘Shot Sage Blue Marilyn’ for a cool $195 million in May, or nearly 10,000 BTC or 1,700 Bored Apes for those keeping score. As an art and crypto ignoramus, these data points provide interesting watercooler talk but also have us thinking about you and your family’s collective balance sheet.Any good CFO or Controller worth their salt knows what’s on their business’ balance sheet, including cash, inventory, property, and debt. But for enterprising families, it is often necessary to go one step further and ask what’s on the family’s balance sheet? Maybe your family has resisted the siren song of cryptocurrency and monkey NFTs, but are there any other sizable assets or liabilities you aren’t considering? It may be your great uncle’s antique car collection, a ski chalet shared by you and your family, or rare art that adorns your office. Whatever it may be, and trust us, we have seen some big bogeys; there are three things we think you should consider regarding your more esoteric family balance sheet items: valuation, diversification, and allocation.What Is It Worth?Without stating the obvious – if you suspect some of your more unique assets have a meaningful impact on your total family balance sheet – it’s worth getting a professional opinion as to the value. Similar to our advice to understand your business’ worth, unique assets ultimately exist on your family balance sheet as it concerns estate planning, gifting strategies, and tax considerations. As noted by estate planner Matthew Erskine in a recent post, artwork can even be an effective asset for executing some estate tax planning strategies. A simple example includes failing to adequately plan your estate accordingly and your estate being hit with a large tax bill. If the majority of taxable assets left are illiquid, you will have to work creatively to meet (liquidity required) tax liabilities. The last we checked, the IRS is still not accepting fractional interests in NFTs.What Is Our Risk?In addition to understanding the value of the unique assets on their own, you need to understand how this asset compares to the rest of your family business balance sheet. Understanding the correlation between your business and other assets, including your more distinctive ones, is key to long-term family wealth preservation and business continuity. A client we work with runs an operating business in the hospitality space with thousands of employees across the county. The family also has a penchant for airplanes, and in that case, the total value of the air fleet is over 10% of the combined value of assets. While this represents diversification, perhaps you and your family business are more concentrated, such as running a family of car dealerships while also holding an antique car collection. Being cognizant of your diversification, or lack thereof can help you better plan for the ups and downs in particular markets.What Do We Want?Beyond knowing what your assets are worth and their impact on diversification, a fundamental question still lingers for members of enterprising families: do we want to own this asset? As we have asked previously, did we fall into/inherit this asset, or are we here on purpose? Like owning and running a business, understanding your shareholders’ preferences and how they view the overall family business is key in determining asset allocation and where your capital should be deployed, stored, or sold.The ski chalet that your parents gifted you and your siblings who don’t ski, the rare art collection that you don’t know what to do with, or the yacht your family owns that sits idly by. Many unique or rare assets have considerable carrying costs to maintain them, and markets can often fluctuate wildly. Your family may view these assets in a separate class worth holding on its own, or it may not know what to do with grandfather’s rare coin collection. While we won’t opine on the relative performance of these assets, asking your family if you want to own and hold them is a question worth asking.Understand the Whole PictureWhile we all wish to find that rare vase or Jackson Pollock painting in our mother’s attic, it’s not likely that there are such economic windfalls hiding in your family’s cupboard. Nonetheless, establishing an inventory of all your family’s assets and agreeing on an ownership philosophy for unique assets is important. Understanding what these assets are worth, their impact on diversification, and whether you and the family have a desire to hold them are some simple housekeeping steps you can take to better understand the holistic family balance sheet and its impact on your family business health.Give us a call to discuss these or any other family balance sheet issues today.

Reconciling Real-World Transactions With the Fair Market Value Standard

When business owners think about the value of their firm, they frequently think in terms of the dollar value that they believe they could sell the business for in an arms’ length transaction. However, the nuances of real world transaction terms in the investment management industry can often obscure what’s being paid for the business on a cash-equivalent basis. This blog post explores various industry transaction structures employed in the industry and their relationship to fair market value. The value of asset and wealth management firms depends very much on context. In the valuation community, we refer to the context in which the firm is being valued as the “standard of value.” A standard of value imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the Transaction, and the manner in which the Transaction is executed. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly selected as the standard of value in buy-sell agreements for investment management firms. Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined by the International Valuation Glossary as follows:A Standard of Value is considered to represent the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, each acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or to sell and when both have reasonable knowledge of relevant facts. Notably, the fair market value standard requires that the price be expressed in terms of cash equivalents. This is consistent with how many business owners think about the value of their business, but it’s inconsistent with the reality of how many real-world transactions are structured.It’s not unusual for investment management transactions to include earnout structures as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. If buyer funding is an issue (as it often is in internal transactions), the deal may include deferred payments or seller financing. It’s also commonplace for the seller to receive all or a portion of their consideration in buyer stock for which there is no active market (if the buyer is private) or which is subject to a lock-up period (if the buyer is public). In order to reconcile real world deal terms with fair market value, it is necessary to reduce the non-cash deal components into a cash equivalent value.Consider the table below, which describes three transaction structures designed to be illustrative of different deal structure components employed in investment management transactions. In each case, we assume that the transactions occur between a willing and able buyer and a willing and able seller acting at arms’ length in an open and unrestricted market, when neither is under compulsion to buy or sell and both have knowledge of relevant facts.Each of the three transactions features a $15 million closing payment and potential additional consideration of $5 million, for total possible consideration of $20 million. In Transaction A, the additional payment is simply deferred for one year, whereas in Transaction B it is contingent on revenue retention, and in Transaction C, it is contingent on revenue growth. In terms of risk, Transaction A offers the most certainty, with the additional payment contingent only on the buyer’s future creditworthiness. In Transaction B, the seller must maintain at least 95% of existing revenue into the second year post-closing. While this is a relatively low bar assuming the firm is able to grow organically and benefits from the upward drift of markets, the payment is at risk if there is significant client attrition or a protracted bear market. In Transaction C, the additional payment is contingent on the acquired firm achieving sufficient net organic growth and market growth over a three-year period in order to generate an 8% revenue CAGR.In each case, we can infer that the Transaction implies a fair market value somewhere between $15 million on the low end and $20 million on the high end. To get more precise, it’s necessary to convert future payments into equivalent cash terms. The methods used for converting contingent consideration to a cash equivalent basis are beyond the scope of this blog post, but as a general rule, the riskier and farther out a payment is, the less such payment is worth on a present value, cash equivalent basis.The figure below illustrates directionally how the transactions compare in terms of the fair market value they imply. The most certain transaction structure (Transaction A) implies a fair market value closest to the top end of the range ($20 million), but still below due to the time value of money and buyer credit risk. The least certain structure (Transaction C) implies a fair market value closer to the bottom end of the range, given the relatively high risk of achieving the growth hurdle. Transaction B is somewhere between the other two transactions in terms of risk and timing of the payment, and as such the implied fair market value lies between the other two.When analyzing real world transactions, it’s important to keep in mind that the headline deal values we see reported are often based on the maximum possible consideration that the seller is eligible to receive under the terms of the purchase agreement. Such headline values may not be indicative of fair market value to the extent that they are not expressed in terms of cash equivalents. As the example above illustrates, making reliable inferences about the fair market value implied by transactions in the industry requires a deeper dive to understand the structure of the deal. Oftentimes, the details of earnout structures are not publicly available, but real world transactions can nevertheless be informative and serve to benchmark thinking regarding the fair market value of investment management firms, provided the transactions are subjected to a proper degree of scrutiny.

What Should We Do About Estate Taxes?

“Ohana” means family…family means nobody gets left behind or forgotten. Lilo & Stitch, the Disney film about a family and an alien, taught us this just over 20 years ago. This is especially true in a family business as family business directors need to work together to ensure they are moving forward together, as a business and more importantly, as a family. As seen on the big screen with Lilo & Stitch, in family business meetings, and maybe even at the dinner table, Ohana is easier said than done. Sometimes your family does, in fact, act alien to you. But at the end of the day, family is vital to who we are and what we do.What Should We Do About Estate Taxes?Most family business owners desire to provide financially for their family. Due to this, one of the widespread concerns of these owners is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way.The Estate Tax is a tax on your right to transfer property at your death. The tax is calculated based on the "decedent’s gross estate," less the taxpayer’s remaining gift and estate tax deduction, which in 2022 is $12.06 million per individual ($24.12 million per couple), as well as other specific deductions. A unique issue for family business owners is that a substantial portion of their estate often consists of illiquid interests in private company stock. If this is the case, liquidating assets to pay the estate tax may prove more difficult as estate taxes are payable only in cash. Family businesses may have to be sold or forced to borrow money to fund the payment of a decedent’s estate tax liability.Keep in Mind Fair Market Value and the Level of ValueThe concept of fair market value is essential to understanding and evaluating any estate planning strategy. For brevity’s sake, fair market value, or “FMV,” is defined by the IRS as the price at which the property would change hands between a willing buyer and seller, not under compulsion to buy or sell, and both having reasonable knowledge regarding specific facts and circumstances regarding the transaction. The IRS is clear, per Revenue Ruling 59-60, that appropriate discounts, or reductions in value, are allowed to account for the fact that the shares in the family business are privately held rather than publicly traded.How does FMV, or the standard of value, intersect with the “level of value”? For example, if an estate owns a controlling interest in a family business (more than 50% of the stock), the FMV of those shares will reflect the estate’s ability to sell the business. In contrast, the owner of a small minority block of the outstanding shares in the family business cannot force the business to change strategy, seek a sale, or unilaterally compel any action. The level of value chart captures two common-sense notions: investors prefer control rather than not, and they prefer liquidity to illiquidity. The magnitude of a lack of control and lack of marketability adjustment depends on specific factors of the subject interest being transferred, but unsurprisingly investors prefer to have control and a ready market for their shares.It’s Not All TaxesMinimizing taxes is one possible objective of an estate planning process, along with asset protection, business continuity, and providing for loved ones. Families should be careful not to let the tax tail wag the business dog; families should consult legal, accounting, and valuation advisors who understand their business needs and family dynamics to ensure that their estate plan accomplishes the desired goals.Families should be careful not to let the tax tail wag the business dogAs an example, one objective of most estate planning techniques is to ensure that no individual owns a controlling interest in the family business at his or her death. However, is the patriarch/matriarch ready to hand the reigns to the next generation? Is the next generation ready? Management and business concerns may need to prioritize the tax/liability side of the equation based on the family and its dynamics.What Now?Some potential next steps include:Review the current shareholder list & ownership table: Based on the current shareholder list, are there any shareholders that – were the unexpected to happen – would be facing a significant estate tax liability?Identifying current estate tax exposures: Will shareholders have to look to the family business to redeem shares or make special distributions to fund estate tax obligations?Identify tax & non-tax goals of the estate planning process: If there was no estate tax, what evolution would be the most desirable for your family and business?Obtain a current opinion of the fair market value of the business at each level of value (control, marketable minority, and nonmarketable minority). We are just a phone call or an email away.

August 2022 SAAR

The August SAAR was 13.2 million units, down 1.1% from last month but up 0.7% from August 2021. This month’s data release marks the third month in a row that the SAAR has been in the low 13 million-unit range, with the metric seemingly having stabilized in the short term. To illustrate this trend, the average SAAR has been 13.1 million units over the last four months.Now that the August data has been released and two-thirds of the year is a known commodity, we have much more visibility to what the full year SAAR might look like. Year to date average SAAR is 13.7 million units, which makes it even harder for us to imagine a full year SAAR over 14 million units. To put numbers in a hypothetical scenario, the turnaround that is necessary to reach an average SAAR of 14 million units in 2022 would require the next four months’ SAAR to average 14.7 million units.Unadjusted sales numbers have also kept with the trends we have seen over the last several months. Comparing the previous eight August’s unadjusted sales figures (in the chart below) emphasizes the longevity of the production issues that have gripped the auto industry. In August 2020, unadjusted sales had begun to recover from the steep drop that started in April 2020 in response to the COVID-19 pandemic. While this recovery seemed strong in late 2020 and into the first half of 2021, supply chain issues reared their ugly head during the summer of 2021 and, by August of last year, had completely stagnated. While August 2022’s unadjusted sales show a modest recovery from this time last year, it is clear that the auto industry is still very much in the midst of an inventory crisis.InventorySpeaking of inventory levels, not much has changed since the last time the data was released. Industry-wide inventory balances for July came in at 0.50x, down from June’s figure of 0.56x. The inventory to sales ratio has been under 1.0x since May 2021 and had been climbing the past few months to the highest levels since August 2021 before declining in July 2022 (most recently available inventory data tends to lag by a month).To put context to this ratio, on average, dealers have been selling twice the number of vehicles that are on their lots during the last several months. Consumers have had to get accustomed to pre-ordering vehicles or simply settling for the vehicle that just so happens to be on the lot when they visit a dealership. Pent-up demand for these vehicles has not had a chance to unwind at all, and the most likely scenario that dealerships can expect is that pent-up demand will hang around until meaningful changes in inventory availability come to fruition (when that actually might happen is still a mystery). See the chart below for a look at the industry’s inventory to sales ratio from January 2020 through July 2022.Transaction Prices, Incentive Spending, and Monthly PaymentsFor our weekly readers, it may seem like there has been a new record for the average transaction price set almost every month over the past year, and that is not far from the truth. According to J.D. Power, the average transaction price for a vehicle in August was $46,259, up 11.5% from this time last year and the highest average transaction price on record. Inventory constraints have continued to push prices higher and higher each month, but these constraints are not the only driver of vehicle prices record-setting rise. For example, OEMs have had to prioritize high-demand vehicles like trucks, SUVs and crossovers, all of which are much more expensive than the typical sedan. We believe this is particularly notable in light of elevated gas prices, which, at least in theory, should temper demand for larger vehicles that guzzle more gas.OEMs have also kept incentive spending low. In August, average incentive spending per unit is expected to total $969, a decline of 47.1% from this time last year and the fourth straight month under $1,000. Higher prices, reduced incentives and rising interest rates are also pushing average monthly payments higher. For example, the average monthly payment on a new vehicle contract reached a new record of $716 in August. As interest rates are expected to continue to rise at the Federal Reserve’s next meeting on September 20th, it is unlikely that average monthly payments will decline any time soon.Imports and ExportsImports and exports are not something that we typically touch on in our monthly SAAR blog, but supply chain issues and persistently low inventory levels have raised questions related to the international flow of vehicles. Mexico and Canada are the two primary importers of vehicles into the U.S. due largely to continental trade agreements (NAFTA and USMCA). The chart below shows the flow of vehicles (in thousands) from August 2019 through June 2022, the most recently available month of data. Like automotive retail generally, import activity is seasonal. Later in the winter season is when import activity typically slows down, and the summer and fall are when imports ramp up. Over the last two years since August 2020, seasonality has been present, but the total number of imports, on average, has fallen. For Mexican imports, the average number of vehicles imported from January 2016 to December 2019 was 105,000 per month compared to an average of 72,000 from January 2020 to June 2022. Canadian imports have followed a similar but more drastic trend, averaging 95,000 imports from 2016-2019 compared to 45,500 from 2019 to June 2022. Exports from U.S. have fallen as well, which makes sense. Producers in the country have retained more vehicles to service domestic markets instead of sending units overseas. From January 2016 to December 2019, an average of 105,000 vehicles were exported to international markets. From January 2020 to June 2022, that number fell to 78,500 vehicles per month. See the chart below for auto unit exports from August 2019 through June 2022. From looking at the raw import/export numbers, it is clear that the flow of vehicles across international lines has soften considerably. Globalization of the automotive manufacturing industry has been clawed back during this period of uncertainty and is unlikely to return to pre-pandemic levels until supply chains recover and inventories are replenished domestically and abroad. It will be interesting to follow import and export activity when inventory balances begin to recover to see how much the import/export recovery lags behind. The import/export ratio steadily declined to a recent low of 1.42x in 2021. While this figure represents a low dating back to 1993 (first published data), the supply chain constraints may only exacerbate a secular trend as this ratio was 1.66x in 2019 and 2020. Imports from Canada and Mexico were below 1.4 million for the first time since 2009 and are just above 1993 levels. While 2021 exports are down 21.1% since 2019, this actually represents a 10.9% recovery from 2020’s reduced export levels. While imports from North American trade partners are nearly the same as over 25 years ago, exports have nearly doubled.September 2022 OutlookMercer Capital’s outlook for the September 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Consumers have largely become conditioned to these higher prices, yet demand remains high due to relatively poor substitutes for personal vehicles, among other factors, of course. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps the September SAAR can eclipse 14 million units and signal a turning of the tide, but we predict that a 14 million unit SAAR for 2022 is an optimistic assumption in the current landscape. We first need to get back to a monthly SAAR of 14 million.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

How Does Your RIA’s Client Base Affect Your Firm’s Value, and What Can You Do to Improve It?

We’re often asked by clients what the range of multiples for RIAs is in the current market. At any given time, the range can be quite wide between the least attractive firms and the most attractive firms. The factors that affect where a firm falls within that range include the firm’s margin, scale, growth rate of new client assets, effective realized fees, personnel, geographic market, firm culture, and client demographics (among others). In this post, we focus in on the client demographics factor, explain how buyers view client demographics and explore steps some firms are taking to reach a broader client base. Client relationships are one of the most significant assets that RIAs possess, and maintaining and profitably servicing these client relationships is key to an RIA’s financial success. In a transaction context, the strength of an RIA’s client relationships and the demographics of the client base can have a significant bearing on the multiple buyers will be willing to pay for the firm. An RIA’s outlook for future asset growth can be significantly impacted based on factors such as expected client retention, which stage current clients are at in terms of wealth accumulation (are they withdrawing assets or contributing assets), and the prospect for future liquidity events within the client base.Client relationships are one of the most significant assets that RIAs possessMany of these factors can be proxied by the age profile of the client base. For most RIAs, the age of the client base tends to skew older (particularly on an asset-weighted basis) simply because older clients generally have more assets. Decades of compounding returns can create some very large accounts for older clients, and these accounts can often be profitably serviced by the RIA. However, with an older client base, the asset base is usually declining as these individuals are withdrawing, rather than contributing, additional funds. And, of course, the remaining life expectancy for older clients is less. As such, the age profile of the client base is a key area of inquiry for many buyers.Because an older average client base tends to suggest headwinds for future asset growth, an older client base is generally seen as a negative (all else equal) from a valuation perspective. In general, the younger the client base, the better the outlook for future asset growth and the higher multiple the firm commands. RIAs can expand their reach to a younger client demographic by increasing focus on retaining assets to the next generation and by positioning themselves to appeal to a younger client demographic.Retaining Assets to Next GenerationIn general, RIAs are not particularly successful at retaining assets to the next generation. According to Cerulli, more than 70% of heirs are likely to fire or change financial advisors after inheriting their parents’ wealth. However, firms that make it a priority to engage and develop relationships with next generation family members today can significantly improve asset retention once the assets are transferred from the current client to the next generation. The earlier this is done, the better the chance at retaining assets into the next generation.Focusing on asset retention today is particularly important, given that more than $70 trillion is expected to transfer from older generations to heirs or charities by 2042. RIAs that can capture or retain these assets as they transfer to younger generations will have a competitive advantage against those that cannot.Attracting Younger ClientsA Wall Street Journal article published last year highlighted the struggle many advisory firms face in attracting younger clients. See Rich Millennials to Financial Advisers: Thanks for the Golf Invite, but You Can’t Invest My Money. As the article suggests, many younger clients are electing to manage their own assets rather than hire a traditional financial advisor. While DIY investment management is popular among younger clients, many see this preference as temporary. Once these clients reach an asset or life stage threshold where their financial lives become more complicated, it’s anticipated that the need for traditional, personalized advice will increase.While attracting younger clients can be difficult, there are several strategies RIAs can use to position themselves to capture this emerging client segment. For one, RIAs should recognize that investment expertise is table stakes for attracting younger clients. These clients are often looking for financial coaching and holistic financial advice that goes beyond simple asset allocation. By offering these “soft” services in addition to traditional investment management, RIAs are better positioned to win younger clients.RIAs should recognize that investment expertise is table stakes for attracting younger clientsRIAs can also attract younger clients by hiring younger advisers. Anecdotally, advisers tend to attract clients that are within plus or minus ten years of their own age. Thus, having a broader age range of advisors can unlock younger client segments (and also contribute to the stability and continuity of the firm).RIAs can also reevaluate their marketing strategies to appeal to younger client demographics. As the WSJ headline suggests, golf invites have fallen by the wayside for most younger clients. While referrals and word of mouth are the traditional sources for new clients, having a strong online presence and digital marketing strategy is critical for attracting a younger client demographic.In order to effectively service accounts for a younger client demographic, RIAs may also want to reevaluate how they determine fees for these accounts. While the traditional percentage of AUM model works well for many clients, RIAs may find this model difficult to apply to a younger client demographic. For individuals still in the prime of their working career, it’s not uncommon to see a significant a significant amount of their net worth tied up in privately held companies. The value of these assets is not generally included in AUM, and thus does not generate fee revenue. Other clients may have significant incomes and financial planning needs, but have not yet accumulated an asset base significant enough for an RIA to profitably service the account using a traditional percentage of AUM model. Many firms that have been successful at attracting a younger client demographic are able to offer alternative pricing arrangements in order to account for situations such as these.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

Themes from Q2 2022 Earnings Calls-Part II

Themes from Q2 2022 Energy Earnings Calls

Part 2: Oilfield Service Companies

In our Themes from Q1 Earnings Calls, Part 2: Oilfield Service Companies blog post, prevalent themes included OFS companies targeting short-term projects, as well as shifting towards a strategy focused on margin expansion. Executives also noted that private operators have an increasing level of importance to public companies due to increased activity.In another recent blog post, Talk To The Hand: Upstream Industry Eyeing Returns More Than Rigs, we further examined the shift towards margin expansion in upstream companies as opposed to ramping up production.This week we focus on the key takeaways from OFS operators’ Q2 2022 earnings calls.Energy Security Takes Center Stage Amid Supply ChallengesMany OFS companies noted in their earnings calls that the industry faces a unique operating environment in terms of both supply and demand. Ongoing COVID-related supply challenges have caused oil and gas prices to rise throughout the past twelve months. This is favorable to OFS Companies as this increases the demand for their products and services. In recent months, firms have seen significantly increased demand as countries worldwide grapple with the impact of the Russia-Ukraine conflict and seek to ensure energy security for themselves.“With energy security firmly in focus, the diversification of supply sources is the central theme in the international markets. Never has energy security been a bigger issue to governments and people all over the world. However, political agendas and years of underinvestment in many markets make it harder to address this critical requirement.” – Jeff Miller, Chairman, President & CEO, Halliburton“Although a potential economic recession has pushed oil and gas prices off recent highs, our outlook remains constructive. The world is facing a significant energy shortfall and the oil and gas industry needs to increase activity in order to provide greater energy security to the global economy. That urgent activity will need to come at a time when the industry's tools, its rigs, drill pipe and pumps have been idled, depleted, cannibalized and worn out through a pandemic shutdown that has produced the most withering downturn the industry has ever seen.” – Clay Williams, Chairman, President & CEO, NOV“I think that my near-term concern has to do with ancillary supply issues because we're hearing a lot of comments about pipe availability… rig availability, sand availability, even cement availability. So I think that there's a desire probably to increase activity beyond the industry's capacity to support that. And I've mentioned that in previous calls that, that was my greatest concern, it's probably even more a concern today.” – Scott Bender, President, CEO & Director, CactusContinued Focus On Margin ExpansionIn earnings calls from the first quarter, many companies highlighted that they were shifting their strategies to focus on expanding margins in the face of limited supply rather than the pursuit of larger market share. This strategy seems likely to continue throughout the rest of 2022.“As the bulk of our integration efforts are not complete, we'll be turning our attention to making incremental improvements in the operating efficiency of our cost structure and we'll be striving to continue to improve EBITDA margins each quarter. We also believe that some of the incremental pricing gains achieved in the second quarter will demonstrate their full effect during the third quarter.” – Stuart Bodden, President & CEO, Ranger Energy“As equipment availability continues to tighten, we expect prices will increase further. Due to the long-term nature of international contracts, only about one-third of our work re-prices every year. This means that margin and pricing inflections internationally will always materialize at a slower pace than in North America. We see evidence of customer urgency indicated by customer preference to pursue direct negotiations for contract extensions. The efficiency gains over the last several years have all accrued directly to operators, and there is still a great deal of room in customer's economics for service providers to earn a fair and durable return.” – Jeff Miller, Chairman, President & CEO, Halliburton“While the second quarter saw a meaningful double-digit percentage increase in drilling activity, completion activity continued to modestly lag during the period with a single-digit percentage growth. However, we believe this activity ratio is starting to normalize and we expect to see more completion activity during the third quarter, supported by continued strong overall commodity price environment. Underpinned by growing activity, strong commodity prices, further price increases and continued operational efficiency gains, we expect to see further improvements to our financial performance, including meaningful free cash flow during the second half of 2022.” – John Schmitz, Founder, Chairman, President and CEO, Select Energy ServicesOptimism in the Face of a Potential RecessionWhile most firms noted that the near-term broad macroeconomic outlook appears bleak, most executives signaled confidence in the long-term performance of their firms given that prices will likely remain elevated due to highly limited supply stemming from limited investment during the peak of the pandemic, among other reasons. Mercer Capital examined some of the reasons for OFS firms to be feeling optimistic in our post, Oilfield Service Valuations: Dawn Is Coming.“In short, this cycle has been nothing like prior cycles. This means any economic slowdown will not solve the structural oil undersupply problem.” – Jeff Miller, Chairman, President & CEO, Halliburton“As noted earlier, given our significant leverage across the company to production and workover barrels, we continue to believe that demand for our services will remain strong even if the commodity price environment deteriorates somewhat due to recessionary conditions.” – Stuart Bodden, President & CEO, Ranger Energy“I'll acknowledge that many are of the view that we face a global recession in the near term. Recessions can reduce demand or more accurately, they usually just flatten growth in demand for oil and gas, thereby reducing prices and activity. However, coming out of historically low levels of oilfield activity that marked the pandemic shutdown, with nearly all excess OpEx back in the marketplace, with the release of the SPR expected to end soon, with the number of viable DUCs in North America drawn down significantly in the past few years, and with oil and gas and product inventories low and falling, man, it's hard for me to imagine anything other than continued growth of this sector for the next several years” – Clay Williams, Chairman, President & CEO, NOVMercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the mineral aggregators with working and royalty interests in the underlying production. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

Introducing the Family Business Director On Demand Resource Center

We are excited to announce the grand opening of our Family Business On Demand Resource Center. The Center is a one-stop shop for enterprising families and their advisors facing the financial challenges that are common to family business. We’ve curated and organized a diverse collection of resources from our staff of family business professionals, including a 5 minute video series, articles, whitepapers, books, and research studies. There’s nothing else like it, and we look forward to your visit.The perspectives we offer at the Center are rooted in our experiences at Mercer Capital working with hundreds of enterprising families in thousands of engagements over the past forty years. Our focus is on the financial challenges faced by family businesses, which include:Capital budgeting. Managers and directors of family businesses are stewards of family capital. Capital budgeting is the disciplined process of allocating that capital to productive uses within the family business.Capital structure. Investment capital for family business comes in two forms: equity from shareholders, and debt from lenders. Capital structure is the relative proportion of debt and equity used by a family business and is one of the most consequential decisions directors are called upon to make.Dividend & redemption policy. Family shareholders may or may not read reports about the performance of the family business, but they always cash dividend checks. A coherent dividend and redemption policy establishes a framework for corporate managers and family shareholders to develop appropriate expectations regarding future dividends and opportunities for share redemptions.Mergers & acquisitions. Whether you are contemplating buying another business or selling all or a portion of your own, M&A transactions are significant events for enterprising families. Buying or selling a business is definitely a “measure twice, cut once” activity for family businesses.Shareholder engagement & education. The long-term sustainability of any family business is determined, in part, by how family shareholders view the family business. In our experience, educated family shareholders are engaged family shareholders.While doubtless a fact of life that cannot be avoided, managing the estate tax burden is one of several objectives considered by successful enterprising families when planning for ownership succession.The fact that most family businesses are not publicly traded does not mean that valuation is irrelevant for family businesses. The value of the family business affects each of the preceding topics. If you’ve ever had any questions about the topics listed above – or know someone that does – please visit our Family Business Director On Demand Resource Center. Check out some of the content, meet our professionals, and give us a call. We look forward to helping you!

Themes from Q2 2022 Earnings Calls-Part I

Themes from Q2 Energy 2022 Earnings Calls

Part 1: Upstream

In the post Upstream Reviews of Q1 2022 Earnings Calls, the common themes among the earning calls of both E&P operators and mineral aggregators included the role of U.S. production in the European market, industry confidence in continued favorable pricing, and the trend of increasing completions.This week, we focus on the key takeaways from the Q2 2022 Upstream earnings calls including strong balance sheets, the increasing role of share buybacks, and supply and demand in the global oil & gas commodities market.Strong Balance Sheets and Cash Positions to Weather Price Volatility and Gain Upside ExposureExecutives zeroed in on the importance of a strong balance sheet amid the continuing volatility of oil and gas commodity prices. Upstream players can utilize robust cash positions to weather different price cycles and increase operational flexibility. Additionally, upstream Q2 earnings calls underlined the greater exposure to the high cycles by minimizing firm debt burden.“My perspective [is] as long as our return objectives are being met, modestly building some cash on the balance sheet is a positive thing. We're obviously in a highly volatile commodity price environment [and] I'd like to have a minimum of $500 million on the balance sheet just to handle intra-month working capital swings. We do have a couple of debt maturities coming up… We intend to retire that debt with cash on hand, so preparing for that time when prices are strong, is a good thing. And then also, it provides us the flexibility… on accretive bolt-on acquisitions that can improve our portfolio… given the macro uncertainties [ and] the volatility. So having a very robust company with strong liquidity, I think is a plus… Our return to shareholder commitment is top priority, but also keeping a bulletproof balance sheet and ample liquidity is right alongside that in our conservative financial model.”– Dane Whitehead, EVP & CFO, Marathon Oil Corp.“We want the absolute debt levels to be at $2 billion or even lower than that. We'd like to approach $1.5 billion over the next kind of medium term… The one times and the $2 billion or less of debt allows us to have a balance sheet that positions us to [future] swings in commodity prices. So, for us it's not as much a mid-cycle price. It allows us to go low and it allows us to go high. And we have a balance sheet that we feel gets us through the different commodity price environments.”– Kevin Haggard, SVP & CFO, Callon Petroleum Co.“The way we think about it is the best hedge is to have a strong balance sheet coupled with the strategy that can pretty much work in [a] multitude of prices and operational environments. So, this allows us to execute through these different commodity cycles. At current prices, our balance sheet is improving rapidly, so I think that's positioned us well to achieve our long-term debt target.”– Tom Mireles, EVP & CFO, Murphy Oil Corp.Increasing Role of Share Buybacks in Capital AllocationE&P operators and mineral aggregators have seen exceptional profitability since the start of the upcycle in 2021; companies started paying down their debt and distributing to shareholders. With the continuance of stable cash flows, the role of share buybacks has increased as a source of returns in lieu of bolt-on acquisitions or other investment opportunities.“So yes, like we’ve mentioned a bunch of different times. I mean, evaluating M&A, we are going to be selective and picky. I mean, we do look at this from an internal kind of risk-adjusted rate of return standpoint -- and as we’ve said before… it has to compete with our other capital allocation opportunities. And right now, at this current time, the best risk-adjusted meaningful for way to grow our free cash flow per share is buying ourselves… We’re always in the know of what’s going on in the M&A space, but with the low-risk opportunity to grow free cash flow per share, so visibly in front of us [by] buying ourselves, it’s hard to compete with that.”– Don Rush, Chief Strategy Officer, CNX Resources Corp.“We certainly think that there's a lot of value in our existing stock price, and we think that, that oil and public equity stocks [are] really undervalued right now… We spent about $500 million in the last 2 to 3 months repurchasing shares, and the Board just essentially doubled our authorization up to $4 billion. So, the base dividend still remains sacred, sustainable and growing followed by this environment share repurchases… [We will] make up the difference... returning at least 75% of free cash flow.”– Travis Stice, CEO & Chairman, Diamondback Energy Inc.“We're always assessing and evaluating bolt-on opportunities in basins where we have a competitive advantage and can generate value for our shareholders… We have a tremendous amount of confidence in our organic case, which delivers market-leading free cash flow and return of capital. And that is [how] we're going to assess all opportunities. So, the bar is quite high, and whatever we do, it's going to have to be accretive to that organic case… So, the same discipline that we show in our business is the same discipline we'll show in assessing inorganic opportunities. But to be clear, we like the assets in our core portfolio, and we're always looking to further improve our core positions.”– Lee Tillman, Chairman, President & CEO, Marathon Oil Corp.Beliefs of a Prolonged Imbalance of Supply and Demand in the Global Oil & Gas Commodities MarketExecutives of E&P companies and mineral aggregators underscored the economic effects of current global events as it pertains to the industry. Global demand for such commodities continues to grow despite the obstacles on the supply side. The current stream of Russian natural gas to Europe is not deemed to be reliable, OPEC+ is either unable or unwilling to meaningfully increase oil production, and U.S. E&P operators can only marginally ramp up production in the near-term. Meanwhile, demand shows no sign of dissipating as China re-opens from Covid-19 lockdowns and European officials attempt to secure enough natural gas in preparation for the winter so as to avoid rationing.“You think about US E&Ps, [and] the inability to really ramp up production because of the supply chain or the return of capital pieces… You think about the current potential issues in Russia and the potential embargo that's going to happen here at the end of December, the need to refill the SPR [Strategic Petroleum Reserve], because we've drawn down on those volumes significantly, and then really kind of the lack of OPEC’s ability to ramp up production here… [it] is really indicative to me of fundamental positives as we think about the second half and into 2023. So, I think you're going to see an improvement in energy markets going forward, and hopefully that yield compresses as well.”– Rob Roosa, Founder & CEO, Brigham Minerals Inc.“As China reopens further [the] utilization rate is expected to climb to the upper 80% range. This higher utilization rate, combined with an estimated 500,000 barrels per day of new PDH capacity coming online in China and over 100,000 barrels per day of new capacity in Europe and North America over the next 18 months, is expected to lead to a tightening propane market as we enter winter, with over 50% of our NGL volumes being exported.”– Dave Cannelongo, SVP of Liquids Marketing & Transportation, Antero Resources Corp.“I'm still very optimistic that the oil price is going to continue to march forward with probably more upside than downside. Demand is coming back. Around the world, people are flying more. China's going to come back and as you know there's not much supply [in] the OPEC agreement… OPEC+ announced a minuscule increase today… They just don't have the supply, [there is] very little left in UAE and Saudi.”– Scott Sheffield, CEO & Director, Pioneer Natural Resources Co. Mercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators comprising the upstream space. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

RIAs Are a Value Investment in a Growth Obsessed World

Maybe That’s Okay

The holy grail for automotive producers is a high-margin (i.e., high priced) product that they can sell in volume. After watching Porsche revive its failing fortunes with a pair of sport SUVs, Lamborghini jumped into the fray with the Urus. Despite an unfortunate name and a face only a Lamborghini driver could love, the Urus has a top speed of 200 miles an hour, seats four comfortably, and has a hatch large enough for a weekend Costco run (just don’t attempt all three at once). Most importantly for Lamborghini, the Urus sold 20,000 units over the first four years of its production run, a number previously unthinkable for the boutique Italian automaker.That unit volume didn’t happen because the Urus is anybody’s idea of a low-cost solution. At $225K plus per copy, the Lambo is proof that there is substantial demand for that kind of all-around product – whether it’s necessary or not.Are RIAs Growth Stocks or Value Stocks?We think of investment management firms as a “growth and income” play. The space has attracted capital specifically because RIAs produce a reliable stream of distributable cash flow with the upside coming from market tailwinds and new clients. For all the trade press touting interest in RIAs, investing trends over the past fifteen years have had a mixed impact on the investment management community.For asset managers, cheap capital makes stock picking less important. Persistent alpha is harder to prove. Passive and alternative products are more competitive. Investment committees are surly. Fee pressure is rampant.For wealth managers, cheap capital has made diversification look kind of pointless and bordering on stupid. In the rearview mirror, owning anything other than the S&P 500 has, since the credit crisis, looked like a mistake. While this may not have had an immediate impact on revenue and margins, it does nothing to cement advisor/client relationships.But what about valuations? Where do RIAs fit in an environment that favors growth stocks?Can RIAs Be Considered Growth Stocks?If you think of growth stocks as companies producing super-normal increases in revenue – double-digit upside that might even exceed their cost of capital – then it’s difficult to put investment management firms in that category. Growing revenue requires growing AUM. Even with favorable markets, consistent AUM growth greater than single digits is difficult to achieve.Breaking down AUM growth into its constituent parts is revealing. A typical client of ours might enjoy significant market returns, even net of fees. But seasoned firms have seasoned clients, and seasoned clients draw income from their accounts and leave for various reasons. Client additions to existing accounts are sporadic, and new accounts can be hard to win. Even with AUM growth, pressure on realized fees can inhibit revenue growth – and increases in realized fees are rare indeed. So, growing profitability faster than AUM requires margin expansion. Margin expansion at an RIA generally requires managing labor costs. In this labor market, that’s difficult.Margin Matters to Value InvestorsSo maybe RIAs aren’t a growth stock, so what about value?Publicly traded RIAs tend to be priced at a discount to prevailing market multiples. IPOs are backed up this year, with several waiting in the wings. The heads of these companies won’t come right out and say it, but most, if not all, are loathe to go public at the six or seven times EBITDA the market is currently offering. Instead, the public investment management space has been characterized by consolidation and buy-back programs aimed at creating shareholder value in the face of increasingly competitive markets.The private market appreciates the promise of strong and consistent streams of distributable cash flow, which has attracted investment dollars in the hopes of building value through scale, enhancing returns with leverage, and multiple arbitrage. An accommodative Fed has made leverage attractive, and the hope of one day selling to a willing public or an aggressive PE firm has kept transaction activity robust. As interest rates march higher and public markets sag, this narrative may become harder to support. Even so, the play on RIAs as a value investment has endured through strong and weak markets for decades, because consistent cash flow margins appeal to certain types of investors.Growth versus ValueOne of the longest running trends in public equities is the persistent outperformance of value stocks versus growth. For nearly 70 years, from the start of World War 2 until the credit crisis of 2008-09, value stocks usually outperformed growth with the exception of brief periods like the dotcom run of the late 1990s. But for a decade now, quality of earnings hasn’t mattered as much as quantity of growth.The recent growth over value phenomenon is easily explained by unprecedented market liquidity, starting with the credit crisis and extending through the pandemic, that provided ample excess capital to fuel demand for financial securities. A quick glance at equity pricing in a low versus a more normal cost of capital environment reveals the impact of cheap money on equity multiples, vis-à-vis expected growth. The specific impact of an accommodative Fed and massive policy stimulus on the cost of equity capital is debatable, but the impact on equity valuations is not. A lower cost of capital leads to multiple expansion, and directly favors growth stocks relative to value. In this rate environment, it’s hard for investment managers to get noticed in the public markets.Everything Has a PlaceIf the automotive market has a place for Lamborghini SUVs, then surely the investor community has a place for RIAs. As it is, the space tends to get ignored as a value play and oversold as a growth opportunity. It’s a bit of both. Those familiar with investor behavior in the SaaS community know about the Rule of 40, in which the sum of revenue growth and cash flow margin are summed (or portioned in a formula) and “better” models produce growth plus margins in excess of 40%.This blended measure of growth and income doesn’t exactly translate into the RIA space, but if we run a sample DCF with some common assumptions about the cost of capital (mid-teens), fee schedules (50 basis points and flat), and margin sustainability (also flat), then we can see implied valuations (measured as a revenue multiple) remaining fairly consistent if you look at a percentage point of AUM growth being worth about the same as 2.5% in margin (say, 25% margin and 5% AUM growth produces about the same revenue multiple as a 30% margin and 3% revenue growth).This example isn’t meant to be probative of anything, except to say that trading some margin for growth can enhance valuations in the RIA space, but it's not an all-or-nothing proposition. Striking a balance between profitability and upside provides more value for investors, and, ultimately, more value for the investment.

September 2022

In this issue: 2022 Core Deposit Intangibles Update

Importance of an Independent Informed Valuation

In contested cases where a business interest comprises a significant portion of a divorcing couple’s net worth, it is common for one or both parties to retain a business appraiser to value the business.

NIB Deposits Anesthetize Bond Pain

The August Bank Watch looks at unrealized losses in bank bond portfolios based upon Call Report data as of June 30, 2022. Our review of unrealized losses as of March 31 can be found here.Fed Chair Powell gave a short 8-minute speech on August 26 at the annual Jackson Hole, Wyoming economic summit that is hosted by the Federal Reserve Bank of Kansas City. The gist of Powell’s speech is that the Fed is solely focused on reducing inflation. Powell’s speech in 2021 discussed “transitory” inflation and the timing of when the Fed might begin to reduce its monthly purchase of $120 billion of U.S. Treasuries (“UST”) and Agency MBS. At the time consumer prices were then advancing around 5% vs 9% now.Last year, equity markets liked what it heard from Powell at Jackson Hole regarding the liquidity spigot; not so this year as the S&P 500 declined 3.4% and the NASDAQ declined 3.9% the day Powell spoke. The NASDAQ Bank Index declined 2.4% and is down 12.8% year-to-date through August 26.Interestingly, UST yields did not move much even though Powell said it would not be appropriate to stop hiking at a “neutral” rate. As such, bank bond portfolios did not incur additional losses. In fact, the peak loss for most bank bond portfolios was in mid-June when the yield on the 10-year UST rose to 3.49% compared to 2.98% on June 30 and 3.04% on August 26.Based upon our review of bank second quarter earnings calls and analysts’ write-ups, investors seem to be taking the losses in stride given solid growth in spread revenues as NIM expansion has been dramatic. Last spring that was not the case when the ~150bps increase in intermediate- and long-term rates produced significant losses in bond portfolios given little coupon to cushion the higher term structure.As shown in Figure 1, the Fed has hiked the Funds target rate much faster and by a greater magnitude than it did in 1994 when the Fed waylaid the bond market with 300bps of hikes. Bond portfolios were hammered as the hikes and an upturn in inflation drove longer-term rates higher by ~275bps. The curve became flatter but never inverted as investors assumed a recession would not develop.1Figure 1: 1994 Bond Bear Market vs 2022 Bond Bear Market Powell’s comments last week imply short-term policy rates may go as high as 4% by next Spring based upon futures markets. Given little movement in UST yields, bond investors are pricing in slowing economic activity and possibly lower yields to come. If so, the inverted UST curve prospectively will become more inverted if the Powell Fed can stomach the seemingly probable fallout as it pushes short rates higher. Figure 2: Unrealized Bond Portfolio Losses vs Cost Basis and Tier 1 CapitalClick here to enlarge the image aboveFigure 3: Unrealized Bond Portfolio Losses vs Cost Basis and Tier 1 CapitalClick here to enlarge the image aboveAs shown in Figure 2, unrealized losses as of June 30 were significant though losses and gains are excluded from regulatory capital for all but the largest banks.Unrealized losses in available-for-sale (“AFS”) designated portfolios ranged from an average of 5.7% of cost for banks with less than $100 million of assets to 8.0% for banks with $1 billion to $3 billion of assets. As a percent of tier one capital the range was from 11.3% for banks with $100 billion to $250 billion of assets to 22.5% for banks with $100 million to $500 million of assets.Figure 3 provides the same data as of year-end 1994 when the ten-year UST was near a cyclical peak of ~8%. The bear market of 2022 is far worse than the 1994 bear market. Unlike 1994, portfolios today have little coupon to cushion the impact of rising rates. Also, duration may be longer today.The “coupon issue” today is reflected in low portfolio yields. As an example, the average taxable equivalent portfolio yield for banks with $1 billion to $3 billion of assets was only 1.96% in 2Q22 compared to 1.80% in 4Q21 immediately before the Fed began to hike. By way of comparison, the yield on one-month T-bills as of August 26 was 2.21% and 30-day LIBOR was 2.49%. Cash yields more than bond portfolios and prospectively will yield much more if the Fed pushes the Funds target to 4% by next spring.The good news is that portfolio cash flow should be reinvested at much higher yields to the extent it is not used to fund loan growth or deposit run-off. The same applies to fixed rate loans, which are not marked-to-market but may have comparable losses given both higher rates and wider credit spreads.The exceptionally good news is that non-interest-bearing (“NIB”) deposits, which are the core of core deposits, are driving NIM expansion and growth in spread revenues. Rate hikes this year are inflating the value of NIB deposits. There is no mark-to-market report for a board to see this; rather, the value is in the income statement.The unknowable question is if the Fed can push short-term rates higher without producing a sharp downturn or serious credit event that forces the Fed to blink again. The downturn in bank stocks this year primarily reflects investor expectations about the potential impact a recession would have on credit costs next year; it is not about unrealized losses in bond portfolios. Figure 4: Credit Spreads WidenClick here to enlarge the image aboveAbout Mercer CapitalMercer Capital is a national valuation and transaction advisory firm that has advised banks for 40 years through bear and bull markets. Please call if we can be of assistance.1 The Fed rate hiking campaigns of 2004-2006 (425bps of cumulative hikes to 5.25%) and 2015-2018 (225bps to 2.50%) did not produce as great of losses as the current cycle and 1994. The curve was exceptionally steep in 2004 such that long-term UST rates rose less than 100 bps (Greenspan called it a “conundrum”) while it took a couple of years for long-term yields to peak in 2018 around 3% vs the “all-at-once” episode this year.

The Importance of Purchase Price Allocations to Acquirers

This is the final article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Growing up an avid sports fan, I always enjoyed picking up the paper and flipping to the sports section to see the box scores from the prior day’s games. While the headline score told you who won or lost, the box score gave more information and insights into who played well and the narrative of the game. For example, the box score might tell you that even though your favorite team won, they were dominated by the other team in all the categories except turnovers, or that the team that lost actually “won” each quarter except the fourth and their star player had a bad game. In my view, a purchase price allocation is similar to a box score in that it provides greater detail from which to derive insights on a particular transaction. While a purchase price allocation (PPA) analysis is primarily an accounting (and compliance driven) exercise, it is also a window into the objectives and motivations behind the transaction. When used proactively and/or during the M&A process, the disciplines of PPA analysis can provide buyers with important perspective concerning the unique value attributes of the target’s intangible asset base, which can help rationalize strategic acquisition consideration or forewarn of potentially unstable or short-lived intangible asset value. Below we explore PPAs further with a broad overview and then a deeper look into the pitfalls and best practices related to them.Introduction to PPAsAcquirers conduct PPAs to measure the fair value of various tangible and intangible assets of the acquired business. Any excess of the total asset value implied by the transaction over the fair values of identified assets is ascribed to the residual asset, goodwill.Intangible assets commonly identified and measured as part of PPA analyses include:Trade name - Trade name intangibles may be valuable if they enhance the expected future cash flows of the firm, either through higher revenue or superior margins. The relief from royalty method, which seeks to simulate cost savings due to the ownership of the name, is frequently used to measure the value of trade names.Customer relationships - Customer relationships can be valuable because of the expectation of recurring revenue.Technology - Technologies developed by the target business are valuable because the acquirer avoids associated development or acquisition costs. Patents and other forms of intellectual property may provide legal protection from competition and help secure uniqueness and/or differentiation.IPR&D - Ongoing R&D projects can give rise to in-process research and development intangible assets, whose values are predicated on expected future cash flows.Contractual assets - Contracts that lock in pricing advantages – above market sales prices or below market costs – create value by enhancing cash flow.Employment / Non-competition agreements - Employment and non-competition agreements with key executives ensure a smooth transition following an M&A transaction, which can be vital in reducing the likelihood of employee or customer defection. The value of an enterprise is often greater than the sum of its identified parts (both tangible and intangible), and the excess is usually reflected in the residual asset, goodwill. GAAP goodwill also captures facets of the target that may be value-accretive, but do not meet certain criteria to be identified as an intangible asset. Notably, fair value measurement presumes a market participant perspective. Goodwill may also include acquirer-specific synergistic or strategic considerations that are not available to other market participants. Consequently, goodwill has tended to account for a significant portion of allocated value in truly strategic business combinations.Pitfalls and Best Practices of PPAsBelow we highlight some pitfalls and best practices gleaned from providing purchase price allocations to acquirers since the advent of fair value accounting.What are some of the pitfalls in purchase price allocations?Sometimes differences arise between expectations or estimates prior to the transaction and fair value measurements performed after the transaction. An example is contingent consideration arrangements – estimates from the deal team’s calculations could vary from the fair value of the corresponding liability measured and reported for GAAP purposes. To the extent amortization estimates are prepared prior to the transaction, any variance in the allocation of total transaction value to amortizable intangible assets and non-amortized, indefinite lived assets – be they identifiable intangible assets or goodwill – could also lead to different future EPS estimates for the acquirer.What are the benefits of looking at the allocation process early?The opportunity to think through and talk about some of the unusual elements of the more involved transactions can be enormously helpful. Similar to a coach who may look at the box score from the first half of a game during the halftime break, we view the dialogue we have with clients when we prepare a preliminary PPA estimate prior to closing as a particularly important part of the M&A project. This deliberative process results in a more robust – well-reasoned analysis that is easier for the external auditors to review, and better stands the test of time requiring fewer true-ups or other adjustments in the future. Surprises are difficult to eliminate, but as they say, forewarned is forearmed.Can goodwill be broken into different components?If so, what are the different components and how are they delineated?In the world of FASB, goodwill is not delineated into personal goodwill and corporate or enterprise goodwill. However, in the tax world, this distinction can be of critical importance and can create significant savings to the sellers of a C corporation business.Many sellers prefer that a transaction be structured as a stock sale, rather than an asset sale, thereby avoiding a built in gains issue and its related tax liability. Buyers want to do the opposite for a variety of reasons. When a C corporation’s assets are sold, the shareholders must realize the gain and face the issue of double taxation whereby the gain is taxed at both the corporate level, and again at the individual level when proceeds are distributed to the shareholders. Proceeds that can be allocated to the sale of a personal asset, such as personal goodwill, may mitigate the double taxation issue.The Internal Revenue Service defines goodwill as “the value of a trade or business based on expected continued customer patronage due to its name, reputation, or any other factor.”1 Recent Tax Court decisions have recognized a distinction between the goodwill of a business itself and the goodwill attributable to the owners/professionals of that business. This second type is typically referred to as personal (or professional) goodwill (a term used interchangeably in tax cases).Personal goodwill differs from enterprise goodwill in that personal goodwill represents the value stemming from an individual’s personal service to that business, and is an asset owned by the individual, not the business itself. This value would encompass an individual’s professional reputation, personal relationships with customers or suppliers, technical expertise, or other distinctly personal abilities which provide economic benefit to a business. This economic benefit is in excess of any normal return earned on other tangible or intangible assets of the company.What other problems/issues beyond a PPA can you help acquirers navigate?As part of our full suite of services for acquirers, we can handle a number of different kinds of special projects that corporate finance departments may be looking to outsource, completely or partially. For example, our firm helps clients think through certain financial or strategic questions – what level of cash flow reinvestment will best balance competing shareholder interests? Or, what is the appropriate hurdle rate when evaluating internal projects vs. acquisitions for capital budgeting exercises? In other instances, we perform financial due diligence and quality of earnings analyses for transactions.ConclusionAs the “box score” of transactions, PPAs can be an important tool for acquirers and provide greater insight into the motivations and narrative behind a transaction by illustrating the value of various intangible components of a business beyond the collection of tangible assets and how those compare to the purchase price being paid. Our purchase price allocations can be more robust with fewer surprises when we have also worked with the clients before the close of the transaction on elements such as financial due diligence or contingent consideration estimates, or even broader corporate finance and PPA studies.Mercer Capital has extensive experience valuing intangible assets for purchase price allocations (ASC 805), impairment testing (ASC 350), and fresh-start accounting (ASC 852) and assisting buyers during financial due diligence. Call us – we would like to help.1 IRS Publication 535: Business Expenses, Ch. 9, Cat. No. 15065Z

The Importance of Purchase Price Allocations to Acquirers

In this article we provide a broad overview of PPAs and then a deeper look into the pitfalls and best practices related to them.

What We’ve Been Reading

We hope you are enjoying the last dog days of summer as the calendar turns to college football, the kids get back to school, and the mid-term political season kicks into high gear. In this post we share several pieces we have been reading that you may have missed over the last few weeks.Advisor CornerThe Family Business Consulting Group discusses how a non-family CEO and a family ownership team got on the same page regarding the financial goals of the company. Where did the CEO need to steer the company to meet the family’s financial objectives? The first step is to quantify and verbalize those goals beyond “be profitable.” The authors provide a simple roadmap for undertaking that process.How do you deal with a family member who needs to let go of the reigns but refuses to get out of the saddle? An article in Harvard Business Review identifies strategies to help family manage an impaired leader to avoid damaging the company — and the family.Are family businesses more resilient? Deutsche Bank recently published a study that showed many German family-owned businesses fare better in complex crises, such as the recent COVID-19 pandemic response. Reasoning included financial stability from more conservative capital structures, shorter (quicker) decision-making channels, and emotional anchoring focused on long-term success.A Fun Family Business StoryFamily Business Magazine recounts the history of Radio Flyer, a family-owned business who makes the iconic Radio Flyer wagon. Robert Pasin is the third-generation CEO (or as he prefers, “Chief Wagon Officer”) and the piece highlights the dramatic, decade long overhaul that was needed to rescue the company. My children and their Radio Flyer tricycle thank Mr. Pasin.Legislative Update: Inflation Reduction ActThe National Law Review did a good job listing the primary provisions of the Inflation Reduction Act, including important corporate tax provisions (stock buyback excise tax and corporate alternative minimum tax) as well as healthcare and alternative energy changes. While the changes in direct tax legislation were aimed at large public corporations, we can’t help but anticipate that the $80 billion in new funding won’t boost the current generationally low tax audit rate for individuals and businesses.Both the Tax Foundation and the non-partisan Penn Wharton Budget Model see little to no impact on near-to-mid term inflation. The Tax Foundation sees long-run GDP declining marginally (negative 0.2%) from baseline projections driven by the bill, while the PWBM sees a 0.2% increase by 2050.

Rideshare: Friend or Foe to Auto Dealers and Manufacturers?

Fifteen years ago, the term “ridesharing” did not exist. There were taxi and coaching services across the country, but ridesharing as an industry emerged in the late 2000s. It changed how people could “catch a ride” when using a personal vehicle was problematic or not a good decision (For example: driving after a night of drinking alcohol or when the rider is not old enough to drive).Ridesharing differs from taxi services in a couple of ways, the most notable difference being the “network effect.” Taxi services are, or at least were for the most part, city-specific, and the network effect that rideshare applications developed made it so that consumers could download one application and have access to a ride in almost every major city across the country. While many companies may call themselves things like the “Uber of X”, an early pitch deck for Uber called it the “NetJets of car services.”While taxi displacement is core to Uber’s rideshare operations, it’s called rideshare, not taxi replacement, because a key tenet of Uber's pitch was to reduce emissions by allowing strangers to carpool. In theory, this would structurally reduce the number of vehicles on the road, a major potential threat to auto dealers. Individuals could turn on a ridesharing application on their mobile phone while on the way somewhere and make a few extra dollars by picking others up and taking them to their destination as well. While this convention certainly caught on and was to the liking of environmentalists, there was another impact that the creators of ridesharing might not have seen coming, the rise of the “gig economy.” The gig economy propelled ridesharing into the stratosphere by giving people a way to work on their own time and using their own resources, namely their personal vehicles.As mentioned previously, the crux of the rideshare strategy was pitched as reducing the number of vehicles on the road, with Uber replacing taxis and also doubling as personal vehicles. It is important to note, however, that executives and shareholders’ goals for ridesharing companies are primarily to earn profits and expand market share, while other stakeholders may view the ridesharing industry as a means to combat climate change and shift United States’ culture away from an automobile-centric society.This “culture-shift” sentiment contradicts the common goal of auto manufacturers and auto dealers, which is to sell as many vehicles to as many consumers as possible. As the rise of mass rideshare companies took hold in the early 2010s, many players in the auto industry were left wondering what the rideshare wave would mean for auto dealerships.In this post, we focus on the impact of Uber and Lyft on the auto industry as a whole, particularly as compared to initial concerns. We address the questions: “How has the rise of rideshare giants affected the auto industry?”, “How did the COVID-19 pandemic affect ridesharing?” and “What can we expect from the rideshare industry going forward?”Expectations and Results – What Was the Anticipated Effect of Ridesharing on the Auto Industry?After Uber Technologies (founded in March 2009) and Lyft (founded in June 2012) took the main stage, some auto industry experts predicted that vehicle sales would not be heavily affected by the rise of the rideshare industry. These optimists expected regular taxis and public transportation (buses, trains, subways, etc.) would take the largest hit from these companies’ emergence. Vehicle ownership was not expected to decline in a meaningful way, as vehicles were expected to remain a staple of the United States’ culture and the economy.On the flip side of the coin, pessimists predicted that rideshare services would lead to a decline in sales volumes of automobiles as more consumers use rideshare applications in lieu of personal vehicles. To take the pessimists' outlook to the next level, many thought that fleets of autonomous vehicles would soon take over the road, eliminating the need for personal vehicles, especially in larger cities where public transportation has historically cut into consumers’ need for a car or truck.From our viewpoint, with the benefit of hindsight, it appears the optimists’ opinions were on the money. Carmakers were experiencing a record sales pace before the COVID-19 pandemic (more than five years into a world with ridesharing applications). The taxi, luxury coaching, and rental car industries were reeling, however, as rides from rideshare applications were much cheaper than these traditional operators, mostly due to aggressive pricing designed to capture market share during each company’s growth phase.From a macro perspective, auto dealers and manufacturers had to be relieved that the pain was felt elsewhere, despite taxi, coaching firms, and rental car companies' position as an important revenue source for auto dealers through fleet sales. However, fleet sales to these operators have traditionally been at much lower margins than sales of autos to individual consumers who might decide to become rideshare drivers. That shift could actually be a positive development for auto dealers.How Did the COVID-19 Pandemic Affect the Ridesharing Industry?The COVID-19 pandemic brought Uber and Lyft to a halt. In April 2020, ridership from both companies dropped between 70-80%. Both operators went into a “survive until we can thrive” mode, intending to hold out until passengers felt comfortable returning to the convenience of ridesharing. This revenue crater was not to the advantage of public transportation either, as those services saw a nearly 90% drop in ridership over the same time period. As an aside, auxiliary services like Uber Eats cushioned the pandemic’s blow on ridesharing companies (Uber Eats revenues grew more than 50% during the first quarter of 2020). This came as a result of consumers leaning into food delivery as a response to fears of being infected by the virus at the grocery store or at restaurants.The drop in ridership was accompanied by a sharp contraction in the SAAR metric, a measure of sales pace for auto dealers. The sales pace for automobiles across the country slowed to a crawl in April 2020 as dealer lots remained packed with vehicles that had very little interest from cautious and confused consumers. Not many folks were willing to make a large purchase with so much uncertainty abound, especially not the purchase of a vehicle during stay-at-home orders and the work-from-home movement.So did the pandemic change the landscape as it relates to auto dealers and the effect that ridesharing is having on the industry? We would say no. A recovery by both rideshare giants in late 2021 and into 2022 was encouraging to see for their investors, and as many of our readers know, auto dealers have seemingly been printing money in late 2021 and 2022. One industry’s success has clearly not been a bad thing for the other industry. Perhaps the pessimists mentioned earlier in this blog were wrong.What Can We Expect From Ridesharing Going Forward?Can we expect the ridesharing industry to continue to co-exist with auto dealers? Our answer is yes. The rise of Uber and Lyft has certainly impacted overall mobility. However, auto dealers have not borne the brunt of this displacement. The emergence of ridesharing has instead displaced taxis, coaching services, and rental car companies.At Mercer Capital, we follow the auto industry and adjacent industries closely to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of August 15, 2022

Far(ther)sighted or Blind Ambition: Tech Platform Nets RIA a Big Price

Farther Finance Advisor’s Recent Capital Raise Implies a Valuation at 20% of AUM and 20x Run-Rate Revenue

We’re sometimes surprised when we hear about buyers paying 20x EBITDA for RIAs with under $1 billion in assets under management, so you can imagine our reaction to MassMutual Ventures, Bessemer Venture Partners, and Khosla Ventures paying an implied valuation at 20% of AUM and 20x revenue for Farther Finance Advisors, a start-up, tech-heavy RIA with $250 million in AUM. We’ll explore the logic and potential pitfalls of this valuation in this week’s post.FarsightedAccording to Farther’s 2020 Form ADV, the firm had $19.5 million in AUM at year-end 2020, and recent reports have client assets at $250 million, which is 12.8x the amount from eighteen months ago with little or no market tailwind. If we extrapolate this growth for another eighteen months then AUM will reach $3.2 billion by the end of 2023, and a $50 million valuation would certainly be justified (1.6% of AUM at that point). We’ve seen RIA start-ups achieve this kind of growth with the right investment performance, market penetration, and/or technology offering. Recent examples include Facet Wealth and Vise AI Advisors, which have both raised significantly more capital with a similar AUM base and trajectory. It’s somewhat rare for RIA firms to achieve this level of growth and investment shortly after inception, but investors are handsomely rewarded if the firm’s ambitious projections are realized.Farther intends to use its proprietary wealthtech offering to enable advisors to focus on client needs and business development rather than the administrative challenges of working for a wirehouse or managing their own practice. This plug-and-play advantage likely explains how it has already recruited 27 advisors from independent channels and wirehouse firms. Farther’s technology also enables these advisors to work remotely, so there are no geographic constraints to serving clients across the country. Continued recruitment of advisors with established books of business should allow the firm to maintain its growth trajectory regardless of market conditions. Current and historic operating losses also create valuable tax shields in future periods to enhance cash flow when the business becomes profitable.ShortsightedIn our experience, RIA investors are generally more focused on earnings (EBITDA or net income) rather than activity (AUM and revenue) metrics since their returns are based on the firm’s underlying profitability. Recent reports state that Farther has 50 employees, so it’s probably safe to assume that it’s still losing money despite its impressive growth trajectory. Much of the firm’s future growth is contingent upon hiring additional advisors and existing advisors growing their book, but the payout to advisors goes from 50% to 75% after their first $500,000 in production, so Farther’s retention ratio declines when this happens. Management fees also start at 1% of AUM (account minimum of $100,000) and decline at higher asset levels, so it's difficult to see Farther entering the black this year even with continued growth in client assets.There’s also the issue of chronic dilution as advisors can gain equity in the firm, which has already completed two capital raises since its founding in 2019. Additional rounds of equity financing may be needed to fund future growth if time to breakeven takes longer than expected.You Have to be Farsighted to Justify This Investment Farther is effectively a long duration asset. It’s currently unprofitable and probably won’t reach breakeven for at least another year, so there’s no real prospect for interim cash flows (dividends) in the foreseeable future. There’s also no immediate market for the stock since it’s illiquid and has only a few shareholders. Farther’s current investors are banking on it to continue its recent growth and eventually hit a normalized margin, but this could take some time given its current headcount and payout structure.We’re used to looking at these businesses through the Fair Market Value lens that focuses on the prospective returns that a hypothetical buyer would reasonably expect to achieve with his or her investment. From that perspective, 20% of AUM and 20x revenue for an unprofitable RIA doesn’t make a lot of sense, but that’s not how its current investors are evaluating this investment. These are sophisticated investors with a long-term horizon and willingness to assume a high level of risk for an investment with extraordinary growth (and value) potential. We hope it works for them and will definitely keep an eye on it.

Powersports: Alternative Growth Opportunity for Auto Dealers

As we’ve written in previous posts, auto dealers have experienced heightened profitability over the last two years. For those without succession in place, the industry continues to experience a high level of M&A and transaction activity. For others interested in growing or scaling operations, bolt-on acquisitions of other franchises in similar or adjacent markets can present an attractive return.While those opportunities don’t always arise, dealers with excess cash from continued profits or remaining PPP funds have alternative investment choices. One such opportunity is entering the powersports industry through an acquisition of a powersports dealership or opening a point themselves. As one auto dealer client recently recounted to us, “if you have the skills and experience in selling high volumes of automobiles to consumers, then you have the necessary skills to also succeed in the powersports industry.”In this post, we discuss what comprises the powersports industry. We also offer some statistics about the size of the market in the United States and highlight similarities and differences to the traditional auto dealer industry.What Is the Powersports Industry?Although not as clearly defined and reported on as often as the automotive or auto dealer market, the powersports industry is a subset of motorsports which generally includes vehicles such as motorcycles, all-terrain vehicles (ATVs), snowmobiles, personal watercrafts, scooters and other alternative vehicles. According to IBIS World, the size of the powersports and related motorcycle dealership industry is expected to reach $34.4B in annual sales in the United States for 2022. The industry is expected to reach $131B globally by 2028, according to Insight Partners, which forecasts annual growth of just under 5% for the next six and half years.Similarities to Auto DealersDealer Agreements – Like traditional auto dealers, powersports dealers have formal agreements with the manufacturer of the vehicles. In powersports, they are referred to as dealer agreements rather than franchise agreements but consist of many of the same elements including territory/area of responsibility, exclusivity of competition, sales volume requirements, etc. One key difference in these arrangements is that most powersports dealers will have dealer agreements with multiple OEMs whereas a higher percentage of auto dealers have only one franchise agreement (single point stores). While all the headlines seem to be about larger public or private auto dealership groups with multiple rooftops in one legal entity, 93% of owners had 1-5 auto dealerships in 2021. By contrast, a powersports dealer may have dealer agreements with Kawasaki, Yamaha, Polaris, Suzuki, Sea Doo, etc.Departments/Profit Centers – Most powersports dealers have four departments or profit centers: new vehicle, used vehicle, service/parts, and finance/insurance. While most powersports dealers do not have rigid/formal financial statements that have to be submitted monthly to the manufactures like their automotive counterparts, there is useful information in their financials to analyze the size and overall profitability and performance of each department. Generally, there is less unit/volume information provided in the financial statements than auto dealers whose manufacturers use this data in order to determine which models are selling better than others.Industry Terminology – The value of a powersports dealership is typically reflected in a single dollar value and as a reflection of Blue Sky or the intangible value of the various brands/dealers they represent. As with auto dealers, the Blue Sky value can be expressed as a multiple of normalized pre-tax earnings. One distinct difference in powersports is the lack of published blue sky multiples. The lack of published multiples makes the valuations, and specifically the market approach, more difficult for powersports dealers. Dealers in this industry subsection also pre-purchase inventory from the manufacturer and refer to the related liabilities as floor-plan debt like their auto dealer counterparts.Recent Industry Conditions – Inventories have also been constrained like traditional automobiles due to ongoing supply chain issues of raw materials and microchips, and also intermittent plant shutdowns of the manufacturers. With tight inventories coupling with high demand, profitability for powersports dealers has also increased in the last two years, but to a lesser degree than the profitability of auto dealers.Pre-order/Direct to Consumer Sales Model – Powersports dealers have shifted more towards pre-orders and several manufacturers have introduced more direct sales models to consumers. Our understanding of this trend in powersports is more directly related to the constraint on new vehicle supply than the struggle over profit allocation between the manufacturer and the dealer occurring in automobiles. Nevertheless, the manufacturer and the dealer are both vying for the ownership of the customer and their related purchasing experience. In our view, direct sales may make more sense for powersports dealers who more frequently see customers wanting customized features on their rides.Zero Emission/Electric Vehicles – The powersports industry is not immune to the increase in investment and the proliferation of electric vehicles that are also occurring with traditional automobiles. Powersports manufacturers emphasize combining electric power trains and battery systems in their vehicles. For example, Polaris introduced a new electric Utility Terrain Vehicle (UTV) Ranger EV equipped with a single 48-volt induction motor with 30 horsepower.20 Group or Peer Groups – Several of our powersport dealer clients belong to peer groups. While not as formal and frequent as their auto counterparts, peer groups can benefit powersports dealers. These groups provide forums for best practices and opportunities to improve the overall management process of the dealership. Further, peer groups can provide comparable sales and profitability data with other dealers in your region that can provide evaluation and benchmarking activities. Powersports dealerships used to be primarily run by enthusiasts who got into the business because they simply enjoyed their vehicles. Over time, management has become more professional particularly as more auto dealers have entered the space, which partly explains why powersports operations have come to more closely resemble auto dealers over time.Differences From Auto DealersMore Dependent on Macroeconomic Factors - Since most of the purchases in the powersports industry represent secondary/alternative or recreational vehicles, this industry is more dependent on macroeconomic factors than the auto industry. As auto dealers have seen in the past year, demand for primary personal vehicles may be more inelastic than previously thought. Specific factors such as the level of disposable income and customer sentiment are important in the powersports industry. Households with median incomes over $100,000 tend to purchase more vehicles in the powersports segment. Consumer sentiment measures the level of optimism consumers feel about their finances and the state of the economy. Consumer sentiment indexes also predict how likely consumers are to buy things based on changes in economic activity. The pandemic had conflicting impacts on the powersports industry. On one hand, business shutdowns and unemployment had a negative impact on the industry. Conversely, the shift to more outdoor recreational activities had a positive impact on the industry. It will be interesting to see how the current economic conditions will impact the industry for the remainder of 2022.More Dependent on Demographics/Geographic Location – While these factors are important for auto dealers, they are perhaps more important for powersports dealers. We have previously written about geographic markets favoring certain brands or types of vehicles, such as trucks in Texas, or SUVs and crossovers in Colorado or Alaska. According to IBIS World, nearly 44% of consumers buying motorcycles and powersports vehicles are between the ages of 25 and 49. Further, since most of these vehicles are used for recreational or secondary purposes, the location of a powersports dealer and the balance of its proximity to rural and urban areas can be critical to performance and success.Less Competition – The number of auto dealerships in the United States has ranged between 16,000 and 17,000 for the last several years, despite the consolidation and transaction volume. While not as clearly defined, First Research reports approximately 7,000 motorcycle dealers. First Research, like IBIS World, are industry research publications that define the industry as including motorcycles, sport vehicles, ATVs, scooters, etc. Whatever the exact comparable number of powersports dealers in the United States, there is much less competition than traditional auto dealerships. Auto dealers compete with countless local/regional dealers in the various franchise segments (domestic, import, mass market, luxury, etc.). Powersports dealers typically compete with 1 to 4 similar dealerships depending on their geographic location. With fewer powersports OEMs and the greater likelihood that a dealer carries these brands themselves, competition on the local level can be a lot easier for dealers that also compete in the auto industry.Repairs & Maintenance as a Percentage of Original Cost – The amount of customization on recreational vehicles is typically a higher percentage of the original cost than for automobiles. Further, powersports vehicles also require more frequent repairs and maintenance than automobiles. Recreational vehicles are subjected to extreme terrain and conditions, such as mud, water, and off-road terrain, causing components to require more repairs or seasonal maintenance. Like auto dealers, these types of services tend to be higher margin and more frequent, which are advantageous from a valuation perspective.ConclusionsThe powersports industry is growing in terms of size and popularity. Numerous similarities to auto dealers could lead to common ownership or potential growth opportunities. Contact a professional within the Auto Team at Mercer Capital if you have a powersports dealership or are evaluating an investment in a powersports dealership.At Mercer Capital, we follow the auto industry and adjacent industries closely to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements.

Review of Key Economic Indicators for Family Businesses in Q2 2022

With economic data for 2Q22 trickling in, we take a look at a few key trends that developed during the quarter. Volatile equity markets, ongoing inflationary concerns, and rising interest rates drove headlines in the second quarter of the year. The information in this post provides a concise and unbiased look at some of the trends that manifested themselves during the quarter. Data and commentary are largely sourced from Mercer Capital’s National Economic Review (subscription required), which is published on a quarterly basis and summarizes macroeconomic trends in the U.S. economy.GDPAccording to advance estimates by the Bureau of Economic Analysis, GDP growth in the second quarter of 2022 decreased at an annualized rate of 0.9%. The decrease was driven by declines in private inventory investment, residential and nonresidential fixed investment, and government spending (local, state, and federal). Mitigating factors to the decrease in GDP were increases in personal consumption expenditures and exports. Imports, which are subtracted from national income and product accounts, increased in the second quarter of the year, which also led to the decline in GDP growth in the second quarter of the year.Economists expect GDP growth to resume in the next two quarters, albeit at slower rates than previously forecast. A survey conducted by TheWall Street Journal in July reflects an average GDP forecast of 1.5% annualized growth in the third quarter of 2022, followed by 1.1% annualized growth in the fourth quarter.Click here to enlarge the image aboveInflationEstimates from the Bureau of Labor Statistics released last week reveal that the Consumer Price Index (“CPI”) was unchanged in July 2022 on a seasonally adjusted basis after rising 1.3% in June. On a year-over-year basis, the CPI increased 9.1% from June 2021 to June 2022, which is the largest year-over-year increase since November 1981. The index increased 8.5% on a year-over-year basis in July. Notably, the gasoline index fell 7.7% in July, which offset increases in the food and shelter indexes, leading to the unchanged overall index. The Wall Street Journal survey reveals the expectation that inflation will remain persistent through the balance of 2022, as respondents predicted, on average, an annual rate of 6.9% in December 2022 before falling back to 3.9% by June 2023. The Producer Price Index (“PPI”) is generally recognized as predictive of near-term consumer inflation. The PPI decreased 0.5% month-over-month in July 2022 and increased 9.8% in the twelve months ended July 2022.Monetary Policy and Interest RatesThe Federal Reserve’s Open Market Committee, or FOMC, raised interest rates at both of its meetings in the second quarter. At its May meeting, FOMC members voted unanimously to raise the benchmark rate by 0.50%, placing the benchmark rate in a range of 0.75% to 1.00%. This was the largest such rate increase since 2000. Additionally, FOMC members approved a plan to shrink the Fed’s $9 trillion asset portfolio by allowing billions of dollars in treasury and mortgage bonds to mature each month through the balance of 2022 without reinvesting the proceeds into new securities. Following the meeting, Chairman Powell indicated that FOMC members broadly agreed that additional half-point rate increases could be warranted at the FOMC’s June and July meetings.The FOMC raised rates by 0.75% at its June meeting, leaving the benchmark federal-funds rate in a range of 1.50% to 1.75%. This was the largest rate increase enacted by the Fed since 1994. According to projections released after the June meeting, all eighteen members of the FOMC anticipated raising the benchmark rate to at least 3.00% by the end of 2022. Further, more than half of the FOMC members indicated that the fed-funds rate could increase to 3.375% by the end of 2022. Following the meeting, Chairman Powell acknowledged the increasing difficulty the Fed could face in executing a “soft landing” in which the economy slows enough to harness inflation without inciting a recession. Observers interpreted this acknowledgment as an implicit concession by the Fed of the downside risks that could manifest themselves as the economy acclimates to a rapidly tightening monetary policy environment.The Fed appears to be willing to take a cool down in inflation in exchange for a weaker short-term outlook in terms of GDP and overall economic growthWhile the U.S. economy has not yet officially fallen into a recession (despite two straight quarters of decline in GDP), most Fed watchers agree that Fed Chair Powell and the FOMC won’t relent in their fight to bring down inflation even if it does cause a recession. In short, the Fed appears to be willing to take a cool down in inflation in exchange for a weaker short-term outlook in terms of GDP and overall economic growth. All eyes will be on Mr. Powell this week as he delivers his remarks at the Fed’s annual economic conference in Jackson Hole, Wyoming, on Friday morning. Astute family business directors and management teams would be well-served to pay attention to these remarks, as they will likely shed light on the magnitude and timing of rate increases through the rest of the year, as well as the overall direction of the U.S. economy.

Value Focus | Exploration & Production

Second Quarter 2022 | Region Focus: Permian

Mercer Capital’s Value Focus: Exploration & Production newsletter provides an overview of the industry through supply and demand analysis, commodity pricing, and public market performance. In addition, each issue of this quarterly newsletter focuses on a region, including, Eagle Ford, Permian, Bakken, and Appalachia, examining general economic and industry trends. In this quarter’s newsletter, we focus on the Permian. Notable topics include the impact of Russia’s invasion of Ukraine on oil prices, the deleveraging of the majors relative to the constituents of the S&P 500, the increase in production in the Permian compared to other basins, and Earthstone Energy’s acquisition of Bighorn Permian Resources’ Midland Basin assets. Download the Newsletter below.VALUE FOCUSExploration & ProductionSecond Quarter 2022Region Focus: PermianDownload Newsletter

Five Takeaways for RIAs From Focus Financial’s Earnings Release

As one of the more active acquirors in the investment management industry, Focus Financial Partners (Focus) has a broad perspective into the state of the RIA industry and M&A activity. In the article below, we summarize five key takeaways for RIAs based on Focus’ recent Q2 earnings release.1. Deal Activity Remains Near Record LevelsWhile deal activity declined for the second consecutive quarter in Q2, the pace of deals remains elevated relative to historical levels despite the macro backdrop (see RIA M&A Update). According to data from Echelon Partners, the total deal count in the first half of the year increased 39.2% relative to the first half of 2021. For its part, Focus closed or announced 14 transactions through August 4, 2022, a slight decrease from 17 transactions during the same period in 2021. Focus CEO Rudy Adolf pointed to succession planning, aging founders, and the need for scale as enduring factors that have helped sustain deal activity even in a down market.2. Rising Rates Beginning to Impact Some AcquirorsFocus (along with many other aggregators) uses floating rate debt to finance acquisitions, leaving them exposed to higher borrowing costs as rates rise. All of Focus’ ~$2.5 billion in borrowings are tied to either LIBOR or SOFR at spreads ranging from 175 to 250 bps (although Focus has effectively fixed $850 million of its borrowings via hedges at 262 bps). Focus’ net leverage ratio was 3.90x at June 30 (relative to a target range of 3.5x-4.5x), and it’s Q2 interest expense was $19.9 million. The earnings deck includes a sensitivity analysis that indicates that Focus’ pre-tax interest expense would increase by $11.9 million if LIBOR/SOFR were 300 basis points higher.On an after-tax basis, such an increase works out to about $0.11 per share (Focus’ adjusted net income per share was $0.99 in Q2). Focus’ management doesn’t consider its exposure to increased borrowing costs to be significant relative to the firm’s approximate $2.0 billion in annualized revenue. However, many of the PE-backed aggregators in the industry reportedly run at higher leverage ratios than Focus and have higher borrowing costs, which could lead to financial strain as rates increase and financial performance of the underlying firms takes a hit.3. Deal Competition StabilizingThe proliferation of PE-backed aggregators and the professionalization of the buyer market have led to a significant increase in competition for deals in recent years, but that may be normalizing in the current market. Focus’ CEO Rudy Adolf described competition for deals in Q2 as stabilizing relative to the intensely competitive environment seen last year and indicated that there has perhaps been a softening in multiples and that some of the more aggressive buyers during the flurry of deal activity last year may have slowed down the pace of acquisitions given rising borrowing costs and declining fundamentals of prior acquisitions.4. Margins Are Under PressureWe wrote earlier this year about the two-front assault on RIA margins (see Hot Inflation and Cold Markets: RIAs Hit With a New Storm Front). Not surprisingly, the Focus earnings call confirms that many of its partner firms have been impacted by declining revenues and rising operating costs, and margins have been squeezed as a result. As firms experience the negative effects of operating leverage, they’re faced with the dilemma of whether to cut costs to preserve margins or maintain expenses in order to take advantage of the upside once the macro environment improves. On the earnings call, Focus’ CEO Rudy Adolf indicated that they’re not pressuring partner firms to cut expenses—at least yet—so that they’ll have the necessary resources to take advantage of the eventual upswing.5. Contingent Consideration Taking a HitEarnouts are frequently implemented in RIA transactions in order to bridge the difference between buyer and seller expectations. It’s not uncommon to see a significant portion of total deal proceeds paid after closing and contingent on future performance, and the deals put together by Focus are no exception. When part of the consideration is contingent, the acquiror records a liability equal to the fair value of the contingent consideration payments, and that liability is later remeasured as the fair value changes over the life of the earnout (see Purchase Price Allocations for Asset and Wealth Manager Transactions). In theory, an increase in the fair value of contingent consideration liabilities is a positive for the acquiror since it means that the acquisition target is performing well and more likely to meet its earnout hurdles. From an accounting perspective, however, the reverse is true: increases in the fair value of contingent consideration liabilities are reported as operating expenses, whereas decreases are reported as deductions to operating expenses.Echoing the “bad news is good news” macro environment, write-downs of contingent consideration have boosted the earnings of several acquirers, including Focus this year (see Bear Markets Cost RIA Sellers, But Boost Buyers). In the second quarter, Focus reported a decrease in the fair value of contingent consideration of $42.8 million, which in turn boosted earnings by the same amount. This non-cash write down accounted for nearly 90% of Focus’ $49.3 million in GAAP net income for the second quarter.Also noteworthy is that the total cash that Focus paid for contingent consideration declined from $57.0 million during the six months ending June 30, 2021, to $21.4 million for the same period in 2022. While the timing of earnout payments is subject to the specific terms of each deal, we find it interesting that the cash earnout payments of a firm that’s consistently grown via acquisitions declined by more than half year-over-year. For RIA sellers, the significant decrease in cash paid for contingent consideration along with write downs of contingent consideration reported by Focus (and other acquirors) serve as a stark reminder that headline deal multiples aren’t always what they seem, particularly in down markets.

Q2 2022 Public Auto Dealer Earnings Calls

Persistent New Vehicle Inventory Shortages Keep Days’ Supply Low and Pre-sales High - Consumers May Be on Shakier Ground, But Demand is Still Strong

Earnings Calls: Executive SummarySupply issues continue to dominate the industry with no end in sight. New vehicle days' supply is significantly below used vehicle supply given the numerous channels through which used vehicles can be acquired. As one would expect, supply chain issues have less impact on domestic dealerships than imports, particularly luxury.Many dealers currently have a significant number of pre-sold vehicles, which would account for either 0 or 1 days' supply if these vehicles were on the lot. While days' supply in the teens seems astronomically low, compared to 60+ days pre-COVID, the level of pre-sales some dealers are seeing, in actuality, means either there are timing issues with reporting or the vehicles that aren't pre-sold are staying on the lot much longer. For example, if a dealer has 50% pre-sold and reports 30 days' supply, that means 50 cars are sold in 0 or 1 day, and the others are sitting on the lot for two months. We find this to be an interesting dynamic and wonder if it means OEMs have yet to perfect which models to build even when prioritizing the most popular vehicles.The question was raised: what do long-term expectations look like, given that the benefits of higher prices have largely flowed to the dealers in this cycle? One analyst suggested dealers might be at peak earnings (which Group 1 said wasn't the case) and that OEMs are starting to see that maybe this is a more sustainable model for everyone. Another analyst noted that dealer margins have tripled in the past couple of years while margins of North American producers have been stable and asked why they haven't repriced some of their vehicle invoices. AutoNation's CEO Michael Manley indicated that the reduction in incentives has effectively improved the net transaction price of their vehicles. However, he conceded that OEMs facing rising costs would likely look to adjust margins going forward.We're going to go ahead and call our shot that a theme next quarter may be share buybacks. This type of capital allocation decision is not unique to auto dealers and therefore is not really an industry "theme," but we still find it notable. The recently passed Inflation Reduction Act came together after earnings were released, and each call mentioned share buybacks as an ingredient in the capital allocation strategy with no mention of the Act.Share buybacks will now be subject to a 1% tax, and it remains to be seen whether that will be enough to deter the activity. As Group 1 Automotive's CEO Earl Hesterberg said this quarter, share buybacks come with no execution risk, unlike M&A. While this opportunity is not really available to private auto dealers, both public and private dealers must figure out the best return available on the heightened profits they're receiving while the inventory shortage persists. Winners and losers will likely be separated by what investments are made before profits normalize.As valuation analysts, we like to note any mention of valuation multiples offered by the public auto dealers, which are pertinent to our private dealer clients. Lithia reiterated their valuation targets (purchase prices 15-30% of revenues, 3x-7x EBITDA, and a minimum of 15% after-tax returns). This quarter, Penske offered their views on current valuations in the marketplace, which are more in keeping with how auto dealers communicate value (in terms of Blue Sky multiples). Mr. Penske said,"If you're looking at a premium luxury, German brand, so BMW and Mercedes, Porsche, Audi you're looking at probably eight or nine times trailing 12 EBT for goodwill plus assets would be what we see. We've been able to make acquisitions for less than that where they're smaller and maybe not in the premium luxury side. Toyota and Honda are very strong. And to me, there are some people that just are going to get out of the business at the point. I think there is competition out there to buy these better points. But what's happening is many of us are running into what we call framework agreements which limit the amount of stores you can have in a particular market or with a particular brand."While this appears to be within the range of Haig's quoted multiples for these brands, it's extremely important to note that this is on trailing earnings or, as one analyst suggested on a different call, "peak" earnings. If a dealer was making $1.5 million pre-pandemic and is now making closer to $3 million, Haig's 3-year average might suggest "ongoing" earnings of $2.5 million. Applying Haig's average mid-point multiple for these four brands (approx. 8.2x), Blue Sky would be approximately $20.5 million. Taking Penske's midpoint 8.5x multiple on LTM earnings of $3 million, Blue Sky value is $25.5 million, or an increase of 24.4%.We also found it interesting that Porsche and Audi were put on the same playing field in terms of multiples, while Haig's Q1 newsletter suggested Audi was closer to 6.75x while Porsche was 9.5x.The comment on framework agreements is also perhaps a different spin on this discussion. While the public dealers have been more acquisitive lately, dealers may not want to wait too long to sell as the buyers able to pay the most may soon run out of runway to complete acquisitions unless a fundamental shift occurs in how many dealerships one company can have in a brand or market.Here are some other major themes from the Q2 2022 Public Auto Earnings Calls:Theme 1: Dealers continue to pre-sell a significant amount of their new vehicles, particularly compared to pre-pandemic pre-sales levels. With questions about an agency model, it's unclear what the long-term rate of pre-sales will look like once inventories normalize."I think the new car business is solid, but it's really hard to understand how strong it is because you have such a low days supply. Generally speaking, we're still pre-selling half the cars that are coming in. So a lot of these cars aren't getting to hit the ground. It varies a little bit by brand, but generally, that's where it is overall." – David Hult, CEO, Asbury Automotive GroupWhen you look at our domestic business, about half of our pipeline is pre-sold. When you look at our volume imports, it's 80%, some as high as 95%. And when you look at our luxuries, it's in the 60% range. And that is right where it's been for the last couple of quarters." – Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 Automotive"I would say on new vehicles, about one-third of our product is pre-sold that's coming in. So that's good. And I think it's a lot of high-demand vehicles. The rest of the stuff may be wait-listed, but it's not pre-sold where we have money on the car. […] We don't have the exact data. We got it by franchise somewhere. But I would say it was close to 50% 90 days ago. So since interest rates have come up, it's definitely affected things, but it's still a robust environment where those cars hit the ground. And if someone that wants to drive the car and there's two other people waiting to drive the same car, and it's still a bit of a frenzy." – Bryan DeBoer, President and CEO, Lithia Motors"Demand is strong as we mentioned. Inventory levels are still incredibly low, high turn rates, and really sustained margins over the last few quarters. In the first quarter, from memory, I reported something like 50% of our incoming three months inventory was sold. I would say that on the domestic side, that is now down to about 35%. On imports, it is sustained, and on premium, it is also largely sustained." – Michael Manley, CEO, AutoNationTheme 2: As one might expect, the degree of unavailability when it comes to the inventory shortage depends on both make and model, with more desirable vehicles being in shorter supply. With global supply chain issues, it also makes sense that domestic vehicles are more readily available."Similar to the last few quarters, we continue to see limited new vehicle production and inventory levels due to supply chain disruptions and strong consumer demand for new vehicles. This contributed to a 33% decrease in same-store retail new vehicle unit sales volume higher than the industry retail SAAR decline of 20% due to our luxury and import weighted brand mix, which continues to have lower days' supply of inventory than domestic brands"– David Smith, CEO, Sonic Automotive"Our domestic days' supply on new is around 60 days. So we have pretty good flow even though there's some in-transit on that. Really our softness in days' supply, which is where we really are selling every car that we get about as quick as we can get them is in our imports, which we're sitting at a 16-day supply and our luxuries are sitting at about a 29-day supply."– Bryan DeBoer, President and CEO, Lithia Motors"We have a 21-day supply of new vehicles with premium at 23, volume foreign at 8, and domestic at 21. New vehicle supply is at 12 days in the U.S. and 32 days in the U.K. We continue to sell into our future new vehicle pipeline to support tour customers, maximize inventory turn and minimize our inventory costs."– Roger Penske, Chairman & CEO, Penske Automotive GroupTheme 3: Continuing a theme from last quarter, analysts asked if executives were seeing signs of a struggling consumer. They also wondered if banks were being tighter with credit, given macro headwinds and inflated vehicle prices, though the public auto dealers generally downplayed concerns. When Penske was asked about entering the captive finance space, their response indicated a level of concern about the strength of the consumer. An analyst offered that there was a tiny sequential erosion in the strength of the consumer, but it was still strong relative to pre-pandemic and relative to supply which AutoNation agreed with."With consumers financially healthy, consumer financing readily available, the car park aged to record levels and sizable pent up demand combined with our technology to improve efficiency and productivity, we are well-positioned to weather the current market conditions. […] I would say people were impulsively buying six months ago. They're probably putting a little bit more thought and care into the selection and the pricing right now."– David Hult, CEO, Asbury Automotive Group"We're seeing no tightening whatsoever. When you think about the asset class performed very well in 2008 and '09. And when I talked to the head of these finance companies, as I said, they're seeing some delinquency increase on the lower end but its back to pre-COVID levels. But I think the reassuring part of that is losses are historic lows and the appetite for car loans is robust. So, we have not lost any car business because of the availability of credit."– Peter DeLongchamps, SVP, Manufacturer Relations, Financial Services and Public Affairs, Group 1 AutomotiveThe demand is there, but the demand is not there for a $640 monthly payment for preowned that's what you're getting and you're selling a 1- to 4- year car right now at $30,000 to $31,000. And so retooling to the 5-year-old plus cars, we're able to get that monthly payment back down into the $400 range, which is historically where it needs to be. So, consumers are buying a little higher amount car at a lower payment. And we've been able to continue to keep our warranty penetration up there. So not concerned at all about preowned demand."– Jeff Dyke, President, Sonic Automotive"Today with delinquencies going up on retail across all other markets, I wonder -- and then you're going to blow up your balance sheet. And on top of that you're going to have to take that and sell it into the market and securitize it. And I think today, the people that buy that are going to say is this really what we want to buy 72-month or 60-month paper from the standpoint in the car business with the inflation that we've had on used car prices? So not that we won't ever get into it, but we think it's a bad idea. Right now, we don't think that glove fits our hand."– Roger Penske, Chairman & CEO, Penske Automotive GroupConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Stock Buybacks and Family Businesses

Stock buybacks were in the news last week as the newly-passed Inflation Reduction Act includes a provision levying a 1% excise tax on share repurchases by public companies. As we’ve noted in previous posts, we question Congress’s grasp of the basic economics of what a stock buyback is, but Congress is not our focus today.Privately held family businesses are exempt from the tax, but it is important for directors to understand the real economics of stock buybacks (or, in the case of family businesses, shareholder redemptions).Family business directors are stewards of family capital. Family shareholders entrust their capital to the family business and the directors and managers of the business use that capital to generate a return. Unlike money from a bank, the family business doesn’t owe interest to its family shareholders. However, that doesn’t mean that family capital is free. There is an opportunity cost associated with family capital. This means that if their capital was not invested in the family business, family shareholders would have the opportunity to invest it elsewhere to earn a return. We refer to that opportunity cost (i.e., what an investor could earn by making a different investment of comparable risk) as the cost of capital. The cost of capital is a critical concept for family business directors as they evaluate how to invest family capital within the family business. The cost of capital is the breakeven point for whether an investment is financially prudent: if the expected return from an investment is less than the cost of capital, the shareholders would be better off investing that capital elsewhere. In other words, outside the family business. The supply of capital projects dwindles as the level of expected return increases. In other words, there are a lot more capital projects that are expected to earn a 5% return than a 15% return. So one of the primary tasks of family business directors is monitoring the supply of attractive capital projects, those for which the expected return exceeds the cost of capital.For some companies, the supply of such projects far outstrips the amount of family capital available to invest. Directors of these companies are faced with a rationing decision: of all the financially acceptable investments that we could make, which ones will we make with our limited family resources? These are generally companies operating in new or growing industries.For others, the supply of capital projects with expected returns in excess of the cost of capital is small. Directors of these companies are faced with different decisions. Do we (1) return capital to family shareholders so they can invest to earn the cost of capital, or (2) do we hold on to the capital and try to find new avenues to invest to earn the cost of capital? Too often, however, directors make a third, ill-advised choice – they hold onto the capital without a compelling plan for how they can use it to earn the cost of capital. When directors elect to return capital, they can do so in two ways, by paying a dividend to all shareholders (pro rata to their ownership interests) or repurchasing the shares of select shareholders. From the perspective of the company, these paths are equivalent economically in that, under both strategies, family capital leaves the family business to be put to use elsewhere. While paying pro rata dividends might seem most “fair,” some family shareholders may prefer to keep their capital invested in the family business, while others might be more eager to put their capital to other uses. Still, other shareholders might be seeking a way to be out of business with their family members. In any of these cases, a share repurchase can be the right tool to both prevent “lazy” capital from accumulating on the family business’ balance sheet and realign ownership interests to better conform to shareholder preferences and risk tolerances. Your congressman may not understand what a share repurchase is, but you and your fellow directors should. If you suspect a share redemption might be in order for your family business, give one of our professionals a call to discuss your situation in confidence.

Bear Markets Cost RIA Sellers, But Boost Buyers

A Public Service Message That Earn-outs Aren’t Always Earned

The history of the auto industry is full of products that were more hype than reality, but maybe none more than the Fisker Karma. The Karma was the luxury hybrid offspring of legendary automotive designer Henrik Fisker. It was supposed to be the future of four-wheel transport: elegant, comfortable, and efficient. It photographed awfully well, and consequently, Fisker got plenty of free publicity in the automotive press. Unfortunately, the product didn’t live up to the promise, as the Karma was cramped for space, not terribly fuel efficient, and very expensive. Battery problems prompted a recall that ultimately killed the company, after selling less than 2,000 units. As we say in the south, Karma’s a biscuit.Earn-outs and ValuationWe’ve written before about how earn-outs are a key provision in most RIA transactions and recent earnings results from public companies in the space bear that out. What some might have characterized as overpayment for past deals has resolved itself via contingent consideration, resulting in right-sized transaction consideration. This lamentable situation for sellers also represents an earnings cushion for buyers. Consequently, we find that RIA valuations in transactions didn’t get as stretched as they might, to many, have appeared.One impediment to getting deals done in the investment management community is the undercurrent that other sellers have received astronomical multiples for their businesses. Indeed, some nosebleed pricing was achieved in many instances in 2021, prompting Focus Financial’s CEO Rudy Adolf to bewail “drunken sailors” who overpaid for acquisitions. The impact of a few irrational players does more than compete away deals from “disciplined” buyers, it also resets expectations for sellers to stay put unless someone is willing to give them a similar deal. Nobody wants nine times when their industry nemesis got fifteen.Earn-outs Resolve Differences in ExpectationsThe gap between buyer and seller expectations can be thought of as a bid-ask spread, and one which often can’t be resolved simply by splitting the difference.The most common way to bridge the bid-ask spread is by way of contingent consideration, also known as an earn-out, in which the buyer agrees to pay something in addition to upfront consideration if the acquired business achieves certain performance metrics after the deal closes. Earn-outs are commonly tied to:Retention: if the acquired RIA retains, say, 95% of AUM as measured at the closing date for a certain period after the transaction. Such a provision guards against the uncertainty of relationship transitions – especially in smaller wealth management practices – as new advisors take over accounts from sellers transitioning out of the business.Growth: if the acquired RIA increases AUM, revenue, EBITDA, or some other key performance metric in the years following a transaction, buyers might pay more to cover some of the increase in value brought about by post-transaction performance improvement. To the extent that sellers can influence the outcome, growth after the close ensures they get paid for some of the upside in their enterprise, while buyers end up with a stronger franchise and often a lower valuation multiple than if the business underperforms.Margin: to the extent that transaction negotiations involve some debate over cost structure, the maintenance or enhancement of profit margins after the close ultimately prove out, or prove wrong, what operating leverage is inherent in the acquired entity. Earn-outs can be structured any number of ways, but ultimately they resolve something of the differences of opinion about the performance that naturally come up between risk-averse buyers and sellers who don’t want to leave money on the table.Earn-outs Resolve Emotional DifferencesEarn-outs also perform an important psychological function in dealmaking. Buyers can report back to their boards and shareholders that they’re only committed to paying for proven performance. If the deal turns out to be less than advertised, the amount they ultimately paid for the target stays fixed – often much lower than it would have taken to close the transaction with entirely upfront consideration. Sellers get bragging rights, as they often anticipate that they will “easily” achieve the projected performance needed to get earn-out payments.Earn-outs help buyers get over the fear of the unknown, as indeed most post-close surprises are negative. For sellers, earn-outs help them get past what is often called endowment effect, or the syndrome that an asset is usually more dear to its holder than it is to someone else.From an M&A marketing perspective, earn-outs fuel interest in deal activity. Sellers tell their friends they got paid X-teen times, a multiple in which the numerator commonly includes contingent consideration as if it had been paid, in full, at close. Buyers don’t mind this, as it attracts other sellers to their brand. And investment bankers love it because it supports deal flow.When Bad News Is Good News, or #FASBknowsbestRecent activity in public RIAs show the impact of earn-outs on ultimate deal consideration, and why sellers shouldn’t confuse contingent consideration with upfront consideration. Several public RIAs, including Focus Financial Partners, Silvercrest Asset Management Group, and CI Financial, reported writing-down contingent consideration in recent quarters on prior transactions.This write-down activity is a peculiar aspect of GAAP (Generally Accepted Accounting Principles), in which the expectation of the payment of earn-outs is made at the time of the acquisition in what is known as the purchase price allocation.By way of example, consider a deal that includes upfront consideration of $25 million and contingent consideration of an additional $15 million, paid over several years and subject to the performance of the target RIA. The transaction isn’t simply booked at the total potential payments, or $40 million. The contingent consideration is risk-adjusted and present-valued. In this example, the $15 million in earn-out payments might be fair valued at only $10 million, such that the transaction is booked at $35 million (upfront consideration plus the fair value of earn-out payments).Over the term of the earn-out, the value of the transaction is effectively remeasured. If the entire earn-out payment of $15 million is earned, the cost of the transaction is $5 million higher than was estimated at close, and the additional payment is recognized as an expense on the income statement. This has a negative impact on the earnings of the buyer.If, on the other hand, the acquired company underperforms, GAAP prescribes that the contingent consideration is remeasured – for public companies on a quarterly basis – in the form of a write-down. In our example, if none of the $15 million in contingent consideration is ultimately paid, then the $10 million fair value of the earn-out would be written off entirely. That write-off flows through the income statement as an offset to expenses; it is money that was to be paid but instead was not paid. Thus, if a target company underperforms expectations, it can – somewhat perversely – increase GAAP earnings of the acquirer.The impact of these write-downs can be material. Focus Financial announced GAAP pre-tax net income in the second quarter of 2022 of $81.5 million. Of this, more than half, or $42.8 million, was a result of a decrease in expected earn-out payments. At CI Financial, about 25% of their GAAP EBITDA in the most recent quarter was a result of writing down contingent consideration ($75 million of $295 million). And at Silvercrest, a similar adjustment to expected earn-out payments constituted nearly half of GAAP pre-tax net income. Of note, the financial disclosures of each of these companies makes the impact of this adjustment very clear, and each eliminates the impact of changes in earn-out consideration from their adjusted (non-GAAP) EBITDA.Earn-out Support Deal Activity in Bear MarketsOn paper, this is how it’s supposed to work. One reason deal activity can remain strong in tough financial markets is that buyers can use earn-outs to control what they pay for deals, offering more money in the event that markets recover and justify higher valuations, and managing their outlays if performance lags. Recent earnings calls allude to this, subtly, with Jay Horgen from AMG noting “constructive pricing and structure” that “insures to the benefit of our shareholders.” Victory Capital’s David Brown noted “some of the way to deal with the difference between buyer and seller expectation is restructuring and timing of payments and partnering in the future of growth.” As a consequence, Focus Financial’s Rudy Adolf noted “overall industry activity is going to remain high. Competition is kind of…normal.”For sellers, the relevant consideration is bear markets may tank a big part of their expected deal consideration, well beyond their control. A falling tide may not simply work to the detriment of sellers, but also hand buyers a bargain purchase when markets improve. Earn-outs align interests in the near term, but can provide asymmetric benefits in years ahead.Westwood Holdings’s recently announced acquisition of Salient Partners is nearly half earn-out consideration: $25 million on total possible consideration of $60 million. 35 to 60 is a pretty tremendous bid-ask spread, although not uncommon in the RIA space. We don’t know what the exact KPIs are that Salient will have to produce to receive full payment. What we do know is that it’s another example of the prominence of contingent consideration in RIA transactions, a situation that we expect to persist.

What Is a Fairness Opinion And What Triggers the Need for One?

For this week's post, we republish a prior post on the subject of Fairness Opinions. It's proven to be one of the most popular posts on the blog. If you missed it the first time, we hope you find it informative and helpful.What Is a Fairness Opinion?A Fairness Opinion involves a comprehensive review of a transaction from a financial point of view and is typically provided by an independent financial advisor to the board of directors of the buyer or seller. The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar companies. The advisor then opines that the transaction is fair, from a financial point of view and from the perspective of the seller’s minority shareholders. In cases where the transaction is considered to be material for the acquiring company, a second Fairness Opinion from a separate financial advisor on behalf of the buyer may be pursued.Why Is a Fairness Opinion Important?Why is a Fairness Opinion important? There are no specific guidelines as to when to obtain a Fairness Opinion, yet it is important to recognize that the board of directors is endeavoring to demonstrate that it is acting in the best interest of all the shareholders by seeking outside assurance that its actions are prudent.One answer to this question is that good intention(s) without proper diligence may still give rise to potential liability. In its ruling in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985), the Delaware Supreme Court effectively made the issuance of Fairness Opinions de rigueur in M&A and other significant corporate transactions. The backstory to this case is the Trans Union board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials. Regardless of any specific factors that may have led the Trans Union board to approve the transaction without extensive review, the Delaware Supreme Court found that the board was grossly negligent in approving the offer despite acting in good faith. Good intentions, but lack of proper diligence.The facts and circumstances of any particular transaction can lead reasonable (or unreasonable) parties to conclude that a number of perhaps preferable alternatives are present. A Fairness Opinion from a qualified financial advisor can minimize the risks of disagreement among shareholders and misunderstandings about a deal. They can also serve to limit the possibilities of litigation which could kill the deal. Perhaps just as important as being qualified, a Fairness Opinion may be further fortified if conducted by a financial advisor who is independent of the transaction. In other words, a financial advisor hired solely to evaluate the transaction, as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a Fairness Opinion.When Should You Obtain a Fairness Opinion?While the following is not a complete list, consideration should be given to obtaining a Fairness Opinion if one or more of these situations are present:Competing bids have been received that are different in price or structure, leading to potential disagreements in the adequacy and/or interpretation of the terms being offered, and which offer may be “best.” Conversely, when there is only one bid for the company, and competing bids have not been solicited.The offer is hostile or unsolicited.Insiders or other affiliated parties are involved in the transaction, giving rise to potential or perceived conflicts of interest.There is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all parties.What Does a Fairness Opinion Cover?A Fairness Opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed in reaching a decision to consummate a transaction. The financial advisor must look at pricing, terms, and consideration received in the context of the market. The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders, especially minority shareholders in particular, provided the advisor’s analysis leads to such a conclusion.While the Fairness Opinion itself may be conveyed in a short document, most typically as a simple letter, the supporting work behind the Fairness Opinion letter is substantial. This analysis may be provided and presented in a separate fairness memorandum or equivalent document.A well-developed Fairness Opinion will be based upon the following considerations that are expounded upon in the accompanying opinion memorandum:A review of the proposed transaction, including terms and price and the process the board followed to reach an agreement.The subject company’s capital table/structure.Financial performance and factors impacting earnings.Management’s current year budget and multi-year forecast.Valuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction price.The investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, and the accretion/dilution to earnings per share, tangible book value per share, dividends per share, or other pertinent value metrics.Address the source of funds for the buyer.What Is Not Covered in a Fairness Opinion?It is important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where a company’s shares may trade in the future.How shareholders should vote a proxy.The reasonableness of compensation that may be paid to executives as a result of the transaction. Due diligence work is crucial to the development of the Fairness Opinion because there is no bright-line test that consideration to be received or paid is fair or not. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock).ConclusionThe Professionals at Mercer Capital may not be able to predict the future, but we have four decades of experience in helping boards assess transactions as qualified and independent financial advisors. Sometimes paths and fairness from a financial point of view seem clear; other times they do not.Please give us a call if we can assist your company in evaluating a transaction.

Navigating Tax Returns Tips and Key Focus Areas Part III

Navigating Tax Returns: Tips and Key Focus Areas for Family Law Attorneys and Divorcing Individuals/Business Owners – Part III

Part III of III- Schedule K-1 and Relevant Business-Related Schedules

This is the third of the three-part series where we focus on key areas to assist family lawyers and divorcing parties. Part III concentrates on Schedule K-1 (Form 1065 or Form 11-20-S) and additional business-related schedules which can be useful in divorce proceedings. Part I discusses Form 1040 and can be found here, and Part II discusses Schedule A (Itemized Deductions) and can be found here.Entities taxed as general partnerships, limited partnerships, limited liability partnerships, limited liability corporations, and S corporations prepare a Schedule K-1 (“K-1”) for each of its owners. The Schedule K-1 identifies the owners of the business and specifies the percentage of equity, profits, and losses that will be attributed to each for tax purposes, among other information. K-1s must be distributed to each owner and filed with the entity’s tax return. Owners then utilize the K-1 when preparing their personal tax returns to substantiate the profits and/or losses they are claiming.Why Would Schedule K-1 Be Important in Divorce Proceedings?Schedule K-1 provides information regarding the business, the individual partner (or member or shareholder), as well as the portion of taxable income or loss that is attributable to each owner. A business owner may not receive a salary and therefore, might not get a Form W-2 Wage and Tax Statement. Schedule K-1 provides the details on profit and loss allocated to the individual from the business. Sometimes other agreements are in place for bonus sharing, etc. and the K-1 reflects each business owner’s proportionate share of taxable income or loss.The K-1 provides evidence of ownership in a business, details the percentage of ownership, and shows business gains and losses for the year allocated to the specific owner, among other information. The business ownership (whether 100% or an interest in the business) may be divisible within the marital estate. If multiple business interests exist, each entity would generate a separate K-1 per owner. The Schedule K-1 can also be used in conjunction with other documents for income determination purposes.Key Areas of Focus for Family Law Attorneys and Divorcing PartiesPart II of Schedule K-1, Information about the Partner –provides details on each individual partner such as the type of entity, partner’s share (beginning and ending) of profit, loss, capital and liabilities, and the beginning and ending capital account of the individual. Box G will indicate if the taxpayer is a general, limited, or other type of partner. Another item to pay close attention to is Box J which is the line that states: “Check if decrease is due to sale or exchange of partnership interest.” If checked, more information may need to be requested to understand the transaction, amended agreement, or other type of sale or exchange.While the K-1 offers helpful information on business ownership percentages and annual profit or loss, additional documentation of the business entity should be requested when performing a business evaluation and/or in conjunction with other forensic services such as income determination.Box L – titled Partner’s Capital Account Analysis presents the ending capital account for the individual partner by showing the following: the beginning capital account, plus capital contributed and current year net income (loss) for the year, less withdrawals and distributions, if any.One should pay attention to the information presented on the Partner’s Capital Account Analysis because it may be a starting point for evidencing distributions (which may or may not be included in W-2 salary), and investments into a business such as a capital call.Part III of Schedule K-1 – is Partner’s share of current year income, deductions, credits, and other income. A few of the individual boxes are explained below.Box 1 – represents the taxpayer’s share of Ordinary Business Income, or Loss, from the corporation. The individual’s income amount is further categorized within Form 1040 depending on whether the income is deemed active or passive. Passive income includes money earned from interest, dividends, and rental property. Active income includes pass-through income or loss, wages and salaries (these may also be included on an individual W-2) or supplemental income. Refer to Schedule E – Supplemental Income and Loss for information on the income; specifically Line 28, which includes column (H) for passive income and column (K) for active or nonpassive income.Box 12 – Section 179 Deduction – is an immediate expense deduction that business owners have the option to utilize for purchases of depreciable business equipment rather than capitalizing and depreciating the asset over a period of time (referred to as straight-line depreciation). This allows businesses to lower their current-year tax liability rather than capitalizing an asset and depreciating it over time in future tax years, i.e., the tax reduction is taken in full versus in smaller amounts over a period of time. The Section 179 deduction is offered as an incentive for small business owners to grow their business with the purchase of new equipment. To qualify, the property is limited to items such as cars, office equipment, business machinery, and computers; this property also must be used for business purposes more than 50% of the time to qualify. This deduction election will also be reported for the individual taxpayer on Form 4562 – Depreciation and Amortization.Information on the K-1 can guide questions to ask and subsequent documents to request in order to understand and evaluate business interest(s).Additional Relevant Business-Related Schedules and Why Each Could Be Important in Divorce ProceedingsForm 4562 – Depreciation and Amortization is used to claim deductions for the depreciation or amortization for tax purposes. Other uses include making an election under Section 179 to expense certain property, and to provide information on the business/investment use of automobiles and other assets. Individuals and businesses can claim deductions for tangible assets, such as a building, and intangible assets, such as a patent. Section 179 property does not include property held for investment, property used outside of the United States, or property used by a tax-exempt organization.The Depreciation & Amortization Schedule can assist the divorce process by providing a listing of depreciable assets. While the form refers to all as “property,” the term stems from an accounting identification of “property, plant & equipment.” These types of assets typically qualify for depreciation, while intangible assets are typically those that qualify for amortization. Amortization is similar to the straight-line method of depreciation in that an annual deduction to taxable income may be allowed over a fixed time period. The taxpayer can amortize such items as costs of starting a business, goodwill, and certain other intangible assets. Part VI – Amortization is the last section of Form 4562, where the business amortization costs are described and listed to calculate amortization for the year for the individual taxpayer.Depreciation and amortization can be found on both the balance sheet and the income statement. Annual and accumulated depreciation/amortization are contra-assets to the respective underlying asset on the balance sheet. On the income statement (also referred to as the profit and loss statement), depreciation and amortization are expense items.One other focus area for divorcing parties is Part V – Listed Property – specifically, Section A – Depreciation and Other Information – Lines 26 and 27. These lines are used to determine depreciation for property used more or less than 50% in a qualified business use, respectively. Generally, a qualified business use is any use in trade or business; however, it does not include investment use, leasing to a 5% or less owner, or the use of property as a compensation for services performed. Column (C) – Business/investment use percentage is where this will be displayed.Schedule L – Balance Sheet per Books, Schedule M-1 – Reconciliation of Net Income/(Loss), and Schedule M-2 – Analysis of Partner’s Capital Account are also worthy schedules to review in conjunction with individuals who own business(es) or interest(s) in business(es). These schedules within Form 1065 or Form 1120-S for S corporations present the financial statements of the business and the activity on a capital account. If business financial statements, such as an income statement and balance sheet, are obtained, these schedules can be used in conjunction with the review of the financial records. Schedule C Profit or Loss from Business can also be helpful if the business owner is a Sole Proprietor, as this schedule is specific to sole proprietorships. As the name implies, this Schedule C provides income, expenses, cost of goods sold, and other expenses during the respective tax year.Schedule L provides the beginning and ending balances on the items on the balance sheet. Schedule M-1, as its name implies, provides the reconciliation of income or loss. The reconciliation occurs because some items are allowed, disallowed, or capped for tax purposes, which may be present on the income statement of the business – travel and entertainment and depreciation are two examples included within Schedule M-1. As we previously discussed, the business may take all of its depreciation in one year for tax purposes, while using straight-line depreciation in accordance with GAAP (generally accepted accounting principles). Depending on the current tax laws, a maximum dollar threshold may be allowed for expensing travel and entertainment for tax purposes, while the business may choose to expense more for internal financial purposes.A review of Schedule M-1 can provide information about potential differences between profits or losses prepared for tax purposes versus internal financial reporting purposes.Some small businesses may not maintain financial statements beyond the information presented in the tax return schedules; hence, it is important to understand which schedules and sections to review if your client owns an interest(s) in a business. However, for businesses that have financial statements, one should request multiple years of financial statements in addition to multiple years of tax returns and understand how to review the documents in conjunction with one another.Reviewing the items listed in these schedules can provide useful information and lead to further document requests in order to review and evaluate business assets, business ownership(s), and active and passive income, among other information.ConclusionUnderstanding how to navigate key areas of Schedule K-1 and supporting schedules is often necessary in divorce proceedings. While we provided background on Form 4562, Schedule C, Schedule E, Schedule L, Schedule M-1, and Schedule M-2, there may be further supporting schedules with helpful information or indicators to request further information. Remember that each case presents different facts and circumstances, and tax returns may vary (specifically which schedules are included).Information within the tax return and supporting schedules can provide support for marital assets and liabilities (specifically those associated with business ownership and/or other types of assets), sources of income, and potential further analyses. Reviewing multiple years of Schedule K-1s and accompanying supplemental schedules may provide helpful information on trends and/or changes and could indicate the need for potential forensic investigations.While we do not provide tax advice, Mercer Capital is a national business valuation and financial advisory firm and we provide expertise in the areas of financial, valuation, and forensic services.

July 2022 SAAR

CHIPS-Plus Act Passes: What Does That Mean for Auto Dealers?

The July 2022 SAAR was 13.3 million units, an improvement from last month's 13.0 million units but down 10.2% from July 2021's rate of 14.7 million units. The SAAR continues to reflect depressed sales rates as supply chain shortages restrict volumes across the United States. The first half of 2022's average SAAR was 13.8 million units, and the beginning of the third quarter has already come in below that figure, further dragging down the full-year 2022 average SAAR. It seems unlikely that the full year SAAR will manage to reach 15 million units absent an unforeseen dramatic reversal.In last week's blog post, the Mercer Capital Auto team discussed industry-wide and Mercer-specific 2022 predictions and laid out revised expectations for the remainder of 2022. In the interest of our regular subscribers, we will not lay those points out for two weeks in a row. See below for some of our regular SAAR blog charts comparing sales and inventory metrics over the last several years:"CHIPS-Plus" Passes – What Does That Mean For Auto Dealers?Several of our posts over the last year have covered the persistent semiconductor shortage in automotive manufacturing. This particular shortage, among other parts' shortages, has been a significant drag on production for over a year now. As far as forward expectations go, most folks that follow the industry have assumed that it would take multiple years for domestic chip-making operations to be able to handle the volume needed to make a dent in chip pricing and availability over the long term. This assumption seems reasonable to us, and not much has happened over the past six months that could change that narrative until this past week.The House of Representatives and the Senate just passed a $280 billion "CHIPS-Plus" (Creating Helpful Incentives to Produce Semiconductors for America) bill in a bi-partisan vote on July 28th, sending the measure to President Biden's desk to be signed into law on August 3rd. This bill raises several questions throughout the auto industry: How will this bill affect the consensus timeline for domestic chip-making facilities to come online? Will the bill subsidize chip-making in a way that will take pressure off pricing? Is there an auto-specific clause in the bill, and if so, what does it lay out? In this post, we try to answer some of these questions and lay out the bill's general structure and contents.Key FactsA recent Forbes article highlights some key facts related to the CHIPS-Plus bill:The bill passed 243 to 187, with 24 Republicans voting alongside 219 House Democrats, one day after the Senate passed it in a similarly bi-partisan 64-33 vote.The bill highlights $52.7 billion in subsidies for U.S. computer chip manufacturing, $39 billion in assistance to build semiconductor facilities, $11 billion to support Research and Development, $2 billion for defense-related chip manufacturing, and $1.5 billion for public wireless supply chain innovation.The bill creates a 25% tax credit for semiconductor manufacturing. The bill also appropriates $10 billion for the Department of Commerce to create 20 regional technology hubs. Political supporters of the bill have touted the measure as a way of easing the microchip shortage by helping the United States catch up with East Asia, which currently produces 75% of the world's microchips. Many of these supporters have said that the bill is critical to national security and the United States' economy, especially given the fact that its key economic rival, China, has rapidly increased its market share in recent years. Wall Street is likely to welcome the support as well. According to a recent Bloomberg article, the Philadelphia Stock Exchange Semiconductor Index has fallen 30% over the past year leading up to the bill's passing, marking the index's worst annual performance since 2008. All 30 stocks in the index were down for 2022 prior to the bill's passing. This decline in semiconductor companies' stock prices can be attributed to rising interest rates and is a part of a larger trend in the equities market (the year-to-date S&P 500's performance was -12.11% as of the writing of this blog). It is great for business owners when the capital markets and the United States legislative bodies come to an agreement on any one thing, so this seems like a win for everyone involved, especially auto dealers and manufacturers. See below for some commentary on how this bill is expected to affect the auto industry.How Does CHIPS-Plus Affect Auto Dealers?While this bill is designed to support domestic chip-making for a large swathe of industries, it is clear that auto manufacturers' pain is among the most severe. According to a recent Automotive News Article, The American Automotive Policy Council released a statement in late July, saying that "There is not a single supply-chain shortage with a greater impact on the U.S. economy than the shortage of automotive-grade semiconductors."Lobbyists and spokespeople for the industry have echoed this sentiment, making it very clear that automotive companies are looking for support to come sooner rather than later, as the process of building a semiconductor fabrication plant can take anywhere from 2-3 years and many of the United States' prospective facilities have been underway for some time now. Senator Gary Peters, a representative from Michigan, has been very outspoken in his support for the CHIPS-Plus bill, saying that "This problem only gets bigger as time goes on. […] The demand for chips is increasing every single year, dramatically. We have to get in front of this problem. […] We have to start building these facilities now."This legislative development is clearly a big win for the auto industry. But how so? What specific positive impact might this bill have? Below, we try and answer some of the questions raised earlier in this blog:So does CHIPS-Plus mean that facilities will come online sooner? The short answer is that it is unlikely. While this legislation might help subsidize these facilities and encourage more facility construction to begin, more subsidies cannot speed up the construction process in a meaningful way. The target for many of the domestic chip-making facilities to come online is still mid-2023. The subsidy is more likely to increase the number of facilities rather than the rate at which they appear.Will the bill subsidize chip-making in a way that will take pressure off pricing? Perhaps. In general, government subsidies are designed to either 1.) encourage an economic activity that might otherwise not occur or 2.) take pressure off of the consumer by artificially lowering the costs of the producer. In the first scenario, legislators might believe that the total economy-wide benefits of chip-making will create positive externalities, or side effects, in the economy, making the subsidy worth taxpayers' money. In the second scenario, producers receive subsidies and can lower prices due to costs being artificially lower, encouraging the purchase of chips through bargain pricing. In our opinion, the first scenario makes more sense in this case, as the demand for microchips is already very healthy. Hopefully, the externalities that come from this bill will carry positive side effects with it, especially for auto dealers.Is there an auto-specific clause in the bill, and if so, what does it lay out? Yes and No. There is not an auto section of this bill, but the auto industry is mentioned two times in the text of the actual bill:Auto manufacturing is mentioned in Section 102 of the bill, referring to the $2 billion incentive program aimed at legacy chip production facilities. This money is intended to support existing facilities in "key industries" as they try and meet demand in the meantime while new facilities come online.Auto manufacturing is also mentioned in Section 103 of the bill, clarifying and amending 2021 legislation to fall in line with Section 102 mentioned above. These sections are aimed at a short-term fix to a long-term issue, with the long-term fix being the new facilities mentioned throughout this blog and throughout the legislation. Going forward, hopefully, this government funding can create some breathing room for manufacturers and dealers in the short term while also addressing the long-term solution.August 2022 OutlookMercer Capital's outlook for the August 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Consumers have largely become conditioned to these higher prices, yet demand remains high due to relatively poor substitutes for personal vehicles, among other factors of course. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Perhaps August's SAAR can eclipse 14 million units and signal a turning of the tide, but we predict that a 14 million unit SAAR for 2022 is an optimistic assumption in the current landscape.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

These Loafers Are Made for Walkin’

Italian Shoemaker, Tod's, Opts Out of the Public Markets

Last week, Tod’s – the Italian maker of luxury shoes – announced plans by the founding Della Valle family to take the company private. Under the proposed transaction, the Della Valle family would invest €338 million to increase its ownership interest from just under 65% to 90%. Following the transaction, the remaining 10% equity position will be held by luxury conglomerate LVMH.The proposed purchase price of €40 per share represents a 21% premium relative to the pre-announcement trading price for the shares of about €33 per share. From a pandemic low of approximately €18, Tod’s share price peaked at approximately €64 per share in June 2021, from which level shares have fallen steadily to the €30 to €35 range preceding the going private announcement.Motivation For TransactionHaving been a public company for more than twenty years, what is the family’s motivation for taking the company private now? According to the Wall Street Journal, the Della Valle family is taking the company private to “accelerate its development” and “free the company of ‘limitations’” resulting from its public status. The plan to “accelerate” development is interesting, given that it seems like the most common reason companies cite for going public is to improve access to capital to “accelerate” company growth.Most family businesses will never have to think about whether to list their shares on a public exchange, much less – having done so – to reverse course and take the family business private again. Nonetheless, we believe Tod’s transaction highlights two obligations of all family businesses, whether publicly listed or not. The first is the imperative to perform, and the second is the responsibility to report.The Imperative to PerformThe stock price chart presented above is uninspiring. Over the past five years (prior to announcing the going private transaction), Tod’s shares had shed approximately 50% of their value. In contrast, the shares of luxury conglomerate LVMH tripled in value over the same period, from €233 to €691 per share, while shares of Gucci parent Kering nearly doubled (from €313 to €553).A quick look at the income statement for Tod’s confirms that the underperformance of the shares mirrored underperformance operationally. Since acquiring the Roger Vivier brand in 2016, annual revenue at Tod’s has fallen at a 2.5% annual clip. Earnings have suffered as well, with the company reporting net losses in 2020 and 2021. The losses in 2020 and 2021 forced the company to discontinue dividend payments, which had already fallen with earnings from €2 per share in 2016 to €1 per share in 2019. In short, the company failed to deliver value to its shareholders, and the financial performance suggests that it may have been strategically adrift. Following the €400 million acquisition of the Roger Vivier brand (from a related party, no less), Tod’s invested approximately €220 million in capital expenditures and one small acquisition during the five years ended 2021 (less than 5% of revenue). Against a backdrop of weakening organic performance, the company had dwindling resources for significant capital investment to spur growth. Not being accountable to public investors frees family business leaders to consider a broader range of performance objectives other than profit alone. However, being privately-held does not free family business directors from the imperative to perform. Any non-financial goal to which a family may aspire, no matter how noble or laudable, is ultimately supported and underwritten by growing, profitable core business operations. One task of a director is to consider how best to allocate the family’s capital resources to earn a competitive return on capital.Being privately-held does not free family business directors from the imperative to performFamily shareholders may not have the flexibility of public investors in the short term, but in the long-term family capital will flow toward its highest and best use. Chronic underperformance will cause the highest and best use to be found outside the family business, which will likely undermine many of the non-financial goals and objectives of the family, often to the detriment of employees, suppliers, customers, and other stakeholders.We can’t quite envision how taking Tod’s private will “accelerate” its growth. That said, the family has recognized that the current trajectory is not sustainable and is attempting to address the company’s underperformance. Are you and your fellow directors holding yourselves accountable for generating sustainable competitive returns on capital for your family shareholders?The Responsibility to ReportThe second obligation is the responsibility to report. While the “limitations” of being a public company prompting the transaction were not enumerated, the burden of reporting results to public shareholders is time-consuming and sometimes requires companies to disclose what they believe is competitively sensitive information. While public companies in Europe are not on the quarterly reporting cycle faced by SEC registrants in the U.S., the annual (and semi-annual) reports of European companies are far more detailed than those of their U.S. counterparts, as you can see here.Having read through the most recent annual report, it is not hard to see why Tod’s management would be eager to get out from underneath that reporting burden. Privately-held family businesses save a lot of time and money by not being subject to onerous financial reporting obligations. However, that does not mean that shareholder reporting is not important for family businesses. In reality, shareholder reporting is more important for family businesses than public companies. After all, public companies are reporting their results and strategy to anonymous strangers and institutional investors, while family businesses report their results to grandparents, parents, siblings, aunts, uncles, and cousins.In our experience, many family businesses ignore the benefits of being intentional and strategic about how they report financial results to family shareholders. They do so at their own peril. Uninformed family shareholders eventually become suspicious family shareholders. And suspicious family shareholders often become disgruntled – or, even worse – litigious family shareholders.Uninformed family shareholders eventually become suspicious family shareholdersFamily business directors are stewards of the family’s wealth, and reporting is a fundamental obligation of stewards. No, it is not necessary to prepare SEC-worthy quarterly reports for your family shareholders. But that does not give directors license to ignore shareholders. Rather, it gives family business leaders the flexibility to report what family shareholders need to know, with the appropriate frequency and in the most relevant format. Any time and resources saved by shirking this responsibility will pale in comparison to the costs and distraction of dealing with suspicious and unengaged family shareholders.We will return to the topic of shareholder reporting for family businesses in a future post. In the meantime, check out our whitepaper on communicating financial results to family shareholders, which you can download here.

Buy-Side Solvency Opinions

n this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. s

Pzena Going Private Could Have Larger Implications for the Investment Management Industry

Last week Pzena Investment Management, Inc. (ticker: PZN) announced that it had entered into an agreement to become a private company again via a transaction in which holders of PZN Class A common stock would receive $9.60 per share in cash, a 49% premium to its closing price before the announcement ($6.44). In this week's post, we attempt to rationalize this premium and any implications for the investment management industry.We haven't interviewed any members of Pzena's Special Committee or Board of Directors that ultimately approved the deal, but we'll speculate on their reasoning for taking PZN private. An obvious explanation is that Pzena management wanted to avoid the additional costs and scrutiny that come with public filings. PZN is smaller than most public companies, and the publicly traded portion of its stock represented 20% of its equity capital, so it was likely devoting a significant amount of time and resources to a relatively modest float of $163 million (transaction price of $9.60 a share multiplied by 16.9 million publicly traded shares). It's very conceivable that Pzena management thought being public was more trouble than it was worth.Public markets haven't been kind to Pzena, as their stock hasn't performed well. The firm went public in 2007 with an IPO price of $18 per share, and it's lost nearly half its value during relatively favorable market conditions. PZN pays a modest dividend, but not enough to overcome the decline in share price. Much of this decline is attributable to the challenges the asset management industry has faced over this time relating to fee pressure and the rising popularity of passive investment products. The dominance of growth investing since the Financial Crisis of 2008-09 has compounded these issues for value managers like Pzena.PZN Founder and CEO Richard Pzena told Citywire in a 2020 interview, "Value investing is more upbringing and personality. Growing up, we learned that the same stuff you pay full price for, you can get at half price sometimes." If his firm was willing to pay a ~50% premium for PZN stock, maybe he felt it was finally half off.There's also been the recent recovery in value stocks and Pzena's (relatively) strong investment performance with its John Hancock Classic Value fund (ticker: PZFVX) outperforming the S&P 500 by just over 500 basis points year-to-date. Alpha often leads to asset inflows, so PZN management is probably optimistic about the firm's prospects despite its lackluster share price performance since the IPO.Does this mean asset managers are worth more as a closely held firm than a publicly traded company? Not necessarily. All else equal, investors will generally pay less for a nonmarketable interest than an otherwise comparable interest that is freely tradable in a public market. This differential in value is commonly referred to as a discount for lack of marketability or DLOM. DLOMs exist in the investment management industry but are generally lower than discounts in most other industries since RIAs and asset managers tend to fully distribute their earnings to shareholders, which enhances their liquidity and lowers their applicable discount.The implication of this transaction is not that private investment managers are worth more but that the public option may not be a viable solution for asset managers (or RIAs) that are PZN's size ($45 billion in AUM at June 30, 2022) or smaller.The investment management industry is not a fixed asset-intensive business that requires substantial investments in property or equipment, so the need to raise capital through an IPO or other form of financing is usually minimal. They're also typically owned by insiders, so it's not essential for their shares to be publicly traded such that third-party investors can enter and exit their position at will.We could see some of the smaller publicly traded investment managers (GBL, HNNA, DHIL, SAMG, and WHG, to name a few) follow Pzena's lead and pursue the private route, but more likely it will serve as further evidence that it doesn't make economic sense for most RIAs and asset managers to go public. We hope that's not the case since we often find public RIA and asset manager pricing instructive in our industry valuations. Nevertheless, it could be a while before we see another IPO in the space. Investment management principals at sizeable firms that are considering a public offering will likely think twice if the Board of one of the larger asset managers ultimately determined that it was in the shareholders' and company's best interest to go private. There are plenty of other exit and liquidity options for RIA and asset management principals, which we're happy to discuss.

Talk To The Hand: Upstream Industry Eyeing Returns More Than Rigs

Second quarter earnings for publicly traded upstream producers are trickling in, and profitability has returned to the energy sector. In the meantime, government officials have been sending mixed messages to the upstream sector, desiring temporary supply relief in the aim of lowering prices whilst remaining bearish on fossil fuels overall. The industry response: thanks, but no thanks (a polite way of putting it). Producers have largely been holding the course set years ago towards returns and deleveraging, snubbing pressure from the Biden administration. It has been tempting for producers to ramp up production amid $100+ oil prices and gas prices the highest they have been since 2008. However, with supply chain issues and labor shortages, the appeal has been dampened.Cash Flow Remains KingAccording to the latest Dallas Fed Energy Survey, business conditions remain the highest in the history of the survey. Concurrently, profits continue to rise. Analysts are pleased and management teams are eagerly talking about free cash flow, debt management, and stock buybacks. By the way, an interesting factoid from Antero’s investor presentation: most oil and gas companies are now much less levered than their S&P 500 counterparts. When it comes to Net Debt to EBITDAX multiples, the majors average about 0.9x while the S&P 500 averages 2.8x. Most independents that I reviewed were aiming towards around 1x leverage.The industry should be able to keep it up. Last year around this time, I was questioning how long this might be able to continue. I noted drilled but uncompleted well (“DUC”) counts as an inexpensive proxy for profitable well locations. However, at today’s prices, DUCs matter less than they did from an investment decision standpoint.I sampled current investment presentations of six upstream companies (randomly chosen) and read them to discern key themes that they are communicating to investors. Adding new rigs to the mix was not on any of their agendas. Not one has announced a revision to their capex plans from early in the year even amid the changes in the past five months.There have been some companies accelerating plans, but not many. This quote from the Fed Energy Survey was representative of sentiment in this area: “Government animosity toward our industry makes us reluctant to pursue new projects.” There are 752 rigs in the U.S. currently, according to Shaleexperts.com. In early March, the week before the pandemic wreaked its industry havoc — there were 792. Yes - we still have not reached pre-pandemic rig counts. To boot, rigs are relatively less productive on a per rig basis, primarily because most new drilling locations are less attractive and productive than the ones already drilled. The capex calvary is not coming to the rescue either. Capex at the world’s top 50 producers is set to be just over $300 billion this year, as compared to $600 billion in 2013 according to Raymond James. 2013 was the last year oil prices were over $100 a barrel for the year. As has been said before, production should grow, but not at a particularly rapid pace.Energy Valuations: A Bright SpotThese industry and commodity forces have contributed to the energy sector having an outstanding year from a stock price and valuation perspective as well. Returns have outpaced all other sectors, and Permian operators have performed at the top of the sector. While the U.S. suffered its second quarter of GDP decline in a row, and the stock market has officially become a bear but energy returns stand out.Some investors appear to be changing their tune towards the energy sector amid these kinds of results, and the valuations are reflecting this. There are some indicators that suggest we could be entering into a long “super cycle” for the energy sector whereby the industry could outperform for years to come. It bears out that to fruition the sentiment I quoted last year as well from the Dallas Fed’s Survey: “We have relationships with approximately 400 institutional investors and close relationships with 100. Approximately one is willing to give new capital to oil and gas investment…This underinvestment coupled with steep shale declines will cause prices to rocket in the next two to three years. I don’t think anyone is prepared for it, but U.S. producers cannot increase capital expenditures: the OPEC+ sword of Damocles still threatens another oil price collapse the instant that large publics announce capital expenditure increases.” That prophecy has come true.Supply Chain WoesThe challenge for producers may be less about growth and more about maintenance. 94% of Dallas Fed Survey Respondents had either a slightly or significantly negative impact from supply-chain issues at their firm. Major concerns about labor, truck drivers, drill pipe and casing supplies, equipment, and sand are hampering the execution of existing drilling plans, to say nothing about expansion.“Supply chain and labor-shortage issues persist. Certain materials are difficult to access, which is hampering our ability to plan, absent a willingness to depart from certain historical practices relating to quality standards.” – Dallas Fed Respondent.Nonetheless, global inventories continue to decline. The U.S. Energy Information Administration’s short-term energy outlook expects production to catch up, but it appears harder to envision that now and nobody exactly knows what that will look like in the U.S. The EIA acknowledged that pricing thresholds at which significantly more rigs are deployed are a key uncertainty in their forecasts.Who knows how much longer upstream companies will continue to tune out the administration or finally try to rev up their growth plans in response to commodity prices? The December 2026 NYMEX futures strip is over $70 right now. There are a lot of potentially profitable wells to be drilled out there at $70 oil. However, management teams know all too well that prices can change quickly. We shall see.Originally appeared on Forbes.com.

Buy-Side Solvency Opinions

Not only is a solvency opinion a prudent tool for board members and other stakeholders, but the framework of solvency analysis is ready made to score strategic alternatives and facilitate capital deployment.

2022: How Is the Auto Industry Doing and What Does the Future Hold?

Status Quo or Winds of Change?

The first half of 2022 is behind us, and with school about to start, report cards will be here before we know it. In that same light, the auto industry has published its statistics for the first six months. This post reviews predictions by industry analysts (and us) made at the beginning of the year by analyzing several key metrics. Additionally, we discuss threats that arose during the first half of 2022 and their impact on the auto industry for the remainder of the year and perhaps longer. Finally, we offer a few predictions for the second half of 2022.Review of 2022 PredictionsMost analysts predicted vehicle sales would continue to improve in 2022 due to pent-up demand from vehicle deficits caused by production shortfalls in the last two years. While demand would continue to outpace supply, analysts believed the tight supply of new vehicles would gradually improve in 2022. Finally, analysts predicted that the production of microchips would begin to see some improvement this year.In terms of predicting the annual SAAR, or estimate of new vehicle sales in 2022, most early estimates ranged between 15-16 million units.Recall the original causes of the microchip shortage stemmed from the following events: 1) OEMs canceled orders of microchips in the early days of COVID-19 as the production of new vehicles waned in the aftermath of shutdown orders for OEM plants and dealerships alike; 2) there was a huge increase in the demand of consumer electronics; and 3) supply chain disruption from the production and plant shutdowns of the microchip factories themselves.Mercer Capital’s predicted a similar bounce back in the production of new vehicles stemming from the vehicle deficit of the last two years. We also predicted there would be fewer incentives offered by the manufacturers, fewer models available, and fewer features on vehicles.We revisit how industry analysts and Mercer Capital fared in these predictions later in this blog.New Threats in 2022Through the first six months of the year, new threats to the auto industry and the general economy have emerged. Headlines have been dominated by inflation (at the highest levels in 40 years), rising interest rates, and rising gas prices. The auto industry is impacted directly or indirectly because these economic headwinds affect a consumer's ability to purchase and finance a new or used vehicle as well as the total vehicle miles traveled.Also contributing to these threats is the Russian invasion of Ukraine and its impact on the production shortage of microchips. Raw materials, such as neon gas that have been compromised during this war, are a key component in the manufacturing of microchips. Additionally, the war has caused production plant shutdowns and further supply chain disruptions for OEM and microchip plants located in/or adjacent to the area.OEMs and the United States are trying to mitigate the impact of the microchip crisis and our dependence on importing these components by opening microchip production facilities domestically, but these will take some time to develop and begin production. Analysts, ourselves included, may have been too optimistic as to how quickly this industry could scale supply to meet increasing demand. (Stay tuned for a microchip update in next week’s SAAR blog).If the current market conditions of inflation, rising interest rates, and rising gas prices lead to a recession, there could be further impacts on the overall auto industry. Yet, depending on your definition, we may already be in a recession. U.S. auto sales declined by 40% during the Great Recession and fell nearly 15% for the first two months of COVID-19, compared to those same two months in 2019.New Vehicle ProfitabilityWith high demand, tight supply, and less incentives offered by the manufacturer, it’s not a surprise that the average transaction prices of new vehicles have been at record levels in 2022. One interesting trend has been the increased shift towards crossovers and light trucks compared to smaller cars which are more fuel efficient. It remains to be seen whether rising gas prices will swing this pendulum back.In addition to high vehicle prices, the total retailer profit per unit realized by auto dealers has also reached record levels. According to the monthly forecasts from JD Power and LMC Automotive, profitability from this metric have been between $4,900 and $5,300 per unit since December 2021. As a point of comparison, this same metric totaled only $2,053 per unit in December 2020, as seen in the graphic below: While the monthly totals in the first and second quarters of 2022 have fluctuated slightly, there doesn’t seem to be any indications yet of this trend changing.Supply of New VehiclesEvidence of the tight supply of new vehicles in the last few years can also be seen in the lack of inventory on auto dealer lots across the country. It’s not uncommon to see more empty spots on the lot than spots filled with new inventory.Another similar measurement of the lack of inventory is the average time in days that a new vehicle sits on the lot before it is purchased. The monthly forecasts provided by JD Power and LMC Automotive report these figures between 19 and 20 days for each month in 2022, a slight uptick in the December 2021 figure of 17 days. As a point of comparison, this metric totaled 72 and 71 days for December 2018 and December 2019, respectively, as seen in the graphic below: In our discussion with auto dealer clients, they continue to indicate that they are operating on a selling volume of 50-75% of pre-COVID years, but at 2-3X greater gross profit – a further reflection of these first two metrics. Dealers and industry analysts both predict the OEMs will increase the supply of new vehicles above current levels when they are able to try and reclaim some of their lost profitability on these units.Trying to predict when supply issues will be resolved feels like predicting when Tom Brady will retire.While most analysts and dealers do not predict the average day's supply will reach pre-COVID levels, there is certainly room between current and prior-year levels. Based on this statistic and overall industry conditions, any improvement in supply seems to be minimal and gradual through the first half of the year. Trying to predict when supply issues will be resolved feels like predicting when Tom Brady will retire.Average Age of CarsS&P Mobility recently released its annual study on the average age of cars on the road in the U.S. As the graphic below indicates, the overall combined average is 12.2 years: This figure shows a slight increase over last year’s study, which concluded the average age to 12.1 years. In fact, this combined figure has grown every year for over a decade. These figures show no signs of decline and could be easily predicted to continue to rise, especially if a recession hits. At some point, conventional wisdom says the average age of cars will peak and begin to decline as consumers have to trade in for a more recent model. However, improvements from OEMs may structurally improve vehicle life cycles just as many hot new features have quickly become standard. The average age of cars also highlights the continued opportunity for auto dealers in terms of fixed operations (service department and parts). Aging cars will require more service than newer vehicles. This opportunity could be mitigated somewhat during a recession, as consumers could be apt to drive fewer miles due to rising costs or lack of employment. In fact, another statistic affected by a recession is total vehicle miles driven. This figure declined sharply for the two years during the Great Recession and also declined rapidly from the effects of COVID-19. The rolling twelve-month average for total vehicle miles driven has finally climbed back to near pre-pandemic levels as of May 2022 (most recently published data). A market recession could easily reverse that trend for the remainder of the year and the length of the recession.Average Trade-In Equity Value of Used CarsLike new vehicles, used vehicle transaction prices also reached record highs in 2022. While the supply of used vehicles has improved gradually, like its new vehicle counterparts, it has not returned to pre-COVID levels. Since fewer new units are available for sale, fewer used vehicles are traded to the dealer. However, the average trade-in equity value for used cars has followed the same trends as profitability on new and used vehicles. According to the monthly forecasts from JD Power and LMC Automotive, the average trade-in equity value has ranged between $9,300 and $10,400 since December 2021, compared to $5,626 just one year prior in December 2020: Rising trade-in values and, perhaps more importantly, equity are key components of rising vehicle prices. Through the first six months of 2022, there is no sign of trade-in values cooling, although those could be impacted in the coming months by the emerging new threats or the onset of a recession. Consumers tend to be more focused on their monthly payment, so a $5,000 increase on vehicles purchased and traded in are a wash to the consumer. If this metric begins to stumble, we expect it to impact transaction prices similarly.Fleet SalesFinally, we examine fleet sales in recent months. In more robust times of new vehicle production, dealers are able to sell off excess inventory in high volumes to rental car companies, government agencies, and corporations, albeit at much lower margins. Fleet sales were also greatly impacted by COVID-19 as rental car companies sold off large portions of their fleet to conserve cash as consumers were no longer traveling during stay-at-home orders.Fast forward two years, rental car companies and others have not been able to replenish their fleets as the entire industry has been operating at a new vehicle deficit. Anyone that has tried to rent a car in the last few years has experienced the lack of availability and heightened prices. We have a friend who recently rented a U-Haul truck on a vacation because the price was half of a rental car. While these conditions have improved recently, fleet sales and corporate fleet sizes still represent a distressed industry segment.As reported by JD Power and LMC Automotive, monthly fleet sales have rebounded some in 2022, but their monthly unit sales are still down almost 50% from prior levels depending on the month, as seen in the graphic below: Another view of fleet volumes can be measured by the percentage of sales of fleet vehicles vs. the overall sales of all new vehicles. According to Cox Automotive, fleet sales have comprised approximately 13-14% of overall new vehicle sales for 2020, 2021, and year-to-date 2022, compared to nearly 19% in 2019. It should also be noted that those reduced percentages representing fleet share are also on greatly reduced overall new unit sales from the same time periods.ConclusionsSo how did industry analysts and Mercer Capital do on their beginning of the year predictions, and where are we headed? Jonathan Smoke from Cox Automotive originally predicted 2022 SAAR at 16 million units. He lowered that prediction to 14.4 million units in the last two months. The predicted trends of high demand, tight supply, and increased profitability have all held through the first six months, although there are signs of softening in new vehicle sales with continued production shortages and rising interest rates. While optimism remains, we’re simply running out of time in 2022 to revert to higher levels, so we expect these predictions to continue to be revised towards where performance has been.How did Mercer Capital do with some of our predictions? While we were correct on fewer incentives from the manufacturer and fewer models available with fewer features offered on those vehicles, we were incorrect in predicting a higher SAAR in 2022.While some of these metrics remained strong, the emerging threats and the onset of a recession could trigger a reversal of fortune for the auto industry and the profitability of auto dealers sooner than most would have predicted at the start of the year.At Mercer Capital, we follow the auto industry closely to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

How to Have “The Talk” With Your Family Directors

As a parent, you have either already broached the discussion or will at some point: you need to have “The Talk” with your kids. You and your husband or wife do your homework, consult some books or websites for a refresher, and think about how to frame the discussion in a language your kids can understand. You might even ask for advice from a financial advisor or trusted attorney. Of course, “The Talk” I am referring to is on family finances and the family business.A recent Barron’s piece highlighted how parents struggle to discuss finances with their kids, and it got us thinking about having family business discussions with your kids and the dialogue among multi-generation family board members. For an overview on basic business vocabulary, Travis Harms, who leads our Family Business Advisory Services practice, has a great series of whitepapers I would encourage any family board member to review, no matter their individual financial proficiency.But as anyone with kids or family knows, it’s not just what you say but how you say it. And while we are not psychologists (we don’t even play one on TV), we do have experience in observing and leading discussions among family board members of varying generations and familiarity with the family business.In our experience, adhering to three simple rules can help promote impactful and productive dialogue between parents, children, and different generations in your family business: big picture first, be transparent, and remember priorities.Big Picture, Then Zoom InBefore you undertake an industry deep-dive, SWOT analysis, or financial study with your family board members, it’s helpful to take a big picture view of why the family is in business in the first place. James Hughes, family meeting facilitator, consultant, and author, explains his philosophy on family business and history in Family Wealth: Keeping It in the Family (see our full review here).Family stories give members a sense of the unique history and values they share.According to Hughes, one reason family businesses struggle is that they “fail to tell the family’s stories… Family stories give members a sense of the unique history and values they share…” (Hughes, 2004, p. 12). Family Wealth also offers guidance on how to craft a family mission statement, documenting the family’s purpose, vision, and values. These areas tie into the question we often ask here at the Family Business Director:What does your family business mean to you? Answering and reviewing these fundamental questions will help convey the shared mission and the “why” of your family business to your newer board members.Transparency Yields TrustNext generation board members shouldn’t be stuck at the kid’s table. Those short folding chairs are uncomfortable, and you can’t just eat mac-and-cheese and dinner rolls forever. To avoid “shirtsleeves to shirtsleeves” for your family business, you must take frank and direct communication seriously. What does that look like? It looks like treating your family shareholders as shareholders. As we’ve discussed, shareholders, regardless of age, deserve and are entitled to adequate financial disclosure and transparency. Educating them in how to understand disclosures and update letters is not only a benefit to your shareholders, but it creates a new set of “free” outside advisors able to form thoughtful questions from a new perspective that can help you run your business more effectively. This has the impact of staving off resentment or distrust often generated by secrecy within family hierarchies.Remember, It’s a “Family Business” Not a “Business Family”One aspect you need to often remember in your family board member relationships is…Family! Again, returning to Family Wealth, Hughes endorses an interesting habit he refers to as “hat work.” While Hughes recommends literally getting multiple hats, the key is to remember the proliferation of “hats” in your family business.When onboarding new directors, remember the dynamics and hats you wear with that person.It is not uncommon for more seasoned family members to wear multiple hats: parent, grandparent, boss, fellow board member, in-law, fellow trustee and/or trust beneficiary. When onboarding new directors, remember the dynamics and hats you wear with that person.>>>The Goal? Long-Term Business ContinuityOlder family members and parents are responsible for educating the next generation, as they will eventually be responsible for ensuring the continuity of the business enterprise. Getting off on the right foot in having these transitional and educational conversations is essential for family businesses. Unfortunately, multi-generation dialogue can often devolve, pitting “has-been-dinosaurs” against the “lazy-good-for-nothings.” Ultimately, remembering why you are in business together in the first place, being transparent and open, and acknowledging familial relationships will lead to better multi-generational conversations.If you need someone to help you lead these conversations, give one of our professionals a call today.

August 2022

In this issue: NIB Deposits Anesthetize Bond Pain

Navigating Tax Returns | Tips and Key Focus Areas for Family Law Attorneys and Divorcing Individuals/Business Owners

This piece is designed to help you better understand how to navigate tax returns on behalf of your clients.

Schwab’s 2022 Benchmarking Study Offers Insights Into the RIA Industry

How Does Your RIA Measure Up?

Schwab recently released its 2022 RIA Benchmarking Study. The survey contains responses from over 1,200 RIAs representing $1.8 trillion in AUM to questions about firm operating performance, strategy, and practice management. The survey is a great resource for RIA principals to see how their firm’s performance and direction measure up against the average firm. We have highlighted some of the key results from the study below. You can download the full survey here.Firm PrioritiesAs part of the survey, Schwab asked RIA principals to rank the top priorities for their RIA. Perhaps unsurprisingly, amidst the Great Resignation and continued tight labor market, recruiting staff to increase the firm’s skill set and capacity became the top-ranked priority for respondent firms in 2022.Acquiring clients through client referrals and business referrals remained key focus points in 2022, ranking second and third, respectively. Enhancing strategic planning and execution ranked fourth, followed by productivity improvements at number five and acquiring new clients through digital channels at number six.Employee RetentionFirms over $250 million reported a median staff attrition rate of 6.5%, while top performing firms reported a median staff attrition rate of 0%. The survey indicates that top performing firms are more likely to have nontraditional benefits packages and offer more professional development and career support opportunities, which suggests that such benefits may help to promote staff retention.GrowthThe firms participating in the survey have seen strong five-year growth on average. Between 2016 and 2021, AUM grew at a compound annual growth rate (CAGR) of 14.1%, while revenue and number of clients grew at a respective 11.3% and 5.1% CAGR over the same time period. The top-performing firms (Schwab defines this as the top 20% based on a holistic assessment across key business areas) saw more robust AUM growth than other firms due to extraordinarily strong net organic growth. AUM growth has outpaced revenue growth consistently in recent years, suggesting that there has been some compression in the fees realized by respondent firms. All of the RIA size categories identified in the survey reported double-digit annualized growth in AUM over the last five years, although firms managing less than $2.5 billion in AUM generally experienced marginally higher growth than firms over $2.5 billion in AUM.M&AM&A contributed to growth for many firms over the last five years. 6% of firms acquired new clients by M&A in 2021, and 21% of firms have completed an acquisition in the last five years. Over the past five years, 27% of firms gained new clients by bringing on an advisor with an existing book of business.Succession PlanningSuccession planning is a key concern for the industry, particularly since only 55% of firms under $250M AUM have a written succession plan. The number increases slightly to 65% for firms over $250M AUM and 80% for top performing firms. Eventually, of course, all of these firms will need an exit strategy for the partners, whether through internal succession or a sale to a third party.As indicated by the Schwab survey, many RIAs lack a written succession plan, but it’s nevertheless a critical issue that all firms will have to face eventually. For more information on RIA succession planning, refer to our whitepaper, Buy-Sell Agreements for Wealth Management Firms.ProductivityRespondent firms reported increases in productivity between 2019 and 2021. Over this period, AUM per professional increased from $99 million to $112 million, and the number of clients per professional increased from 53 to 59. Also, over this period, hours per client for operations and administration decreased from 17 to 16, while hours per client for client service decreased from 34 to 31, suggesting that firms have continued to improve efficiency.

Strategic Benefits of Stress Testing in an Uncertain Economic Environment

Having gone on many a camping trip over the years, the only consistency between these trips into the woods is that there is no consistency. While some trips might have beautiful weather, others might be plagued with storms, cold fronts, heat waves, or strong winds. The campsite may or may not have amenities. And most importantly, contending with the wildlife adds another variable that can’t be predicted. However, the key element of how the trip goes is how prepared we are. The trips where we assumed blue skies were by far the most stressful. If we prepared for different outcomes and weather based on the uncertainty of going into the woods, the trip could always be salvaged.Banks and credit unions are currently facing a similar “into the woods” predicament, as the economic environment seems to grow more volatile and contradictory day by day. While hiring remains strong and unemployment continues to stay near historically low levels with the Bureau of Labor Statistics reporting 3.6% as of June 2022, other indicators are flashing warning signs.Inflation concerns continues to plague the economy after accelerating to 9.1% in June 2022, the highest increase since November 1981. Drivers of inflation in the past several months include rising food and gas prices as global supply remains disrupted from Russia’s invasion of Ukraine and the remnants of the pandemic. Economists are taking notice, with nearly 70% of economists surveyed by the Financial Times and the Initiative on Global Markets believing that the National Bureau of Economic Research (NBER) will make a call at some point in 2023 identifying a recession.These conflicting indicators are convoluting the economic forecast through the rest of 2022 and 2023, and the differing potential circumstances would have very different impacts on banks and credit unions. Though this uncertainty can certainly cause headaches and stress for banks and credit unions worried about their capital positions in a severely adverse economic scenario, stress testing can help to prepare your bank or credit union in the face of uncertainty and help to optimize strategic decisions.Stress Test OverviewA stress test is defined as a risk management tool that consists of estimating the bank’s financial position over a time horizon – approximately two years – under different scenarios (typically a baseline and severely adverse scenario). The OCC’s supervisory guidance in October 2012 stated “community banks, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial conditions.” 1 Further, the OCC’s guidance considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.” 2 A stress test can be defined as “the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making with the bank.” 3There are a few different types of stress tests that banks and credit unions can utilize in estimating their financial position:Transaction Level Stress Testing: This method is a “bottom up” analysis that looks at key loan relationships individually, assesses the potential impact of adverse economic conditions on those borrowers, and estimates loan losses for each loan.Portfolio Level Stress Testing: This method involves the determination of the potential financial impact on earnings and capital following the identification of key portfolio concentration issues and assessment of the impact of adverse events or economic conditions on credit quality. This method can be applied either “bottom up,” by assessing the results of individual transaction level stress tests and then aggregating the results, or “top down,” by estimating stress loss rates under different adverse scenarios on pools of loans with common characteristics.Enterprise-Wide Level Stress Testing: This method attempts to take risk management out of the silo and consider the enterprise-wide impact of a stress scenario by analyzing “multiple types of risk and their interrelated effects on the overall financial impact.” 4 The risks might include credit risk, counter-party credit risk, interest rate risk, and liquidity risk. In its simplest form, enterprise-wide stress testing can entail aggregating the transaction and/or portfolio level stress testing results to consider related impacts across the firm from the stressed scenario previously considered.By utilizing one or more of these stress testing exercises, banks and credit unions can better position themselves for multiple different economic scenarios in order to assure they have sufficient capital and financial strength to withstand an economic downturn if there is one.Economic Scenarios OverviewOne question that often arises is: Given the uncertainty, what economic scenarios should we consider in our stress testing? While it is difficult to answer this question, the most recent Stress Test scenarios prepared by the Federal Reserve are described in a February 2022 report, 2022 Supervisory Scenarios for Annual Stress Tests Required under the Dodd-Frank Act Stress Testing Rules and the Capital Plan Rule, and provide some guidance to assist with this decision. The scenarios start in the first quarter of 2022 and extend through the first quarter of 2025. Each scenario includes 28 variables, nineteen of which are related to domestic variables in the U.S.While the more global economic conditions detailed in the Fed’s supervisory scenarios may not be applicable to community banks or credit unions, certain domestic variables within the scenarios could be useful when determining the economic scenarios to consider. The domestic variables include six measures of real economic activity and inflation, six measures of interest rates, and four measures of asset prices. The baseline scenario includes an economic expansion over the 13-quarter scenario period, while the severely adverse scenario is a hypothetical scenario that includes a severe global recession, accompanied by heightened stress in commercial real estate and corporate debt markets. Below, we have included charts of some of the more relevant domestic variables (GDP, unemployment rates, the Prime Rate, and commercial/residential real estate prices) and their historical levels through year-end 2021 as well as the Fed’s assumptions for those variables in the baseline and severely adverse scenarios. 2022 Supervisory Economic Scenarios OverviewBenefits of the Stress TestAs the U.S. moves into a more uncertain economic environment, a financial institution’s preparation for its trip “into the woods” of this uncertain economic environment can reap dividends. Improved valuation, performance enhancement from enhanced strategic decisions, and risk management are some of these benefits. Greater clarity into the bank or credit union’s capital position, credit risk, and earnings outlook under different economic circumstances helps management to make more informed operational decisions.ConclusionWe acknowledge that bank and credit union stress testing can be a complex exercise. The bank or credit union must administer the test, determine and analyze the outputs of its performance, and provide support for key assumptions/results. There is also a variety of potential stress testing methods and economic scenarios to consider when setting up their test. In addition, the qualitative, written support for the test and its results is often as important as the results themselves. For all of these reasons, it is important that bank and credit union management begin building their stress testing expertise sooner rather than later.In order to assist financial institutions with this complex and often time-consuming exercise, we offer several solutions, including preparing custom stress tests for your institution or reviewing ones prepared by the institution internally, to make the process as efficient and valuable as possible.To discuss your stress testing needs in confidence, please do not hesitate to contact us. For more information about stress testing, click here.Endnotes1OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.2 Ibid.3 “Stress Testing for Community Banks” presentation by Robert C. Aaron, Arnold & Porter LLP, November 11, 2011.4 OCC 2012-33 “Supervisory Guidance” on Community Bank Stress Testing dated October 18, 2012 and accessed at www.occ.gov/news-issuances/bulletins/2012/bulletin-2012-33.html.

Meet the Team: J. David Smith, ASA, CFA

In each “Meet the Team” segment, we highlight a different professional on our Energy team. This week we highlight David Smith, Senior Vice President of Mercer Capital and a senior member of the Oil and Gas Industry Team. The experience and expertise of our professionals allow us to bring a full suite of valuation, transaction advisory, and litigation support services to our clients. We hope you enjoy getting to know us a bit better.What attracted you to a career in valuation?Admittedly, I really didn’t know what a “valuation analyst” was back in 1992 when I responded to a job posting that was distributed by our local CFA Institute chapter – then known as the Houston Society of Chartered Financial Analysts. I had just completed my MBA and was wanting to get into a position that involved more analysis than my then-current job involved, and the Valuation Analyst job description seemed just right to me. I interviewed, got an offer, accepted the position, and was probably a month into the job before I really started to get a good grasp as to what a Business Appraiser “does” – and realized that I loved the job.Once in the job, what really attracted me to making a career in Business Valuation was the combination of applying economics, accounting, finance, investment analysis, equity analysis, fixed income analysis, money and capital markets, as well as so many other disciplines that I’d studied in my undergraduate and MBA programs. Basically, all the interesting parts of the Chartered Financial Analyst body of knowledge. I have a strong curiosity as to “how things work” or “what makes things tick,” and that curiosity is abundantly satisfied in the analysis that takes place in appraising a business.What does your personal practice consist of?As with many in our profession, my Business Valuation career began as a generalist. We performed appraisals for all four primary “purposes” – tax, transaction, financial reporting, and litigation – and we appraised businesses in many different industries. However, having started my Business Valuation career in Houston, our practice always had a double dose of subject companies in the oil and gas industry. Over time, I also developed an industry concentration in the biotech industry. There is plenty there to satisfy my interest in understanding how things work.Also, over my career, I’ve had the opportunity to work on and gain expertise in performing Fairness Opinions and Solvency Opinions. To this day, those types of projects remain a large part of the projects I’m involved in.What types of oil & gas industry engagements do you work on?The types of O&G industry engagements that I work on vary, although they’re somewhat concentrated in oilfield services (OFS). So, I’ve been part of projects involving mud companies, drilling companies, oilfield waste disposal (saltwater disposal) companies, oilfield equipment (pumps, valves, downhole tools, drilling pipe, seismic equipment, seismic vehicles, drilling equipment, offshore floatation equipment, offshore trenching, ROVs, etc.) manufacturing businesses, and a variety of oilfield services companies. The purpose of those projects is quite varied as well, including federal tax, financial reporting, and transaction purposes.What are the capabilities of Mercer Capital’s Oil & Gas Industry team?Mercer Capital’s Oil & Gas Industry Team capabilities are unusually broad. In addition to our capabilities in the exploration and production (E&P), OFS, midstream and downstream areas, we also have top-notch capabilities in appraising reserves, mineral interests, and other O&G “interests,” which is not nearly as common among our peers. In a sense, this broad O&G industry capability isn’t much of a surprise considering our team has four individuals who’ve practiced business valuation for 20+ years in Texas.What is unique about Mercer Capital’s oil & gas industry services/expertise compared to your competitors?Probably the most unique aspect of our Oil & Gas Industry services is our expertise in appraising reserves, mineral interests, and other O&G “interests” (royalty, working, etc.). While there is any number of business appraisal firms that dabble in appraising these types of assets, unless the appraiser has real expertise, you can often end up with a somewhat questionable valuation. Our Oil & Gas Industry Team is a bit unusual, even among our larger peers, as to the depth of knowledge that we bring to appraising these assets. Knowledge of decline curves and the varying geophysics of different oil and gas basins is not a common body of knowledge in the Business Appraisal community, but we have that knowledge – in abundance.What is the one thing about your job that gets you excited to come to work every day?Early in my career, the exciting part of my job was certainly getting to understand what made the subject company tick. It was, and remains, fascinating to me. As I’ve moved deeper into my career, I’ve also grown to really enjoy many of the broader aspects of running a business valuation practice – such as working with our younger analysts to help them advance in their careers, growing our Houston and Dallas offices, continuing to grow and expand our presence in the Oil & Gas industry, and learning new technical skills as our profession develops more and more sophisticated methodologies for modeling value. Over time, I’ve come to realize that this career in Business Valuation — that I sort of fell into back in the early 1990s — really fits me like a glove. I thoroughly enjoy it and can’t see myself doing anything else.

Carvana Is Looking More Like Icarus

How the Pandemic Darling May Have Flown Too Close to the Sun

Lately, Carvana has been in the news for all the wrong reasons.Its share price is down over 90% since its pandemic peak and currently sits below the low levels of March 2020.This post provides an abbreviated history of Carvana from its founding in 2012 to 2022 and discusses what its successes and struggles mean for traditional auto dealerships.Where It All beganThe company was founded by Ernie Garcia III in 2012. Garcia sought to improve the vehicle buying experience for consumers. He attributed the idea partly to how cars are bought and sold at wholesale auctions. These auctions are key sources of supply for auto dealers, particularly used vehicle dealers with limited opportunities to acquire cars via trade-ins. Garcia noted it took dealers all of 30 seconds of seeing a vehicle to purchase it. His vision was to bring this ease of acquisition mainstream.Prior to founding Carvana, Garcia began working at DriveTime Automotive Group in 2007, an auto giant owned by his father. This is where he got the idea of selling cars online, though it would take years for this idea to take off.What Makes Carvana UniqueCarvana has become known for its iconic car vending machines which debuted in late 2015. These worked as a centralized location for customers to pick up vehicles, lowering delivery costs. It was also a novel concept with marketing benefits for the brand. Compared to a traditional dealership, going vertical reduced the upfront investment in real estate compared to large, expansive lots that are largely sitting empty in the current inventory shortage.Another thing that makes Carvana stand out is its online-first presence. Carvana operates as an online platform to buy and sell used cars, but this option for consumers isn't new. The difference with Carvana is that the company acts as the dealership rather than taking a fee for simply listing the vehicles. The company also earns a substantial amount of its gross profit from financing rather than the actual sale of vehicles. Vehicle financing has increasingly become a key aspect of profitability for traditional dealerships as well.While Carvana fixes the vehicles it purchases prior to reselling them, they don't provide after-sale services like repair and maintenance, a key driver of profitability for traditional dealerships.Scaling the BusinessCarvana seeks to provide a uniform buying experience with price transparency, an oft-cited pain point with traditional auto sales for consumers. To achieve this, the company needed to significantly increase scale in order to be profitable.A few years after its founding, the company struggled to gain traction. It resorted to two tactics instrumental to the company's success. First, it subsidized consumers by selling vehicles at or sometimes below cost. This, of course, raised the company's sales from a volume perspective and contributed to significant growth. The company has for years sold a growth story like many other online companies. The thought process is that it can increase its prices once it achieves sufficient scale using its aggressive pricing strategy.Carvana's strategy was to use its aggressive pricing (selling cars at or below cost) to create scale. From there they could increase prices and reach profitability.Carvana's second tactic was listing its inventory in numerous markets. While it had fewer cars to sell than its competitors, it began using virtual addresses in order to appear to have a presence in more markets than it actually did. Consumers surveying their options might go into a dealership if they know the brand they want but aren't sure about the model. Before Carvana, third-party listing sites were a better way to start the research process for consumers that were brand-agnostic.Carvana's strategy enabled its vehicles to show up in more markets, and they subsidized the cost of shipping the vehicle once a sale was recorded. While this strategy was not sustainable from a profit perspective, the investment paid off and generated significant traction. The company's IPO in 2017 further increased its visibility, and its growth story and positioning as a "disruptor" captured public attention in an industry with room for improvement in the customer experience.Flying Too Close to the SunThe company rode its growth story to a stock price of $110 in February 2020. In less than a month, concerns around the COVID-19 pandemic led the stock price to decline 73% to $29. Less than a week later, the stock was back to $63 as the market, at large, sought to reprice all stocks based on uncertain expectations of the path forward.By June 2020, the stock peaked again as the company was viewed as an early "winner" from the pandemic. Auto sales plummeted in March and April 2020 as dealers were thrust into the world of online sales as a means of survival. For Carvana, the forced shift to online played directly to their strengths.Prior to the pandemic, the online market for purchasing vehicles was presumed to be relatively small. While online retail works great for certain products, large purchases like cars and mattresses were supposed to be impervious to the "Amazon-ification" of retail. There were two main reasons for this thesis: life cycle of the purchase and cost.It has long been held that consumers spending large sums of money on products they intend to use for years want to touch and feel what they're buying to ensure they like it. The last thing you want to do is get a bad night's sleep on a bed the first night after you've just shelled out $100s of dollars for a new mattress. The same can be said for the style and feel of automobiles, which is why dealers keep so much inventory on the lots for consumers to test drive various options.Consumer financing for cars can also be difficult to complete online. Having a dealer walk people through their options or direct them to more affordable options is beneficial to the dealer who still gets the sale and the consumer that needs help wading through the financing process. Carvana appeared to solve both of these problems with easy-to-use online financing tools and a 7-day test drive period. This was a plus compared to the traditional ~30 minutes a consumer spends with a vehicle prior to purchasing it from a dealership.Before the end of 2020, it was clear that auto dealers (both traditional and online) were benefiting from the economic environment caused by the pandemic as sales bounced back and an increased reliance on technology and lower headcount, interest rates, and advertising led to lower costs. As the pandemic continued, auto dealerships saw heightened profitability, and Carvana's stock price soared to a high of $370 in August 2021. Conditions were so strong that the growth-focused Carvana actually reported positive earnings per share in Q2 2021. This appeared as though it could be the turning point for the company. Maybe it was reaching the necessary scale to generate large profits in the future.Unfortunately, the wind has been taken out of its sales as the macro environment has changed in 2022 with rising interest rates and now fears of a recession. At $25 as of last Friday (July 22, 2022), the stock now sits lower than it did in the depths of the pandemic and is closer to where it traded in the first half of 2018. It's fair to raise the question: "If the company couldn't make money in the most ideal of conditions for auto dealers (in addition to forced adoption of online retail), what is its ultimate path to sustained profitability?" While the company's innovative ideas generated plenty of traction with consumers, they did not lead to a moat for its operations. Stated plainly, other companies can copy Carvana's offerings, reducing or removing all of its competitive advantages from being the first-mover.Recent StrugglesMatching stock price declines, headlines about Carvana are becoming increasingly negative as its fairy tale ride may be coming to an end. Recently, the company has announced layoffs in order to preserve cash. However, a smaller staff may only exacerbate the back-end paperwork issues the company is currently facing. While the company downplays the pervasiveness of the issue, an article in Barron's (subscription may be required) chronicles consumers' struggles with registration delays and issuance of multiple temporary license plates from various states enabling it to sell vehicles for which it had not yet received the title. In many states in which the company does business, such sales are illegal. For these consumers, the relative ease of front-end purchase as compared to in-store dealerships may not be worth the back-end headaches as Carvana seeks to straighten out these issues. Long-term, Carvana is selling a better customer experience, which will extend beyond the initial purchase by getting all the necessary paperwork completed to be street legal.Anecdotally, we had a colleague last week who spent the better part of a day at the DMV attempting to get his car registered after temporary plates could no longer be extended by law. While the DMV may have shared in some of the blame in this situation, he has yet to receive a title four months after purchase. Interestingly, there were about ten other people at the DMV with similar Carvana issues, though many of them were happy, loyal customers that raved about the front-end experience despite the back-end frustrations.Carvana's core profitability lever (financing) is seeing demand cool.In addition to back-end issues, the company's core profitability lever (financing) is seeing demand cool. While Carvana is well-known for its vending machines and no-haggle pricing on its website, its earnings (or lack thereof) are more dependent on its financing. Instead of marking up the vehicles, it sells to market levels, the company subsidizes lower purchase prices to scale and also makes money on the auto loans it originates. Rather than holding these on its balance sheet, the company packages or "securitizes" these loans and sells them to investors.With near-zero interest rates and a strong economic environment, there was plenty of demand for the increased yield offered on these loans. However, with concerns about the financial strength of consumers and rising interest rates, there is less demand for the loans generated by Carvana. In the second quarter, Carvana didn't sell a pool of non-prime loans. In previous quarters, it had securitized both prime and non-prime loans. The company is due to report "earnings" on August 4, and some analysts are pessimistic.Takeaways for Auto DealersDespite its issues, Carvana is the poster child for many consumer-centric shifts in the car buying space.Consumers across the country now have numerous options to buy vehicles online, with extended test drive options becoming more available. Carvana's decentralized approach and lower investment in real estate may also change the level of investment needed for the dealership of the future, though one could argue the current inventory shortage situation may have pushed the industry in this direction even without Carvana.The auto dealer industry will continue to rely on and require investments in technology, particularly technology centered around the online buying experience. Dealers unwilling or unable to make these investments may opt to divest their dealership while profits and values are at relative peaks.The fortunate thing for dealers is their access to new and used vehicles, in addition to financing and servicing of vehicles, ultimately means there are numerous potential profit centers that provide downside protection through all economic cycles. Online retailers like Carvana are seeking to disrupt the industry, but their lack of new vehicles and service departments put them at a distinct disadvantage that even explosive growth may not be able to overcome.Mercer Capital follows the key players in the auto industry in order to stay current with the operating environment of our privately held auto dealer clients. To see how these trends may impact your dealership, contact a Mercer Capital professional today.

2022 Benchmarking Guide for Family Business Directors

Making Sense of 2021

Benchmarking is a powerful tool for family businesses. Done well, benchmarking provides managers and directors with valuable insight and context for evaluating the operating performance of the family business and the strategic investing and financing decisions made by their leaders. Comparison may be the thief of joy, but unfortunately for family businesses, ignorance is not in fact bliss.This blog post summarizes some of our findings related to financing, operating, investing, and distribution activities. For a comprehensive and detailed report on all the above questions, be sure to check out our 2022 Benchmarking Guide for Family Business Directors. For our benchmarking report, we have used the Russell 3000 Index Companies, excluding Financial Institutions, Real Estate companies, and Utilities. We also excluded companies with less than $10 million of revenue in 2021. We have also sorted the data into five quintiles based on company sizes as well as industries.How Much Money Do Companies Like Ours Make?While Wall Street often looks at earnings, EBITDA is the key earnings measure for family businesses. EBITDA serves as a proxy for discretionary cash flow available to service debt, pay taxes, fund reinvestment, and provide for shareholder distributions. EBITDA promotes comparability among firms with different capital structures, tax attributes, and fixed asset intensity.The following chart summarizes the influence of industry on EBITDA Margin for CY21.2021 EBITDA Margin by Industry The overall average EBITDA Margin for the entire group was 14.3%. However, as depicted in the preceding chart, there is significant variation among different industry sectors analyzed. Asset-Intensive industries, including Energy and Materials, earned higher EBITDA margins in 2021, buoyed by energy and commodity pricing. In Table 2, we summarize the effect of company size on EBITDA margin.2021 EBITDA Margin by Company SizeGenerally, comparing average EBITDA margins across different sized companies confirms the importance of economies of scale. Larger companies tend to earn higher margins and outpace the smaller companies.How Much Money Do Companies Like Ours Invest?One prominent question for family business directors is, “How much should we invest?” Our tip: it depends. We analyzed corporate investment in the form of capital expenditures and M&A activity relative to EBITDA (gauging investment relative to cash flow), revenue (removing the effect of profitability on investment), and invested capital (assessing investment relative to previous investments).Excluding maintenance capital expenditures, spending on acquisitions exceeded growth capital expenditures by 160%.The median level of capital expenditure relative to EBITDA ranged from 28% (consumer discretionary) to 57% (energy). Consumer discretionary firms allocated more net investment dollars to growth CAPEX, while M&A was the primary form of investment for health care, information technology, and industrial companies.Click here to enlarge this image How Much Money Do Companies Like Ours Distribute?Dividend policy is one of the most important decisions for a family business (see our Family Business Dividend Survey for more) Looking at benchmarking data can help you analyze the best strategy for you. Public companies generally prefer a sustainable level of dividends that can withstand temporary downturns in performance. As a result, aggregate share purchases exceeded dividends paid during the preceding five years. For the universe of companies we analyzed, total distributions (dividends + share repurchases) exceeded net investment by over 60% for the period.The following table summarizes aggregate distribution trends and compares them against available investment opportunities.In our sample of companies, 15% did not repurchase any shares nor did they pay any dividends, while 37% did both. Only 6% of companies only paid dividends, while 42% of companies only repurchased shares. Approximately one-fourth of the companies in our sample reported a net loss during CY21, however, 66% of these companies still made a distribution to shareholders. Of the profitable companies in our sample, approximately 22% made total distributions in excess of total net income in CY21, while about 9% chose not to make any distributions at all. Distributions also varied greatly by industry. Capital intensive industries such as communication services devote a smaller portion of cash flow to shareholder distributions. Relative to consumer staples companies, consumer discretionary companies hedge their higher volatility by relying more on share repurchases than dividends. Information technology companies were the most aggressive share repurchasers. How Much Money Do Companies Like Ours Borrow?“Debt” is often a four-letter word with family business directors, who often skew toward conservatism in their capital structure. But how do smaller public companies compare?Financial leverage can be measured by comparing total debt to invested capital (book values of debt and equity), market values, or relative to cash flow. On a market value basis, leverage at the end of 2021 ranged from 6% (IT) to 27% (Energy).There is little discernable size effect with respect to book or market values. However, lower EBITDA margins on the part of the smaller firms increase the aggregate ratio of debt to EBITDA for such firms. With respect to the companies in our sample, the use of debt is evenly distributed, with approximately 28% of companies having less than 20% debt in their capital structure, 46% between 20% and 60%, and 25% above 60%. Health care and IT firms are most likely to avoid debt, while companies in the communication services, energy, and consumer discretionary sectors are more likely to fund capital needs with larger debt. Assessing the annual change in debt and equity balances reveals how companies view the marginal costs of incremental financing needs. On a relative basis, the companies in our sample borrowed most aggressively during CY20 in the face of the economic slowdown resulting from the response to COVID-19. Companies relied on incremental equity financing at the margin in 2021.Download your complimentary copy of the 2022 Benchmarking Guide for Family Business Directors, which gives you an in-depth analysis of the topics discussed here as well as discusses additional questions, including:What are investment hurdle rates for companies like us?How fast should companies like us grow?What kind of return do companies like us generate for their shareholders?For more targeted insights and observations, give one of our professionals a call to talk about a more customized benchmarking analysis for your family business.

Buy-Side Fairness Opinions: Fair Today, Foul Tomorrow?

This is the eighth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Directors are periodically asked to make tough decisions about the strategic direction of a company. Major acquisitions are usually one of the toughest calls boards are required to make. A board’s fiduciary duty to shareholders is encapsulated by three mandates:Act in good faith;Duty of care (informed decision making); andDuty of loyalty (no self-dealing; conflicts disclosed). Directors are generally shielded from courts second guessing their decisions by the business judgment rule provided there is no breach of duty to shareholders. The presumption is that non-conflicted directors made an informed decision in good faith. As a result, the burden of proof that a transaction is not fair and/or there was a breach of duty resides with the plaintiffs. An independent fairness opinion helps demonstrate that the directors of an acquiring corporation are fulfilling their fiduciary duties of making an informed decision. Fairness opinions seek to answer the question whether the consideration to be paid (or received from a seller’s perspective) is fair to a company’s shareholders from a financial point of view. Occasionally, a board will request a broader opinion (e.g., the transaction is fair). A fairness opinion does not predict where the buyer’s shares may trade in the future. Nor does a fairness opinion approve or disapprove a board’s course of action. The opinion, backed by a rigorous valuation analysis and review of the process that led to the transaction, is just that: an opinion of fairness from a financial point of view.Delaware, the SEC and FairnessFairness opinions are not required under Delaware law or federal securities law, but they have become de rigueur in corporate M&A ever since the Delaware Supreme Court ruled in 1985 that directors of TransUnion were grossly negligent because they approved a merger without adequate inquiry and expert advice. The court did not specifically mandate the opinion be obtained but stated it would have helped the board carryout its duty of care had it obtained a fairness opinion regarding the firm’s value and the fairness of the proposal.The SEC has weighed in, too, in an oblique fashion via comments that were published in the Federal Register in 2007 (Vol. 72, No. 202, October 19, 2007) when FINRA proposed rule 2290 (now 5150) regarding disclosures and procedures for the issuance of fairness opinions by broker-dealers. The SEC noted that the opinions served a variety of purposes, including as indicia of the exercise of care by the board in a corporate control transaction and to supplement information available to shareholders through a proxy.Dow’s Sour PickleBuy-side fairness opinions have a unique place in corporate affairs because the corporate acquirer has to live with the transaction. What seems fair today but is deemed foul tomorrow, may create a liability for directors and executive officers. This can be especially true if the economy and/or industry conditions deteriorate after consummation of a transaction.For instance, The Dow Chemical Company (“Dow”), a subsidiary of Dow Inc. (NYSE: DOW), agreed to buy Rohm and Haas (“RH”) for $15.4 billion in cash on July 10, 2008. The $78 per share purchase price represented a 75% premium to RH’s prior day close. The ensuing global market rout and the failure of a planned joint venture with a Kuwait petrochemical company led Dow to seek to terminate the deal in January 2009 and to cut the dividend for the first time in the then 97 years the dividend had been paid.Ultimately, the parties settled litigation and Dow closed the acquisition on April 1, 2009 after obtaining an investment from Berkshire Hathaway (NYSE: BRK.A) and seller financing via the sale of preferred stock to RH’s two largest shareholders.Dow was well represented and obtained multiple fairness opinions from its advisors (Citigroup, Merrill Lynch and Morgan Stanley). One can question how the advisors concluded a 75% one-day premium was fair to Dow’s shareholders (fairness is a mosaic and maybe RH’s shares were severely depressed in the 2008 bear market). Nonetheless, the affair illustrates how vulnerable Dow’s Board of Directors or any board would have been absent the fairness opinions.Fairness and ElonBefore Elon Musk reneged on his planned acquisition of Twitter, Inc. (NYSE: TWTR) on July 8, 2022, one of the most recent contentious corporate acquisitions was the 2016 acquisition of SolarCity Corporation by Tesla Inc. (NASDAQGS: TSLA). Plaintiffs sought up to $13 billion of damages, arguing that (a) the Tesla Board of Directors breached its duty of loyalty, (b) Musk was unjustly enriched (Musk owned ~22% of both companies and was Chairman of both); and (c) the acquisition constituted waste.Delaware Court of Chancery Judge Joseph Slights ruled in favor of Tesla on April 27, 2022. Slights noted courts are sometimes skeptical of fairness opinions; however, he was not skeptical of Evercore’s opinion, noting extensive diligence, the immediate alerting of the Tesla Board about SolarCity’s liquidity situation and the absence of prior work by Evercore for Tesla. Tesla Walks the Entirely FairLine with SolarCityDownload Presentation

Buy-Side Fairness Opinions: Fair Today, Foul Tomorrow?

Directors are periodically asked to make tough decisions about the strategic direction of a company. Major acquisitions are usually one of the toughest calls boards are required to make. Buy-side fairness opinions have a unique place in corporate affairs because the corporate acquirer has to live with the transaction. What seems fair today but is deemed foul tomorrow, may create a liability for directors and executive officers. This can be especially true if the economy and/or industry conditions deteriorate after consummation of a transaction.

Is the Best Wealth Management Platform Really an Independent Trust Company?

The most frequently ignored topic in the wealth management industry may be its first cousin, the independent trust industry. While many still associate trust work with banks, and banks still represent more than three-quarters of the trust industry, the growing prominence of independent trust companies is causing many participants in the investment management space to take another look. In some regards, independent trustcos look a lot like wealth managers, only more evolved.FeesSince the credit crisis, there has been a broad-based decline in pricing power across the investment management industry. Assets have poured into low-fee passive products, driving down effective realized fees for asset managers. Wealth managers have been more resilient, but the threat of robo-advisors remains. Virtually all discount brokerages have been forced to cut trading fees to zero. The message is clear: assets across the financial services industry are gravitating towards lower-fee products.So how have trust companies fared in this environment? Despite the pricing pressure in the broader industry, trust companies have fared remarkably well, with fees at least flat if not headed higher. For many of our independent trust company clients, the story has been similar. Realized fees have remained steady or even increased over the last five years, while assets under administration have grown through market growth and net inflows.Market CorrelationThe 2022 bear market is having a significant negative impact on the top line for trust companies, as it will for all investment managers that charge a percentage of assets under management. As of the date of this post, equity prices are down around 20% year-to-date.The effect on trust company profitability will depend on the length and severity of the economic slowdown caused by the market dynamics and the potential of a looming recession.Normally, trust would be shielded from some of the market volatility because of a higher exposure to fixed income. Unfortunately, the change in the term structure of interest rates this year means bonds are also well off their prices from a few months ago. Consequently, trust company revenue will take a big hit. The effect on trust company profitability will depend on the length and severity of the economic slowdown caused by the market dynamics and the potential of a looming recession. The range of likely scenarios is beyond the scope of this post, but it suffices to say that there is still significant uncertainty regarding the impact on people, markets, and economic activity.Unlike many asset and wealth management firms, trust companies often have revenue sources that aren’t based on AUM (e.g., tax planning, estate administration fees) which should provide some protection during a market downturn. This, combined with a resilient fee structure, should help trust companies weather the economic climate.Favorable DemographicsAs America becomes older and wealthier, the number of potential clients for the trust industry is poised to grow markedly.Trust companies primarily service high net worth and ultra-high net worth clients, and both demographics are growing in number. Credit Suisse’s Global Wealth Report estimates that fully 1% of Americans are millionaires, numbering almost 22 million people in 2021. This is more than double the number a decade ago, and represents more than a 20% increase over the prior two years. At the same time, the median age in the U.S. has increased by 1.5 years in the past decade, and the oldest members of the baby boomer generation are now in their mid-70s.The average age of millionaires in the U.S. is 62, and over a third of U.S. millionaires are over the age of 65. Consequently, there is a growing pool of clients in need of the kinds of services that the trust industry provides, and that points to a sustained period of organic growth for the industry. While this will also provide a tailwind for wealth management firms – who often start working for clients around the time they retire – it is a more certain opportunity for trust providers, especially to the extent that wealth transfer services are part of a client’s equation.Regulatory TrendsAs trust law has developed, a handful of states have emerged as being particularly favorable for establishing trusts. While the trust law environment varies from state to state, leading states typically have favorable laws with respect to asset protection, taxes, trust decanting, and general flexibility in establishing and managing trusts. Opinions vary, but the following states (listed alphabetically) are often identified as states with a favorable mix of these features.AlaskaDelawareFloridaNevadaSouth DakotaTennesseeTexasWashingtonWyoming Over the last several decades, many states such as Delaware, Nevada, and South Dakota have modernized their trust laws to allow for perpetual trusts, directed trustee models, and self-settled spendthrift trusts (or asset protection trusts). The directed trust model, in particular, is a major change in the way trust companies manage assets, and it has been gaining popularity among trust companies and their clients. Under the directed trust model, the creator of the trust can delegate different functions to different parties. Most frequently, this involves directing investment management to an investment advisor other than the trust company (this could be a legacy advisor or any party the client chooses). The administrative decisions and choices related to how the trust’s assets are used to enrich the beneficiary are typically charged to the trust company.The directed trust model, in particular, is a major change in the way trust companies manage assets, and it has been gaining popularity among trust companies and their clients.The directed trustee model leads to a mutually beneficial relationship between the trust company, the investment advisor, and the client. The trust company avoids competition with investment advisors, who are often their best referral sources. The investment advisor’s relationship with their client is often written into the trust document. And most importantly, this model should result in better outcomes for the client because its team of advisors is ultimately doing what each does best—its trust company acts as a fiduciary, and its investment advisor is responsible for investment decisions.SuccessionIn our experience, the ownership profile at independent trust companies is often similar to that which we see at wealth management firms, and ownership succession is often a topic of conversation. Ownership issues include concentration at the founder level or even extensively held by outsiders who helped capitalize the firm’s startup. As with most investment management businesses, independent trust companies tend to be owner-operator businesses, so finding ways to include younger partners and key staff in equity participation is sometimes a challenge.As we’ve written about in articles, blog posts, and whitepapers on buy-sell agreements, the dynamic of a multi-generational, arms-length ownership base can be an opportunity for ensuring the long-term continuity of the firm, but it also risks becoming a costly distraction. As the trust industry ages, we see transition planning as potentially being either a competitive advantage (if done well) or a competitive disadvantage (if ignored).OutlookMany independent trust companies performed remarkably well over the past decade and much better than expected during the pandemic. The current bear market is an immediate headwind, but demographic trends in the U.S. and the increased visibility of independent firms as an alternative to bank trust departments should form a solid basis of growth for the foreseeable future.

Only 2% of Small Businesses Know This Key Fact

Do you know how much cash is on your family business balance sheet? How about receivable health and your debt position? Reading this blog, you likely answered “yes” to these questions. Do you also know how much your family business is worth? If you answered “Yes,” you are in a select company as 98% of small businesses polled by M&T Bank over the past two years didn’t know the value of their businesses. Knowing and understanding the value of your family business is essential to making critical decisions around dividends, capital structure, or capital budgeting that have long-term effects on your family business. Travis Harms, who leads Mercer Capital’s Family Business Advisory Services Group, spoke to CNBC recently on the importance of valuation and understanding the value of your business. This week’s Family Business Director post highlights the piece, and we hope you check it out below. Originally appeared as "Most Small Business Owners Don't Do the Math on Their Most Valuable Asset" on CNBC.com’s Small Business Playbook by Cheryl Winokur Munk.Many small company owners don’t know what their enterprise is worth, a practice that can amount to risky business. A whopping 98% of small businesses polled by M&T Bank over the past two years didn’t know the value of their companies. This is especially troubling, given that for most business owners, their company is their most valuable asset. “People whose home is their primary asset want to know what it is worth. If you open up a brokerage account, you want to know how much it’s worth. You’d never give your money to a financial advisor who told you to trust them while they invest it and never report back to you on what it’s worth,” said Travis W. Harms, who leads Mercer Capital’s family business advisory services group. “Just because your business is not liquid wealth, doesn’t mean it’s not real wealth.” Here are five points to help entrepreneurs understand the importance of valuing a business.Valuation is critical to running a business, and selling itMany business owners may be too overwhelmed with day-to-day operations to focus on having their company valued. Others don’t want to spend the money or simply don’t realize the importance of having an objective third-party measure of its worth.A valuation, however, can be critical for many reasons. These include an impending sale, the issuance of stock options, succession planning, tax and estate planning, capital raising, implementing a buy-sell agreement, insurance needs or to obtain business funding, said Robert King, partner on the investment banking team at Crewe.Say, for instance, you want to gift company shares to a family member. Understanding the company’s valuation is important for tax and estate-planning purposes. Another reason to value the business is as a checkpoint so partners are all on the same page. Even if there’s a buy-sell agreement, there can be disputes over how a business is valued for the purposes of separation. Having realistic expectations for the business along the way can prevent a prolonged and messy fight over the company’s worth if the time does come for owners to part ways, Harms said.Knowing your business’s up-to-date worth is also important because many owners don’t plan to sell their business until a suitor comes knocking, said Brett Dearing, partner and exit planning specialist with the wealth management firm Cerity Partners. If you don’t have a current valuation, you’ll be at a disadvantage from a negotiation standpoint. You could either have an overly rosy outlook for your business, or conversely, be grossly underestimating its potential.“A lot of business owners don’t understand the value of their business before they sit down with a buyer at the negotiating table,” Dearing said.Certified experts exist to value your businessOne of the best ways to find an expert to value your business is through one of three credentialing bodies.The Accredited in Business Valuation credential is granted by The American Institute of Certified Public Accountants to CPAs and qualified valuation professionals who meet the requirements. There’s also a business valuation certification by the American Society of Appraisers. And the National Association of Certified Valuators and Analysts offers the Certified Valuation Analyst designation.While having one of these certifications alone doesn’t guarantee an appraiser’s quality, it should be your baseline starting point given the level of expertise these designations require, business valuation professionals said.The cost of calculating a valuation will varyThere’s no single answer to the question of cost because it depends largely on the size and complexity of the business, the scope of work required, and the purpose and intended use of the valuation, Harms said.Given these parameters, an appraisal could cost anywhere from around $5,000 to around $50,000, according to valuation professionals. Be sure to be specific with the appraiser about the reasons you are seeking a valuation so they deliver what you’re asking for.Some of the assumptions that go into a valuation for estate planning purposes or issuance of equity compensation could be decidedly different than for raising capital or selling a business, said King. “One size does not fit all,” he said.Business owners should update this asset value regularlyDepending on what you need the valuation for, it can be something you do annually or every few years.It can also be done more frequently as you are trying to grow your business. M&T Bank offers a free digital platform that allows businesses to model how different outcomes would impact their valuation. It’s not an accredited valuation, but the service offers a baseline before you take that next step, said Jonathan Kolozsvary, director of new ventures at M&T Bank.Valuing the business regularly can help you determine weak spots and make improvements. “If you go through the valuation process and the value isn’t quite where you want it to be, you can improve the valuation based on the areas identified,” said Tami M. Bolder, director at CBIZ Valuation Group. “It’s also helpful for general planning purposes,” she said.

Meet The Team

David W. R. Harkins, CFA, ABV

In each “Meet the Team” segment, we highlight a different professional on our Auto Dealer Industry team. This week we highlight David Harkins, Senior Financial Analyst.David Harkins, CFA, ABV began his valuation career at Mercer Capital as an intern in the summer of 2016. After finishing his degree at Sewanee in 2017, David joined Mercer Capital as a financial analyst in the Memphis office. In 2018, he drove a U-Haul up I-40 to Mercer Capital’s Nashville office and began covering auto dealerships. Since then, he has worked on various types of engagements for auto dealerships including marital dissolution, gift/estate tax planning, shareholder oppression, and limited procedures buy and sell side analysis, among others.What is your favorite part about working with auto dealerships?David Harkins: I like all the analytical detail provided on the monthly factory statements. There is a certain uniformity, even across the various brands, that makes it easier to analyze the dealership and compare dealerships across brands. I know right where to go for the key value drivers, such as the volumetric information and data by department. We started our Auto Dealer blog during the depths of the pandemic, so that timing wasn’t necessarily great. But the discipline of weekly content has been extremely helpful to my understanding of the industry. That is particularly the case when it feels like industry news, trends, and disruptions are occurring on a weekly basis. I enjoy following the industry because of its benefits when discussing expectations for dealerships with our clients. We can speak their language better than a business valuation generalist that may not do another auto dealership that year. We have the greater context of the industry at large, so we can spend more time on the key impacts they see for their brand(s) in their market(s).How does your CFA background assist with analyzing auto dealerships?David Harkins: I think the CFA designation has three primary benefits. The first and most important in my mind is the analytical rigor of the tests and the knowledge gained from committing to passing each level. I did not take many accounting classes at Sewanee, for instance, and it deepened my knowledge of the interaction between the three main financial statements. Additionally, the CFA impressed upon me the importance of valuing the expected cash flows in order to determine the value of any business interest. For auto dealers, cash flows have improved since about mid-2020, and it seems increasingly likely that at least part of this benefit will be retained once the supply chain disruptions moderate. The question for valuation analysts is at what level will earnings settle? The market largely sets the multiple for businesses where high-growth industries (e.g. big tech) are likely to receive higher multiples than declining industries (e.g., big box department stores). If the market sets the multiple, the analyst's job is to understand the expected level of ongoing earnings, which is then capitalized by the multiple. The corollary benefits of the designation are networking opportunities and a recognition that I have a strong analytical background. I believe these will both help me as I develop in my career, but I have yet to be able to use them fully. I received the charter in August 2020, so opportunities to meet more folks have been somewhat limited, though it’s been great to attend events such as TAA and NADC. Hopefully, the CFA will provide a nice complement to these activities.What is a unique challenge when working with auto dealerships?David Harkins: I think parsing the allocation of value by rooftop is interesting. Haig Partners and Kerrigan Advisors publish Blue Sky multiples in a quarterly newsletter that is brand specific (because the market tends to ascribe higher multiples to luxury dealerships, for example). This analysis quickly becomes complicated for auto groups carrying more than one brand. Having multiple rooftops is a great expansion strategy for dealers that provides cross-selling opportunities and risk mitigation if one brand has a lackluster product lineup. It can also expose the auto group to various points along the demand curve where luxury might outperform in a strong market, whereas more economical offerings might do better in periods of market turbulence. If a company has a Lexus and a Toyota dealership whose mid-point market multiples might be 9x and 7x, respectively, what multiple gets applied to a transaction involving both dealerships? Part of the reason dealer principals want to add rooftops is what makes this analysis more difficult: sharing of operating expenses. If a dealer principal is paid $100,000, how much of that salary is attributed to one dealership or another? Without truly separate P&L statements, it takes more art than science to determine the contribution to value of multiple rooftops.What did your internship at Vulcan Materials Company teach you that has translated to your work with auto dealerships?David Harkins: Prior to my internship at Mercer Capital, I got the chance to intern at Vulcan Materials. While I was an intern at Vulcan, I think I gleaned a fair amount about how a public company operates. I worked primarily with the market research department and was impressed by the internal/proprietary research available to the company. Given the large size and intentional growth exhibited by the six public auto dealership companies, I’m sure they have similar departments, which afford them numerous insights into where the competition is and where it’s going. While industry resources are available to analysts at valuation shops like Mercer Capital, it will likely always pail in comparison to the data available to the dealerships themselves, particularly those that operate many brands across many markets. That’s why I find it so valuable to tune into the earnings calls from these companies because they get reports from on the ground relating to the day-to-day changes in supply and demand that shape the industry as a whole.What goals do you have when it comes to working with auto dealerships?David Harkins: I’d like to cover every brand. There isn’t an equal number of dealerships by brand across the country, and some are more prevalent than others. Some may also have different valuation needs than others. While there are some brands I’ve worked with numerous times, there are a few I have not yet had the opportunity to work with. I’ve worked with all the domestic brands and have even been exposed to numerous high-line brands. But there are still a few mid-line import brands and luxury brands that have eluded me.

Another Tumultuous Quarter for RIA Stocks Puts the Industry Firmly in Bear Market Territory

Publicly Traded Alt Managers and RIA Aggregators Have Lost Nearly Half Their Value Since Peaking Last November

The RIA industry extended its losing streak last quarter with all classes underperforming the S&P, which also continued its decline. The market is part of the problem as this industry is mostly invested in stocks and bonds, which have decreased considerably over the last six months. The additional underperformance for asset and wealth managers is likely attributable to lower industry margins as AUM and revenue falls with the market while labor costs continue to rise. Rising interest rates have exacerbated this decline for alternative asset managers and RIA aggregators, who frequently employ leverage to make investments. The one bright spot for the industry is the group of smaller (under $10 billion in AUM) publicly traded RIAs, which is the only segment to outperform the market last quarter. This group is still down over the last three months but is holding up relatively well due to the lack of aggregator firms in its composition. As valuation analysts, we’re often interested in how earnings multiples have evolved over time since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and first quarter of 2021, LTM earnings multiples for publicly traded asset and wealth managers declined modestly in the back half of last year before dropping nearly 40% so far this year, reflecting investor anticipation of lower revenue and earnings from the recent market decline. Implications For Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with closely held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products.In contrast to public asset/wealth managers, much smaller, private RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures asset flows, and deal activity for these companies have reflected this.Notably, the market for privately held RIAs remained strong in 2021 as investors flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity for these businesses continued to be significant in 2021, and multiples for privately held RIAs tested new highs due to buyer competition and a shortage of firms on the market. As these dynamics continue into 2022, the outlook for continued multiple expansion and robust deal activity remains favorable, assuming interest rates and market conditions stabilize in the near future.

U.S. LNG Exports

Part 2: A Closer Look at Projected U.S. LNG Export Terminal Capacity

In Part 1 of our analysis on U.S. LNG Export Terminal Facilities, we examined trends in the number of LNG export facility applications and approval rates from 2010 through 2021 and examined the projected export capacity relative to the projected export volumes of U.S. LNG from 2022 through 2031. In Part 2 of our analysis, we take a closer look at the anticipated export capacity proposed to come online over the near and mid-term horizons to better understand the underlying factors that have spurred so many projects, seemingly far in excess of the projected level of LNG exports from the U.S.Excess Export Capacity?As noted in Part 1 of our analysis, the Federal Energy Regulatory Commission (“FERC”) received approximately 145 long-term applications for export facilities seeking to send liquified natural gas to countries both with and without free-trade agreements with the U.S from 2010 to 2021. Of these applications, 64% were approved, with the vast majority of approvals made from 2011 through 2016. What was particularly striking was the apparent excess capacity of all the export terminals, from both existing and proposed facilities, relative to the export levels as projected by the U.S. Energy Information Administration (“EIA”), as presented in the following chart:What is not so apparent is that very few projects (ergo, capacity) have firm commitments from buyers to purchase the produced LNG, with even fewer projects having reached an affirmative final investment decision (“FID”). The nameplate export capacity from all proposed facilities skews the picture a bit, suggesting the U.S. is well able to ship out LNG as fast as natural gas can be extracted, without considering the financial support backing these major capital builds. When stratifying the export capacities of all facilities for which an in-operation date has been put forth, all facilities for which an affirmative FID has been made, and all facilities which are currently in operation, it becomes clear that the capacity of the last group represents the boundary by which the projected LNG export levels anticipated by the EIA over the next 5 years are limited.Further detail regarding the export terminal facility and capacity expansion projects are provided in Appendices A and B at the end of this post (updated and revised from Part 1 of our U.S. LNG analysis). Furthermore, we see that a total export capacity level is slated to be “operational” over the course of 2023 through 2027, while only a portion of that capacity has affirmative FIDs underlying such progress. In other words, quite a few projects are behind schedule. Far behind. For this reason, we will consider “reasonably-expected” LNG export capacity to be based solely on existing capacity and FID-supported capacity. In order to reasonably include any capacity levels for which an in-operation (but no FID) date is provided, the supporting engineering, procurement, and construction (EPC) activities for those projects would have to be either near completion or well underway. This simply cannot be assumed to be the case given the lack of clarity regarding the expected timing of any FIDs for these projects, and considering the greatly extended lead times on equipment deliveries due to increasing costs, supply chain constraints, and tight labor markets.The projected capacity utilization over the next ten years is as follows:Click here to expand the image aboveAt face value, the projected annual utilization rates indicate potential tightness in the ability to ship out LNG volumes over the next 6-18 months. While this possible bottleneck appears – based on current projections – to ease up over the following 2 to 5-year period, other factors should be considered aside from just export terminal capacity. After all, these facilities can only send out what they receive.Ancillary FactorsOn June 8, the failure of a safety valve caused a pipeline to burst at the Freeport LNG facility, releasing approximately 120,000 cubic feet of LNG. In addition to posing a “risk to public safety, property or the environment,” U.S. natural gas futures prices fell as the spigot was shut and natural gas slated for export had to remain in storage onshore. The EIA expects that the shutdown, projected to last for at least 3- to 6-months, will reduce the total U.S. LNG export capacity by 17%. Widening our focus from the Freeport LNG shutdown, this event reveals the potential risk and impact of total U.S. LNG exports stemming from a significant unforeseen or unplanned shutdown from any of the major (>1.0 Bcfd) 4 export terminals currently in operation. Until more or larger facilities come online, any major shutdown at a currently-operational export facility may impact the ability of the U.S. to serve oversea markets.Until more or larger facilities come online, any major shutdown at a currently-operational export facility may impact the ability of the U.S. to serve oversea markets.Further upstream, midstream O&G operators, such as Williams (NYSE:WMB), are setting up to help supply natural gas to LNG export terminals. On June 29, Williams announced its FID to proceed with its Louisiana Energy Gateway (LEG) project, which will gather and help deliver 1.8 Bcfd of natural gas from the Haynesville Shale to Gulf Coast export terminals by way of several existing and future intermediate trunklines.Beyond the physical capital infrastructure required to move gas volumes from the wellhead to the liquefaction terminal, support for LNG export activity remains constrained by political crosswinds as the Biden administration attempts to balance its initiative of supplying U.S. gas to Europe, in order to reduce its reliance on Russian-sourced fuel, while simultaneously addressing a greater public interest in lower domestic energy prices and progressing a platform to mitigate climate change, primarily by reducing the use of fossil fuels.In an attempt to appeal to the various parties with a particular interest in these respective goals, the Biden administration has sent mixed signals with countervailing rhetoric and actions. Increased LNG exports to Europe directly leads to increased domestic energy prices and does little in the way of improving the current trajectory of climate change. Keeping the supply of natural gas onshore helps mitigate high domestic energy prices, but falls short of helping fuel Europe, and still does little to curb climate change. In the pursuit of meaningful change with respect to transitioning away from fossil fuels, neither LNG exports nor promoting greater levels of natural gas production are truly viable policy options. In the pursuit of all goals, no goals are likely to be achieved. It's a stalemate. Given the factors at hand, it remains to be seen just how U.S. LNG export terminal projects develop. There are clear indications that demand is present, but nebulous political actions, words, and potential regulatory issues still cast a shadow on any perception of a clear path forward.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.Appendix A – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick here to expand the image aboveAppendix B – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick here to expand the image above

June 2022 SAAR

Quantifying Pent-Up Demand

The June SAAR was 13 million units, up 2.3% from last month but down 16% compared to June 2021. This month's release closes out the second quarter of this year, bringing the total Q2 2022 SAAR to 13.4 million units. Q1 2022 SAAR of 14.1 million units was already considered low compared to pre-pandemic, and the last few months have analysts wondering if the total 2022 SAAR will manage to exceed the first quarter's sales pace at all. It would certainly take a major turnaround in the second half of this year for the 2022 SAAR to normalize by the time it is all said and done.As far as unadjusted sales figures are concerned, June 2022's performance can be put in a more appropriate perspective when compared to the last seven years of June releases (See the chart below). June 2022's unadjusted sales pace narrowly outpaced June 2020, but compared to 2015-19, the unadjusted sales pace over the last month is significantly depressed. Even when compared to June 2021, a month where high demand intersects with dwindling supply for only the second month in a row, the June 2022 SAAR still comes up short. The story behind the slow sales pace remains the same in 2022 as it was this time last year, but to a magnitude that no one expected when we wrote our June 2021 SAAR blog. A lack of available inventory continues to be the largest factor limiting sales. According to Wards Intelligence, inventory at the beginning of June was down 25% from this time last year and was less than a third of pre-pandemic levels. See the chart below for a look at the industry inventory to sales ratio, which has been trending lower and lower since the inventory shortage began to take hold around March 2021. Alongside inventory tightening, other recent trends in the auto industry have also intensified. For example, incentive spending per unit continues to fall, reaching $930 this month (59.4% lower than this time last year). As incentive spending per unit falls, sticker prices have risen. According to J.D. Power, the average transaction price per vehicle was $45,844 over the last month, an increase of 14.5% from June 2021. Furthermore, as a result of climbing sticker prices and rising interest rates, the average monthly payment that consumers are paying for new vehicles has climbed to$686, an all-time high. While almost all consumers that are financing vehicles are feeling the sting of high monthly payments, a growing share of new car buyers are now paying over $1,000 per month. According to a recent WSJ article, over 12% of new car buyers are signing up for monthly payments in excess of $1,000, a much larger proportion of buyers than many would guess. Due to this shift in the environment for the auto consumer, the relative inelasticity of purchasing a new vehicle is being highlighted now more than ever.Pent-Up Demand – What Does That Really Mean During the Auto Inventory Crunch?In several of Mercer Capital's auto blogs (most recently last week's blog) as well as other industry commentaries, there have been references to the idea of "pent-up demand." Pent-up demand has become commonly accepted as a reason for the relative price inelasticity of new vehicles. Inelasticity is the economic concept that a large change in the price of a good, results in a small change in the demand for that good. Pent-up demand can also be predictive. For example, many people following the auto industry have been predicting that once sticker prices eventually "normalize", then many folks that would have bought a vehicle in a more price-friendly environment will finally pull the trigger and make that new vehicle purchase. With prices still climbing and dealers still selling through most all of the inventory they get immediately, we're seeing that some consumers aren't able to wait for a more favorable buying environment.What will "normalized" volumes look like after supply chains recover? From 2015-2018, light vehicle sales in the U.S. exceeded the threshold of 17 million, which has been bandied about as the new normal. Expanding the lookback to 2014-2019, average annual light vehicle sales were 17.1 million, and it has become common within the industry to assume that a return to normal after the pandemic and chip shortage will carry the SAAR back to those levels, if not higher (due to the pent-up demand mentioned earlier).However, is a speedy return to a 17 million unit SAAR a reasonable expectation? And is 17 million even the correct number?We can look at the historical volumes to answer these questions. See below for a chart of the SAAR from 1976 to the first half of 2022. We have included a trend line to show the overall trend of upward movement during this period.It is easy to see that the market for new vehicles has been increasing over time. Population growth and the shift from 1 car households to 2+ car households are two obvious reasons to explain the upward growth of new vehicle sales. It is also easy to see that the market for new vehicles is cyclical. A period of elevated sales is typically followed by a down period where the demand for autos dips due to an economic recession or just general softening of demand. The last period where we saw this occur was centered around the credit crisis in the late 2000's where OEMs particularly struggled. This recovery was also compounded by storms in Asia in 2011.From 2013 to early 2020, the new vehicle market could be characterized as being in an up-cycle. SAAR figures being reported during that period may not have been unsustainable from the perspective of OEMs or dealers. Still, a general softening of demand was bound to happen at some point. While population growth and more vehicles per household lead to a general uptick, OEMs have improved the useful lives of new vehicles as well.However, an organic softening of demand was not allowed to take its natural course due to the COVID-19 pandemic and the resulting supply chain disruptions associated with it. The 17 million units sold prior to the pandemic are above the line of best fit in the data set. With population growth and increases in the number of new vehicles per family, we believe a linear line of best fit is appropriate for the data set. The formula on the graph shows each year, 184 thousand more vehicles are sold than the previous year. It also estimates volumes of about 16.6 million in 2022, which looks very unlikely at this point. While this long-term view is not a good predictor for sales next month, particularly in light of supply chain constraints, we believe it reasonably supports that sustainable sales levels may be lower than the 17 million achieved pre-pandemic.Extrapolating forward with current data, 17 million in annualized volumes wouldn't be anticipated until April 2025. It will be interesting to see how this data changes in the coming months if/when supply constraints are removed. All that being said, perhaps a return to the long-term trend is the most reasonable assumption that industry experts can make. Based on the trend line in the chart above, a normalized SAAR of 16.5 million seems to make sense. While the difference between a predicted 17.5 million unit SAAR and a 16.5 million unit SAAR certainly does not make the largest difference in the grand scheme, it is important to have a more nuanced discussion around what "normalized" sales are going to look like in the wake of the inventory crunch that is gripping the industry in 2022.July 2022 OutlookMercer Capital's outlook for the July 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Stay tuned for more updates on next month's SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a Mercer Capital auto dealer team member today to learn more about the value of your dealership.

RIA M&A Update - Through May 2022

Year-to-date RIA M&A activity has surpassed last year’s record levels so far in 2022 even as macro headwinds for the industry continue to mount. Fidelity’s May 2022 Wealth Management M&A Transaction Report listed 93 deals through May of 2022, up from 72 during the same period in 2021. These transactions represented $135 billion in AUM, up 12% from 2021 levels.The continued strength of RIA M&A activity amidst the current environment dominated by inflation, rising interest rates, and a tight labor market is noteworthy given that all of these factors could put a strain on the supply and demand dynamics that have driven deal activity in recent years. Rising costs and interest rates coupled with a declining fee base will put pressure on highly-leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. Despite these pressures, the market has proven robust (at least so far). Demand for RIAs has remained strong, with the professionalization of the buyer market continuing to be a theme driving M&A activity. Deal volume is increasingly driven by serial acquirers and aggregators with dedicated deal teams and access to capital. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the first five months of the year. This group of companies, along with other strategic acquirers and consolidators, have continued to increase their share of industry deal volume and now account for about half of all deals. In addition to driving overall industry deal volume, the proliferation of strategic acquirers and aggregator models has led to increased competition for deals throughout the industry. This has contributed to multiple expansions and shifts to more favorable deal terms for sellers in recent years. While there are some signs that deal activity from these acquirers may slow down (CI Financial’s CEO Kurt MacAlpine remarked on the company’s first quarter earnings call that their pace of acquisitions has “absolutely slowed down”), we’ve not yet seen that borne out in the reported deal volume.On the supply side, the motives for sellers often encompass more than purely financial considerations. Sellers are often looking to solve succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment, and will likely continue to fuel the M&A pipeline even in a downturn. And despite years of record setting M&A activity, the number of RIAs continues to grow—which suggests the uptick in M&A activity is far from played out.Whatever net impact the current market conditions have on RIA M&A, it may take several months before the impact becomes apparent in reported deal volume given the often multi-month lag between deal negotiation, signing, and closing. But at least through May, transaction activity has remained steady or even surpassed last year.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has continued to trend upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquiror models will likely continue to support higher multiples than the industry has been accustomed to in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions.For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions as they are in most transactions. But how the deal is financed is often an important secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling: After years of steadily increasing multiples and fundamental performance, RIA valuations are now at or near all-time highs. But whatever the market conditions when you go to sell, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a wide spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for different levels of autonomy post transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision, and one which can have a significant impact on personal and career satisfaction after the transaction closes.

July 2022

In this issue: Strategic Benefits of Stress Testing in an Uncertain Economic Environment

Valuing Stock Options of Start-up Companies: A Complex Issue in Marital Dissolutions

The valuation of stock options is a complex issue that divorcing parties may face during the determination and division of the marital estate.

Medtech and Device Industry Newsletter - Q3 2022

E&P Third Quarter 2022

Bakken

Bakken // Oil prices declined in the third quarter of 2022, as West Texas Intermediate (WTI) and Brent Crude front-month futures ended the quarter at about $79/bbl and $85/bbl, respectively — a decrease from $108/bbl and $112/bbl, respectively, at the start of the quarter.

Transportation & Logistics Newsletter

Third Quarter 2022

Demand for services in the logistics industry is tied to the level of domestic industrial production.

State of the Industry From the Tennessee Automotive Association Convention

Musings From Mercer Capital’s Music City Office

Last week we attended the Annual Tri-State Convention for the Automotive Associations of Tennessee, Mississippi, and Alabama. The event provided a great opportunity to discuss trends in the automotive industry with industry participants and dealers from different manufacturers and geographic areas. In this post, we discuss some of the trends discussed last week, including a variety of topics that we have covered before in this space. We also incorporate highlights of a presentation from noted industry analyst Glenn Mercer (no affiliation with Mercer Capital) regarding the "Dealership of Tomorrow."Supply and PricingAs the last few publications of the monthly SAAR figures (April and May) have indicated, the production of new vehicles by auto manufacturers and suppliers to auto dealerships continues to be impaired by a variety of economic factors.In fact, analysts from Cox Automotive have recently tempered 2022 estimates of new vehicle sales to 14.4 million units, from their original estimate of 15.3 million units. The average annual SAAR for 2016 through 2019 was approximately 17.2 million units. Using this figure as an estimate of the average demand in the United States, the lost sales caused by COVID-19, the microchip crisis, and continuing production issues will total approximately 7.9 million units from 2020 through estimates for 2022.Even if auto manufacturers are able to scale production back to pre-COVID levels plus some excess to account for this pent-up demand, full recovery and stabilization could take 3-4 years.Glenn Mercer forecasts that annual demand should continue at the 17 million unit average through 2030. While we find this reasonable, we plan to delve into this topic further in a future post. With demand exceeding supply for the last several years, auto dealers have continued to capitalize on higher margins for new vehicles. According to Cox Automotive, the average transaction price for new vehicles climbed to $47,148 in May 2022. One byproduct of these trends is that some auto dealers have been able to sell new vehicles for a higher price than the manufacturers' suggested retail price ("MSRP"). As the following chart indicates, the average customer-facing transaction price has exceeded the MSRP for the same vehicles since the fall of last year. The question on most dealers' minds that we spoke with is how long are these trends sustainable? With the rising costs of vehicle transactions coupled with general inflation and rising gas prices, how long will consumers be able to afford new vehicle purchases at these levels? As the chart below indicates, the median number of weeks of income needed to purchase a new light vehicle has risen dramatically to 41.3 weeks in April 2022, fluctuating between 32-36 weeks for the prior decade. This figure will probably continue to climb as average transaction prices rose in May and are expected to climb again in June. Click here to enlarge the imageDemographics of Number of Dealerships and OwnersWith all of the headlines of heightened transaction volume in the auto dealer M&A market and increased activity and investment by the public auto groups, we find two charts from Mr. Mercer's presentation to be informative, which we have attempted to combine for comparative purposes: store count and owner count.We have written numerous times about the resiliency and adaptability of auto dealers and the entire automotive industry during challenging economic times. Despite the challenges, the number of auto dealerships or stores in the United States has remained relatively stable at around 18,000 since 2009.While store count has largely remained unchanged, consolidation has occurred in the owner count. Factors contributing to the decline in the number of owners include the retirement of aging owners, increased size and profitability of the average dealership, and the aforementioned activity and appetite for acquisitions by the public and larger auto groups.The following chart displays the declining owner count from its previous high of just over 10,000 in 2008. While we expect there may be further industry consolidation, conventional wisdom is that this reduction will continue to come in the form of fewer owners than fewer stores. However, as we discussed with Tony Karabon in a recent post, ownership counts may not continue this downward trajectory with the appetite displayed by first-time buyers. Auto dealerships are attractive investments, and many dealers offer a minority equity stake in dealerships as part of the compensation package for GMs. We'll be curious to see how this trend evolves because regardless of who owns the dealership and how many they own, someone still has to run each one. And after you own a piece of an attractive investment, you tend to want one all for yourself. While larger groups benefit from their scale, there are limits to how large OEMs will allow their dealers to grow, and there is an appetite from smaller buyers looking to get involved.Future Impact of Fixed Operations on Auto DealershipsAnother hot-button topic discussed at the Conference was the continued speculation that OEMs might shift to an agency model or direct sales to consumer model, which could decrease the auto dealers' portion of profits from new vehicles. In some discussions, the auto dealers' participation might shift to a delivery center whereby the dealer would receive a delivery fee if the customer selected that particular dealership to pick up their new vehicle.These changes could lead to physical changes at a dealership if there are no longer requirements to house and showcase new vehicles. If costs can be removed from the sales and distribution model and shared in a mutually beneficial way, it may not be the worst thing for dealers, though most are reasonably skeptical.Regardless of the prospects of a changing share of new vehicle profits, dealers would be wise to refocus on their fixed operations, specifically parts and services. Fixed operations have historically been a stabilizing segment for successful dealers. Even with heightened vehicle sales profitability, fixed operations remain the highest margin for a typical dealership, though their contribution to total gross margin has declined with higher GPUs.One trend lost in the shuffle of higher profits is that auto dealers' percentage of the total parts and service market has actually eroded over time to independent and after-market repair centers. These alternative options have climbed in recent years, and consumers often cite their convenience and reluctance to the dealership experience as reasons for their selection.The following chart illustrates that dealerships' total parts and service market percentage has generally declined since 1955, hitting an all-time low of approximately 30% in 2020. The bay and outlet count of the various types of parts and service outlets are as follows. Dealers should strongly consider offering some versions of mobile service or potentially satellite locations to mitigate the locational and convenience factors of the aftermarket alternatives in an attempt to recapture some of this market and high-margin business. And if the industry moves more toward an agency model, there may be fewer bad memories from the purchase experience that could negatively impact the likelihood of capturing after-sales work. We can even envision a situation where OEMs do more to push consumers back to the dealers for service work in order to make up for a decreased role in the sales process. In the transport refrigeration business, it is more difficult for consumers to get repairs from non-dealer repair shops. With increasingly complex light vehicles with all the microchips being used and features being added, it's possible service and repair work will naturally shift back towards auto dealers.Electric VehiclesThe other widely discussed topic continues to be electric vehicles (EV). Industry participants all have their predictions based on early adoption rates, government subsidization, and other factors. While adoption rates are still relatively low, (EVs are ~5% of the market), Mr. Mercer predicts this penetration figure could reach 8% by 2025, but full-scale adoption could be years off.The agency model discussions above have really picked up due to EVs. On the face of it, the sales method doesn't depend on the vehicle's powertrain, whether an internal combustion engine (ICE) or EV.While adoption remains relatively low, there is a clear stratification in the marketplace as current EV buyers tend to come at the upper end of the market. These buyers are less likely to have low credit scores, have negative vehicle equity on their trade-ins, or have any other complications that generally push would-be online car buyers to the dealership for more help in the sales process. These buyers are also generally willing and able to pay for this convenience, so a top-down approach from the manufacturer to sell vehicles to this top end of the market makes more sense than the franchised distribution model utilized when sales become more complicated.Political Considerations of Electric VehiclesOne factor impacting the adoption of EVs may be politics. As seen from the survey conducted by Strategic Vision in 2020, more Republicans purchase trucks and SUVs, while more Democrats have historically purchased alternative powertrain vehicles (APTs), including hybrid electric vehicles (HEVs) and battery electric vehicles (BEVs). It will be interesting to monitor the success of Ford's Lightning (which recently had a recall for low tire pressure warnings) and other EV truck offerings to see if they break these political buying trends and lead to quicker adoption of EVs. Other constraints against EV adoption have also been the battery life and difficulties with public charging stations. While the entire infrastructure of public charging stations would need to be built out with the continued adoption of EVs, consumers currently list the following barriers to their experience in areas where more charging stations currently exist, such as San Francisco: membership requirements, operability issues, price, payment issues, and locating a convenient charging station location. Full-scale adoption of EVs can also lead to other geopolitical factors. Just as the Russia-Ukraine conflict has made us aware of the industry's dependence on Ukraine as a chief exporter of neon that is used in the production of microchips, many of the components in the batteries for EVs are exported from China. The following is a list of some of the key battery components and the share of processing volume by country in 2019: Click here to enlarge the imageConclusionsThe recent Tri-State Convention (Tennessee/Alabama/Mississippi) provided a great forum to discuss current trends in the auto dealer industry and predictions for the future. It's informative to hear how individual dealerships are confronting their own unique challenges.All of the trends/factors discussed in this post will continue to impact the operations of dealerships and, ultimately, their profitability and valuation. We thank Glenn Mercer for his informative talk and him allowing us to reproduce many of the graphics in this post.Mercer Capital provides business valuation and financial advisory services, and our auto team assists dealers, their partners and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your auto dealership.

Bond Pain and Perspective on Bank Valuations

Equity investors define a bear market as a 20% or greater reduction in price from the most recent high price. There is no consensus for fixed income. A bond’s maturity and coupon are key variables in determining the sensitivity of price except when overlaying credit and prepayment variables when applicable.A simple definition might be when the price falls more than three times the annual income for any bond with a maturity greater than five years. If so, it is a low bar when coupons are as low as they are. Definitions aside, the bond market is in a bear market.Figure 1 :: 1994 Bear Market vs 2022 Bear Market The yield on the 10-year U.S. Treasury note (“UST”) was 3.21% on June 27, up from 1.51% as of year-end. Ignoring the impact of the intervening six months for what would be a bond with 9.5 years to maturity, the increase in yield has produced a ~14% loss in value. The last bond bear market that was brutal occurred in 1994 when the Fed raised the Fed Funds target rate from today’s aspirational rate of 3.0% beginning in February to 6.0% by February 1995. The yield on the 10-year UST rose from 5.19% on October 15, 1993 to a peak of 8.05% on November 7, 1994 once the market could see the last few Fed hikes to come. The 286bps increase in yield pushed the price of the 10-year UST down by 17%, which modestly exceeds the 14% loss this year. Coupons matter. Fixed income investors entered the current rising rate environment with little coupon to cushion rising yields unlike in the years immediately after the Great Financial Crisis when the Fed first implemented a zero-interest rate policy (“ZIRP”). Worse, banks entered the current bear market with much bigger securities portfolios given the system was inundated with excess deposits because of actions taken by the Fed and government to offset the COVID-19 recession. To get a sense of the damage in bank bond portfolios consider Figures 2 and 3 where we have compared the unrealized losses in bank bond portfolios as of March 31 with the unrealized losses as of year-end 1994, which roughly corresponded to the bottom of the 1994 bear market. The data reflects averages. Figure 2 :: Unrealized Losses in Bank Portfolios as of March 31, 2022Figure 3 :: Unrealized Losses in Bank Portfolios as of December 31, 1994 We make the following observations for banks with $1 billion to $3 billion of assets: Banks are better capitalized with average leverage and tier one capital ratios of 10.6% and 17.0% as of March 31, 2022 compared to 8.3% and 12.9% as of year-end 1994.Securities classified as available-for-sale (“AFS”) and held-to-maturity (“HTM”) averaged 19.0% and 2.5% of assets as of March 31, 2022 compared to 11.2% and 14.6% as of year-end 1994.The unrealized loss in the AFS portfolio equated to 4.7% of the cost basis and 11.3% of tier one capital (excludes the deferred tax asset adjustment) as of March 31, 2022 compared to 2.8% and 5.7% as of year-end 1994. 1 Unrealized losses in HTM portfolios in Figure 2 may appear too small even though many banks classify long-dated municipals as HTM because these illiquid bonds had not been adequately marked yet to reflect a rapidly declining market.Unrealized losses will increase once June 30 data is available because UST rates have risen ~75bps since March 31. Banks are sitting on large unrealized losses today. Investors know that. The bear market in bank stocks (the NASDAQ Bank Index is down ~19% YTD) primarily reflects investor expectations about the potential impact a recession would have on credit costs next year even though NIMs will increase this year (excluding the impact of PPP loan fees) and next provided the Fed does not pivot and reduce rates. The current equity bear market is not about unrealized losses in bond portfolios; it is about the economic outlook. From a valuation perspective, we primarily look to the impact of rising (or falling) rates on a bank’s earnings rather than how changes in rates have impacted the value of the bond portfolio and tangible book value. Assuming an efficient market, the unrealized losses represent the opportunity cost of holding bonds with coupons below the current market rate. If the underwater bonds are sold and immediately repurchased, then the bonds repurchased will produce enough extra income over the life of the bonds to recoup the loss (assuming an efficient market). Further, the AFS securities portfolio is the only asset for most banks that is marked-to-market other than mortgage loans pending sale. Fixed rate residential and CRE loans would have sizable losses, too, if subjected to mark-to-market. Rates have risen, prepayment speeds have slowed and in the case of CRE credit spreads have widened. Also not marked-to-market are deposits. Though a liability, core deposits are the key “asset” for commercial banks. Value for deposits—especially non-interest-bearing deposits—are soaring given a low beta to changes in market interest rates when loan-to-deposit ratios are low. The monthly report that really matters is not the bond report but the asset-liability model (“ALM”). Banks manage net interest margin (price) and assets (volume) to drive earnings; and earnings (or cash flow) drive stocks over time. Earnings also build book value to the extent earnings are retained. Rising rates—gradually rather than rapid—are a positive development given the commercial bank business model, assuming that credit quality does not deteriorate. Having said that, we cannot completely dismiss the unrealized losses in the bond portfolios. Some investors focus on tangible book value, though we view it as a proxy for earning power because tangible book value is levered to produce net interest income. Also, M&A is more challenging because day one dilution to tangible BVPS is greater to the extent unrealized bond losses are recognized via fair value marks applied to all assets. Of course, earnings then increase from accreting the discounts as additional yield. Aside from the soaring value of core deposits, the glass half full view is bonds and fixed rate loans eventually mature. In the interim, cash flows should be reinvested to produce better yields.About Mercer CapitalMercer Capital is a national valuation and transaction advisory firm that has advised banks for 40 years through bear and bull markets. Please give one of our professionals a call if we can be of assistance.

Portfolio Valuation: Private Equity and Credit

Second Quarter 2022

Cliff Asness, the co-founder of AQR Capital Management, raises a couple of interesting questions about investing in private equity in a recent Morningstar podcast that speak to his background as a “quant” who runs one of the largest and most successful quant-focused funds.

Always Cash Flow and Earning Power

So how does one value private equity and credit when financial conditions are tightening, IPO and M&A activity is moribund, and a recession may be developing?

Is Your Family Business Worthy of Its Name?

This week, McDonald’s was in the news with a new plan raising expectations for franchise operators. The more stringent renewal reviews will include an assessment of performance history and customer complaints. The company told its franchisees that “…receiving a new franchise term is earned, not given.”Franchisees pay handsomely for the right to use the McDonald’s name, expecting that the goodwill associated with the golden arches will generate attractive returns for them as owner-operators. For its part, McDonald’s is dependent on the operations of its franchisees to maintain and enhance brand goodwill. After all, consumer perceptions of the brand are driven by their experiences in franchise-operated locations far more than activities at the corporate office. In other words, franchise operators are stewards of the McDonald’s brand. The company intends a more intensive review process to ensure that poor-performing or non-conforming operators do not reduce the value of the brand.While it is rare for family businesses to license the family name for use, family business managers and directors are stewards of the family name and the family’s capital. Directors and managers use the family’s capital (both social and financial) to operate the family business with the goal of providing an attractive risk-adjusted return for family shareholders.If your family business had to go through a renewal process to continue using the family’s name and capital, what factors would determine whether the business was worthy of renewal?Stewardship ReportingPeriodic reporting to owners is a fundamental obligation of stewards. The content of that reporting will be unique to each family. However, there are some broad elements that should be considered for any stewardship reporting model.Capital allocation. How is the family’s capital being allocated? Is the family’s capital being invested in real estate, working capital, production equipment, rolling stock, or intangible assets like a tradename? How much of the family’s capital is allocated to assets that don’t directly support the operations of the family business? What is the rationale for the allocation decisions that have been made? How do those decisions further the company’s strategy?Risk. To what risks is family capital exposed? To what degree is family equity capital being blended with third-party debt capital to extend the reach and scale of the family’s resources? What are the economic, regulatory, and industry risk factors that could influence company performance in the future? What customer/supplier concentrations or key person dependencies could adversely affect the company? What steps are available to mitigate these risks, and are those steps financially feasible?Operating performance (over time). Is the family business growing or shrinking? Is it gaining or losing market share? Are there new products or markets that offer an attractive growth platform for the company? If the family business has momentum, what is it doing to keep it? If the family business doesn’t have momentum, what is it doing to gain it?Operating performance (relative to peers). How does the operating performance of the family business compare to available benchmark measures? What is the cause of significant variances – underperformance, overperformance, or a fundamental difference in the business model or strategy?Efficiency. How do operating results compare to the resources allocated to producing those results? While not perfect, return on invested capital (ROIC) is a useful performance measurement framework for many family businesses. How much revenue is the family business generating per dollar of invested capital? How much operating profit does the family business generate per dollar of revenue? What is the trend in these measures over time, and how do they compare with available benchmarks?Investment returns & valuation. Family capital could be invested elsewhere, so what investment returns are being generated by the family business over time? Calculating investment returns requires developing periodic estimates of the value of the family business – what are the controllable (company performance) and uncontrollable (market performance) factors influencing the value of the family business and investment returns?What returns are being generated by alternative investments? How does the risk of the family business compare to the risk of those alternatives? Does the resulting tradeoff between risk and return “fit” your family shareholders?ConclusionFamily business directors and managers don’t have to submit to a renewal process to secure the right to continue using the family’s social and financial capital. But pretending that you did have to is not a bad exercise for directors and managers. What factors could you cite to support your continued stewardship of the family’s capital? Do you have a periodic reporting process in place that addresses those factors?Designing a reporting process that is tailored to your family and business can help ensure that family capital continues to be put to good use. Give one of our family business professionals a call to discuss your reporting needs.

What’s the Price of Growth?

Infrastructure Spending in the Investment Management Community

In the golden age of asset intensive businesses, companies made giant capital expenditures on fixed assets and research & development to fuel long term growth strategies. In those days, economies had similar opportunities. The U.S. system of interstates, launched by President Eisenhower, is a prime example of major spending in support of long-term opportunities. (I could lament the days of fresh asphalt and real yields, replaced now by potholes and QE, but that’s another blog.)As our economy has evolved to feature more service-based, asset-light businesses, so too has the need to rethink what infrastructure means and what investing in long term growth looks like. Even businesses like investment management have a type of infrastructure, and their long-term growth opportunities require investment in that infrastructure.The Tangible Value of an RIA’s WorkforceOne common feature of RIA financial statements is the simplicity of their balance sheet. We not infrequently work with clients whose asset base consists of little more than a token amount of cash, receivables, and leasehold improvements. On the righthand side of the balance sheet, we commonly see nothing but a few payables and equity.But as the old (pre-pandemic) saw goes, an investment management firm’s assets get on the elevator and go home each night, such that the real infrastructure of an RIA is its staff – sometimes referred to in the valuation profession as the “assembled workforce” – an intangible asset that is more-or-less measurable using a replacement cost methodology (oftentimes achieving a result that is more precise than it is accurate).Our recent blog series has focused on the tradeoffs that RIAs make in providing returns to labor and returns to capital. Ultimately, for each dollar of revenue that an RIA brings in, the process of deriving profitability is largely a function of setting up a compensation structure. The portion of revenue devoted to expenditures other than staff and ownership is comparatively small (and less discretionary in nature).The balancing act between returns to capital and returns to labor is also a balance between current return and long-term growth.But spending on staff isn’t simply a tradeoff with profitability, it is also a tradeoff with growth. Most growth opportunities in the RIA space involve staffing – whether it’s for new initiatives, succession, or further development of the existing business model. Staffing requires spending that may not be immediately accretive to earnings. To the extent that spending on staff is front-loading the costs of opportunities for growth, the margin tradeoff can be rightly characterized as infrastructure spending – building the workforce needed to support more growth and profitability in the years ahead. Most understand the tradeoff, but little has been written about what sort of tradeoff is appropriate.The Rule of 40Elsewhere in the business community, this issue of the tradeoff between growth and margin has been explored thoroughly. In the subscription software industry (SaaS), there is a well-known concept called the Rule of 40. The Rule of 40, or R40, holds that venture investors like to invest in businesses in which the profit margin plus the growth rate adds up to at least 40%.So, if a growing SaaS company shows a profit margin of 30% and a growth rate of 15%, the total margin and growth (30% + 15%) is 45%, exceeding the R40 expectation. Companies with combined growth and margin rates of 50% are top performers and get lots of attention.The R40 function is a shorthand way of determining the strength of a business model, in measuring the degree to which growth requires a tradeoff with profitability (whether through price concessions, marketing, or other customer acquisition costs). If growth plus margin equals more than 40, it indicates a business that can maintain profitability and still expand at better than average levels. Imagine a unique development stage business in a market with lots of upside and little competition – the sort of environment that promotes high growth with the pricing power to maintain substantial margins. On the contrary, a measure below 40 indicates a mature business with few expansion opportunities and increasing competitive threats.Now, which profit margin are we speaking of, and is it unit growth, top-line growth, or profit growth that matters? As with everything, the devil is in the details. But the concept, measuring the aggregate return of growth and margin, has merit in a “growth and income” business like investment management.Is R40 Applicable to RIAs?The most attractive feature of investing in the RIA space is that it generates lots of distributable cash flow and has the market tailwind (recent months notwithstanding) to provide growth. But more margin and more growth is always a better thing. As with SaaS businesses, RIAs that produce more margin and more growth are going to be worth more – ceteris paribus – than those which produce less margin and less growth.What’s a reasonable expectation of “R” for investment management? This is definitely a topic worth further study, but for the time being, let me venture out to offer a few thoughts on using this type of economic thinking to evaluate an RIA’s performance. Established wealth managers commonly produce EBITDA margins in the range of 20% to 30%. So, any measure of the efficacy of an RIA's business model – including evaluating whether it is investing for the long term – should develop an “R” that is in excess of that level. That “excess” metric is growth – but to what extent?Growth from market performance is always welcome, but as we’ve said many times in this blog, organic growth is the key to long term performance. Years like this are a cruel reminder that the market doesn’t always fuel AUM growth, and that a growth minded RIA needs a demonstrable and repeatable strategy to capture new assets. Without real organic growth, clients eventually spend off their assets, pass away, or take their business elsewhere.So, we would look at organic growth. That’s new client assets and additions to existing accounts, net of client terminations and withdrawals. The net growth of AUM, absent any market activity. Organic growth is a question of how quickly one can envision doubling an RIA’s business. 15% organic growth would imply doubling the business every five years. 5% is closer to 15 years. What organic growth rate will your model sustain?R35?If organic growth in the 5% to 15% range can be supported by a 20% to 30% normalized EBITDA margin, the combination of these ranges, or about 35% at the midpoint, suggests that something on the order of R35 is a decent norm to observe – at least in the wealth management space. Totals that far exceed 35% would indicate a more effective business model. RIAs that produce growth plus margin much lower than 25% suggest a comparatively weak model.The Rule of 40 – extended to the RIA space – works pretty well. The higher the “R” (percentage growth plus percentage margin), the better performing the business model – showing less of a tradeoff between margin and growth.We need to develop this idea further, but it’s promising as a diagnostic. R40 works in the SaaS world because the VC community investing in these companies has a cost of capital around 25%. R40 produces approximately the same present value of interim cash flows regardless of the tradeoff between margin and growth, provided they total about 40%. In the RIA space, where WACCs are more in the mid-teens, R35 appears to accomplish a similar parameter.The New GARPGrowth at a reasonable price (margin) is an old concept in investment management, but it bears extending to practice management as well. RIAs are fortunate not to have to spend billions on factories, only to grieve them as “money furnaces” (sorry Elon). But that doesn’t mean RIAs don’t have the same imperative to invest in the people who compose their businesses.

The Importance of a Quality of Earnings Study

This week, we welcome Jay D. Wilson, Jr., CFA, ASA, CBA to the Energy Valuation Insights blog. Jay is a Senior Vice President at Mercer Capital and a member of the firm’s Financial Institutions and Transaction Advisory teams. The post below originally appeared as part of an ongoing series from Mercer Capital’s Transaction Advisory team regarding the importance of quality of earnings studies in transactions for middle market companies.Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

Considering Contingent Consideration

This is the seventh article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Contingent consideration is a common feature of M&A when both parties are private, or the acquirer is public, and the target is private. There are many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.What Do Earnouts Entail?The most common contingent payment is an “earn-out” that bridges the buyer’s bid and the seller’s ask by ensuring the business produces an agreed upon level of revenues and/or earnings (typically EBITDA) within an agreed timeframe before the payment is made.Earn-outs could be considered the ultimate form of confirmatory due diligence. From a buyer’s perspective, earn-outs reduce risk by reducing up-front cash and the likelihood of materially overpaying absent an adverse turn in the economy or industry conditions. From a seller’s perspective, contingent consideration allows sellers to obtain an acceptable price and sometimes a premium or stretch valuation if the Company attains the agreed-upon targets. Further, earnouts create an alignment of interests to the extent roll-over management and ownership is incented to optimize the company’s performance.In our experience, most buyers are willing to pay in a range of value that produces an acceptable return based upon conservative assumptions about the business’ future earning power (EBITDA or EBITDA less capex) and growth rate. Unless the business is viewed as having above average risk, most buyers’ required rate of return on an unlevered basis will be conservative but not ridiculously high. This reflects buyers’ natural aversion to risks that may not be readily apparent to most sellers. An earn-out is a means by which to close or narrow this gap.When earnouts are involved, buyers and sellers must understand the waterfall of post-closing events, and their respective timing and terms to gain a full understanding of transaction consideration. Earnouts are a form of purchase consideration where acquirers tender value to the target seller if certain future events occur. Earnouts provide sellers with potential value fulfillment or upside while simultaneously allowing buyers to defer payment of consideration with the possibility of recovering a designated portion of the purchase price if post-closing hurdles are not achieved.By its nature, contingent consideration adds complexity for both buyers and sellers, particularly when the features of the earnout reflect significant speculation on post-closing outcomes. These might include high growth, reversals of trend, or specific events such as new business developments or failed business retention.Despite the complexities, earnouts and other forms of contingent consideration can be critical to achieving a successful closing when market conditions are ebbing more than flowing or when winning the day requires the buyer to make a stretch offer.Mid-Market Deals Increasingly Reflect Up-Market Deal StructuresAccording to GF Data®, a firm that provides data on private equity-sponsored M&A transactions with an enterprise value of $10 to $250 million, 38% of 432 transactions in 2021 entailed either seller financing or earnouts compared to 44% of 329 deals in 2020. The reduction last year reflected a seller’s market that was characterized by too much capital chasing a limited pool of sellers. Given tighter financial conditions this year that may lead to a recession later this year or next, it would not surprise us to see the percentage of deals with an earnout increase because the risk to a target’s earnings and maybe long-term growth prospects will rise.A financial advisor can be an important intermediary for both buyer and seller to craft a well structured earnout to facilitate successful deal negotiations rather than letting a poorly crafted and/or poorly socialized earnout create a negotiation wedge that can delay or overwhelm momentum required to finalize a purchase agreement.Buyer Awareness and Financial ReportingWhile it should not impact the economics of a transaction, buyers face the added burden of accounting for contingent consideration per FASB’s ASC 805, which addresses business combinations. It requires that the fair value of contingent consideration be recorded as a liability at the acquisition date, resulting in an increased amount of goodwill or other intangible asset depending upon how value is allocated to the acquired assets. Fair value also must be re-measured for each subsequent reporting period until the contingency is settled. Mercer Capital’s years of M&A purchase price allocation work for both strategic and financial acquirers gives us unique insight into the sometimes nettlesome issues of purchase price allocations in M&A transactions.Concluding ThoughtsWhile this article is an installment in our larger buy-side series of content, it is important to draw advice for buyers from our near universal advice to sellers.We often advise sellers to be content with the consideration they receive at closing and to assess contingent consideration with a healthy degree of skeptical risk, particularly when achieving the earnout represents a stretch in future outcomes.A logical extension of that advice for buyers is to be prepared to pay even if the benchmarks are deemed a stretch. The occasional extraordinary outcome can create significant buyer liability. Whether the net effect on the buyer is a beneficial deferral of payment or a deal premium (or otherwise) must be assessed in the context of the overall offering stack.Buyers should determine the reason for using an earnout and then determine an appropriate design for the earnout. Clear, unambiguous terms and measurements are recommended to minimize negotiating friction and incent smooth post-closing integration and alignment of interests both operationally and financially.If your development needs involve growth through acquisition, and you find the market for quality targets requires the thoughtful use of earnout consideration, Mercer Capital can provide useful insight while helping quantify the real-time financial equivalency of any earnout consideration offered.

Considering Contingent Consideration

Contingent consideration is a common feature of M&A when both parties are private, or the acquirer is public, and the target is private. There are many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.

An Overview of Auto Finance

Credit Risk, Trends, Used vs. New Vehicle Sales

Auto dealers that sell new vehicles around the country rely on their Finance and Insurance (F&I) departments as an important source of earnings. While top-line revenue in these departments is typically a small portion of a new car dealership’s total revenue mix, these departments have much more favorable margins than their counterparts in the selling division. For used dealers without subsidiary captive finance operations, third-party lenders take a larger role in the financing process and the economics tends to be different than their new vehicle-selling counterparts.In this blog post, we examine the layout and current state of the auto finance industry as well as quotes from public auto executives pertaining to the current financing environment.What Is the Layout of the Auto Finance Industry?The auto finance industry includes establishments that provide financing for both sales and leasing of automobiles. Sales financing establishments are primarily engaged in lending money for the purpose of providing vehicles through a contractual-installment sales agreement, either directly from or through arrangements with auto dealers. Industry participants generate revenue through the interest and fees that are included in the installment payments of borrowers.The auto finance industry includes establishments that provide financing for both sales and leasing of automobiles.There are two major types of auto finance operators: captive finance companies and third-party lenders:Some examples of captive finance companies are Toyota Financial Services, General Motors Financial Company, Honda Financial Services and BMW Group Financial Services. These companies are “captive” to the larger OEM’s leadership and have less decision-making autonomy. The purpose of these captives is to provide the parent company with a substantial source of profit and also limit the company's risk exposure. Captive finance lender loans are typically exclusive to new vehicles.Third-party lenders like Ally Bank, Capital One, Chase, Wells Fargo, and Truist provide insurance and financing to dealerships and their customers that primarily sell used vehicles or new vehicle dealerships without a captive finance subsidiary. Consumers can also decide to use a third-party lender in place of a captive finance company on purchases of new vehicles as well. Banks are not the only entities that participate in the auto lending industry. Credit Unions, Specialty Finance companies and “Buy Here, Pay Here” (BHPH) companies also lend to car buyers. (It is important to note that BHPH companies may hold the consumer’s loan on their balance sheet or sell the loan in the open market. Thus, these companies have attributes of captive finance subsidiaries as well as third-party lenders.) See the graphic below (Source: Piper Sandler) featuring auto finance lenders in different industry classifications. It is easy to see how the different classes of lenders outlined in the graphic above might have different risk tolerances and return targets. For example, the “Buy Here, Pay Here” companies are more likely to lend to subprime borrowers. While these companies have taken scrutiny for charging higher interest rates on said borrowers, they are undoubtedly taking on more risk while demanding a higher return in response. Additionally, the cost of repossessing vehicles is endemic to their operations, not a “normalization” adjustment that one might consider in the valuation of a new vehicle dealership.State of the Auto Finance IndustryExperian releases a “State of the Automotive Finance Market” webinar on a quarterly basis. The information in the most recently released webinar outlines origination, portfolio balances, and delinquency trends observed in the first quarter of 2022. A summary of these trends follows.Origination TrendsOver the last three Q1’s, around 60% of total vehicles financed were used vehicles.Retail volume is down in 2022. Using January as an example, 3.48 million units were financed in 2022 compared to 4.22 million and 3.89 million units in 2020 and 2021 respectively.The market share of total financing has shifted a bit in the past year, with banks and credit unions capturing bigger pieces of the auto finance pie when compared to captives and Buy Here, Pay Here operators. Captives gained some market share following the onset of the Covid-19 pandemic as banks tightened underwriting standards, but banks have recently regained their position.The average credit score by vehicle type has been consistently increasing since the first quarter of 2017 for both new and used vehicles. (Q1 2022: 736 for New and 669 for Used) These scores compare to Q1 2017’s 725 and 644.Prime borrowers (buyers with credit scores between 661-780) made up just over 64% of total financing, while subprime borrowers made up around 17%. The most substantial growth in originations over the past quarter has been with prime borrowers.Despite rising trade-in values, the average amount financed has also been on the rise. The average amount financed and the average monthly payment were $39,450 and $648, respectively in Q1 2022.Portfolio Balances and DelinquencyOverall loan balances grew to $1.37 billion in Q1 2022.Delinquencies have ticked up over the past year. Auto loans that are 30 days delinquent grew from 1.46% of total loans to 1.55%. Auto loans that are 60 days delinquent grew from 0.51% of total loans to 0.59%.Independent, used dealers are seeing the highest rates of delinquency. As discussed above, this is part of the normal course of business for BHPH operators. As prime borrowers are flocking to new car loans and delinquencies on these loans remain low, subprime used car buyers are beginning to show signs of financial stress. Rising sticker prices and monthly payments are the most likely cause of an uptick in delinquencies.Public Auto Executives Chime In – Sonic AutomotiveIn our Q1 Earnings Calls blog, we touched on a theme that came up throughout this quarter’s public auto exec interviews: affordability. Many of the franchised, new vehicle-selling dealers downplayed affordability concerns, which is consistent with what we have seen in the trends outlined above.Heath Byrd, CFO for Sonic Automotive, when asked about new vehicle affordability concerns, said that:“What we’re seeing from a macro perspective is there’s not any material impact to the prime and near prime consumers. […..] Are you starting to see a little bit of degradation in credit and portal in the lower income brackets, which is a very small part of both our franchise as well as our EchoPark consumers? So, what you’re starting to see [is] a little bit on the lower income, but on the upper tier we’re not seeing anything material.”Jeff Dyke, President at Sonic Automotive, echoed these concerns around used vehicle affordability:“The problem is, is that we’re pushing $500 a month payments, and we used to pay $400 a month payments, and it’s too close to the new car pricing. […] You really want your average used vehicle selling price to be one half that of your new vehicle selling price. And in my whole career, it’s always run 50% to 55%, somewhere in there. It’s at 70%. It’s too close to the new vehicle pricing and prices are too high, $500 whatever, $525 a month payment. That’s just not — that’s out of the norm.”With a lack of new vehicle affordability, buyers are increasingly bidding up used vehicles. The explosion of companies like Carvana, Shift, Vroom, etc. has exacerbated used vehicle demand, lifting prices above historical norms, further squeezing subprime buyers.ConclusionRising rates and record levels of inflation may put auto purchases out of reach for some lower income consumers and create hardships for those trying to pay down existing floating rate notes that weren’t locked when interest rates were low. Facing the possibility of a recession and deteriorating credit quality, auto lenders will likely adopt more conservative lending practices and credit portfolios linked to auto loans may trade at steeper discounts to par to recognize the increased risk. While this could impact vehicle sales in the case that would-be buyers are unable to obtain the financing they need, as we’ve seen in the past two years, vehicle demand tends to be pretty inelastic. Ultimately, those focused on prime borrowers seem to be on solid footing for now while lenders with more exposure to subprime borrowers may start to experience more difficulty.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

The Importance of a Quality of Earnings Study

This week, we welcome Jay D. Wilson, Jr., CFA, ASA, CBA to the Family Business Director blog. Jay is a Senior Vice President at Mercer Capital and a member of the firm’s Financial Institutions and Transaction Advisory teams. The post below originally appeared as part of an ongoing series from Mercer Capital’s Transaction Advisory team regarding the importance of quality of earnings studies in transactions for middle market companies.Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

Permian Production Remains Strong

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Permian.Production and Activity LevelsEstimated Permian production (on barrels of oil equivalent, or “boe,” basis) increased approximately 11.4% year-over-year through June. This is notably greater than the production increases seen in the Eagle Ford, Bakken and Appalachia (8.0%, 2.2% and 1.9%, respectively). There were 345 rigs in the Permian as of June 10, up 49% from June 4, 2021. The Bakken, Eagle Ford, and Appalachia rig counts were up 131%, 106%, and 34%, respectively, over the same period. In terms of production growth, the Permian has far exceeded the other basins, and Permian production is expected to continue increasing over the next several months based on anticipated increases in the rig count and new-well production per rig.Commodity Prices Continue to RiseOil prices generally rose through the second half of 2021, although they started to decline in mid-Q4. The shale revolution had largely put geopolitics in the back seat as the key driver of commodity prices. However, geopolitics once again came front and center as Russia launched its invasion of Ukraine in late February. Western nations responded with a series of economic sanctions against Russia. Although the sanctions generally included carve-outs for energy exports, issues with financing and insurance, and the exit of Western oil companies and oilfield service providers from Russia resulted in a substantial decline in oil exports from the country. The exclusion of oil from Russia, the third-largest producer of petroleum and other liquids in 2020 according to the U.S. Energy Information Administration, from global markets led to a high degree of volatility in oil prices. WTI front-month futures prices began the latest quarter at ~$99/bbl and were floating around $121/bbl as of mid-June. With no indications of any near-term resolution of the Russian-Ukraine war, and a continued outlook of relatively flat production in the U.S., the upward trajectory of global energy prices has no foreseeable inflection point at the moment. Natural gas prices fluctuated over the past year, albeit with slightly less volatility than oil prices, and have exhibited the same upward trend over the past quarter. Natural gas is becoming more globalized as Europe grapples with replacing imports of Russian gas. In late March, President Biden pledged to boost LNG exports to Europe, which may re-invigorate the advancement of U.S. LNG export terminal projects.Financial PerformanceThe Permian public comp group saw moderately positive stock price performance over the past year (through June 10). The prices of Diamondback Energy and Laredo Petroleum rose 79% and 78%, respectively, and more than the broader E&P sector (as proxied by XOP, which rose 68% during the same period). Pioneer Natural Resources’ stock price rose 66% over the period, and Callon Petroleum rose a relatively tepid 24%.Survey Says Eagle Ford Wells Among Most EconomicAccording to participants of the First Quarter 2022 Dallas Fed Energy Survey (the latest available as of mid-June), wells in the core plays of the Permian are positioned as some of the most economical in the nation. Survey respondents indicated that the average WTI price needed to break even on existing wells in the primary Permian plays was $28/bbl to $29/bbl. This exceeds the average breakeven in the Eagle Ford ($23/bbl) but is still lower than other parts of the U.S. (over $30/bbl). The average breakeven price for new development in the Permian is in the middle of the pack at $50/bbl to $51/bbl, greater than the Eagle Ford’s breakeven ($48/bbl), but notably lower than in other parts of the country ($60/bbl to $69/bbl). ConclusionProduction growth in the Permian continued to exceed growth in the Eagle Ford, Appalachia and Bakken over the past year as the basin remains one of the most economical regions in U.S. energy production. With the surge in commodity prices over the past quarter, it might have been expected that producers would start bringing more rigs online, leading to more production growth than what we saw. However, as upstream companies have signaled, it may not be realistic to expect such increased deployment of capital from public operators in the near future, though private operators may very well move to take advantage of the higher price environment. With greater emphasis on returning cash to shareholders, continued levels of relatively low investment in growth capital may be expected. However, its significantly large contribution to total energy production continues to make the Permian a steady source of growth for overall U.S. oil and gas production.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Compensation Structures for RIAs: Part II

Last week we introduced our series on compensation structures for RIAs. That post outlined the three basic components of compensation at investment management firms.Three Basic Components of CompensationBase salary/Benefits. This is what an employee receives every two weeks or so. It’s fixed in nature and is paid regardless of firm or employee performance over the short term. On its own, base salary provides little incentive for employees to grow the value of the business over time.Variable Compensation/Bonus. In theory, variable compensation can be tied to any metric the firm chooses. The amount of variable compensation paid to employees varies as a function of the chosen metric(s). Variable compensation is also called at risk compensation because all or part of it can be forfeited if target thresholds are not met. Variable compensation is most often paid out on an annual basis.Equity compensation. Equity incentives serve an important function by aligning the interests of employees with that of the company and its shareholders. While base salary and annual variable compensation serve as shorter term incentives, equity incentives serve to motivate employees to grow the value of the business over a longer time period and play an important role in increasing an employee’s ties to the firm and promoting retention. Last week we focused on variable or bonus compensation, so this post covers the equity component.Equity CompensationIf the other forms of compensation are meant to attract (salary) and retain (bonus) qualified talent, RIA equity is intended to align shareholder and employee interests while rewarding long-term contributions to firm growth and value. This structure inherently blends returns to labor (employee comp) with returns on investment (shareholder distributions) by its very design. It is typically the most complicated and misunderstood component of RIA compensation but can be highly effective when implemented correctly. We often use the following depiction to simplify the distinction between these sources of return: Unfortunately, this distinction between returns to capital and labor becomes blurred when the business is owner-operated like most investment advisory firms: As a result, most investment management firms offer their key employees some form of equity compensation to align their interests with shareholders and incentivize them to continue growing the business. Equity comp can also be a differentiator that allows some RIAs to recruit top talent from other investment management firms that don’t offer any sort of stock consideration to their employees. Equity comp has become more common during the Great Resignation and is part of the reason we’re seeing so much turnover in the industry now.Common Equity-Incentive PlansWhile implementing an equity incentive plan will typically have a dilutive impact on existing shareholders, a properly structured plan will facilitate attracting and retaining the right talent and motivating participating employees to grow the value of the business over time. In that sense, a well-structured equity incentive plan is accretive to existing shareholders, not dilutive.Some of the more common equity-incentive plans are discussed below:Direct Equity Ownership: For most investment management firms, equity is held by senior management. As these executives retire or leave the business, equity is transferred to the firm’s next-generation management. In these cases, the internal market for the company’s shares serves the function of an equity incentive plan by placing equity ownership in the hands of the individuals with the greatest influence on the performance of the company. Direct equity incentive plans are typically the most straightforward way of transferring equity to the next generation but may not be the most practical if the current principals are unable or unwilling to relinquish ownership or control of the business, or if next-generation management is unable or unwilling to purchase equity.Stock Option Grants: Stock option grants give employees the right, but not the obligation, to purchase equity in the company for a specified period of time at a specified exercise price. Typically, the exercise price is equal to the fair market value of the company’s shares as of the grant date, which allows employees receiving the option grants to participate in any appreciation in value over the value at the grant date. Stock option grants may be subject to vesting periods in order to promote employee retention.Synthetic Equity Plans: Under synthetic equity plans, employees receive something that mimics equity ownership from an economic perspective, but typically without the non-economic rights (such as management and voting rights) that accompany direct ownership. Examples of such plans include phantom equity and stock appreciation rights (SARs). Under these plans, a select group of employees (usually senior management) receive payments tied to the company’s stock value at a certain date or dates. In the case of phantom equity plans, the payments can be based on the value of the stock at a certain date (a full value plan) or only the appreciation in value relative to the grant date value (an appreciation only plan). These plans can be highly customizable with respect to dividend participation, vesting schedule, and triggering events for redemption/forfeiture.Profits Interests: RIAs structured as LLCs can issue profits interests, which represent an interest in the future profits or appreciation in value of the firm. Profit interests offer potential tax advantages in that they should not result in taxable income for the recipient when they are granted, and the appreciation in value may be taxed as capital gains rather than ordinary income.ConclusionThere are advantages and disadvantages to each type of plan, and the most appropriate one for your firm will depend on what you and your aspiring owners are trying to accomplish. We’re happy to walk you through this if you need some guidance.

Tesla Walks the Entirely FairLine with SolarCity

Evaluating Fairness of the Tesla Motors, Inc. and SolarCity Corporation MergerIn March 2016, Jonathan Goldsmith retired from a long advertising stint for Dos Equis beer as the Most Interesting Man in the World with a final commercial in which he was sent on a one-way trip to Mars. The same month Elon Musk, arguably the most interesting man in global business then and now, was laying the ground work for the merger of Telsa, Inc. (NASDAQ: TSLA) and SolarCity Corporation of which he owned about 22% of both companies.Fairness as an adjective means what is just, equitable, legitimate and consistent with rules and standards. As it relates to transactions, fairness is like valuation in that it is a range concept: transactions may not be fair, a close call, fair or very fair.This presentation looks at the issues raised by plaintiffs who alleged Musk orchestrated the deal to bail-out SolarCity, and how the Delaware Court of Chancery ruled on the issues on April 27. 2022 under the entire fairness standard rather than deferential business judgment rule.

Middle Market Transaction Update First Quarter 2022

In the first quarter of 2022, U.S. middle market deal value and volume experienced somewhat of a pullback from year-end 2021 levels.

Valuation and M&A Trends in the Auto Dealer Industry

Let the Good Times Roll?

A few weeks ago, Scott Womack sat down with Tony Karabon of DCG Acquisitions to discuss trends in the auto dealer industry. Tony is Managing Director with DCG Acquisitions. Prior to joining DCG, Tony spent 24 years as the Vice President and General Counsel for two large dealership groups.DCG Acquisitions is a national, full-service mergers and acquisitions firm representing buyers and sellers of automobile dealerships. DCG Acquisitions is part of the Dave Cantin Group of Companies along with DCG Capital and DCG Media.What trends do you see with transaction volume and overall multiples paid for auto dealerships?Tony: Transaction activity remains very strong. The volume of dealership sale transactions for 2022 could surpass that seen in 2021 and exceed 400 transactions. Sellers include single-point operators, small and medium-sized groups, and the largest groups, including those that are publicly traded. However, we are also seeing a fair number of first-time buyers. Our firm has an Ownership Accelerator Program which assists first-time buyers in acquiring dealerships. We have had many success stories with the program, so the number of dealership owners might not shrink quite as fast as some are predicting. There is no doubt that larger groups will continue to gain a greater percentage of the dealership market share. Still, dealership ownership is available to entrepreneurs and owning a single dealership can be a very good investment. Implicit in a multiple is risk. There seems to be less risk for dealerships of all brands. Multiples are rising as virtually all brands are doing well. Nissan is recovering, Kia and Hyundai are on a very nice trajectory, and the domestics are doing well. Toyota, Honda, Lexus, Subaru, Audi, Mercedes-Benz, and BMW continue to command high multiples. We look at more than multiples for many reasons, including that the data behind the published multiples is incomplete at best, and multiples are not a perfect science. It is incumbent upon a buyer to consider numerous factors other than multiples. When pricing a dealership, we look at the return on investment, growth and profitability trends for the particular manufacturer, whether real estate is part of the transaction, the amount of leverage in the transaction, the dealership's potential, and many other metrics.The multiple approach as a method to value dealerships will be tested in late 2022 and early 2023.The multiple approach as a method to value dealerships will be tested in late 2022 and early 2023. With 2021 and very likely 2022 representing record profit years for dealers, simply averaging a few years of profits and assigning a multiple may not work if current profits are considered abnormally high. Presumably, as each month passes, the industry should start to resolve the chip and other part shortage issues. Consequently, as vehicle supply ramps up, margins will be reduced along with profits. If the record years 2021 and 2022 and another one or two years of profits are used to arrive at an average profit, the multiple model may be unworkable. By simply including 2021 and 2022 profits in the equation, unless these profits represent a "new normal", the result might be an unrealistic average profit, particularly if lower profits are on the near horizon. And that doesn't even consider the effects inflation, higher interest rates, and increased gas prices will have on profits and consequently on dealership values.Mercer Capital Comment: Mercer Capital's approach to dealership valuation includes the use of published Blue Sky multiples but also incorporates other factors such as ongoing earnings, risk, and growth, among other factors.With regard to multiples and value, do you think the majority of deals, and therefore value paid and implied multiples, reflect strategic control factors in addition to value to a financial buyer?Tony: I think that it is both. There is considerable capital on the sidelines looking for dealership acquisitions. Dealers of all sizes have excess cash and want to deploy it. I have received far more inquiries from dealers concerning what dealerships are available and to help them find additional dealerships to acquire. History has shown that dealerships are good investments, and this is the business dealers know best. However, prices for dealerships are high. Buyers need to justify paying those prices. Certain strategic control factors can, at least in part, provide that justification. Adding a good dealership to one of the buyer's current markets, adding a brand that is a favorite of the buyer, adding a brand that the buyer does not have, or simply providing some diversification can persuade a buyer to pay a higher price, with limits, and we have seen that.History has shown that dealerships are good investments, and this is the business dealers know best.I also think that more buyers are taking a deeper look at the numbers. While the multiple method provides a traditional, easily understood method to price a dealership, the current strong multiples and record profits give buyers a reason to pause. Traditionally, dealerships are priced on past performance. Price is determined by past profits times a multiple that varies by brand, location, dealership size, and other factors. Many other investments are priced based on the expected future performance. When a person buys shares in a publicly traded company, the future, good and bad, is priced into the stock each day, actually constantly. In reality, the buyer of that stock is stating by its decision to purchase, that the stock will do better than the market is suggesting. With higher prices comes more scrutiny of the dealership's past and future performance. We have seen that buyers still expect value for their dollar. Future cash flow, rate of return on the necessary investment, and risk command a greater portion of the discussion.Finally, I have seen a number of groups that own primarily large metro dealerships acquire smaller dealerships in smaller markets, particularly if there are three or four dealerships available in one transaction. These dealerships have long, consistent histories and likely can benefit from the technology, best practices, buying power, and other things that a large group can provide. These dealerships generally have less expensive real estate, better service retention, and a stable workforce. They simply are good investments. Moreover, major metro stores are getting scarcer and those stores can create a bidding war. Buyers are also looking in all parts of the country. The warmer states or "smile" states as we used to call them, being the Southeastern states and all across the South to the West Coast, remain popular, but the Midwest is receiving a lot of attention. The Midwest has many large cities with sizable dealerships.Mercer Capital Comment: The presence of elements of strategic control can partially explain some of the Blue Sky multiples on the higher end of the published ranges for each franchise. Other factors, such as size and location of the dealership, can also impact implied multiples.In buy-sell negotiations, do you see that most deals make adjustments to pre-tax earnings to make them equivalent to FIFO rather than LIFO?Tony: I know some purchasers do analyze the impact of a LIFO recovery on earnings, and it is now top of mind for DCG. I view FIFO/LIFO as a bit of a conundrum. The annual benefits of LIFO are rarely thought about. Still, the recovery of LIFO upon the sale of a dealership or other event that triggers a LIFO recovery are often painful. Typically, for dealers who utilize the method, which are most new car dealers, profits are usually understated each year. That understatement has largely been ignored when valuing a dealership. The amount of understatement annually is not that much in the scheme of things. Recently, we have seen large annual income increases as a result of LIFO recoveries. These recoveries are typically deducted from earnings because these recoveries are abnormal, largely apply to past years, and can be viewed as non-operating at least for evaluating the last two or three years. So, yes, adjustments are made for LIFO recoveries. Mercer Capital Comment: Valuations of auto dealerships are performed for a variety of purposes, including acquisition, gift/estate planning, litigation, and others. While the nature and extent of adjustments to historical earnings may differ depending on the purpose for the valuation, actual buyers and hypothetical buyers focus on ongoing earnings. Those expected earnings should eliminate any non-operating, non-recurring or discretionary items.In your deals and consultations, are you hearing any discussion/concerns about the implications of an agency model for OEMs on either EVs or all vehicles?Tony: Dealers know these are major issues. I think the industry is at the very beginning of what will be a series of discussions, fights, and in some cases, litigation over these proposed changes. The agency model and electric vehicles encompass a multitude of potential issues. There are at least two major aspects to the agency model. One is selling vehicles directly to consumers, typically on the internet, and a second is over-the-air upgrades sold by a manufacturer.The agency model and electric vehicles encompass a multitude of potential issues.Prior to becoming a broker, I was the General Counsel for two large dealership groups for 24 years. The central theme of the various state dealer statutes is to balance or perhaps even protect the dealers from unfair or overreaching activities or treatment by the manufacturers. In a sense, a balance should be struck as manufacturers are much larger than dealers. They control the production and distribution and the like. In order to achieve that balance, manufacturers are generally prohibited from owning dealerships or selling directly to consumers. While some states have made changes to their dealer statutes as a result of the emergence of new manufacturers such as Tesla, it must be noted that Tesla, at least at this point, has no franchised dealers.The future contention will be between the manufacturers who have franchised dealers and their respective dealers and will center on whether a manufacturer is selling a vehicle directly to a consumer. This question is not easily answered and will vary under each state statute. The particular activities of a manufacturer will also affect the discussion. All manufacturers have their own websites with considerable information available. However, does reserving a vehicle, ordering a vehicle, or some similar activity violate any particular state statute? As of today, the final sale transaction is consummated at a dealership, but the manufacturers are pushing hard for that to change.Over-the-air upgrades present another problem. We all appreciate over-the-air upgrades to our cell phones and other devices. These upgrades are often tweaks to improve the performance of the product. With vehicles, a customer could purchase a vehicle without some features such as navigation, working cameras, adaptive cruise control, etc. Suppose a manufacturer, post-delivery, sells these features and options, whether for a certain price or on a subscription basis. Does such activity violate current dealer statutes or adversely impact the manufacturer-dealer relationship? The answer might vary depending on whether the dealers share in the revenue generated from this post-delivery activity by the manufacturers. I also want to make clear that not all dealers are against all of these developments.Electric vehicles present the issues of potentially lower service revenues for dealers and again, direct sales by manufacturers. The lower service revenue for electric vehicles is anticipated because electric vehicles have fewer parts and certainly fewer mechanical or moving parts. It seems like manufacturers are attempting to segregate electric vehicles from their fleets for purposes of selling directly to customers. Other than preferring a direct sales model, I do not see any reason why electric vehicles are not subject to the same direct sales analysis and or criticisms as ICE vehicles, as we discussed earlier.Mercer Capital Comment: In a recent blog, we discussed the over-the-air updates and other issues regarding connected cars.We thank Tony Karabon and DCQ Acquisitions for their insightful perspectives on the auto dealer industry. It will be interesting to see how long the current trends of increased transaction volume, heightened profitability and multiples, and low inventory levels will continue. Will any evolving market conditions such as higher interest rates, inflation, higher gas prices, and the discussion of the agency model begin to impact the industry?To discuss how recent industry trends may affect your dealership's valuation, feel free to reach out to one of Mercer Capital's Auto Dealer team professionals.

Bear Market Silver Lining? An Estate Planning Opportunity

As we highlighted previously in the Family Business Director blog, companies are beginning to batten down the hatches and prepare for stormy weather. The risk of a recession continues to escalate, and inflation printed a new four-decade high in May. Former Fed Chair and current Treasury Secretary, Janet Yellen, appeared before Congress to answer questions regarding inflation, which she sees as staying elevated for an extended period. Gas prices hit a nationwide average of $5 a gallon for the first time ever in the United States, and little relief is on the horizon.The Fed expects to continue raising rates to battle inflation, and a new law was passed unanimously in the House and Senate to ban the word “transitory,” which awaits President Biden’s signature. Well, maybe the last one was just floated in committee.All to say, companies and consumers alike are feeling the squeeze, and markets are reflecting less-than-rosy expectations. At the time of this writing, the S&P 500 was down almost 16% year-to-date, while the Russell 2000 was down almost 19%. Outside the energy sector, stocks are bleeding red in 2022. Lower broad market pricing translates to lower valuations for family businesses.Click here to enlarge the imageSo what? Well, for family businesses undertaking long-term intrafamily transfers and gifting plans, a market downturn represents an opportunity to reduce estate and gift tax exposure by considerable margins. How? We explain below.Fair Market ValueIf you are reading this post, you are likely familiar with the gift and estate tax process in the valuation of private company stock. To consummate an intrafamily transfer (via gift or sale) companies generally must retain a business appraiser to determine the fair market value of shares. Appraisers use a two-step process:Appraisers estimate the value of the business as if the shares were publicly traded. In other words, they consider how public market investors would view the shares if they had the opportunity to purchase them in the stock market.Appraisers consider an appropriate discount, or reduction in value, to account for the fact that the shares in the family business are privately held, rather than publicly traded. All else equal, investors prefer to have liquidity. In order to accept the illiquidity inherent in private company shares, investors require a marketability discount. The size of the marketability discount depends on several factors, including the expected holding period, yield, capital appreciation, and incremental risks associated with illiquidity.Based on the downturn in the market, the fair market value of minority shares in family businesses is likely lower today than it was just a couple of months ago. It does not matter if your family has no intention of selling the family business at a reduced value; the fact is that – if you were to sell an illiquid minority interest now – the value would reflect current market conditions. The IRS itself makes this clear in Revenue Ruling 59-60:The fair market value of specific shares of stock will vary as general economic conditions change from ‘normal’ to ‘boom’ to ‘depression,’ that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future.The potential silver lining to the cloud of depressed market values is that it provides an opportunity for more tax-efficient transfers of family wealth for estate planning purposes.Long-Term Mindsets and Estate PlanningFactors leading stocks lower are real and are affecting public and private companies alike: continued supply chain bottlenecks, rising input prices and limited ability to pass along to consumers, distressed margins, and low consumer confidence all will cause pain in the short term. However, private family businesses have the benefit of time, and a resilient family business should return to form once issues plaguing markets subside. Exhibit 2 depicts the expected value trajectory for a family business, including a bear market downturn.The immediate impact is straightforward: the magnitude of the dollar gift for the same amount of ownership or stock is reduced relative to prior periods. Exhibit 3 shows a simple example of the current market downturn on transfers of private company stock.How does this benefit private companies engaged in estate planning?If the transfer is a gift, the debit against the lifetime estate and gift tax exemption of the gifting party is reduced, leaving more room to make future gifts (both estate and gift) tax-free. Since the ownership percentage transferred remains the same, the receiver’s resulting ownership percentage is unchanged.If the transfer is a sale, the buyer (likely a younger generation) can buy into the business at a more favorable price.Both of these strategies reduce the transferer’s total estate by a larger amount, assuming measurement of the estate (ie, death) comes later once the company’s valuation has recovered.Final Thoughts – Keep an Eye on Rates and the CalendarA couple of final thoughts you should also keep in mind related to estate planning in the current environment.Private Loan Rates: The IRS publishes monthly tables identifying what is known as the applicable federal rate or AFR. The AFR is significant for estate planning because it establishes the threshold interest rate for private loans. While rates have ticked up, rates are still well below commercially available rates. The Federal Reserve is, however, planning to aggressively continue hiking rates to battle inflation, making these “on-sale” prices unlikely to last.For family businesses and estate planners, while the transfer exemptions remain at current levels, they are still set to drop by 50% on January 1, 2026. The Treasury Department has confirmed the additional transfer tax exemption under current law is a “use it or lose it” benefit. If a taxpayer uses the “extra” exemption before it expires (by making lifetime gifts), it will not be “clawed back” to cause additional tax if the taxpayer dies after the exemption is reduced. The window to capture the current exemption is undoubtedly closing, and family businesses will likely only get so many more bites at this apple before it turns sour.The example in this post is simple and perhaps obvious, and our reminders may be old news. However, we understand it is hard to have a long-term mindset when things take a sudden downward turn. Being opportunistic in stormy weather makes for better sunny days ahead.

M&A in the Permian: Acquisitions Slow as Valuations Grow

Transaction activity in the Permian Basin cooled off this past year, with the transaction count decreasing to 21 deals over the past 12 months, a decline of 6 transactions, or 22%, from the 27 deals that occurred over the prior 12-month period. This level is in line with the 22 transactions that occurred in the 12-month period ended mid-June 2020. It is difficult to interpret the significance with any certainty. On one hand, it could indicate increased trepidation regarding production prospects in the basin. On the other hand, it could simply be a sign that regional E&P operators have started to "right-size" their inventories in the West Texas and Southeast New Mexico basin. Based on the evolving economics of the region, as we will examine further below, the latter case may be closer to the truth.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below. Relative to 2020-2021, the median deal size nearly was $387 million, just 4% lower than the median deal size of $405 million in the prior 12-month period. However, the median acreage purchased over the past year was 21,000 net acres, just over 42% lower than the 36,250 acres among the deals in the previous year. Given the concurrent decrease in acquired acreage and relatively unchanged median transaction price, the median price per net acre was up 16% period-over-period. Looking at acquired production, the median production among transactions over the past year was 5,500 barrel-oil-equivalent per day ("Boepd"), a 39% decrease from the 8,950 Boepd metric from the prior year.Given the relatively unchanged level in the median transaction value in conjunction with a lower median production level, the median transaction value per Boepd, unsurprisingly, jumped 54% from $31,886 in the prior 12-month period to $49,143 in the latest 12-month period. This willingness to pay over 50% more per acre and/or per Boepd suggests that these targets' underlying economics have been, and remain, supportive. However, the marginal costs of these acquisitions may be approaching the perceived marginal returns projected for these properties, as evidenced by the decrease in the transaction count relative to last year.Click here to expand the image above. The approach to the marginal "equilibrium" appears to have been a pretty short runway to land on. Of the 21 transactions completed, 14 occurred from June to December, with the remaining 7 occurring from January 2022 to the present. One metric we analyzed, based on the deal value per production (annualized) per acre, indicates a sharp decline in the "bang for the buck" exhibited by the transactions before and after year-end 2021. As presented below, the median cost per production acre for the 14 transactions from June to December 2021 was $1.072. In contrast, the median metric for the seven transactions from January to June 2022 was $10.762, indicating a 10.0x increase in the cost per production acre.A deeper dive into the details of each transaction would be needed to discern any common causes for this movement, but this could indicate a shift in focus from proven reserves towards unproven acreages. In other words, acquirers may be putting increased value on the potential optionality for greater-but-yet-proven production presented by these targets.Click here to expand the image above.Despite the upward trend in energy prices over the past year, what we are seeing is a likely slowdown in M&A activity in what is generally considered to be the most economical oil and gas basin in the U.S. If the Permian is a bellwether of U.S. production in general, are we likely to see a slowdown in M&A activity in other basins soon? I would venture to say "yes."Earthstone Energy Acquires Bighorn's Permian PortfolioIn late January 2022, Earthstone Energy announced its agreement with Bighorn Permian Resources to acquire its Midland Basins assets for a total consideration of $639 million in cash and 5.7 million shares of Earthstone's Class A common stock (the "Bighorn Acquisition"). The effective date of the Bighorn Acquisition was January 1, 2022, and the deal closed on April 18, 2022. The Bighorn Acquisition included 110,600 net acres (98% operated, 93% WI, 99% HBP), primarily in Reagan and Irion counties, with an estimated production of 42,400 Boepd (57% liquids, 25% oil), and proved reserves of 106 MMBoe (20% oil, 34% NGL, 46% natural gas).Robert Anderson, President, and CEO of Earthstone Energy, commented, "The transformation of Earthstone continues with the announcement of the significant and highly-accretive Bighorn Acquisition. Combining the Bighorn Acquisition with the four acquisitions completed in 2021 and the pending Chisholm Acquisition, we will have more than quadrupled our daily production rate, greatly expanded our Permian Basin acreage footprint and increased our Free Cash Flow generating capacity by many multiples since year-end 2020. The proximity of the Bighorn assets to existing Earthstone operations positions us to create further value by applying our proven operating approach to these assets, primarily in the form of reducing operating costs. The addition of the high cash flow producing assets from Bighorn to the strong drilling inventory of Earthstone, including the Chisholm Acquisition, furthers Earthstone's transformation into a larger scaled, low-cost producer with lower reinvestment in order to maintain combined production levels."Earthstone Energy Acquires Midland Basin Assets from Foreland InvestmentsIn early November 2021, Earthstone Energy announced the completion of its acquisition of privately held operating assets located in the Midland Basin from Foreland Investments LP ("Foreland") and from BCC-Foreland LLC, which held well-bore interests in certain of the producing wells operated by Foreland (collectively, the "Foreland Acquisition"). The aggregate purchase price of the Foreland Acquisition was $73.2 million at signing, consisting of $49.2 million in cash and 2.6 million shares of Earthstone's Class A common stock valued at $24.0 million based on a closing share price of $9.20 on September 30, 2021. The Foreland Acquisition included approximately 10,000 net acres with an estimated production of 4,400 Boepd (26% oil, 52% liquids), and PDP reserves of approximately 13.3 MMBoe (11% oil, 31% NGL, 58% natural gas).Mr. Robert Anderson, President and CEO of Earthstone, commented, "This transaction will be our fourth acquisition this year as we continue to advance our consolidation strategy and enhance our Midland Basin footprint with additional scale. The acquisition of these low operating cost, high margin, producing assets at an attractive valuation is a nice addition to our production and cash flow base. The Bolt-On Acquisition also includes approximately ~10,000 net acres (100% operated; 67% held by production) in Irion County. We expect to benefit from additional operating synergies when production operations are combined with other assets in the area. As we have done in prior acquisitions, we look forward to applying our operating approach to these assets in order to reduce costs and maximize production and cash flows."ConclusionM&A transaction activity in the Permian declined at an increasing rate over the past year, with two-thirds of the 21 transactions occurring in 2021, and the remaining third transpiring in the YTD period ended in mid-June. But the overall upward trend in deal cost per unit (be it per-production level, acreage, or production-acre) indicates buyers' willingness to pay more to achieve their desired asset base. The overall story is one of the companies right-sizing their presence in the basin.We have assisted many clients with various valuation needs in the oil and gas industry in North America and globally. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Compensation Structures for RIAs: Part I

Compensation models are the subject of a significant amount of hand-wringing for RIA principals, and for good reason. Out of all the decisions RIA principals need to make, compensation programs often have the single biggest impact on an RIA's P&L and the financial lives of its employees and shareholders.The effects of an RIA's compensation model are far-reaching, determining not only how compensation is allocated amongst employees, but also how a firm's earnings are split between shareholders and employees, what financial incentives employees have to grow the business, and what financial incentives are available to attract new employees and retain existing employees.Compensation models at RIAs tend to be idiosyncratic, reflecting each firm's business model, ownership, and culture. In an ideal world, these compensation programs evolve purposefully over time in response to changes in the firm's size, profitability, labor market conditions, and various other factors. However, inertia is a powerful force: we often encounter compensation programs that made sense in the past but haven't adapted to serve the firm's changing needs as the business has grown in scale and complexity.Effective compensation programs need to change with the times, and the times have certainly changed. The RIA industry has seen tremendous growth over the last decade. As a result, firms today face increasingly complex compensation decisions that affect a growing list of stakeholders: outside shareholders, multiple generations of management, retiring partners, new partners, possible minority investors, and so on. On top of that, a persistent bull market and the accompanying earnings growth over the preceding decade have made it relatively easy to appease both shareholders and employees. Now, financial market conditions and the state of the labor market have led many RIAs to scrutinize their compensation models more than ever before.Introduction to RIA Compensation ModelsAt the outset, it's important to note what compensation models do and don't do. Compensation models determine how the firm's earnings are allocated; they don't (directly) determine the amount of earnings to be allocated. When it comes to determining who gets what, it's a fixed sum game. The objective of an effective compensation policy is to allocate returns in such a way as to increase this sum over time.Compensation for RIAs are broken down into three basic components, each of which serves different functions with respect to incentivizing, attracting, and retaining employees:Base salary / Benefits. This is what an employee receives every two weeks or so. It's fixed in nature and is paid regardless of firm or employee performance over the short term. On its own, base salary provides little incentive for employees to grow the value of the business over time.Variable Compensation / Bonus. In theory, variable compensation can be tied to any metric the firm chooses. The amount of variable compensation paid to employees varies as a function of the chosen metric(s). Variable compensation is also called at-risk compensation because all or part of it can be forfeited if target thresholds are not met. Variable compensation is most often paid out on an annual basis.Equity compensation. Equity incentives serve an important function by aligning the interests of employees with that of the company and its shareholders. While base salary and annual variable compensation serve as shorter-term incentives, equity incentives serve to motivate employees to grow the value of the business over a longer time period and play an important role in increasing an employee's ties to the firm and promoting retention.Variable CompensationIn this blog post, we focus our attention on the variable compensation component (we'll address the others in subsequent posts).Variable compensation plays an important role in incentivizing employees over the relatively short term (1-3 years). The evidence suggests that such incentives work, too: According to Schwab's 2021 RIA Compensation Report, firms using performance-based incentive pay saw 25% greater AUM growth, 134% greater client growth, 54% greater revenue growth, and 52% greater net asset flows over a five year period than firms without performance-based incentives.What Do You Want to Incentivize?As the name suggests, variable compensation changes as a function of some selected metric, typically revenue, profitability, or some other firm-level metric or individual-level metric, depending on the specific aspects that management intends to incentivize.In our experience, variable compensation pools tied to firm profitability and allocated amongst employees based on a combination of individual responsibilities and performance provide the most effective incentives for most firms to grow the value of the business over time. Such structures tend to work well because linking variable comp to profitability creates a durable compensation mechanism that scales with the business and aligns shareholders' and management's financial and risk management objectives. Variable comp linked to profitability also promotes a cohesive team, rather than the individual silos that can arise out of revenue-based variable comp, which further helps to build the value of the enterprise.In markets like today's, where RIA margins face the dual threat of rising costs and declining AUM, compensation mechanisms that directly link employee pay to firm profitability have the additional benefit of helping to blunt the impact of market conditions on firm profitability. Consider the example below, which shows the impact of a 10% AUM increase and a 10% AUM decrease for a hypothetical firm under two comp programs, one in which all compensation is fixed and the other in which there is a variable bonus pool equal to 20% of pre-bonus profitability.Click here to expand the image above.In this example, both compensation programs result in $4 million in EBITDA and an EBITDA margin of 24.6% in the base case scenario. In the downside scenario, however, the fixed comp structure leads to a high degree of operating leverage. As a result, a 10% drop in AUM leads to a decline in EBITDA of over 40% and a decline in the EBITDA margin to 16.2%. Under the variable comp structure, the variable bonus pool helps to mute the impact of declining AUM. In this example, a 10% decline in AUM results in a 32.5% decrease in EBITDA and a decline in the EBITDA margin to 18.5% under the variable comp program. In the upside scenario, the increase in EBITDA is greater under the fixed comp structure than under the variable comp structure (an increase of 40.6% vs. 32.5%).From a shareholder perspective, a variable compensation program such as the one described above effectively transfers some of the risk borne by equity holders to the firm's employees. In downside scenarios, some of the declines in profitability that would otherwise accrue to shareholders is absorbed by employees. Similarly, some of the increase in profitability is allocated to employees in upside scenarios. The logic of such a compensation program is that employees are incentivized to grow and protect the same metric that shareholders care about—the firm's profitability.ConclusionInvestment management is a talent business, and structuring an effective compensation program that allows the firm to attract, retain, and incentivize talent is critical to an RIA's success. In the coming posts, we'll address additional compensation considerations such as equity compensation options and allocation processes.

May 2022 SAAR

Can Auto Dealers Continue to Outperform OEMs?

The May 2022 SAAR was 12.7 million units down 12.6% from last month and down 24.9% from May 2021. This month’s SAAR did not meet expectations, and the dip in May’s sales pace increases the likelihood that the second quarter of 2022 will not improve on the first quarter’s average SAAR of 14.1 million units. May’s SAAR was low due to limited inventory around the country, which is not news to anyone following vehicle markets over the past year.Vehicle production around the world has been constrained by the lack of manufacturing components available to auto manufacturers. The ongoing invasion of Ukraine, as well as globally lingering COVID-19 related effects, have come together to create a very tough environment for manufacturers to meet the demand for new vehicles (check out our March SAAR blog for insights into Ukraine’s impact on auto manufacturing). While most March and April forecasts reflected the impact of Russia's invasion of Ukraine, updates in May to these projections addressed some additional challenges that have arisen, including a slow recovery in semiconductor supplies, the impact of further COVID lockdowns in China, and the longer-term influence of high raw material prices that put added pressure on new vehicle affordability. In short, May was a month that the production sting was sharp. One example is Toyota, which announced a 10% global production cut in May, citing tightened lockdowns in China.In the U.S., transaction prices remained elevated throughout May, with dealers reporting an average transaction price of $44,832 per vehicle, an all-time May record and up 15.7% from this time last year. Likewise, incentive spending per vehicle has continued to fall, with NADA estimating just $965 per vehicle over the last month. Like new vehicles, trade-ins continue to demand higher values across the country, providing buyers with increased equity in their existing ride to mitigate climbing monthly payments. In May, the average monthly payment on a new vehicle contract was $687, another record high. The Fed’s two rate hikes in the early months of 2022 have not helped the affordability of monthly payments either. J.D. Power reported that the average interest rate on a new vehicle finance contract in May was 4.92%, up 62 basis points from May 2021.Have Higher Interest Rates Hurt Auto Manufacturer Stock Prices?Higher monthly payments on new vehicle financing contracts are not the only impact that rate hikes have had on the auto industry. Domestic manufacturers like the Big 3 (Ford, Stellantis, and GM) have seen their share prices decline, though this drop in market cap was not exclusive to OEMs, as losses were observed throughout the United States economy across many growth-centric industries like technology and data science. The S&P 500 is down 13.3% in 2022 (see chart below). The Nasdaq 100, a technology-heavy index, is down 23.0%. The Dow Jones Industrial Average is also struggling, down 9.5% on the year. An auto manufacturer has not traditionally been considered a “growth company.” In the last decade, that moniker has been reserved for the Apples, Microsofts, and Facebooks of the world. A growth industry is a sector of an economy that experiences a higher-than-average growth rate as compared to other sectors. Growth industries are often new or pioneer industries that did not exist in the past, and their growth is a result of newfound demand for products or services offered by companies in that field. Growth companies may carry large interest-bearing debt balances that finance the research, implementation, and expansion of their products and services. This means that, for a growth company, an increase in the cost of debt could make growth that much more expensive. Tesla (TSLA) is a great example of a growth company. Tesla, which boasts a spot among the highest valuations in auto manufacturing, has benefitted from a changing regulatory environment and the emergence of new electric vehicle technology. From the perspective of Ford, Stellantis, and General Motors, it makes sense to begin investing in similar technologies to cash in on the growth story and unlock higher multiples and valuations, which is exactly what these companies have sought to do. On March 2nd, Ford announced it would boost its spending on electric vehicles to $50 billion through 2026, up from its previously announced $30 billion. In July 2021, Stellantis announced $35.5 billion in investments toward electric vehicles through 2025. Likewise, General Motors released its own plan in 2021 to invest $35 billion through 2025. With the Big 3 committed to significant EV investments over the next five years, there is increased execution risk with delivering vehicles that fulfill the promise of EVs that benefit consumers without representing a trade-off between fuel efficiency and performance. To the extent these investments are financed by debt, the rising cost of financing may drag on profitability. Pushing returns further out into the future also tends to reduce valuations as interest rates rise, as seen in the decline in tech stocks. While the stock price of a public company is subject to exogenous forces outside of the realm of what may impact the valuations of closely-held businesses, the private markets ultimately are impacted by the public markets. See the charts below for a look into the stock prices of Ford, Stellantis, and GM compared to the timing of rate hikes by the Federal Reserve in 2022: OEMs are also likely to see share price declines due to continued production cuts and rising input costs. A decline in the share price does not necessarily affect the company's operations directly, but there are less direct impacts on manufacturers which executives keenly observe. What do lower valuations of OEMs mean for auto dealerships across the country? Over the long-term, OEM executives are not likely to tolerate sluggish shareholder returns while auto dealers are making record profits. While OEMs are down with the market as discussed earlier, it’s important to note that the publicly traded auto dealers are generally worth more than they were to start the year, a sharp contrast. With talks of an agency model growing ever more present, it appears that there will be changes to the current landscape. Hopefully, these changes will benefit all interested parties including OEMs, dealers, and consumers.June 2022 OutlookMercer Capital’s outlook for the June 2022 SAAR is consistent with the status quo. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Long term, it will be interesting to see how the landscape evolves and whether OEMs try to wrestle a greater share of profits from their auto dealer partners. Stay tuned for more updates on next month’s SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership

Recession, Expectations & Value

The uncertain macroeconomic environment is causing corporate managers to consider how a recession would influence their businesses. Last week, the Wall Street Journalpublished comments from eleven public company CFOs discussing their expectations for how their businesses would fare if the expected economic downturn occurs.Perhaps not unexpectedly, the CFOs interviewed by the Journal were generally optimistic regarding the outlook for their companies in the event of a recession.Some focused on how recession-resilient their industries are, including Big Lots (discount retail), Match Group (online dating), Anheuser-Busch InBev (beer), and Olaplex Holdings (beauty products). The CFO of Tripadvisor anticipated that 2+ years of pandemic-induced cabin fever will put travel at the top of consumers’ wish lists even amid a recession.Others highlighted actions that they have already taken, or can take, to mitigate the effects of a downturn: ClubLending has tightened credit standards for hourly workers, the CFO of Williams-Sonoma cited the ability to cut expenses and reduce inventory and capital spending, PerkinsElmer indicated that a larger base of recurring revenue will put the company in good stead, and Krispy Kreme discussed the company’s strategy of expanding distribution points.Finally, the CFO of Applied Materials replied that – in terms of order flow – no slowdown in demand is evident yet, while the CFO of Whirlpool believes that pandemic-related demand will continue to outpace constrained supply. How realistic are these expectations? Only time will tell; however, since all eleven companies are publicly traded, we can see how investors are grading those expectations. Exhibit 1 summarizes year-to-date share price performance for each company.Consistent with general stock market trends, share prices are down for each company, with Anheuser-Busch InBev faring the best (-12%) and discount retailer Big Lots feeling the most pain (-51%). Investors seem to be on board with the thesis that beer consumption is recession-proof but less convinced about the prospects for Big Lots. Your family business doesn’t receive a daily grade from the market, but you do have expectations for the future. How will your family business fare if a recession sets in, and how are expectations affecting the value of your family business today? When discussing value, we find it helpful to group expectations into three primary categories: cash flow, risk & return, and growth.Cash FlowValue is not a “what have you done for me lately?” game – it is a “what will you do for me tomorrow?” game. How will stubbornly high inflation, tight labor markets, and persisting supply chain disruptions affect the cash flows for your family business over the next year?What effect will rising prices have on demand for your product or service? Are your customers net beneficiaries of rising price levels, or will rising prices put a dent in their propensity to spend on your product?How are labor availability and wage pressures influencing the cost of doing business for you? Are you able to pass higher operating costs along in the form of higher prices, or are your profit margins getting squeezed?Is maintaining an appropriate level of working capital tying up more of your cash flow? Have supply chain disruptions caused you to hold larger quantities of more expensive goods? Are any of your customers facing financial distress that could stretch out collections?Is the increasing cost of capital goods reducing cash flow that would otherwise be available for debt service or owner distributions?Risk & ReturnSince the end of 2021, yields on long-term treasury securities have increased from 1.94% to around 3.30%. Our colleague Brooks Hamner, CFA, ASA wrote about the inverse relationship between interest rates and valuation multiples several weeks ago. While Brooks was writing specifically about the value of investment management firms, his observations apply broadly to all companies. In short, all else equal, rising interest rates put downward pressure on the value of all financial assets.But thinking about your family business specifically, how have expectations regarding risk evolved as the economic picture has become murkier? Like A-B InBev, do you have a compelling case that your family business really is recession-proof? Or would investors be skeptical of the strategies at your disposal to counteract the negative effects of a broader economic slowdown?GrowthFinally, how would a prolonged recession change the ground rules for your industry and the effectiveness of your family business’s growth strategy? Would a downturn cause you to defer capital investment in support of the next growth engine for your family business? Or, would a slowdown allow you to capture market share at the expense of financially-weaker competitors? How could the structural changes that accompany economic disruptions alter the demand trajectory for your product or service?ConclusionCash flows, risk & return, and growth provide a helpful framework for evaluating expectations for your family business. If the Wall Street Journal had called you last week, what would you have told them about your plans?

The Importance of a Quality of Earnings Study

As we’ve been writing in recent blog posts, consolidation efforts in the RIA space are facing multiple headwinds. Among them, market conditions and inflation are motivating buyers to scrutinize profit estimates more than ever. In that light, we thought our readers would appreciate this guest post by our colleague, Jay D. Wilson, Jr., CFA, ASA, CBA, who works with banks and FinTechs. We’re getting more requests for QoE assessments from both the buy-side and sell-side (the latter wanting to buttress their CIMs).Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

The Importance of a Quality of Earnings Study

Negotiating Working Capital Targets in a Transaction

This is the sixth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. In middle market transactions, some of the most crucial points of negotiation are the net working capital targets agreed upon by the buyer and seller. Net working capital targets set a defined minimum amount of working capital that the buyer requires the seller to leave in the business at the close of a transaction. Given that net working capital targets can have a direct effect on the final purchase price of a transaction, understanding the how and why of these types of negotiations is crucial for buyers looking to negotiate deals that not only look good at closing but also pass the test as the buyer takes over the operation of the newly acquired business. Defining Net Working Capital Before negotiating working capital targets and benchmarks, it is important that the buyers, sellers, and their advisors in a deal setting have a clear understanding of what will and won’t be included in net working capital for the purposes of closing the deal. By the book, net working capital is defined as current assets less current liabilities. While this definition is acceptable for financial statement analysis and other accounting-adjacent applications, in the M&A universe, the most commonly used measure of net working capital is cash-free, debt-free net working capital. This is the standard definition of net working capital in a deal setting because it assumes that a seller will retain the cash in the business after paying off any short-term debts that the business owes. These debts could potentially include related party notes and lines of credit with banks. In an M&A transaction, net working capital and net working capital targets are often defined terms in both the letter of intent and the purchase agreement. For buyers, it is crucial to understand these definitions because the basis of the net working capital calculation could directly affect the final purchase price. Why Are Net Working Capital Negotiations Necessary in a Deal? Net working capital targets are necessary in deal settings because the amount of net working capital in a business often fluctuates from month-to-month and even week-to-week. Therefore, it is important that a benchmark or base level of net working capital to be left in the business at closing is agreed upon by both the buyer and the seller. For example, a seller could aggressively collect accounts receivable in the months leading to closing in an effort to convert these receivables into cash. Conversely, a seller could let accounts payable inflate in the months leading to closing and theoretically retain a higher amount of cash. Even absent any sort of concentrated effort to impact the working capital, most companies have some level of fluctuation in their various balance sheet accounts. Setting a net working capital target negates the impact of these fluctuations and prevents the seller from “gaming” cash and working capital levels in anticipation of a transaction. If net working capital levels at closing are not in line with the targets established in the negotiation process, an adjustment to the purchase price can be triggered. The purchase price adjustment related to net working capital is typically applied after the close of the transaction – based on a final accounting as of the closing date. Usually, a defined amount of the purchase price is set aside in a short-term escrow specifically for any negative adjustment related to the final net working capital balance. If the final determination of net working capital comes in below the established threshold, then the buyer retains funds from the escrow to make up for this shortfall. If the final net working capital figure is above the threshold, the buyer makes an additional payment to the seller for the excess amount. From the buyer’s perspective, it is important to negotiate an escrow amount that is large enough to cover any potential swings in net working capital that could result at closing. Negotiating Net Working Capital Targets The most practical and commonly used method of setting net working capital targets and benchmarks is to calculate a historical average amount of net working capital needed to fund a company’s operations. This is most often done by calculating the average net working capital on a monthly basis over the twelve months preceding the valuation date used in the transaction. Calculating an average over a historical period removes any seasonality effects and reveals a “normalized” level of net working capital needed to support the company’s ongoing operations with no capital disruption. Since valuations are typically predicated on trailing twelve months EBITDA (or some other measure of earnings), it is typical that the lookback period for the net working capital target calculation coincides with the twelve-month period in which EBITDA is calculated. In other words, the calculation of a net working capital target should be on the same historical basis as that of the measure of earnings used to support the transaction value. In situations where EBITDA from the most recent period is deemed to be unsustainable or if there is significant short-term growth underlying the transaction value, it might be necessary to calculate the net working capital benchmark by applying a percentage (based on historical averages) to an ongoing revenue figure in order to consider that net working capital needs will change as revenue either declines or increases post-closing. While conducting due diligence, buyers may find potential adjustments to certain balance sheet items that comprise net working capital, which can affect the calculation of the net working capital target. Buyers will want to confirm that the seller has properly accrued (both historically and at closing) for certain items such as accrued vacation, payroll, bonuses, warranty obligations, etc. These potential adjustments can add another layer of complexity to the negotiation of net working capital targets, as buyers may find that there is an excess or deficiency of net working capital at certain points in the historical lookback period. Sellers will often make the argument that they have historically operated with excess working capital based on comparisons to industry averages. Buyers should always approach any “excess” adjustment of this type with caution. It can be difficult to understand why the selling company would have operated with this “excess” when the capital could have been paid out to shareholders or invested in another way. With further analysis, there is often an explanation as to why the “excess” working capital has historically been carried on the company’s balance sheet. As an example, the “excess” could have historically resulted from a quick turnover of payables such that the company has lower current liabilities than the industry average. The quick payments may have earned the company discounts from its vendors, which likely equated to higher profit margins. If the cash flow figures underlying the transaction value include the benefit of these discounts, then it could be double counting to adjust the net working capital to a “normalized” level. One question that will arise in the negotiations is whether a specific dollar amount or a range should be utilized as the net working capital target. The logic of applying a range is straightforward – it prevents minor variances from creating a post-closing adjustment and reduces the likelihood of disagreements between the buyer and seller regarding the calculation of net working capital to the specific dollar. A word of caution on ranges: if the range is left too wide, it invites the same type of balance sheet “gaming” from the seller that the setting of a target was meant to prevent in the first place. Our experience has been that, if a range is preferred, it should be tight enough that any amount that would be potentially gained from the closing working capital figure falling at the bottom or top of the range should be immaterial to both the buyer and the seller. Concluding ThoughtsHaving a team of seasoned advisors to assist with the acquisition and due diligence process can ensure buyers that the net working capital targets, and thus the purchase price, are set at levels that are appropriate and fair to the buyer. Mercer Capital has acted in this capacity in hundreds of transactions over our 30+ years of existence. If you are looking for an experienced team of professionals to assist in the due diligence and negotiation process, please reach out to one of our Transaction Advisory Group professionals to assist.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of May 12, 2022

Negotiating Working Capital Targets in a Transaction

This is the sixth article in a series on buy-side considerations. Our focus in this article is on understanding how and why net working capital targets are crucial for buyers looking to negotiate deals that look good at closing and pass the test as the buyer takes over the operation of the newly acquired business.

June 2022

In this issue: Bond Pain and Perspective on Bank Valuations

Meet the Team – David W. R. Harkins, CFA, ABV

In each “Meet the Team” segment, we highlight a different professional on our Family Law team.

A Look Into The Family Business Director's Summer Reading Catalogue

We at Family Business Director trust that all of you had a pleasant and relaxing Memorial Day Weekend. As this past weekend served as the unofficial kickoff to the summer season, our intent this week is to provide you with a thought-provoking portfolio of “summer reading” material. Don’t worry, there won’t be a test in August. We’ll return with our regularly scheduled programming next week. In the meantime, we hope you enjoy these pieces on a beach or by the pool somewhere, preferably with a tall cool beverage in hand. Happy reading!Estate Planning During A Bear MarketWith the major indices approaching bear market territory over the past several weeks, Matthew Erskine provides some practical tips and considerations for estate planning in bear markets. Despite short-term pain, bear markets can often provide potentially fruitful long-term planning opportunities.Click here to read.Building a Multidisciplinary Advising Team for Your Family EnterpriseSpeaking of planning, building a team of trusted advisors in a variety of disciplines is a crucial step to ensuring long-term continuity and positive outcomes for your family’s business. In this article from The Family Business Consulting Group, Wendy-Sage Hayward lays out benefits, challenges, and practical steps for building a multidisciplinary advising team to assist your family enterprise.Click here to read.Considerations in Merger Transactions When considering a buy-side transaction to expand, many middle-market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well. In this article, Mercer Capital’s Nick Heinz takes a comprehensive and practical look at mergers and the ways that these often overlooked types of transactions can provide long-lasting benefits to both parties. Click here to read.Get the Most Out of Your BoardOf course, any transaction that your family business undertakes will be subject to board approval. Chris Yount lays out some excellent points regarding family business board dynamics in this recent article for Family Business magazine.Click here to read.

Themes from Q1 Energy Earnings Calls

Part 2: Oilfield Service Companies

In a prior post — Themes from Q4 2021 Earnings Calls, Part 3: OFS — we noted common themes from OFS companies’ Q4 earnings calls, including macro headwinds, industry consolidation through M&A activity, and ESG activity.In Themes from Q1 2022 Earnings Calls, Part 1: Upstream, we explored key topics among the upstream segment of the oil & gas industry through the earnings calls of E&P operators and mineral aggregators. These themes included:The future role of U.S. production in the European market as European nations plan to phase out Russian oil & gas;Confidence of continued favorable pricing exhibited through shorter-term deals and unhedged positions;Increasing completion rates in Q1, with expectations of further growth in completions beyond Q1. This week we focus on the key takeaways from the OFS Q1 2022 earnings calls.Short-Cycle Projects to Bolster Near-Term Production Are Those Most Sought AfterOFS companies have highlighted that — as E&P companies remain focused on returning near-term profits to shareholders — their investment efforts are sighted on capitalizing on short-cycle developments, rather than longer-term developments. Amid ESG headwinds and supply chain disruptions, OFS companies have been more commonly tasked with supporting active rigs, supplying marginal equipment, and other services necessary for E&P companies to capitalize on this commodity upcycle.“In addition, I expect an important change in our customers behavior and priorities will provide structural support to oil prices throughout this upcycle. I believe supply dynamics have fundamentally changed due to investor return requirements, public ESG commitments and regulatory pressure, which make it more difficult for operators to commit to long-cycle hydrocarbon investments and instead drive investment flexibility through short-cycle barrels.” – Jeff Miller, Chairman, President & CEO, Halliburton“The shorter cycle [is] catching up, improving the situation around our very, very constrained supply chain challenges [and] meeting sort of the near-term demand of supporting rigs, frac fleets and stimulation equipment…both land and offshore, I think that's kind of the biggest near-term needle mover for NOV.” – Clay Williams, Chairman, President & CEO, NOV“There have been episodic supply chain disruptions with our customers, where we've been on location waiting for another service company to arrive or complete a job, and that's becoming, unfortunately, more frequent. I think that you're seeing a lot of marginal equipment being deployed and you're going to see a lot more marginal equipment being deployed as we pass through the 700 level in the U.S. rig count on the way to maybe just under 800 by year-end.” – Scott Bender, President, CEO & Director, Cactus Shifting Priority to Margin ExpansionThough the demand for oilfield services has particularly revolved around short-cycle projects to support production, executives note that total demand for these products and services has still increased across the board. Amid a plague of supply constraints and a tight market for their products and services, OFS companies have shifted their focus towards increasing margins, rather than gaining market share. Despite a surge in demand, margins face pushback as inflation and rising wages erode the pricing power of OFS companies.“It's probably fair to say that we're entering into a period of potential meaningful margin expansion. And I think that volume expansion in terms of shipments is going to be constrained. And unlike some of our peers, we have the capacity to manage increased volumes. So we could potentially benefit from [this].” – Scott Bender, President, CEO & Director, Cactus“We are seeing increasing demand across all services. And I'd say, particularly on the well servicing side just because for a lot of operators, some of their cheapest incremental barrels are workover barrels. So we are seeing that demand. As Brandon indicated, we're now running 157 rigs and we would expect through the year that, that number starts to kind of trend up.We are being pretty diligent in maintaining margins, but we do think we can deploy additional rigs and maintain margins.” – Stuart Bodden, President & CEO, Ranger Energy ServicesPrivate Companies Have an Increasing Role Within the Customer BaseA recurring theme, as mentioned in previous blog posts, is how private companies have been more active than public companies in ramping up production. As this relates to OFS, Q1 earnings calls have acknowledged that relationships with private operators are of greater importance than in the past. This shift comes in light of capital restraint from public operators. While perspectives differ about the future activity plans of the public E&P companies, OFS company executives commonly recognized increased activity from private operators, due to growth, consolidation, and greater capital freedom.“Our penetration of privates is undeniable. It's going to increase this year because I think the privates are becoming much more sophisticated. They're consolidating. And as they become more sophisticated and larger, then our product becomes far more attractive to them. They're not nearly restrained from a capital perspective. And we're doing our level best to call on those customers with whom it makes economic sense for us to pursue that business.” – Scott Bender, President, CEO & Director, Cactus“Today, as I look at a combination of customer activity and inflation, my outlook has improved, and I now expect North America spending to increase by over 35% this year. With respect to activity, over 60% of the US land rig count sits with private companies and they keep growing, while public E&Ps remain committed to their activity plans. Activity and demand for our services are increasing, both internationally and in North America.” – Jeff Miller, Chairman, President & CEO, Halliburton“As far as mix, I'd say it's twofold. We referred on the call that we are working for larger group of operators and I'd say the preponderance of that increase is probably in the private side ... so I think we will see growth in both sides, but two different dynamics driving this.” – Kyle Ramachandran, CFO & President, Solaris Oilfield Infrastructure Mercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the mineral aggregators with working and royalty interests in the underlying production. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

Private Capital Better Than Public for the RIA Community?

It’s Not Supposed to Work That Way, But…

Last month I received an abrupt reminder of the roots of my career when the latest iteration of Shannon Pratt's "Valuing a Business" landed on my desk. At 1200 pages and weighing in at more than eight pounds, the current installment is the sixth edition of what has been the go-to resource for the business valuation community since Dr. Pratt published the first edition in 1981. Shannon didn't quite live to see VAB6 in print, but he was available to provide guidance and moral support to me and the other four members of the working group who saw the sixth edition through to completion, and I know he would be happy with the outcome.While working on VAB6 often felt like a distraction from my day job, it was a useful discipline to remember how the broader finance community views valuation issues outside of the echo chamber of the RIA community. BV still means "business valuation" to the RIA team at Mercer, but there are also "beyond valuation" moments where we're working on consulting engagements that take us far from our traditional "solve for X" profession. And, leafing through my printed copy of VAB6, I'm reminded of the many times long accepted valuation truths that seem to conflict with observed market behavior.Is Private Capital Better Than Public for the RIA Community?Valuation professionals generally accept that public market capital is cheaper and leads to higher valuations than can be achieved by closely-held businesses. The words and actions of market participants who invest in RIAs do not necessarily align with this belief.In a recent webinar, two heads of prominent private consolidators in the investment management space reflected, indirectly, on this dilemma, noting internal valuations with multiples double that of prominent publicly traded consolidators. One went so far as to say that the public markets weren't "ready" for the RIA consolidator model.Anyone can be accused of "talking their book," but that's not my point. These moguls are in a good position to understand this, and they are far from alone. The past decade has seen the ascent of more than a dozen privately funded acquirers of investment management firms, many of whom have prospered even while their public counterparts languished.The news suggests there is no “multiple-arbitrage” available to buy private RIAs with public funding.Public consolidators appear to be caught in a bind. The recent news that Focus Financial Partners was going to use cash to repurchase up to $200 million in stock (instead of using that same money to buy RIAs) and CI Financial's announcement that they were "slowing" (pausing?) acquisition activity to focus on integration got our attention.The news suggests no "multiple-arbitrage" is available to buy private RIAs with public funding. If the evolution of equity ownership can be described as a never-ending search for cheaper capital, the cheapest capital today is not necessarily from public markets.Why Is This Happening?In the valuation world, we use a simple diagram to illustrate the different financial perspectives of public and private investors. It's known as the "levels of value" chart, and while there are different versions, most generally look something like this:The "Levels of Value" Chart The general concept of the Levels of Value chart is the fair market value of equity securities corresponds to the public (or as-if-freely-traded) cost of capital (market risk, or beta), adjusted for idiosyncratic or non-systemic risks associated with a particular company (alpha). That exercise derives a valuation at the "marketable, minority" interest level of value (think public-share equivalent). Deviations from that anchor point are consequent from factors exogenous to the value of the enterprise. Some acquirers of controlling interests in a business might be able to pay more than the as-if-public price because of issues specific to them – usually operating synergies. Holders of minority interests in closely-held businesses might not be willing or able to pay as-if-freely-traded pricing because of the illiquidity inherent in the shares.PE relies on financial synergies (cheap capital and long time horizons) to fund their ambitionsThis chart is sacramental to the business valuation community, but the reality of the RIA industry suggests it's more of a tautology. Minority interests in RIAs often sell to institutional investors for multiples that rival control stakes, as the minority investors prize alignment with management control. And consolidators of control stakes in RIAs rarely have operating synergies available to pay premium valuations. Instead, PE relies on financial synergies (cheap capital and long time horizons) to fund their ambitions. Those financial synergies are fueling PE's competitive advantage when bidding for RIAs.Is Private Equity's Advantage in the RIA Space Durable?Ironically, recent public market volatility appears to be driving more retail investors to private equity from public markets, reinforcing this inversion of the levels of value chart. Will this last? It's hard to imagine the mass affluent providing a sustainable flow of funds to maintain PE behavior, especially if institutional investors reallocate elsewhere. And PE's current advantage may be their undoing.Private equity may be a permanent middle road between public and private ownership, but it’s still subject to the laws of financial gravity.Entry pricing is, after all, a highly reliable indicator of expected returns. Earning enough to justify premium acquisition multiples requires leverage (financial risk), value-added stewardship (operating risk), superior exit pricing (timing risk), or some combination of the three. Plenty of PE skeptics have already been "early," and they don't need me to pile on. But I was raised to profess that public market returns were the logos, the reference point of finance. Our founder, Chris Mercer, had me tape a Levels of Value chart above my desk when I was a junior analyst. Private equity may be a permanent middle road between public and private ownership, but it's still subject to the laws of financial gravity.In the summer of 2008, the head of a prominent community bank told me he was grateful his bank was closely-held so he could avoid all the unpleasantness going on in the stock market. That perspective wasn't durable.

Buy-Side Considerations

Many observers predict that the market is rife for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity.Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth.For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition.In this series of articles, we cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market.Click the links below to read the articles in this series.1. Identifying Acquisition Targets and Assessing Strategic FitOur first topic in this buy-side series starts at the beginning. Whether your motivations to buy are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.2. How to Approach a Target and Perform Initial Due DiligenceThis is the second article in a series on buy-side considerations from the perspective of middle-market companies looking to enter the acquisition market. Our focus in this article is to summarize some practical considerations for approaching and vetting an identified target.3. Strategic Premiums: Can 2+2 Equal 5?Many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium. In this article, we discuss the theory behind strategic premiums, and how they can be advantageous or detrimental to acquirers.4. Considerations in Merger TransactionsWhen considering a buy-side transaction to expand, many middle-market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well. In this article, we discuss the key questions that must be addressed when considering a merger transaction, including, corporate governance, social issues and economic questions.5. The Importance of a Quality of Earnings Study This is the fifth article in a series on buy-side considerations. Our focus in this article is on how the quality of earnings (QoE) analysis can help acquirers better analyze possible acquisition targets. 6. Negotiating Working Capital Targets in a Transaction This is the sixth article in a series on buy-side considerations. Our focus in this article is on understanding how and why net working capital targets are crucial for buyers looking to negotiate deals that look good at closing and pass the test as the buyer takes over the operation of the newly acquired business. 7. Considering Contingent ConsiderationThis is the seventh article in a series on buy-side considerations. In this article we discuss the many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.8. Buy-Side Fairness Opinions: Fair Today, Foul Tomorrow?This is the eighth article in a series on buy-side considerations. Directors are periodically asked to make tough decisions about the strategic direction of a company. Major acquisitions are usually one of the toughest calls boards are required to make. Buyside fairness opinions have a unique place in corporate affairs because the corporate acquirer has to live with the transaction. What seems fair today but is deemed foul tomorrow, may create a liability for directors and executive officers. This can be especially true if the economy and/or industry conditions deteriorate after consummation of a transaction.9. Buy-Side Solvency OpinionsIn the ninth article of this series we discuss solvency opinions.Not only is a solvency opinion a prudent tool for board members and other stakeholders, but the framework of solvency analysis is ready made to score strategic alternatives and facilitate capital deployment.10.The Importance of Purchase Price Allocations to AcquirersIn the last article of this series we provide a broad overview of PPAs and then a deeper look into the pitfalls and best practices related to them.

Strategic Premiums: Can 2+2 Equal 5?

This is the third article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read previous articles click here. When given the choice between paying more or less for a good or service, it only makes sense that people prefer to pay less. Following this, a rational person would be expected to pay no more than the minimum available price for an item. Many modern business acquisitions appear to defy this logic – at least at first glance. According to Bloomberg, acquirers paid an average premium of 25.86% when making transactions in 2021. In other words, the average acquirer was willing to pay almost 26% above the intrinsic market value of a target business to successfully bid on an acquisition. Theory holds that the value of any corporation, especially a controlling interest in such corporation, should have a value equal to the present value of the cash flows expected to benefit shareholders. This is called a financial control value and represents the intrinsic value of the company on a stand-alone basis. As evidenced by the premium data noted above, many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium.What Is a Strategic Premium?A strategic premium exists when a buyer expects that two plus two equals five, or possibly even some figure above five. In less abstract terms, acquirers pay a strategic premium when they expect that the combination of their business with another will generate more cash flow than both businesses on a standalone basis. A strategic premium reflects the portion of this added benefit that the buyer is willing pay to the seller to secure a deal.To give an example, let’s say that Company A and Company B both generate $2 in EBITDA each year. Both companies may have an intrinsic stand-alone value of $12 (6x EBITDA). When Company A acquires B, they might pay 7.5x EBITDA ($15) because they expect that by combining into Company AB, the Company will generate a total of $5 of EBITDA per year (2+2=5) – providing for a combined intrinsic value of $30 (6x EBITDA). The difference between Company B’s stand-alone value of $12 and the $15 that Company A is willing to pay for it is $3, a 25% strategic premium. Company A spends $15 to increase their value from $12 to $30 – a deal that is accretive to shareholder value.What Justifies a Strategic Premium?The framework we provided for the strategic premium begs a larger question: what justifies a strategic premium? Ultimately, there are several possible explanations. Acquirers pay a strategic premium when they expect to gain some sort of efficiency through a business combination. As outlined in our previous example, they expect that these efficiencies will generate more cash flows than both companies can produce on a standalone basis. There are many efficiencies that companies could expect from a transaction, but three are most common.Cost SavingsCost savings are the most common justification for strategic premiums, often because they are comparatively easy to forecast.Let’s go back to our two companies from earlier. Let’s say that Companies A and B both need to purchase the same raw material to create widgets. Once the companies combine, they still need the same amount of raw materials, but they will likely place a smaller number of larger orders. Since each order that comes in will now be larger, their suppliers may give them a bulk discount, which lowers the overall cost. By combining, Companies A and B are spending less money to bring in the same amount of revenue-generating raw materials, leading to larger amounts of profit and free cash flow.Cost savings can come from supply costs, staff eliminations, or any number of other areas. These savings are usually both the most obvious and quickly achieved strategic enhancements following an acquisition.Revenue EnhancementsRevenue enhancements are another common justification for strategic premiums but are harder to model.There are many ways in which revenue enhancements can occur, but we focus on a simple example for the sake of this article. If Company A has a large distribution network, they can use that network to sell Company B’s products to a larger group of people than Company B had been able to previously. Bringing in this additional should increase profits and create more free cash flow.Process ImprovementsProcess improvements come about when the companies involved in a transaction absorb each other’s core competencies or assets. Mixing these competencies or assets can create revenue enhancements and/or operational efficiencies.Continuing our examination of Companies A and B, Company A might pay a premium for Company B if they see that Company B has some sort of proprietary efficient process for creating widgets that Company A could learn and take advantage of. In today’s world, such considerations often focus on technology – be it software of some other form of technology. If the target company’s technology can be utilized by an acquirer to enhance the acquirer’s own cash flow, a strategic premium may be in the offing.Should You Pay a Strategic Premium?Now that we have reviewed the theory behind strategic premiums, we discuss how they can be advantageous or detrimental to acquirers.Perhaps the most obvious benefit of paying a strategic premium is that it can prevent other firms from purchasing the acquiree first. Sellers in a transaction are incentivized to maximize price. By paying a higher premium, strategic acquirers can entice sellers away from financial buyers or other seemingly “less strategic” buyers. On the other hand, paying a strategic premium is a potential risk. A higher acquisition price increases the amount of cash flows necessary to recoup the acquirer’s investment. If the premium is too high, even an acquisition with compelling strategic benefits can become unprofitable.Ultimately the reasonable price to pay for a target depends on the buyer. Different suitors will expect different efficiencies from the acquisition. To avoid paying too large of a premium, acquirers must have a realistic notion of what they can pay for a target before entering negotiations. Even then, buyers need to exercise discipline and know when to walk away from a bidding war that has gotten too heated.Acquirers are most likely to be successful when they have an organized process for ensuring that the rationale behind the acquisition justifies the transaction price. Such a process usually includes the analysis (and scrutiny) of the specific enhancements anticipated from a transaction. Strategic enhancements often seem reasonable when considered generally but may fall apart (or at least shrink in magnitude) when under the light of detailed financial inspection. Premiums paid on the basis of only a general consideration of strategic enhancements could be doomed for failure. The success of such deals is often based more on luck than anything else.Concluding ThoughtsTo mitigate the risk of overpaying for an acquisition (and to reduce the impact of pure luck), we recommend a detailed financial inspection of both the target company and the potential strategic value of any transaction. As part of this analysis, it will likely benefit an acquirer to retain a transaction advisory team that possesses financial and valuation expertise.Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

Considerations in Merger Transactions

This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well. A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company. Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.Why a Merger?A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:Neither ownership group wants to truly exit; and/orNeither company has enough capital to fund a buy-out acquisition. In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position. Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.Relative ValueIn a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.True-UpsAs with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.Who Is in Charge?As with any acquisition, an organized post-transaction integration is critical to the success of a merger.No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.Concluding ThoughtsWe think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.

Considerations in Merger Transactions

Strategic Premiums: Can 2+2 Equal 5?

Many acquirers buy businesses at a value higher than this intrinsic value, paying what is referred to as a strategic premium. In this post we discuss the theory behind strategic premiums, and how they can be advantageous or detrimental to acquirers.

Considerations in Merger Transactions

This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well.A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company.Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.Why a Merger?A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:Neither ownership group wants to truly exit; and/orNeither company has enough capital to fund a buy-out acquisition.In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position.Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.Relative ValueIn a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.True-UpsAs with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.Who Is in Charge?As with any acquisition, an organized post-transaction integration is critical to the success of a merger.No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.Concluding ThoughtsWe think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.

The Importance of a Quality of Earnings Study

This is the fifth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. Our focus in this article is on how the quality of earnings (QoE) analysis can help acquirers better analyze possible acquisition targets.

Buy-Side Considerations

In this series of articles, we cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. Read the articles in this series.

Peloton, Planet Fitness, and Family Business

Pedaling Too Close to the Sun

Think back to March 2020. Many businesses and operations saw immediate stoppages and closures with no idea when they could restart. The fitness industry was no exception. Planet Fitness, the gym operator, completely shut down its locations and its stock plummeted. Peloton Interactive saw sales surge for its at-home exercise spin-bike and its stock soar.In short: these two businesses entered very different seasons at the onset of the COVID-19 lockdowns and slowdown. Planet Fitness was facing a sudden and bitterly cold winter, while Peloton was spinning its way into summer. But as Barron’s highlighted recently, fortunes and seasons can change quickly. We often compare stock prices to scoreboards, and currently, the at-home-fitness company Peloton is receiving a drubbing. Its stock is down a dot-com bubble-esque 91% from its all-time high. Revenue fell in the most recent quarter, and EBITDA fell from near-break-even in fiscal 2021 to nearly a $1.2 billion EBITDA loss (a negative 31% margin). Meanwhile, Planet Fitness, the no-frills gym operator that franchises the majority of its locations, is ready to flex in 2022. Revenue and EBITDA are expected to surpass 2019 levels and the company plans to continue opening new gyms. But what can family businesses learn from this rapid change in fortunes for these two companies? We think there are three lessons that can prevent you from pedaling in place: understand what season your business is in, be prepared for slow-downs, and diversify prudently.What Season Is Your Family Business In?How you invest, or plant, and your decision to diversify and return capital, or harvest, depends in part on your family business season (Travis Harms expounds on this great analogy here). In short, just as any farmer worth his salt knows what time of year to plant and harvest, businesses need to have a keen understanding of where their business sits before making a major capital investment or allocation decisions.Planet Fitness saw a fast-approaching winter with the onset of the COVID-19 pandemic and cut costs drastically. It also worked with its franchisees to defer required equipment outlays in order to preserve capital for its operators. In an industry that saw 17% of all fitness studios and gyms fail in 2020, Planet Fitness’s CEO was proud to report none of its gyms closed over the course of the pandemic. As we highlighted in our 2021 Benchmarking Guide, many smaller companies curtailed capital expenditure and lowered distributions in the face of uncertainty to preserve capital. Family businesses need to make decisions that reflect both the sunny days and the coming squalls as they exist today, and be flexible enough to do so.Winter Is (Or Will Be) ComingWhile we have the benefit of hindsight, management at Peloton appears to have been dreaming of an endless summer. Revenue skyrocketed, with its bikes and treadmills perfect for people that were looking for ways to stay active at home. Peloton responded to its incredible growth by sacrificing margin to deliver more equipment quicker to its customers as well as committing to build a factory to speed up production. The company spent massively on marketing and its headcount rose precipitously.Where did this lead? Growth plans have now been cut in the midst of a demand slowdown, Peloton’s CEO stepped down, and production was halted as unsold inventory sat in warehouses. Its stock currently sits at all-time lows.While we do not wish to play Monday morning quarterback regarding Peloton’s decisions, perhaps a bit of temperance in its growth plans could have staved off the nasty hangover the company is currently experiencing. Protecting its margin and maintaining a sober view of notoriously fickle fitness spending trends, as well as holding more dry powder, could have all served the company well. Regardless of exact policy prescriptions, family businesses should manage their companies through long-term colored glasses, rather than assuming sunny days will always be with us.Keep Your Wardrobe VariedThe reversal of fortunes for Planet Fitness and Peloton highlights another old maxim: Don’t put all your eggs in one basket. Per BMO Capital Markets analyst Simeon Siegel, “[Planet Fitness] embraced an omnichannel offering, [Peloton] argued solely for At-Home. Even the most high profile digital-only retailers realized they need to meet the customer where the customer wants to be, and not restrict their options.”Peloton draws an almost cult-like following from its adherents and boosts high usage rates and low subscription churn. However, its end-users do represent a market niche, and Peloton overestimated the change in market dynamics brought on by the pandemic to expand its singular end-market. While the company is currently tightening its belt and looking to diversify its app offerings, whether new management can shift the company into the right gear remains to be seen.Planet Fitness, in addition to its non-ostentatious wardrobe and defensive posture, is using success to fund smart diversification. Its digital fitness app is the number two free app on the Apple Store, and the company is currently beta testing a paid version to take a slice of the digital fitness market. While likely not to convert to a digital-first company overnight, Planet Fitness sees this diversification to strengthen its core business: Asset-light, low-frills, and industry-leading pricing.Stuck in Colder WeatherNobel Prize-winning economist Paul Samuelson once said that Wall Street had predicted nine out of the last five recessions. And while some economists or perma-bears may sometimes overreact to the state of the economy, the fall from grace of Peloton has us thinking more about how family businesses can weather storms when they undoubtedly arrive.Family businesses think of their lifespans over generations, and we think this gives them the perfect perspective to face the current stock-market sell-off, rise in interest rates, and potential economic slowdown.Understanding your business season, preparing for the downside, and intelligently diversifying are all ways family businesses can traverse the middle way.

Q1 2022 Earnings Calls

Large Dealer Groups Continue to Invest in the Franchise Dealer Model, Managing Their Dealerships as Portfolios

There continues to be no end in sight for new vehicle supply constraints. So much so that it's taken as a given, and there was less direct mention of inventory shortages in 2022's first quarter public auto dealer earnings calls. Despite this shift, scarce inventory remains the key theme underpinning the operating environment for auto dealers.Demand continues to exceed supply across all OEMs. For example, Lithia Motors noted it started a month with 13,000 vehicles and ended with 12,000 vehicles but was still able to sell over 24,000 vehicles. We've seen this with our auto dealer clients, and it really brings into focus what Days' Supply consistently under 30 looks like. When dealers are selling nearly double the inventory on their lots, it will take a long time before inventories can build back to pre-COVID levels. And with higher profits for dealers and OEMs, we may not ever reapproach those levels.Even more so than last quarter, there are a couple of interesting nuggets that don't quite fall into themes that were noteworthy. For example, much has been made about the future of electric vehicles and the impact on auto dealers. There have been concerns about a shift towards an agency model and conventional wisdom has been that EVs would generate less service work for dealers. Asbury's VP, Dan Clara, challenged that notion this quarter with the following:"My belief is the propensity or the frequency of [EVs] coming to the shop will be less. But the time in dollars will be greater, not just what they spend, but what we end up charging because of sophistication to work at it. And putting electric aside and not talking about autonomous, there are some technology features in cars today, braking where your car can break with someone in front of you, lane changing, the shifting and learning you. That's all technology that could have bugs in them. So while the cars really get heavy content with technology, not just the battery piece, it allows for more opportunity for things to go wrong. And when you talk about driving a 5,000-pound vehicle at 60 miles an hour down the road, there's a lot of liability in touching those cars. So you've really got to be thoughtful and think about what you're going to do over the [airwaves] that are nice to have and what you're going to do that may have a real liability issue in driving the vehicle."So, while he acknowledges there may be fewer ROs, dealers stand to potentially increase their pricing power for more complex work while also taking market share from less sophisticated body shops. As we've noted before, a significant amount of repair work is not performed by auto dealers at present, which provides an opportunity if the shift in powertrain steers more consumers back to the dealership. Fixed operations have generally improved as vehicle miles traveled increase and people continue to return to the roads. However, a depressed SAAR since 2020 has held back warranty work for many public auto dealers.While the themes presented below touch on M&A and large auto groups seeking to manage their investment in dealerships as a portfolio, Roger Penske discussed the benefits of open point locations, which are amplified in this low inventory environment:"On an open point, they have a plan that says this is the planning potential for a point, let's say, it's 1,500. And what they will do is preload you with those cars when you-- before you open and you get those for about, I think, probably about 90 to maybe 180 days, but then you're on a run rate based on your history. So it works out well. And I think -- after spending $15 million or $20 million on a facility, you certainly need the cars to start the business. I think it's certainly good for future allocation because you continue to meet the requirements of the planning potential and to give you the cars or trucks to be able to meet that early on. So it's up to you to drive it, and then maintain it."Here are the major themes from the Q1 2022 Public Auto Earnings Calls:Theme 1: CarMax kicked off earnings season by attributing a decline in its used car volumes to affordability issues. Affordability became a common question of the franchised dealerships due to this statement, particularly as interest rates rise. While Penske acknowledged that affordability likely had some impact, other companies tended to downplay any concerns."Inflation is never good for the consumer, but clearly, it's going to hit the lower demographic sectors of the market first. And there is such a massive gap and has been such a massive gap for the last 18 months between supply and demand. But first of all, demand would have to come down on new vehicles a long way before it got anywhere close to supply. […] And our core customers, while it may be not ideal, we just don't have data that shows that that we're seeing less activity in our stores yet." – Earl Hesterberg, President and CEO, Group 1 Automotive"What we're seeing from a macro perspective is there's not any material impact to the prime and near prime consumers. Are you starting to see a little bit of degradation in credit and portal in the lower income brackets, which is a very small part of both our franchise as well as our EchoPark consumers? So, that you're starting to see a little bit on the lower income, but on the upper tier that we're not seeing anything material." – Heath Byrd, CFO, Sonic Automotive"And then, there is some affordability issues there which are going to have some impact on margin. But from an overall standpoint, the demand is strong, we're selling into our pipeline from the standpoint of our new car business, and sequentially in our units are up from 101,000 to 114,000. If you look at Q4 to Q1, so we're not seeing it at the moment that we're having any impact negatively at this point. – Roger Penske, Chairman & CEO, Penske Automotive Group"The demand is there. I'd disagree with the comment made a few weeks ago. I don't think that's accurate. There's still plenty of demand. There'll be 37 million to 40 million cars sold in America this year in terms of pre-owned. So, the demand is there. The problem is, is that we're pushing $500 a month payments, and we used to pay $400 a month payments, and it's too close to the new car pricing. […] You really want your average used vehicle selling price to be one half that of your new vehicle selling price. And in my whole career, it's always run 50% to 55%, somewhere in there. It's at 70%. It's too close to the new vehicle pricing and prices are too high, $500 whatever, $525 a month payment. That's just not -- that's out of the norm and that's what's causing someone to maybe think that there's not a demand there. – Jeff Dyke, President, Sonic AutomotiveTheme 2: With the backdrop of framework agreements, large public auto groups are managing their stores as a portfolio, seeking to optimize by brand and geography. When certain OEMs only allow a certain number of stores per auto group, they are more selective about the markets in which they choose to operate their finite number of dealerships."We'll continue to monitor the M&A market as we believe there are potential opportunities that would enhance our already strong dealership portfolio. […] We have the ability through relationships today to go out and purchase another $5 billion if we wanted to today. Our goal is not to grow quickly. Our goal is to grow thoughtfully and be great capital allocators for our shareholders. So I think that the timing, cadence and pace is important. I think the states where you've seen us grow in our thought process of balancing the brands with the right states, you won't see us differ from that and acquisitions going forward will be accretive for us. The one thing I don't think our space gets a lot of look at is portfolio management. What do they buy? What do they sell? What did that do from an accretion standpoint? Not from a top line revenue, but what did that really do to them as a whole? And so I think you'll see us really manage the portfolio well. You'll see more divestitures over time, probably at some point in the future. And you'll certainly see more acquisitions as well. But that's just really maximizing the portfolio to generate the highest returns and create the most stable company for our employees and our shareholders." – David Hult, CEO, Asbury Automotive Group"I think most importantly, we always optimize our network to make sure that it's clean. We bought stores over the years that, that were in groups typically that weren't right for Lithia and it's a matter of divesting those. I believe it was annual run rate of about $90 million were sold in the quarter. And a number of those were assets that we just don't believe were to some extent salable okay and in this environment, everything is kind of salable. So we took advantage of that and divest of those stores. And you'll see, you'll probably see more of that in the next few quarters. You probably have a half a dozen stores that are typically smaller stores may be located in an area where it's not helping our network at all, meaning, it's a duplicate store, secondary store or it's into smaller market where you're utilizing a General Manager talent and you can reposition them in a better and bigger store." – Bryan DeBoer, President and CEO, Lithia Motors"We signed up for framework agreements probably, what, 10 year sago, there were some with some like Honda, Lexus had it, and we've lived with those over time. Now they are getting more active now when you look at BMW and other of these manufacturers are coming in now with probably not as much to try to curtail the growth but more to be sure that the dealerships that you already have are meeting the CSI requirements, and the CI and the market performance. And that's what they're looking at before they would allow you to grow. […] I don't think they're saying no. In fact, if you're a good dealer, and you've got a good track record, they [only] limit you to [a] number in a particular market, so you're not the only dealer in the marketplace. I think other than that, they're very appreciative when we come to them with an opportunity because they know we've got the capital, we've got a track record. We've got a management team that many of them know. And I've seen you've seen the growth just in the public, and they've been approved with big acquisitions. Now in some cases, you might have a market where you have to sell something off. But I think that is easy. I mean we made a move from Lexus in New Jersey to buying the two Lexus stores in Austin, and we had to divest the two to get two more. But obviously, I looked at the Jersey market versus the Austin market, and feel, on a longer-term basis, it would be a better opportunity for the Company." – Roger Penske, Chairman & CEO, Penske Automotive Group"We're in a cyclical business, right? So obviously for me I like the blend that we have in terms of brands. I think it's a really good blend particularly when I think through the plan for the individual OEMs are put in place, because ultimately the product that they are working on today really is going to dictate the success on the new car side of the business going forward. Firstly, I am encouraged by the level of investment has been made. And secondly, it doesn't really change my view on the balance that we have in our portfolio today. I think it just reinforces we have a good balance. – Michael Manley, CEO, AutoNation"It's a timing situation. We were competing to buy LHM. We didn't know who we're competing against and didn't know we were getting the deal. The Stevinson deal […] came together quick. We didn't want to pass on that opportunity not knowing if we're going to get the Miller organization. Then fast forward, we signed Stevinson and then we got the Miller one. So we knew we had an issue because the manufacturer has a limit to how many stores you can own and reach in. So we knew that we would have to sell some stores." – David Hult, CEO, Asbury Automotive GroupTheme 3: The franchise dealer model is alive and well. Multiple companies emphasized vehicle acquisition as the key to performance in used vehicles, and a primary driver is trade-ins when customers purchase new vehicles."We continue to focus on the acquisition of the inventory. We all know that is in used cars, where the return is generated. Close to 85%, 86% of our acquisition is coming through the consumer, whether it is in the form of our leased earnings, trades or buying cars through -- directly from the consumers." – Daniel Clara, SVP and CFO, Asbury Automotive Group"As we all know, success in the used car market is dictated by your ability to manufacture great quality, well priced desirable used cars and this clearly covers key elements of the business, including efficient and effective reconditioning for example, but it all starts fundamentally with your ability to competitively acquire used inventory and with strong consumer demand we continue to focus on our self-sourcing capabilities for used vehicles, which I think further strengthened both our franchise dealerships but also our AutoNation USA businesses." – Michael Manley, CEO, AutoNation"We're a different business than CarMax or Carvana and some of these used car retailers. Because, number one, we've got a large parts and service business, which covers 60% to 70% of our fixed costs. We also have OEMs that we're tied to would give us an area of market that we operate in. And they provide us with all the umbrella advertising to drive customers, both new and used to our stores, and then we have the relationship with the captive finance companies. And then, the lease returns that are coming in give us in the future when the cars are available for additional use. So looking at that, taking that as really a base to work from, we've got a short supply of new cars, which is driving used car prices up. And certainly, our acquisitions have been very tough at the moment when you think of about just looking at CarShop in the U.S., in the UK and the U.S. are our cost of sales up $8,500 [per unit] and the UK is up [$4,400 per unit]. And when you add that on to the existing number, it's really pricing us on the U.S. side, up into almost new car numbers." – Roger Penske, Chairman & CEO, Penske Automotive Group"As a top of funnel, new car dealer that gets to used vehicles coming in on-trade. We're making about $1,900 more on vehicles that come in from consumers than that we buy at auctions or from other dealers and we turn that much faster. So it's a huge advantage that we have […] a pipeline of inventory coming in quickly on the used car side." – Chris Holzshu, EVP & COO and CEO, Lithia MotorsConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

What Can We Make of All This Turnover in the RIA Space?

Some Thoughts on How RIA Principals Can Minimize or Even Capitalize on the Chaos

You’re not the only one dealing with turnover. The pandemic spawned the Great Resignation, and rising inflation means there’s probably a better salary (or signing bonus) out there for anyone that’s looking. The ensuing talent war has created more industry turnover than the end of broker protocol in 2017, and RIA principals are having to invest more time and resources into recruitment and retention than ever before.This trend actually started last year when the RIA industry was relatively healthy. Favorable market conditions and rising AUM levels meant that most investment management firms could easily afford to replenish departing staff members to service a growing revenue base. So far this year, the fixed income and equity markets have reversed course, and most RIAs are suddenly having to deal with declining assets under management and fee income. Add inflationary labor and overhead costs into the mix, and declining margins and profitability seem almost inevitable this year.This doesn’t necessarily have to be all bad for you and your firm. As Petyr ‘Littlefinger’ Baelish once proudly reassured Lord Varys during particularly turbulent times at King’s Landing in Season 3 of Game of Thrones, “Chaos isn’t a pit. Chaos is a ladder.” Fidelity Investments seems to agree and plans to make 28,000 hires in 2021 and 2022 to increase industry dominance as its competitors struggle with thinning margins and a fleeting workforce. James Lowell, editor-in-chief of Fidelity Investor, elaborates, “The discrepancy in the numbers of Fidelity hires suggests a new game is afoot: gaining market share of talent which will, in turn, better enable them to out-compete on service, not just products.”That’s probably easier for a firm like Fidelity which has $11 trillion under management and countless resources at its disposal. There are still ways for smaller RIAs to capitalize on this chaos or at least minimize the damage until normalcy is restored:Increase the payout percentage to leading advisors. In all likelihood, their compensation is falling with AUM and management fees. Increasing their payout will soften the blow and incentivize them to continue growing their book of business and servicing clients. If you don’t, there’s a good chance a competitor will.Offer some sort of equity compensation to key staffers. Our RIA contacts continue to tell us that an increasing number of tenured employees (and sometimes even prospective hires) are asking about ownership or some form of equity consideration as part of their total compensation package. In some cases, their inability to offer equity or a clear path to ownership has led to retention issues since many of their competitors can offer these benefits. Equity ownership is the best way to strengthen employees’ ties with the firm and align their interests with other RIA principals.Don’t offer the same raise to all staffers (in percentage or absolute terms). It’s highly unlikely any RIA’s employees are equally productive and deserving of the same bump in pay. Your revenue is likely declining with the markets, so an across-the-board increase in salary (at currently elevated rates of inflation) will compound the adverse effect on margins and profitability. Varying raises and shifting towards more performance-based forms of compensation should minimize undesired turnover and further declines in profitability.Consider establishing a bonus pool for key employees tied to firm profitability. Many RIAs have established a bonus pool that sets aside a certain percentage of pre-bonus operating income for its management team. This structure will incentivize them to run the business efficiently and maintain profitability when revenue hits.Articulate a plan on how the firm will weather the storm and potentially come out stronger. This probably isn’t the first market downturn that your firm has endured. Your AUM, revenue and earnings are still probably higher than the COVID bear market and almost certainly higher than the last Financial Crisis. The next few months (and maybe even quarters) will likely be rough, but there’s no reason to believe you can’t endure this cycle and be in a better position when the market recovers. Your staff needs to be reminded of that. Many of these suggestions may dampen your distribution or ownership in the short run, but it’s likely a worthy sacrifice to avoid losing key staffers in addition to AUM and management fees. It may not be a ladder, but it’s certainly a lifeline.

Have Reserve Reports Been Relegated To Investor Footnotes?

In the early part of my career, I vividly recall first learning about what was then arguably the most important document that an upstream company produced – the reserve report. Full of pertinent information, the reserve report struck at the heart of an oil and gas company’s economic relevance.The now discontinued Oil and Gas Financial Journal once described reserves as “a measurable value of a company’s worth and a basic measure of its life span.” Thus, understanding the fair market value of a company’s Proven Developed Producing (PDP), Proven Developed Non-Producing (PDNP), and Proven Undeveloped (PUD) reserves was key to understanding the fair market value of the company. Investors and analysts looked to the reserve report before reviewing the financials sometimes.Not these days.Consigned to back pages, footnotes, and appendices, the reserve report’s relevance has waned. Current investor presentations of four Permian-focused oil and gas companies (Pioneer, Centennial, Laredo, and Callon) exemplify this. What I found pertaining to reserve reports continues a years-long trend and was a far cry from what I saw for most of my career. Only one, Laredo, spent any meaningful discourse on their reserve report over the course of a few pages in their investor presentation. They were the smallest company of the group. As for the others: Centennial and Callon spent one whopping page each on their reserves; and the most valuable of them all, Pioneer, showed a single curt reserve figure just in front of their footnotes.Investor presentations are notable in that they represent a company’s current communication to investors, aspiring to highlight some of the most important information investors want to know. Under that argument, management believes investors don’t care to know much about reserve reports.For decades, an oil and gas company (all else being equal) often expected to have an enterprise value somewhat close to their PV-10 calculations in their annual reserve report.Not these days.The table below shows that current Permian valuations don’t track very close to their PV-10 figures at all. Remember, SEC pricing utilized in these PV-10 calculations below were $66.56 per barrel and $3.60 per Mcf. The enterprise values below reflect today’s prices of over $105 per barrel and over $7.50 per Mcf so price volatility is also a big factor considering that reserve reports reflect a snapshot in time, just like values. We also looked at the enterprise value relative to developed and oil reserve mixes. No clear pattern emerged there either. It begs the question: if Pioneer is lapping the others regarding this time-tested metric, why are they currently burying it next to the fine print?As of May 11, 2022 Source: S&P CAPIQ The answer is because investors are focused on other things – namely the types of themes that show up in the big bold print of these investor presentations: returns to shareholders, free cash flow and deleveraging. Looking through that lens, we noticed a clearer picture of why Pioneer is valued so highly. Let’s quickly analyze these other metrics in the table below:As of May 11, 2022 Source: S&P CAPIQ Immediately Pioneer’s dividend yield and Debt/EBITDA ratio stand out on this table. Pioneer is also the only company on this list with an investment grade credit rating. This appears to be what investors notice. It can’t be understated that the return of capital theme is emphasized for the first ten pages of Pioneer’s investor presentation. Laredo, Callon and Centennial all centered their presentations on these themes too, sans the dividend yield that they don’t have. Valuations appear to be driven by: (i) near term cash flows, (ii) returns on capital, (iii) well margins, and (iv) deleveraging. There are other ancillary things that analysts and management teams additionally reference frequently such as: held by production (margin related metric), cost per lateral foot drilled (margin related metric), and inventory (near term cash flow related metric). Reserve reports speak into some of those things, but certainly not all and not comprehensively. Stock prices suggest that investors are less concerned about having 15 years of reserves life, or what a company’s probable and possible reserves could be, but more about how profitable next years’ worth of wells will be. It’s also clear that investors do not want management teams beholden to their bankers for capital but prize the ability to operate more self-sufficiently going forward. It is not that reserve reports are obsolete. They have valuable information, and the core components of value are still found within the walls of a detailed reserve analysis. Reserve reports give investors an idea of the possible production management can reasonably be sure of getting. That’s critically important. It also shows investors what production profiles look like for a company’s current (and perhaps future) wells. It also endeavors to measure near term well drilling and production costs. Bankers still utilize reserve reports as an input to lending decisions (although there has not been much reserve lending happening lately with the deleveraging trend). Most of the elements I touched on above (near term cash flows, returns on capital, well margins) can be dug out of the details of a reserve report. What’s different now is that how production, costs, risk, and growth are analyzed have gotten more nuanced, detailed, and challenging. More layered analytical work needs be done in an increasingly complex, regulated, and integrated global oil and gas market. So, can an investor reliably breeze through a reserve report, look at proven reserves, an SEC pricing deck, and a 10% standardized discount rate to come up with the fair market value of an oil and gas company? Not these days.Originally appeared on Forbes.com.

Smart Connected Cars, OTAs, and Their Impact on Auto Dealers

The Future of Automobiles

Lost in all of the headlines surrounding electric vehicles is another trend that has emerged in automobiles over the last several years: Connected Cars.The presence of connected features transitions the car (or light-weight truck) from just a vehicle getting you from point A to point B to a computer-like device with customizable technology features, making the trip an experience. Just as mobile phones and appliances have gone from single-function devices to smart devices, so have cars.(Why the moniker "connected" cars, and not "smart" cars. With apologies to the discontinued venture between Swatch and Mercedes Benz, the term "smart" car has historically been synonymous with a compact, fuel-efficient design.)In a previous post, we discussed the future of auto dealerships and how they will be affected by inventory shortages and electric vehicles/direct selling.In this post, we examine the size and growth of the connected car segment and discuss the struggle between auto manufacturers/OEMs and auto dealers over servicing these features.Connected Cars and Size of the MarketConnected cars are vehicles with their own connection to the internet, usually through a wireless local area network (WLAN) that enables the vehicle to share data with other devices inside and outside the vehicle.Connected technology features can include satellite-navigation systems with traffic monitoring capabilities and remote features that utilize smartphone apps such as starting the engine, warming or cooling the car, or locking/unlocking the car. In theory, connected cars could also communicate with other smart products opening up a whole new world of possibilities.These features are not without limitations in the current automobile manufacturing environment. As we have discussed on this blog, automobile manufacturers have faced numerous production challenges including COVID-related plant shutdowns and, more recently, shortages of microchips due to supply chain issues. Modern automobiles continue to use more microchips for features such as emergency brakes, back-up cameras, and airbag deployment systems. Not to be overlooked, microchips are also used in connected features such as touchscreens and are present in engines to improve engine efficiency and lower emissions.There were 84 million connected cars on the road in 2021 compared to ~3 million electric cars. And the number of connected cars is estimated to grow to 305 million by 2035.What is the size of the connected car segment and how does that compare to the size of the electric vehicle (EV) market? According to estimates by Hedges Company, there were approximately 286.9 million cars registered in the U.S. in 2020. The figure was expected to climb to 289.5 million by the end of 2021. Most prognosticators estimate that the number of electric vehicles on the road in the U.S. is less than 1% of the total cars, SUVs, and light-duty trucks. Using these figures, total electric vehicles would top out at less than 2,895,000.By contrast, Statista estimates there were 84 million connected cars on the road in the U.S. in 2021. Based on the numbers and despite all of the headlines about electric vehicles, the majority of connected cars would be traditional ICE (internal combustion engine) vehicles. Over the last few years, all major OEMs have been introducing new models with connected features. According to projections by Statista, there will be over 305 million connected vehicles on the road by 2035 in the U.S. alone.Size of the Global Connected Car Fleet in 2021, With a Forecast for 2025, 2030, and 2035, by RegionSource: StatistaThis implies that while EVs are expected to be a growing percentage of future vehicles produced, the vast majority of vehicles being produced today are connected cars.OTAs and Service DepartmentsLike smart phones and smart appliances, the connectivity features of cars can be controlled and updated through a technology referred to as Over the Air updates (OTAs). An OTA is a software improvement or upgrade that is sent from an OEM or industry software company directly to the vehicle through a wireless internet connection.We are all familiar with technology updates sent to our phones that most of us initiate at night so we can wake up to their successful completion and implementation (if we remember to keep them on the charger). With connected features in automobiles, the technology is very similar. OEMs or product manufacturers can deliver updates or communicate directly with these features in times when the software is not working properly.Auto-related OTAs are usually grouped into two broader categories: infotainment and drive control. Infotainment refers to the touchscreen and features that combine information and entertainment to improve the in-vehicle experience. Examples of infotainment include maps/navigation, phone calls, and Bluetooth connection, music, and podcasts. Drive control refers to safety protocols to improve the performance of the vehicle such as system enhancements or corrections to powertrain systems, fuel efficiencies and engine emissions features, and advanced driver assistance systems.This spring, West Virginia became the first state to introduce a bill that would ban auto manufacturers from offering OTA updates directly to vehicle owners – forcing visits to dealerships. Will other states follow?Drive control features are typically less noticeable to the average driver. For perspective, MARKETSANDMARKETS estimates that the size of the global infotainment market is $20.8 billion and is expected to grow to $38.4 billion by 2027, at a compound annual growth rate (CAGR) of 10.8%. Another study by Acumen Research and Consulting estimates the entire global automotive OTA update market will grow by a CAGR of 18.1% through 2028.What are the advantages to OTA updates?Less or no in-person recalls – For software-related issues on connected features, an OTA could eliminate the need to visit the dealer.Cost Savings – Vehicle owners can save time and money without having to visit the dealer, and OTA updates could mean significant savings for automakers in labor costs.Additional Features – With OTA updates, certain features on the vehicle will continually be improved, potentially leading to a slower depreciation rate on aging vehicles.Safety/Compliance – As new legislation and standards are enacted, such as emissions standards or autonomous driving, OTA updates would be able to address changes in a timelier fashion. What are the disadvantages to OTA updates?Fewer visits to auto dealers – What can be an advantage to a vehicle owner can be a disadvantage to an auto dealer. Service departments in traditional auto dealers rely on service visits to assess and recommend other service items in addition to the primary reason for the visit, such as tire rotations, brake repair, oil changes, and other routine and scheduled maintenance. The service department allows the dealer to maintain an ongoing relationship with the customer through these frequent touchpoints. The service department is historically the most profitable department in the dealership in terms of margin. To spin this positively, happier consumers may lead to more brand stickiness for dealers.Cybersecurity – As with all technology and wireless internet connections, OTAs present risks of technology malware and theft or exposure of personal information. Who will seek to capture and monetize the OTA update market? Just as Tesla has been the poster child for innovation and technology in the electric vehicle market, they have also implemented OTA updates as part of their operating strategy and ongoing revenue. Will the traditional OEMs try to monetize and capture some of the market through a subscription model, and will it be at the expense of auto dealers? A few other key players in the automotive OTA updates industry are Airbiquity, Continental AG, Blackberry QNX Software, and Hitachi, among others. We recently attended the Spring Conference of the National Auto Dealer Counsel (NADC), and the topic of OTAs was discussed in a session presented by NADA. Specifically, Andrew Koblenz shared that the OEM's strategy regarding technology revolved around three premises: improving the overall customer experience through such measures as single price selling, driving efficiency and eliminating unneeded costs, and optimizing downstream revenue opportunities through OTAs. Perhaps the "right to repair" battle over OTAs is just beginning to intensify. This spring, West Virginia became the first state to introduce a bill that would ban auto manufacturers from offering OTA updates directly to vehicle owners – forcing visits to dealerships. The provision was later dropped as part of a larger bill. It will be interesting to see if other states will seek to address OTAs or whether OEMs and auto dealers can share the same vision for the increasing number of connected features in automobiles and how these features will be serviced and maintained.ConclusionConnected cars are here to stay. We will continue to monitor the issues presented by connected cars and their impact on auto dealerships. In the meantime, feel free to contact a member of the Mercer Capital auto dealer team today to discuss a valuation issue in confidence. Mercer Capital provides business valuation and financial advisory services, and our auto team assists dealers, their partners, and family members in understanding the value of their business.

Review of Key Economic Indicators for Family Businesses in Q1 2022

In this week’s post, we take a look at a few key macroeconomic trends that developed in the, shall we say, busy, first quarter of 2022. Between volatile equity markets, mounting global geopolitical tensions, raging inflation, and increasing interest rates, a lot went on in the year's first quarter from a macro perspective.We hope that the discussion below cuts through some of the “noise” and provides our readers with a concise and unbiased look at economic trends from the first quarter of 2022. Data and commentary are largely sourced from Mercer Capital’s National Economic Review, which is published on a quarterly basis and summarizes macroeconomic trends in the U.S. economy in each quarter.GDPAccording to advance estimates by the Bureau of Economic Analysis, GDP growth in the first quarter of 2022 decreased at an annualized rate of 1.4%. The decrease was driven by declines in private inventory investment, exports, and government spending (federal, state, and local). Mitigating factors to the decrease in GDP were increases in personal consumption expenditures, nonresidential fixed investment, and residential fixed investment. Imports, which are subtracted from national income and product accounts, increased in the first quarter of the year, which also led to the decline in GDP growth in the first quarter of the year.Economists expect GDP growth to resume in the next two quarters, albeit at slower rates than previously forecastEconomists expect GDP growth to resume in the next two quarters, albeit at slower rates than previously forecast. A survey of economists conducted by TheWall Street Journal in April reflects an average GDP forecast of 3.0% annualized growth in the second quarter of 2022, followed by 2.8% annualized growth in the third quarter. While these estimates call for GDP growth to resume in the next two quarters, respondents in the survey pegged the probability of a recession in the U.S. in the next 12 months at 28%, which is up from 18% in the January survey. The downgrade in GDP expectations and increased probability of a recession is primarily predicated on the surging rates of inflation seen in the first few months of 2022 and the Fed’s potential response to this rampant inflation. Still, a majority of survey respondents (63%) believe that the Fed will be able to rein in inflation without triggering a recession.Click here to enlarge this imageInflationEstimates from the Bureau Labor Statistics released last week reveal that the Consumer Price Index (“CPI”) increased 0.3% in April 2022 on a seasonally adjusted basis after rising 1.2% in March. On a year-over-year basis, the CPI increased 8.3% from April 2021 to April 2022 following an increase of 8.5% annual increase in March 2022. Individual indexes that saw the greatest month-over-month increases in April were the shelter, food, airline fares, and new vehicles indexes. The Wall Street Journal survey reveals the expectation that inflation will remain persistent through the balance of 2022, as respondents predicted, on average, an annual rate of 7.5% in June 2022 and 5.5% by December 2022 before falling back to 2.9% by late 2023.According to a Wall Street Journal survey, expectations are that inflation will remain persistent through the balance of 2022The Producer Price Index (“PPI”) is generally recognized as predictive of near-term consumer inflation. The PPI increased 0.5% month-over-month in April 2022 and 11.0% in the twelve months ended April 2022.Monetary Policy and Interest RatesAt its March meeting, the Federal Open Market Committee ("FOMC") voted nearly unanimously to lift the benchmark federal-funds rate by a quarter percentage point to a range of 0.25% to 0.50%. After the meeting, Chairman Powell signaled the possibility of the FOMC raising rates in half-percentage point increments at some point in 2022 rather than quarter-percentage point increments, which the Fed has not done since 2000. The FOMC acted on this possibility at its recent May meeting, as it unanimously approved a rare half-percentage-point rate increase, which raised the benchmark federal-funds rate to a target range of 0.75% to 1%. Following the May meeting, Chairman Powell stated that FOMC members broadly agree that additional half-point increases could be warranted in June and July to continue to combat surging inflation in the economy.ConclusionIn summary, the broad consensus among economists is that inflation remains the primary macroeconomic risk in the U.S. This has caused the Fed to respond aggressively thus far in 2022, as the speed and magnitude of rate increases have outpaced prior expectations for 2022, and the Fed appears primed to continue to aggressively increase rates. The balancing act for the Fed going forward will be attempting to thread the needle between cooling the economy enough to rein in record levels of inflation, but not so much that it accidentally creates a pullback in consumer spending and increases in unemployment.Family business directors and management teams should keep an eye on upcoming FOMC meetings. Commentary from these meetings offers insight into the future direction of the U.S. economy.Family business directors and management teams would be well-served in the coming months to keep an eye on upcoming FOMC meetings and subsequent commentary in the wake of these meetings. While this appears to be neither a glamorous nor exciting suggestion, commentary following these meetings does offer a great deal of insight into the future direction of the U.S. economy, given that the FOMC’s primary goal in executing its rate increases is to rein in inflation, which is almost certainly having real and tangible effects on nearly all family businesses right now.

Active vs. Passive Appreciation of Closely Held Companies

Determining the value of financial assets in a divorce case can often be the most complicated aspect of the case.

Is a Slowdown in RIA M&A Imminent?

RIA M&A activity and multiples have trended upwards for more than a decade now, culminating in new high watermarks for both activity and multiples set late last year. Deal momentum continued strong into the first quarter, but we sense at least initial signs of slowing as the macroeconomic backdrop has deteriorated.What Does the Future Hold for RIA M&A?On CI Financial’s first quarter earnings call last week, CEO Kurt MacAlpine remarked that the company’s acquisition pace has “absolutely slowed down” relative to 2021 as they focus on integrating existing firms and delivering. We suspect that other serial acquirers will follow a similar path as CI this year, particularly in light of rising interest rates and declining fundamentals for existing firms. Add to that the challenges of negotiating a deal when equity markets are swinging as wildly as they have been, and it’s easy to imagine at least a temporary slowdown in the pace of M&A in the coming months.The driving force in recent years has been strong demand and low supply for investment management firmsWill we look back at 2021 as the year RIA transactions peaked, or is the current slowdown merely a blip on the radar amidst a longer-term trend of consolidation and rising valuations? To look forward, it’s helpful to first consider what shaped the RIA transactions landscape over the last decade. In short, the driving force in recent years has been strong demand and low supply for investment management firms. On the demand side, the amount of capital and number of acquirer models has increased rapidly in recent years as investors have sought out the high margins, strong growth profile, and low capital intensity that the fee-based business model offers.At the same time, the number of RIAs in the market for a third party acquirer has remained limited, despite the industry’s often cited lack of succession planning. As the ratio of buyers to sellers has increased, so too have multiples and transaction activity.We don’t see those long-term supply and demand dynamics changing with the current market environment. Certainly, some buyers (like CI) will be sidelined temporarily, but they’re still around. When markets eventually stabilize, it’s more than plausible that transaction activity will return to the long-term trendline.What About Multiples?Supply and demand dynamics have certainly played a role in the rising multiples we’ve seen over the last decade, but the macroeconomic backdrop has added fuel to the fire as well. The era of extremely low interest rates lowered the cost of capital for acquirors and enabled consolidators to finance RIA acquisitions with cheap debt. And a persistent bull market has made it easy for buyers to justify projections that look like something out of a SPAC deck.A persistent bull market has made it easy for buyers to justify projections that look like something out of a SPAC deckSo far this year, margins for RIAs have been attacked on two fronts: falling equity markets eroded the fee base, while high inflation and a tight labor market threatened to drive up personnel costs and other overhead. There’s a lot that goes in to pricing, but it’s safe to say that on many recent transactions, the buyer’s projection model likely looked very different than what’s actually transpired so far this year. While many of these deals may work out in the long term, chances are there are sellers out there who feel they timed things perfectly, and some buyers that feel they’ve been left holding the bag.With the cost of capital for aggregators rising rapidly and the growth outlook for RIAs declining, we expect to see some multiple contraction relative to the high watermarks seen last year. And while private transactions for wealth management firms have historically been priced very differently than public asset/wealth management firms, it’s equally likely that at least some of the decline we’ve seen in the public firms will translate to the private markets.There’s still much uncertainty about the duration of the current market environment and the ultimate impact it will have on RIA performance and transaction activity. As it stands, a near-term slowdown in transaction activity and multiples seems likely, but so too does a return to normal once markets stabilize.

Themes from Q1 2022 Energy Earnings Calls

Part 1: Upstream

In Part 1 (E&P Operators) and Part 2 (Mineral Aggregators) reviews of Q4 Earnings Calls, prevalent themes among the E&P Operator calls included cost inflation, a shifting focus towards liquids, and policy headwinds towards the Oil & Gas industry. Among the mineral aggregators, common themes were capital discipline, flat production growth, and the strength in the position of aggregators amid the highly inflationary environment.This week, we take a holistic upstream perspective on the themes of both the E&P operator and mineral aggregator earnings calls for Q1.The Future Role of U.S. Production in the European MarketRussia invaded Ukraine on February 24, 2022. Global markets blinked, and commodity futures skyrocketed. In the weeks following the invasion, European nations discussed plans to phase out sourcing energy from Russia. With OPEC holding firm on its production plans, attention turned towards the U.S. — the world’s largest hydrocarbon producer and a vocal supporter of sanctions towards Russia. Upstream Oil & Gas companies recognize that their role in supplying European energy markets, and the global market generally will grow.“As the war in Ukraine and the resulting governmental sanctions continue, Russia's oil production is expected to be impacted by shut-ins, natural declines, storage limitations and lower exports, creating a global shortage of oil. Over the next few years, we will need to make up for this lost production, and we believe that the U.S. oil and gas industry is best suited to provide the low-cost environmentally-friendly barrels needed to ensure global energy supply. However, today, we are operating in a constrained environment with inflationary pressures continuing to increase across all facets of our business. Also labor and materials shortages are now present across the supply chain…[an] increase in activity now would result in capital efficiency degradation that would not meaningfully contribute to fixing the global supply and demand imbalance in the oil market today.” – Travis Stice, Chairman and CEO, Diamondback Energy“The reality is that energy markets were already tightening from supply and demand fundamentals before this Russian action, and the risk premium now embedded in commodities, including oil and gas has returned with a vengeance. Even in the unlikely event of a near-term resolution to this crisis, the die has been cast and actions, particularly by European countries are already underway to move away from Russian oil and gas and secure more reliable supply from the Middle East and the U.S. It has underscored the need for an orderly energy transition that includes oil and gas as part of all of the above strategy, and has recalibrated global views as to the current and ongoing role of U.S. oil and gas in the world economy.” – Lee Tillman, Chairman, President and CEO, Marathon Oil“On the supply side, the shift towards maintenance capital plans and supply chain constraints led to moderated global supply growth. Then during the first quarter of 2022, this bullish fundamental backdrop was further strengthened by the geopolitical events in Europe. Unlike prior commodity price spikes, these events had a large impact on the futures curve, where we saw the natural gas strip move up 45% throughout the curve all the way to calendar year 2026. As Europe looks to strengthen its energy security, it has become clear that there will be a significant call on U.S. shale gas in the coming decades.” – Paul Rady, Chairman, President and CEO, Antero Resources“Recent world events have highlighted the global strategic importance of U.S. gas reserves, and we believe the Haynesville shale is the best position play to benefit from continued growth in LNG export volumes over time.” – Tom Carter, Chairman and CEO, Black Stone MineralsConfidence of Continued Favorable PricingIn Part 1 (E&P Operators) of the Q4 earnings call themes, we noted upstream companies’ strong desire to reap the full benefits of the pricing environment. Executives focused on shorter-term deals, unhedged positions, and a more opportunistic approach when it came to derivatives contracts. With fewer hedges in place or shorter-term contracts, operators continue to pursue maximizing their upside from continued price appreciation or a prolonged favorable pricing environment.“We’re happy where we are right now on shorter-term deals, whether it’s selling on the day or on the month. We’re not interested in longer-term supply deals unless we receive significantly higher premiums. There is too much optionality today to get in prematurely. We are virtually unhedged on all commodities in 2023. This attribute will allow us to capture the upside to growing LNG and LPG export demand.” – Paul Rady, Chairman, President and CEO, Antero Resources“As we look to 2023, we have positioned the portfolio with a good base layer of hedges. With strength in the oil and natural gas, we’ll opportunistically add 2023 hedges over the remainder of this year. However, we expect to hedge less volumes, or said another way, a lower percentage of production than we have historically.” – Kevin Haggard, Senior Vice President and CFO, Callon Petroleum“If oil prices were to average $60 for the remainder of the year, Pioneer's shareholders would receive approximately $17 in dividends per share. At $120, approximately $31. Shareholders have significant upside on higher oil prices as we have zero 2022 oil hedges.” – Scott Sheffield, CEO and Director, Pioneer Natural Resources“While the Permian led all of the basins in terms of growth in rig count, we believe strong natural gas prices will compel improved activity in the Haynesville, Marcellus and Mid-Con as we continue through 2022.” – Bob Ravnaas, Chairman and CFO, Kimbell Royalty PartnersCompletions Trending UpUpstream operators commonly noted that their Q1 completion rates increased, with expectations that completions will continue to increase throughout 2022. This is an encouraging sign for aggregate production.“[Regarding] completions, our field team continues to see really good improvements and they’ve increased their overall completed lateral per foot per day by 10% compared to 2021.” – Jeff Leitzell, Executive Vice President-Exploration & Production, EOG Resources“As you mentioned, 11-wells went online earlier, and they are performing above the type curves. We still have six more to turn online, making 23 Eagle Ford for this quarter. And we have even more wells set to come online in the Eagle Ford through third quarter. It is very early, but we’re very excited about the wells coming online earlier and at higher results.” – Molly Smith, Vice President of Drilling and Completions, Murphy Oil“The decrease in oil volumes was primarily a result of lower suspended revenue volumes received in this quarter as compared to last quarter. Our staff successfully worked with producers in the second half of last year to release suspended production volumes across our mineral position… Given the temporary nature of these items and combined with the generally positive industry environment and the ramp up in activity, we expect to see the Haynesville and Austin formation shock through our organic growth programs. We expect that growth trajectory to resume throughout the year.” – Jeff Wood, President and CFO, Black Stone Minerals“Strong commodity prices during the quarter translated into increased activity on our acreage as evidenced by the 20% increase in the rig count actively drilling on our acreage at no cost to us. In addition, line of sight inventory from our major properties increased 6% sequentially to 5.03 net DUCs and permits. This is notable since we only need approximately 4.5 net wells completed each year to keep production flat.” – Bob Ravnaas, Chairman and CFO, Kimbell Royalty Partners “Looking ahead, our net activity well inventory, which represents the combination of our drilled but uncompleted locations, or DUCS, in our permits was 11.7 net locations at the end of the first quarter, our net DUCs and inventory at the end of the first quarter stayed roughly flat versus the fourth quarter, despite our extremely strong aforementioned DUC conversions. We anticipate that PDC, Chevron, Pioneer, Oxy, and Diamondback will convert the majority of our DUC inventory.” – Rob Roosa, CEO, Brigham MineralsConclusionMercer Capital has its finger on the pulse of the minerals market. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators in the upstream space. For more targeted energy sector analysis to meet your valuation needs, please contact a Mercer Capital Oil & Gas Team member for further assistance.

Case Review: Observations From a Recent Auto Dealer Litigation

A recent Appellate Court decision was released from a case (Thomas A. Buckley v. Grover C. Carlock, Jr. et.al.) that we were directly involved in back in 2019. The case centered around a shareholder oppression issue involving a minority owner of an “ultra-high-line” auto dealership. Mercer Capital was hired by the Defendant to serve as the expert witness.The company at issue, TLC of Franklin, Inc. (“the Company”), was an official auto dealer for Aston Martin, Alfa Romeo, Lotus, Maserati, Rolls-Royce Motorcars and Bentley. The valuation aspect of the case required both experts to determine the fair value of the oppressed shareholder’s 20% interest in the Company as of January 31, 2017.The Appellate Court upheld and affirmed the Trial Court’s determination of value of the 20% interest. A summary of each expert’s valuation opinion and the Court’s conclusion of value is as follows: The nature of the Company’s underlying operations created several valuation challenges in this case. First, the unique set of the brands offered by TLC, that are referred to as “ultra-high-line,” is not as prevalent in auto dealerships across the country. Among the nearly 17,000 auto dealers in the U.S., there are very few that retail the premium brands offered by TLC of Franklin. Because of this, there is little published data on these franchises – from details of their historical profitability to market multiple representations of their value in transactions. The other challenge presented in this case was that the Company’s historical operations did not report consistent profitability during the reviewed period. In this post, we highlight the differences in the assumptions and conclusions of both valuation experts, as well as provide observations regarding some of the commentary provided by the Trial and Appellate Courts in arriving at the ultimate conclusion of value. We also touch on normalization adjustments, valuation methodologies, and the way in which the Court decided its determination of value.Normalization Adjustments to EarningsWhat Are Normalizing Adjustments?It is important in the valuation of an auto dealership to review the company’s financial statements to determine if any normalization adjustments should be made. Normalization adjustments take private company financials and adjust the balance sheet and income statement in order to view the company from the lens of a “public equivalent.” Typical normalizing adjustments to the income statement are made to non-recurring items, as well as discretionary expenses related to current management that would not necessarily be incurred by a hypothetical owner of that business. As mentioned previously, the actual historical operating performance of the Company was inconsistent during the reviewed period. In some years, the Company reported operating losses, making the determination of these adjustments difficult.The Experts’ Application of Normalizing AdjustmentsThe experts disagreed with respect to the magnitude of normalization adjustments, though they agreed such a normalization adjustment would be necessary. For example, after directly identifying several adjustments to earnings, Mercer Capital selected a 1.5% normalization factor of pre-tax earnings-to-revenue based on the Company’s actual operating performance, similarly sized auto dealerships, and our experience valuing luxury and ultra-high-line dealerships. The Plaintiff’s expert determined a normalization factor of 5% of pre-tax earnings-to-revenue based on their experience valuing ultra-high-line dealerships.The Trial Court’s DeterminationThe Trial Court selected a normalization factor of 2.8% - 2.9% of revenue based upon historical data for 2015 and 2016 as published by the National Auto Dealers Association (“NADA”). Specifically, the Court cited annual historical profitability for “Luxury” and “Import” brands noting they were the best comparison to TLC of Franklin. Until October 2021, NADA published monthly profitability data referred to as Dealership Financial Profiles for categories of auto dealerships, including average, domestic, import, mass market, and luxury, and the Trial Court relied heavily on this data.The Use of Industry Comparable DataThe use of comparable data to compare a subject company to industry averages can be important to the valuation process. While NADADealership Financial Profiles is more specific than general industry profitability data, such as the Annual Statement Studies provided by the Risk Management Association (“RMA”), no single comparison is perfect, and appraisers should be careful in applying average percentages to their subject company.The use of comparable data to compare a subject company to industry averages can be important to the valuation process.TLC’s ultra-high-line brands were not included in the descriptions of the NADA Dealership Financial Profiles classifications, even among luxury dealerships, despite connoting a similar type of consumer. In reality, the representative average data in these studies is comprised of many dealers performing at higher or lower levels than the ultimate average. A rigid comparison to the average could potentially ignore the fact that the subject company has been performing below average since its operation or in recent history.The other caution against a rigid normalization adjustment to an industry benchmark is the implied level of the resulting adjustment. In other words, by normalizing a company to a certain % of pre-tax earnings, what is the resulting dollar amount of the adjustment? Take, for example, a company with revenues of $35 million. To normalize earnings to a 5% pre-tax earnings level would imply that there are $1,750,000 of expenses to be normalized or added back.The Plaintiff’s expert offered no evidence or specific expenses that would rise to that level in their review of the historical financial statements. Mercer Capital determined several normalization adjustments to earnings after reviewing the Company’s financial statements and discussions with management before making an overall normalization adjustment of 1.5% of earnings based on our experience with similar dealerships to TLC.Valuation Methodologies UsedIncome ApproachThe income approach is a general way of determining the value indication of a business or ownership interest using one or more methods that convert anticipated economic benefits into a single present amount. The income approach allows for the consideration of characteristics specific to the subject business, such as anticipated earnings, level of risk, and growth prospects relative to the market.Mercer Capital ultimately determined the value of the subject interest through the use of a capitalization of earnings method. Historical earnings were adjusted through a combination of direct normalization adjustments and an industry adjustment to 1.5% of revenues. The resulting value under the income approach represents the overall value of the dealership, both tangible and intangible. The difference between the overall value of the dealership under the income approach and the value of the dealership’s net tangible assets represents the implied value of the dealership’s intangible or Blue Sky value. Therefore, Mercer Capital’s income approach included and quantified the Blue Sky value of TLC.The application of the income approach assumes that the company possesses the appropriate level of assets and liabilities to produce the level of anticipated earnings in the income approach. Only non-operating or excess assets are added to the value determined under the income approach. For example, some dealerships carry much more cash than needed for operations before eventually distributing it to owners. In such cases, the excess cash is added back on top of the indication of value under the income approach.Mercer Capital did not identify any non-operating or excess assets owned by TLC. Therefore, no assets were added to our conclusion of value under this approach.The Plaintiff’s expert did not employ an income approach in his determination of value.Market Approach – Recent TransactionsOne method under the market approach is to examine any transactions within the subject company's stock. Appraisers will often examine whether any transactions have occurred, when they occurred, and at what terms they occurred. There is no magic number, but as with most statistics and data points, more transactions closer to the date of valuation can often be considered better indicators of value than fewer transactions further from the date of valuation.Three transactions occurred within the stock of TLC in the three to five years prior to the date of valuation. A summary of those transactions and their indicated equity values are as follows: The Plaintiff’s expert used the internal transactions as one of his three valuation methods but only relied upon the first and third transaction in the figure above. All three transactions occurred in relatively similar proximity but obviously indicated materially different implications of overall value. Ironically, the second transaction that the expert excluded involved the plaintiff’s buy-in to the company. The third transaction involved a minority sale to a celebrity, and no evidence was provided as to the motivations of the buyer and seller in that transaction or whether any financial information or due diligence was performed by the buyer. As such, it may be reasonable to consider this transaction less reliable as an indication of value than the other two. The first transaction was for a 75% interest, which represents a controlling interest basis, which is a different level of value than the other two transactions. Since the subject interest is non-controlling, the level of value would be more comparable to the last two transactions in the table above.Motivations of buyer and seller in internal transactions can be critical to their consideration in the overall valuation process.Motivations of buyer and seller in internal transactions can be critical to their consideration in the overall valuation process. Motivations may not always be known, but it’s important for the financial expert to try to obtain that information. Suppose there have been multiple internal transactions, such as with TLC of Franklin. In that case, appraisers must determine the appropriateness of which transactions to include or exclude in their determination of value possibly. Without an understanding of the motivation of the parties and specific facts of the transactions, it becomes trickier to include some, but exclude others. The more logical conclusion would be to consider all of the transactions or exclude all of the transactions with a stated explanation.The Trial Court was critical of the Plaintiff’s expert’s exclusion of transaction #2 and noted the material impact it would have on concluded values.Mercer Capital observed the internal transactions of TLC but did not place any reliance on this method.Market Approach – Blue Sky MethodUnder the market approach, the Blue Sky method determines value by applying a brand-specific multiple to pre-tax earnings. This method estimates the intangible value or franchise rights of the specific brands they retail.Blue sky multiples are published quarterly by two sell-side advisory firms in the auto dealership industry: Haig Partners and Kerrigan Advisors. Specific multiples are calculated and presented for each represented brand by quarter based on observed transactions. It should be noted that neither Haig nor Kerrigan publishes any multiples for ultra-high-line dealerships or any of the brands retailed by TLC.The Plaintiff’s expert concluded a Blue Sky multiple of 8x based on reported multiples for luxury brands and applied that multiple to two different income streams. First, he applied the Blue Sky multiple to normalized earnings based on his 5% pre-tax figure described previously. Secondly, he applied the Blue Sky multiple to projected earnings based on figures from a management presentation.The Trial Court was especially critical of the use of projections for TLC since it was not a start-up entity. Projections are rarely used in the valuation of auto dealerships. It should also be noted that no evidence was provided as to where the management projections came from, who produced them, and for what purpose. Blind or rigid reliance on management forecasts should be avoided especially if they are not discussed with management. Projections should be viewed with caution, especially in instances where projected results greatly exceed historical operating results or if the company has historically performed below previous projections or budgets. If projections must be used, appraisers typically account for this by using more conservative multiples to balance these lofty projected earnings.To these approaches, the Plaintiff’s expert added back the net tangible assets of TLC since these methods estimate the intangible value or franchise rights of the brands represented by the dealership.Mercer Capital did not rely on a direct Blue Sky method to value TLC since no published multiples exist for the brands represented by TLC. When applicable, we employ the use of a similar methodology to value dealerships in conjunction with or to support the valuation determined under another method, such as the income approach. The transaction multiples reported by Haig and Kerrigan are derived from negotiations between buyers and sellers. The ultimate consideration paid is determined by the buyer’s assessment of expected cash flows, the growth potential of those cash flows, and the anticipated rate of return. The multiple reflects the price paid in relation to a financial metric, in this case pre-tax earnings.Courts’ Determination of ValueThe Trial Court ultimately determined value through several calculations. The Court utilized the profitability data provided by the NADA Dealership Financial Profiles for luxury and import dealerships for 2015 and 2016 and applied profitability factors of 2.9% and 2.8% to TLC’s historical revenue for those years.The Court concluded the use of an 8x multiple or factor to normalized pre-tax earnings to estimate value for TLC. The Court’s final conclusion of value for the subject 20% interest was $1,745,500. This conclusion included an average of those four calculations along with half of the adjusted net assets to reflect the inclusion of market and income methods. The Appellate Court affirmed the concluded value and methodology used by the Trial Court in this case.ConclusionAs evidenced by this litigation case, the valuation of auto dealerships can be very challenging and complex. The subject company, in this case, provided additional challenges given the unique specialty of the brands that they retail, combined with their inconsistent and lack of historical profitability.Mercer Capital provides valuation services to auto dealers and their advisors all over the country for litigation and non-litigation purposes. Contact a Mercer Capital professional today to learn more about the value of your dealership or if we can assist you in a litigation issue involving the value of your dealership.

Your Family’s Guide for the Next 100 Years

How does your family business think about success? James Hughes poses a question to the reader early on in Family Wealth: Keeping It in the Family that likely reorients our focus relating to successful family enterprises.“The Question: Can a family successfully preserve its wealth for more than one hundred years or for at least four generations?” – (Hughes, 2004, p. 4)In our need-it-now, two-day-shipping-is-too-slow modus operandi of 2022, the thought of thinking in centuries seems almost quaint. But Hughes successfully supports the importance of this mindset in a way that would make even the most “next quarter’s numbers” advisor or family board member think twice.Long-Term Wealth PreservationHughes is now a retired sixth-generation counselor-at-law, prolific author, and renowned multi-generation family meeting facilitator. He has advised numerous wealthy families on how to maintain and grow their wealth over time. Hughes views “shirtsleeves to shirtsleeves in three generations” plaguing family businesses not as destiny but as a cycle family businesses can overcome with thoughtful practices and patience over many years.Wealth is more than what your business is worth or the size of your brokerage account.“Wealth,” according to Hughes, is more than what your business is worth or the size of your brokerage account. A family’s wealth includes the family's human, intellectual, and (purposely placed last) financial capital. Families struggle to preserve wealth over generations due in part to not focusing on two of the three sources of family capital, failing to realize that human capital (health, well-being, and happiness) and intellectual capital (education and life experience) lead to an expansion of financial capital.In practice, families should aim “over a long period of time, to make slightly more positive than negative decisions regarding employment of their human, intellectual, and financial capital” (Hughes, 2004, p. 36). This series of positive decisions includes creating effective family governance structures, supporting each member’s pursuit of happiness, and a consistent reaffirmation of the family’s governance and vision. Only with constant reaffirmation, inculcation, and cultivation can a family hope to sustain itself over multiple generations.Practices for Your Next Family CouncilA strength of the book is its mix of real-world examples with philosophy, economics, and political theory. Homer, Aristotle, psychology, and pedagogy all make it in Family Wealth, making it both an informative and practical look at how we should view family businesses and enterprises.For example, chapter 3 on “Ritual” includes a short summary review of “rituals” as they relate to ancient families and tribes. Hughes then provides modifications and applications of these “rituals” for modern businesses and family enterprises. The chapter is couched in anthropologist Arnold van Gennep’s framework from The Rites of Passage in discussing rituals. Chapter 10 on “Beneficiaries” discusses how beneficiaries to familial trusts should handle and view their responsibilities and role as a beneficiary, as well as beneficiary education. Hughes leans on his practical experience with aggrieved and unhappy beneficiaries to provide a simple list of roles and responsibilities for beneficiaries to ensure familial harmony and happiness.Most of the book follows this style, highlighting in bite-sized 5-to-10-page sections, various practices and questions that affect family businesses and boards. These include crafting a family mission statement (chapter 2), the family bank (chapter 7), family philanthropy (chapter 12), and the roles of aunts and uncles (chapter 16) to name a few. Chapters are woven within common themes, but each has the weight to stand alone and act as a springboard at a family council or advisory board meeting.You Have No Time to WasteThere is a common, inconvenient thread throughout the book in its lessons and applications: there are no shortcuts. Besides saving for retirement or raising a child, the difficulty of making up for lost time reveals itself in the power of compounding. Failing to inculcate your family’s values or educate the next generation on the family business may not rear itself head early on or even over the next generation. Rather, the consequences manifest in the "shirtsleeves to shirtsleeves" adage that spells the end of many a successful family enterprise.Failing to inculcate your family’s values or educate the next generation on the family business may not rear itself head early on or even over the next generation.But family businesses are not powerless. Hughes’ book serves as a helpful guide to drive conversations and lays a roadmap for your family business for years to come. Other families have done it, with names synonymous with wealth and longevity such as the Rothschilds and the Rockefellers. Hughes shows that your family is capable of such longevity with careful planning, deliberate practice, a solid governance structure, and a long-term focus.Hughes’ favorite metaphor for long-term wealth preservation is the tree that adorns his book’s cover: the copper beech tree. This tree is found in the northeastern United States, takes 150 years to mature, and no one who plants a seed of a copper beech tree will see it fully grown. Years of nurturing and protection are needed from those who will not fully be able to appreciate its grandeur – but early planters have a perspective beyond even their lifetimes.The famous French General Mashal Lyautey, who served under Napoleon, is said to have had the most beautiful garden in France. He told his gardener he wanted to plant a copper beech in his garden, to which his gardener protested, given the work and time it would take. Lyautey is said to have replied without hesitation, “Then we must plant today – we have no time to waste.” Indeed, your family business has no time to waste. The next 100 years start today.

April 2022 SAAR

The April 2022 SAAR was 14.3 million units, up 6.5% from 13.4 million in March but down 21.9% from the recent high April 2021 SAAR of 18.3 million units. The last three April SAAR figures (’20, ’21, and ’22) are interesting to compare to one another, as dynamic conditions resulted in three very different narratives surrounding the SAAR.In April 2020, the COVID-19 pandemic had taken its grip on the world economy, stifling the demand for vehicles as economic uncertainty pushed consumers to hold off on vehicle purchases. This pause in activity kept potential buyers off dealer lots despite adequate inventory levels across the entire industry. Cooled conditions resulted in very low sales and a relatively high inventory to sales ratio (3.93) compared to the all-time high of 4.64 in January 2009. It may be hard for some to remember, but dealers were turning as much inventory as they could even at lower GPUs in order to shore up their cash position.In April 2021, demand had more than recovered. Pent up demand from the pandemic was showing its face, resulting in the highest ever recorded level of April raw sales. Inventory balances would have been considered healthy but declining due to strong demand. Sales outpaced the rate of OEM vehicle production.In the current environment, the tables have now completely turned from the observed conditions in April 2020. Demand has continued to stay strong, but historically low balances of inventory have restricted raw sales numbers well below what was observed in April 2021. While there may be some signs or reasons to expect some pullback in demand, it is still overwhelming when compared to historically constrained supply.Thomas King, president of the data and analytics division at J.D. Power shared his takeaways from April: “The April sales pace may look disappointing compared with April 2021, but last April’s record sales pace was enabled by the combination of extremely strong consumer demand and enough inventory (nearly 1.7 million units) to turn that demand into actual sales. This April, demand remains strong, but with fewer than 900,000 units in inventory at dealerships, sales volumes will necessarily be well below year ago levels.” As the last three Aprils have shown us, striking a balance between the number of available vehicles on dealer lots and the demand that exists in the market has been difficult over the last two years and will likely continue to be difficult until the supply/demand dynamics of the auto market align more closely. During the valuation process of several engagements, many of our auto dealer clients have spoken about the sales pace on their lots compared to their limited stock of vehicles. We are seeing that most of these dealerships ended April with just about the same inventory balance as the start of the month while selling at almost a 1:1 relationship between inventory-in and inventory-out. This is due to a high number of pre-order sales, which brings lot-time for these vehicles close to essentially zero days. It is truly impressive that dealers can sell more vehicles in a month than they had sitting on their lots at the start of the month. A sign of the times.Keeping with the trend over the last year, year-over-year growth in profits has been observed as high as 20%, hammering home the fact that dealers continue to thrive in this high price environment. Many consumers may balk at transaction prices that continue to run up the charts, but it is worth noting that the demand for vehicles has seemed much less elastic (sensitive to price changes) than many previously thought. Speaking of transaction prices, the industry average remained elevated at $45,232 per unit, up 18.7% from this time last year and an April record. The all-time record was set last December and there have only been small incremental changes up and down since then.High transaction prices have come alongside decreasing incentive spending per vehicle. April’s incentive spending per unit came in at $1,034, an all-time low. See below for a comparison of the last seven April’s incentive spending per unit: The cost of financing a vehicle has also worsened for consumers as rising interest rates have pushed monthly payments up to an April high of $685. The Federal Reserve, after already having introduced a rate hike in the first quarter of 2021, opted to raise rates by half a percentage point on May 4. This increase is twice the size of a typical rate hike due to the Fed’s aggressive strategy against inflation. The Fed has also announced that it expects to raise rates further over the summer.Despite interest rates adding fuel to the fire, monthly payments are only up 15.6% from this time last year while transaction prices have increased 18.7% over the same period. This can be attributed to longer terms on loans, as 72 and 84 month terms become more commonplace. Lower and middle-income buyers will have to weigh the rising costs of financing a vehicle as affordability challenges limit the options that these buyers have available.May 2022 OutlookMercer Capital’s outlook for the May 2022 SAAR is consistent with the last several months. Industry supply chain conditions continue to stagnate. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arriving. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Stay tuned for more updates on next month’s SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value.

Investment Management Confronts Stagflation and More

Malaise, Anyone?

Last week my colleague, Brooks Hamner, took us down the rabbit hole of the impact of higher interest rates on valuation in the RIA space. With the expansion of acquisition multiples over the past few years, it’s a healthy reminder that very low interest rates helped fuel those higher prices, and that cheap debt is a two-way street.There’s more to the story, but, unlike most things in finance, the other economic factors that accompany higher interest rates exacerbate the negative impact on RIAs, rather than mitigating them. The Fed is raising rates, after all, because inflation is higher. Investment management is a labor-intensive business and has an expense base that is, therefore, highly sensitive to inflation. Further, higher interest rates don’t just hit RIA valuation multiples – they also impact the valuations of the very securities that RIAs charge fees against to derive revenue.If you haven’t already (I imagine many of you have), this is an excellent time to stress-test your financial condition to see what impact weakened markets, higher inflation, and rising interest rates will have on your firm.Base Case: Successful Wealth ManagerAssume a successful wealth management firm with $5 billion in AUM that generates fee revenue at a blended rate of 75 basis points. On the expense side, salaries run about $15 million which, at 40% of revenue, is within norms. Variable – or bonus – compensation runs 20% of pre-bonus EBITDA, after consideration of non-personnel related expenses which total 20% of revenue. The net result of this is an EBITDA margin of 32% - very healthy for the sector. With strong margins and a variable compensation structure that buffers some of the impact of changes in profitability, this is the profile of a firm designed to weather most RIA operating environments.Base Case Plus DebtNow, let’s take our sample firm case one step further, and assume that part of this wealth manager’s business was acquired in recent years in leveraged purchases using covenant-light financing from a non-bank lender. Acquisition debt outstanding is $30 million, amortizing over 15 years at a base rate plus 550 basis points, or (until recently) 5.75%. This computes to annual debt service of about $3.0 million.Under the circumstances described in our base case, debt is well within conventional covenants, with debt to EBITDA of 2.5x and debt service coverage (EBITDA to debt service) of nearly 4x.Threat 1: Impact of Bear MarketAs I write this, major U.S. equity indices are down between 15% and 25%. Normally, a wealth manager could expect falling equity markets to be offset by a flight to quality. That market rotation would increase bond prices, or at enable help them to hold steady and offset the impact on AUM from falling stocks. As we all know too well, debt markets haven’t offered any shelter from the equity storm this year, such that it’s difficult to assume much help from fixed income to mitigate the downturn in equity markets. Higher rates appear to be repricing different classes in such a way that we’re seeing more correlation than usual – certainly more than we would prefer.A 20% drawdown in AUM has a corresponding impact on our sample firm’s revenue, but the only expense offset is to bonus compensation. With this one change, our sample firm’s EBITDA margin declines to 17.5%, and the leverage ratio doubles.Threat 2: InflationInterest rates are rising because inflation is well above the Fed’s target. Lots of expenses borne by RIAs are subject to inflation. The biggest expense for a wealth manager is, of course, labor – and especially so in this market because talent is scarce. The RIA industry may actually be experiencing negative unemployment, as the demand for skilled staff from client-facing to compliance positions exceeds the number of people employed in the industry. Peruse your LinkedIn and you’ll see investment management talent playing musical chairs, all of which threatens to increase costs for everyone at something exceeding inflation. In major markets, non-staff costs like rent are back on the rise, and other costs from tech to insurance are at least keeping pace.If we increase fixed costs at 10%, overall expenses grow considerably. Again, because of the hit to profitability, bonus compensation drops – at least in theory. Cuts in variable comp may prompt staff to look elsewhere, increasing talent replenishment costs and reducing the function of profit-sharing schemes in cushioning the blow of lower margins.Couple inflation with the drawdown in markets, and the EBITDA margin is cut even further. At this point, leverage ratios are beyond compliance levels even for non-bank lenders, and our sample company is at risk of not being able to service its debt.Threat 3: Higher Interest RatesIf EBITDA drops when interest rates are increasing, what does that do to our sample firm’s ability to service their debt. Well…it doesn’t help. If interest rates increase by 300 basis points, which seems to increasingly be the consensus, our highly diminished EBITDA barely covers principal and interest payments.Efforts to stave off default mostly include restructuring debt into longer amortization terms and cutting owner compensation. My stepfather often told me that you can always tell which one of a banker’s eyes is glass: it’s the one that shows sympathy.What About You?This illustration is overly simplistic, but useful nonetheless. Consider what this means for your own firm. If you’re interested, shoot me an email and I’ll send you the excel file behind this post that you can use to build your own stress test. Or hire us and we’ll do a more elegant version using your particular circumstances.I was reminded this week of a few comforting words from noted British economist Elroy Dimson: “Risk means more things can happen than will happen.” Given the possibilities I’ve presented here of things that can happen, we can all hope that other things will happen. Dimson probably didn’t intend to be quoted on this matter in the spirit of optimism, but right now it sounds better than President Jimmy Carter’s description of similar times: malaise.

Three Reasons to Hold Cash on the Family Business Balance Sheet

For one weekend a year, the spotlight of the financial world shifts from New York to Nebraska. The annual meeting of the Berkshire Hathaway company has developed a cult following among shareholders and financial journalists alike. A compound annual return of 20% over 55 years (!) will do that for you.Actuarially speaking, the number of opportunities to see Warren Buffett, 91, and his longtime partner Charlie Munger, 98, on stage together at the annual meetings is dwindling. One area of particular interest for the Oracle of Omaha’s followers in recent months has been Berkshire’s overflowing war chest. At the end of 2021, Berkshire’s balance of cash, equivalents, and short-term treasuries stood at nearly $144 billion, compared to $71 billion at the end of 2016, and “just” $34 billion ten years prior.The consummate value investor, Mr. Buffett attributed the growing cash stockpile to an absence of compelling investment opportunities. Better to hold cash than make bad investments, after all. Market volatility in the early months of 2022 did loosen the purse strings a bit as Berkshire made a large acquisition (Alleghany Corp) and built large positions in three publicly traded companies (HP, Occidental Petroleum, and Chevron). All told, the first quarter investing activity drew cash down to approximately $105 billion, which is still enough to cover payroll for a while.Mr. Buffett certainly doesn’t need us to remind him of the perils of “lazy capital” on the corporate balance sheet – the yearend cash stash represented approximately 20% of Berkshire’s overall market capitalization. Giving Mr. Buffett the benefit of the doubt (which he has probably earned at this point in his career), are there any good reasons for family businesses to hold some cash in reserve? In our view, there are three potential benefits to keeping some cash on the balance sheet.Reduce RiskAs the adage goes, no one goes bankrupt holding cash. While modern finance theory suggests that public company managers should not be willing to sacrifice much return to reduce bankruptcy risk, family business directors cannot be so sanguine. Since the family business often represents a significant portion of overall family wealth, corporate bankruptcies are catastrophic for the family. Some families can leave a bit of marginal return on the table if it helps push the likelihood to financial distress to a negligible level. There is no single right answer that will fit every family; however, directors need to acknowledge the tradeoff, calculate the decrement to return from holding cash, and be deliberate about the decision they make.Fund Opportunistic InvestmentsCash is the contrarian’s friend. You can keep wealth by staying in the middle of the investment pack, but you only get wealthy by venturing away from the pack, buying when prices are depressed and other investors are afraid to invest. Or, don’t have the liquidity to invest. While describing the stock market as a “gambling parlor” at Saturday’s meeting, Mr. Buffett acknowledged that the attendant market volatility allowed Berkshire to identify attractive investments saying, “We depend on mispriced businesses.” Unfortunately, credit availability is inversely related to the volume of attractive investment opportunities. To take full advantage of market dislocations, sometimes it helps to be your own banker. Ample cash on the balance sheet can afford your family business that luxury.Be Strategic About OwnershipIn addition to making opportunistic investments, Berkshire has also used its cash hoard to repurchase over $50 billion of shares during 2020 and 2021. So long as markets are efficient, share repurchases are, by definition, a zero net present value project. While Mr. Buffett would prefer to make investments in other businesses, when he believes that attractive opportunities are not available, he has not been averse to buying Berkshire shares.Berkshire doesn’t really care about the identity of its owners. Shareholders come and shareholders go. When Berkshire repurchases shares, it does so in open market transactions, not knowing – or caring – who the selling shareholders are. Family shareholders can be described in many ways, but anonymous is not one of them.DNA is not a reliable indicator of whether an individual will be an effective family shareholder. As a result, there is – for many families – a significant difference between what the shareholder list is and what the shareholder list should be. The capacity of many families to “muddle through” with suboptimal ownership for years and even decades is remarkable. But other families elect to make ownership a strategic priority. It is much easier for families to be intentional about who owns shares in the family business when there is enough liquidity on the corporate balance sheet to repurchase shares from departing shareholders.ConclusionWe have previously sounded the warning about allowing excess cash and other non-operating assets to accumulate on family business balance sheets. We stand by that warning, but the example of Berkshire Hathaway does highlight that – in addition to its (opportunity) costs – cash has its uses. Is there a purpose behind the cash on your balance sheet? Have you accumulated cash with intention or through inattention? What is your cash doing for you?

May 2022

In this issue: Specialty Finance Acquisitions

U.S. LNG Exports

Part I: The Current State of U.S. LNG Export Terminal Facilities and Projected Export Capacity

Up To This Point…From 2010 to 2021, the Federal Energy Regulatory Commission (“FERC”) received approximately 145 long-term applications for export facilities seeking to export liquified natural gas to countries both with and without free-trade agreements (“FTA”) with the U.S. Of these 145 applications, 93 (or 64%) have been approved, with approximately 80% of the approved applications coming from submissions made from 2011 through 2016.Up to this point, we have seen applications either submitted or reasonably anticipated to be submitted for approximately 25 export facilities.To be clear, a significant portion of these applications pertain to capacity expansions to either existing or proposed export terminals where the initial application for a proposed facility was approved, and another application for expanded output volume was later submitted prior to the actual construction of the facility. Additionally, there are separate applications for exporting to FTA and non-FTA countries; if a facility seeks to export to both types, there is one application for the FTA markets and one for the non-FTA markets. In other words, 145 applications received do not directly translate to 145 LNG export facilities.The number of submitted applications dropped in 2017 and has since remained far below the annual numbers seen in 2011 through 2016. This was primarily caused by the massive decline in LNG export prices starting in Q1 of 2015. The subsequent decline in the applications submitted, which was not very evident until 2016, was not as steep. This was most likely due to project sponsors either hedging against sustained lowered natural gas export prices, or playing into the sunk cost fallacy of submitting an application after already having expended the time and resources necessary to prepare it in the first place.Further expanding on the element of LNG export prices, the following chart presents the monthly prices of LNG exports from January 2005 through January 2022, with annual 2010-2016 average prices also presented over the time period.In light of the clear increase in LNG export prices during mid to late 2021, it may be slightly surprising that the number of applications in 2021 and in 2022 (so far) has not picked back up. However, a prior Energy Valuation Insights post noted that there were massive pullbacks in 2020 and 2021 capital expenditures throughout the oil and gas sector. Real growth projections for projected capital outlays in 2022 are modest as upstream operators remain focused on returning capital to shareholders, paired with maintenance level capital expenditures that will keep overall oil and gas production relatively flat or modestly higher. In addition, there are a number of outstanding final investment decisions (“FIDs”) to be made regarding the construction start for proposed facilities that have already received FERC approval. There are drilled but uncompleted (“DUC”) wells in the field – wells that are queued up to be put into action. Similarly, one may think of FERC-approved export terminal projects with outstanding FIDs as, “ready to roll”, relatively speaking, as compared to LNG export projects that still need regulatory approval. Approved LNG export terminal projects loom over potential new projects that may or would otherwise pursue FERC approval. In essence, the U.S. LNG export terminal market is relatively saturated with projects that could be started and put into operation fairly quickly as compared to new entrants still in the pre-application or pre-approval stages of project development. The development of already-approved projects would increase the capacity to supply global demand for U.S. LNG exports. This would likely tank the underlying economics supporting any new (yet-to-be-approved and pre-FID) projects; and not by virtue of poor planning on the part of project sponsors at the micro level or weak energy prices at the macro level, but rather due to the total timing of the approval process, an affirmative FID, and the construction and commissioning phases of project development. They would be showing up to register for the race right as everyone else was already taking off from the starting line. On that front, it’s worth taking a look at existing export capacity, total FERC-approved export capacity, and how that capacity may satisfy the demand for U.S. LNG exports.The Current State of AffairsHistorically, the U.S. has exported LNG to European markets, East Asian markets, and other markets, including within South America, the Caribbean, and within the past six years to parts of the Middle East, including Egypt, Israel, Jordan, and even Kuwait and the U.A.E. As presented in the following two charts, growth in export volumes to the Asian and European markets has far outpaced export volumes to the other markets. On a forward looking basis, projections of global natural trade by the EIA in its International Energy Outlook 2021 report indicate a natural gas deficit may be the norm over the next 30 years. (Negative values represent net exporters, with positive values representing net importers.)As it stands, total U.S. LNG export capacity is projected to grow approximately 13% from 14.0 Bcf/d at year-end 2021 to 15.9 Bcf/d by year-end 2022. LNG export volume at year-end 2021 was 9.8 Bcf/d (or 70% of capacity) and is projected to increase 17% to 11.5 Bcf/d by year-end 2022 (or 72% of projected export capacity). Regarding the export terminals themselves, eight were operational at year-end 2021, with one additional facility (Venture Global Calcasieu Pass) expected to be operational and delivering cargo by year-end 2022.Beyond 2022, export volume capacity is anticipated to increase rather sharply, reaching 38.5 Bcf/d (nearly 145% from year-end 2022) in 2027, indicating a compound annual growth rate of approximately 19% in export volume capacity over the prospective five-year period. These projected volumes only consider the 18 export facilities for which the project sponsors have provided an anticipated date of the projects’ operational status; they do not consider the incremental volumes stemming from a new terminals or capacity expansion projects for which it is unclear as to when the additional export capacity might come online. Clearly, the export capacity of U.S. LNG is primed to take off. But take off to where?As we saw in the chart above concerning global natural gas trade projections, with the U.S. presented clearly as a net exporter of natural gas, export volumes are anticipated to rise quickly to just over 18 Bcf/d by 2030, then slowly tick up annually, topping out at around 20 Bcf/d in 2045-2050.To put this in better context, the following chart summarizes the projected export capacity by region and year of anticipated operational status, as well as the projected annual LNG export volumes through 2031.Further detail regarding the export terminal facility and capacity expansion projects are provided in Appendices A and B. Based on the eye-ball test, it’s pretty clear that projected export capacity could far outstrip demand for U.S. LNG, based on the EIA’s export projections (as of early 2021), only if all that capacity were to come online. Free Market Economics 101 theory would indicate, rather decisively, that such excessive capacity would clearly not be worth building out given the export volumes projected as of early 2021. Then, on February 24, 2022, Russia – the largest supplier of LNG to Europe – invaded Ukraine. In Part 2 of our analysis on U.S. LNG Exports, we will take a closer look at the destination markets of U.S. LNG export cargoes, with a particular focus on Europe and its move away from Russian natural gas, and the commitment by the U.S. to help mitigate that transition while balancing its policies and goals aimed at addressing climate change. We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.Appendix A – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick here to expand the chart aboveAppendix B – U.S. LNG Terminals – Existing, Approved Not Yet Built, and ProposedClick Here to Read Part 2 of This SeriesIn part 2 we take a closer look at the destination markets of U.S. LNG export cargoes, with a particular focus on Europe and its move away from Russian natural gas, and the commitment by the U.S. to help mitigate that transition while balancing its policies and goals aimed at addressing climate change.

Statutory Fair Value vs Fair Market Value (and Fair Value): Not So Subtle Differences

Over the past year we have seen an uptick in transactions (and contemplated transactions) in which boards seek to reduce the number of shareholders via reverse stock splits and cash out mergers. The central question for a board aside from fairness and process is: what price?While the terms “fair market value” and “fair value” appear to be similar, they are very different concepts.When seeking a business valuation, it is critical to ensure that the appraisal is performed according to the relevant and proper standards.Transactional ValueFair market value (“FMV”) and fair value as defined in Accounting Standards Codification (“ASC”) 820 define value in the context of a market clearing price. Statutory fair value (“FV”) is defined in state statutes and is interpreted through precedents established in case law over the year, most notably in Delaware.The accounting profession defines fair value in 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.The accounting profession defines fair value from the seller’s perspective with the indicated value used for a variety of purposes including disclosure in financial statements for Level 1, 2, and 3 assets and liabilities.In the business valuation community, FMV is the most widely recognized valuation standard. FMV is the primary standard used in valuations for estate tax, gifting, and tax compliance.The IRS defines fair market value in Revenue Ruling 59-60 as:The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.What brings hypothetical, willing buyers and sellers to the intersection point of fair market value is their respective assessments and negotiations regarding the expected cash flows, risk, and growth associated with the subject interest. Depending on the corporate governance of the specific interest, fair market value also may incorporate discounts to reflect a business interest’s lack of control or lack of marketability. 1, 2Expropriated ValueStatutory fair value is governed by state law and interpreted by state courts in which dissenting shareholders to certain corporate transactions (e.g., a merger approved by a shareholder vote) petition the court for the fair value of their shares.Most state statutes provide appraisal rights that allow shareholders to obtain payment of the FV of their shares in the event of various corporate actions, including amendments to the articles of incorporation that reduce the number shares owned to a fraction of a share if the corporation has the right or obligation to repurchase the fractional share.In 1950, the Delaware Supreme Court offered this interpretation of fair value:“The basic concept of (fair) value under the appraisal statutes is that the (dissenting) stockholder is entitled to be paid for that which had been taken from him viz. his proportionate interest in a going concern. By value of the stockholder’s proportionate interest in the corporate enterprise is meant the true intrinsic value of his stock which has been taken by merger.”In effect, the noncontrolling shareholder who is dissenting to a transaction is entitled to his or her pro rata share of value of the company as interpreted in most jurisdictions. As a result, the controlling shareholder cannot expropriate value from the minority shareholder who is being forced out. Therefore, some state statutes explicitly declare and most case law affirms the view that neither a discount for lack of control and/or an illiquidity discount should be considered in determining fair value. 3While there is no official valuation hierarchy in the Delaware Court of Chancery, based upon a review of recent cases a few observations can be made:Unaffected stock price immediately before the transaction announcement in an efficient market (with regards to both volume and information) is the best indication of valueDeal price is a reliable indicator if the analysis excludes the benefit of synergiesNo recognized valuation methods have been ruled outThe discounted cash flow method is generally one of the preferred valuation methods if unable to observe efficient transaction prices that occurred before the transactionThe observations from Delaware case law about the meaning of statutory FV are reflected in some states’ business corporation act. For instance, FV according to the Guam Business Corporation Act §281301(d) shall be determined:Immediately before the effectuation of the corporate action to which the shareholder objects excluding any appreciation or depreciation in anticipation of the corporate action objected to;Using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; andWithout discounting for lack of marketability or minority status except, if appropriate, for amendments to the articles pursuant to §281302 (a)(5).Shown below is a graphic detailing the different levels of value and how we at Mercer Capital think about them in relation to fair value and fair market value.Controlling interest basis refers to the value of the enterprise as a whole and may be analyzed from two perspectives:Strategic Control Value is best described as Investment Value, based on individual investment requirements and expectations. The strategic control level of value is not generally consistent with FMV, in that it considers the motivations of a specific buyer as opposed to a hypothetical buyer. In other words, the “strategic control premium” is often deemed to be outside both the fair market value and statutory fair value standards. Most bank M&A deals take place at this level of value given cost save assumptions that are common in the industry. In a statutory fair value appraisal, deal value generally may not include the benefit of synergies.Financial Control Value is most often consistent with the fair market value and statutory fair value standards because (i) the underlying premise is a going concern; (ii) it typically does not include any premiums that might be paid by a buyer with specific motivations and the ability to implement synergistic structural and financial changes; and (iii) no minority interest or marketability discounts are applied.Marketable minority interest basis refers to the value of a minority interest, lacking control, but enjoying the benefit of liquidity as if it were freely tradable in an active market. The marketable minority level of value also is an enterprise level of value that may align with the financial control value.Nonmarketable minority interest basis refers to the value of a minority interest, lacking both control and market liquidity. The standard of value for a nonmarketable minority interest valuation is usually fair market value and is seldom statutory fair value.ConclusionMercer Capital has decades of experience working with boards of directors regarding statutory fair value in the context of transactions that create appraisal rights and dissenters’ rights. While we sometimes are called to assist in such matters once a transaction has occurred, it is better to address the issue of fair value (and fairness) beforehand. Please call if we can assist your institution.1 Valuation of Noncontrolling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes, page 8, Accessed Online March 31, 2022 | https://www.irs.gov/pub/irs-utl/S%20Corporation%20Valuation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf2 Statutory Fair Value, Accessed Online March 25, 2022, https://mercercapital.com/content/uploads/MerceCapital-Statutory-Fair-Value.pdf.3 Tri-Continental v. Battye, 74 A 2d 71, 72 (Delaware 1950)

What Happens to RIA EBITDA Multiples When Interest Rates Rise?

2021 may be remembered as both the busiest M&A year in history for the investment management industry, as well as the year in which valuation multiples in the space peaked. Transaction volume surged last year and carried into the first quarter, as deals negotiated during a period of cheap money, strong multiples, and the threat of changes in tax law drew both buyers and sellers to the negotiating table. Between Thanksgiving and New Year’s, however, we began to detect a change in the atmosphere for RIA valuations that, in hindsight, may prove to have been a turning point. It was around the same time that the topics of inflation and interest rates began to dominate the financial press, and it’s no coincidence. With the Fed in tightening mode, it’s time to question what impact the change in market conditions has for the investment management space.Many industry observers believe anticipated rate hikes will have little or no impact on the sector since most RIAs don’t have any debt on their balance sheets. While it’s true that most investment management firms do not employ leverage in their capital structure, rising rates will nonetheless have an impact on their cost of equity and, consequently, their valuations. We can illustrate this by way of a common decomposition of the most prevalent valuation metric in the RIA space, the EBITDA multiple.In the interest of simplicity, and to avoid trying to show side-by-side discounted cash flow models, we’ll use the EBITDA single period income capitalization method. We won’t dwell on every detail, but you can read more about it in a related article on our website.This method uses the capital asset pricing model (CAPM) to develop EBITDA multiples based on a company’s risk/growth profile, interest rate levels, and historical returns on publicly traded stocks. We’ve incorporated it here to determine what happens to EBITDA multiples when interest rates go up. This methodology is especially useful to the RIA industry because EBITDA is the most cited performance metric since AUM and revenue rules of thumb tend to vary with profitability. Further, EBITDA is usually a good proxy for cash flow when capital expenditures and interest payments are minimal.In the first example, we’ll demonstrate the impact of a 250 basis point increase in interest rates on EBITDA multiples for RIAs with no debt in their capital structure. We’ve assumed this increase based on an expected 2.5% increase in the Fed Funds Rate from the end of last year to the beginning of 2023 (year-ends depicted on the X-axis below). (Some are now anticipating a 300 bps increase.)A sample build-up in the cost of capital for an RIA might look something like the illustration below. The cost of equity is the sum of expected equity returns in excess of long-dated treasuries, plus a non-systemic, or company specific, risk premium. The cost of debt is typical of covenant-light loans from non-bank lenders to the space, set at a premium to some base rate, illustrated here as Libor. Most RIAs operate without debt, so the weighted average cost of capital, or WACC, is the same as the cost of equity. If you subtract expected growth in cash flow from the WACC, you’re left with a capitalization rate (the inverse of which is a multiple) applicable to debt-free net income. This can be grossed up by the firm’s effective tax rate to derive an EBIT multiple, and further adjusted for depreciation to derive an EBITDA multiple. In this case, the implied EBITDA multiple is one that would be familiar to many industry participants.Of course, this illustration derives an implied EBITDA multiple prior to expected increases in interest rates. As noted below, a 2.5% increase in the federal funds rate (which we’re using to approximate changes in the risk-free rate here) results in a 25% decrease in the EBITDA multiple (holding everything else constant) even though we’ve assumed no interest-bearing debt in the capital structure. The reason is higher interest rates raise an RIA’s cost of equity capital because investors in these businesses will require the same incremental return over riskless alternatives to induce investment, so a higher risk-free rate means a higher required return on RIA investments. Sellers will have to offer lower prices to satisfy a buyer’s need for an increased return, and the EBITDA multiple (assuming no changes in EBITDA) will fall with the transaction price.Last week we noted that RIA acquirers and aggregators now account for roughly half of the industry’s deal volume. Since these firms are responsible for a significant portion of the sector’s acquisitions, changes in their cost of capital will affect how much they’re willing to pay for RIAs and the resulting multiple for many industry transactions. In a rising interest rate (and cost of capital) environment, they’ll have to transact at lower prices to generate an ROI that justifies the investment.RIA consolidators typically use debt to purchase investment management firms, so their cost of capital can be viewed very differently than a pure-play RIA with little or no leverage. Aggregators employ debt financing because it’s cheaper (lower required rate of return) than equity capital, and interest rates have been hovering at historic lows until recently.The illustration above shows an 80/20 equity/debt capital ratio, which is more conservative than many consolidators have employed. Push the capital structure more toward the debt-side, and you’ll quickly get to the 20x or more multiples we’ve heard private consolidators use to describe their valuations.The higher the multiple, the greater the impact from rising interest rates. Unlike most investment management firms, rising interest rates adversely affects both debt and equity financing costs for RIA consolidators, so their cost of capital has likely gone up dramatically in recent months. If we illustrate that same 250 basis point increase in rates for a consolidator, the impact on EBITDA multiples increases proportionate to their leverage. In this instance, the two and half percentage point increase in rates cuts the EBITDA multiple by more than a third.A couple of weeks ago, we referenced that RIA aggregators had gotten off to a rough start in 2022. Our RIA aggregator index is off nearly 40% since November when the Fed first started signaling rate hikes to stave off inflationary pressures.Underlying EBITDA is also getting squeezed as labor costs rise and AUM falls with the fixed income and equity markets, and we’ll dive into that more next week.

E&P Capital Expenditures Set to Rise, but Remain Below Pre-Pandemic Levels

The upstream oil and gas sector is highly capital intensive; production requires expensive equipment and constant maintenance. Despite higher oil and gas prices, E&P operators have refrained from increasing capital investment and instead, are delivering cash to shareholders. This post explores recent capex trends in the oil & gas industry and the outlook for 2022 through 28 selected public companies.Historical and Projected Capital ExpendituresCapital expenditures, as measured by spending on property, plant, and equipment (PPE) has varied widely during the last five years. After the recent high in capital investment in 2019 of $138 billion, guideline group capex dropped 33.5% in 2020 to $91 billion. After minor growth from 2020 to 2021 on the order of 1.8%, capital expenditures are expected to ramp up investment to about $109 billion in 2022, representing a growth of 17.5% but still below pre-pandemic levels.Leading this growth, Exxon (XOM) is expected to increase capital expenditures by 44.0% to $17.4 billion in 2022, up from $12.1 billion in 2021. Chevron follows Exxon with an estimated $11 billion in capital spending for 2022, up 37.5% from 2021’s level of $8 billion. All in all, global integrated companies and E&P companies are expected to experience capex growth on the order of 26.3%, up from $71 billion in 2021 to $89 billion in 2022. The global guideline companies account for the lion’s share of total forecasted growth in capital spending, as summarized in the chart below.Appalachia Is Regional Leader in 2022 Capex Growth EstimatesThrough the lens of our company groups by region, the Appalachian Basin is expected to see the largest upswing in capital expenditures.This is by no means an exhaustive indication of growth by region, but it is indicative of the industry environment in Appalachia — capital expenditures are expected to total $5.4 billion in 2022 from the five major operators active in the area, up from $3.9 billion in 2021. As shown below, 2022 is set to be the first year of significant capital investment growth since 2018.Companies in the Eagle Ford are expected to increase capital spending modestly by about 12.6% to $5.1 billion, up from $4.5 billion in 2021. On the other hand, companies in the Bakken and Permian have lowered their capital plans after relatively high spending in 2021, representing a decrease of 52.8% and 15.0%, respectively. Cost Inflation Baked into 2022 Capex BudgetsWhile the expected rise in 2022 capital investment levels from 2021 is encouraging for the global supply of oil & gas, spectators need to acknowledge the effects of cost inflation in the estimates. According to the Bureau of Labor Statistics ' March Consumer Price Report, inflation has reached a four-decade high in March 2022 as the Consumer Price Index (“CPI”) rose 8.5% over the last 12 months. Cost inflation, by definition, will detract from operators’ “bang-for-the-buck,” and it is no secret that this is baked into 2022 capex estimates.“In this upcycle, investors have made it clear they wanted to see discipline from all players. So far, E&Ps for the most [part] are exhibiting capital discipline. A significant part of E&P capital spending growth this year (2022 versus 2021) will be consumed by cost inflation as the cost for all inputs continues to increase…” – Dallas Fed Respondent, Q1 Dallas Fed Energy SurveyMoreover, estimates are directly tied to operators’ budgets and management forecasts — which also commonly attribute rising capital expenditures levels within their budget to, among other things, inflation — a theme we covered in a previous blog post. This helps bridge the divide between rising capital investment budgets and the common industry theme of “capital discipline”.ConclusionCapital expenditures fluctuate as operators react to global marketplace demand for Oil & Gas commodities. After a recent low in 2020, capital investment is expected to pick up — rising by about 17.5% in 2022, after relatively stagnant growth in 2021. Rising capital expenditures are generally a precursor to increased production, which will likely help to alleviate the current imbalance of supply and demand of oil & gas in the global marketplace at some point. However, capital expenditures for 2022 are expected to trail pre-pandemic levels still, and rising inflation is eroding the value generated by those investment dollars.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss. your needs in confidence and learn more about how we can help you succeed.Appendix A – Selected Public Company Capital ExpendituresClick here to expand the chart above

RIA M&A Q1 2022 Transaction Update

RIA M&A activity continued to trend upward through the first quarter of 2022 even as potential macro headwinds for the industry emerged. Fidelity’s March 2022 Wealth Management M&A Transaction Report listed 58 deals in the first quarter, up 26% from the first quarter of 2021. These transactions represented $89.2 billion in AUM, down 2% from the prior year quarter.Deal volume continues to be led by serial acquirers and aggregators. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the quarter. This group of companies, along with other strategic acquirers and consolidators, have continued to increase their share of industry deal volume and now account for about half of all deals. In addition to driving overall industry deal volume, the proliferation of strategic acquiror and aggregator models has led to increased competition for deals throughout the industry, which has contributed to multiple expansion and shifts to more favorable deal terms for sellers in recent years. While deal activity remained robust, the first quarter this year was dominated by macro headlines like inflation, rising interest rates, tight labor markets, and multiple contraction in equity markets—all of which are factors that have potential to impact RIA performance and M&A activity. Rising costs and interest rates coupled with a declining fee base could lead to strain on highly-leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. While the duration and extent to which these trends will ultimately impact RIA M&A are still uncertain, recent pricing trends for publicly traded consolidators suggest that investors aren’t particularly optimistic about these models in the current environment. On the other side of the equation, historically tight labor markets and rising costs could amplify certain acquisition rationales like talent acquisition and back-office synergies. Structural trends continue to support M&A activity as well: the RIA industry remains highly fragmented and growing with over 13,000 registered firms and more money managers and advisors who are capable of setting up independent shops. As advisors age, succession needs will likely continue to bring sellers to market. Whatever net impact the current market conditions have on RIA M&A, it may take several months before the impact becomes apparent in reported deal volume given the often multi-month lag between deal negotiation, signing, and closing. But at least through March, transaction activity has remained steady. The Fidelity report lists 19 deals in March, a record level for the month and in line with the levels reported in January and February.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has continued to trend upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquiror models will likely continue to support higher multiples than the industry has been accustomed to in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions. For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions as they are in most transactions. But how the deal is financed is often an important secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling: After years of steadily increasing multiples and fundamental performance, RIA valuations are now at or near all-time highs. But whatever the market conditions when you go to sell, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a wide spectrum of buyer profiles has emerged to accommodate different seller motivations. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision, and one which can have a significant impact on personal and career satisfaction after the transaction closes.

Would Elon Musk Want to Buy Your Family Business?

"Twitter has extraordinary potential. I will unlock it." – Elon Musk Elon Musk, in Elon fashion, tweeted his SEC filing to acquire 100% of Twitter for $54.20, a 38% premium above the pre-announcement price. This is after Musk’s 9.1% stake in the company was revealed, followed by his rejection of a board seat, all accompanied by the public fanfare and consternation that generally follows the CEO of Tesla and SpaceX. The board of directors adopted a poison pill to prevent a takeover if Musk’s share in the company rises above 15%. Musk subtweeted a Goldman Sachs "sell" rating and price target of $30.00 on Twitter stock. Just another week at the office for Elon. What can family businesses learn from the current saga unfolding on social media and in the B-section of the Wall Street Journal? Through the memes and tweets, we see two areas family businesses should keep top of mind related to Musk’s offer to take the helm of what he sees as a sinking ship: 1) don’t stay stagnant and 2) stay true to your business meaning.Don’t Stay StagnantHow does your family company avoid being left behind? We have written on diversification numerous times at the Family Business Director. We understand you have to focus on your core competencies, no matter your business, and too many new initiatives can distract you and your company’s key proposition to the market. Twitter has a robust digital infrastructure and owns the "breaking news" space for quick online dissemination. It’s the de facto "public square" for debate in the digital age, and even a begrudging social media user (like myself) has an account in order to be plugged into the most up-to-date news.But there is a balance – a look at Twitter’s diversification reveals a surprising lack thereof for a tech company whose peers include Facebook, Instagram, Tik Tok, and non-social media FAANG stocks. Over nearly a decade, the platform has remained essentially unchanged, with its most significant innovation being doubling the number of characters permitted per tweet. Family businesses with a strong core offering/product are often tempted to rest on their laurels, but unless they diversify intelligently around the core, they will not be able to fully unlock the potential value in the business.Stay True to Your Business MeaningIn our experience, families tend to assign one of four basic meanings to their family business:Economic growth engineStore of valueSource of wealth accumulationSource of lifestyle Readers of Family Business Director will be familiar with these concepts, but in sticking with the Twitter theme of TL;DR (that’s "Too long, didn’t read"), the idea is that your family business’ appetite for growth and investment relative to current income and capital preservation depends on what meaning your family assigns to the business. Twitter shareholders likely view their investment as a growth engine – or at least a part of their "growth" portfolio. Taking a look at the scoreboard (stock price), returns from Twitter have failed to materialize. From its IPO price of $26 in 2013 to today ($48 at writing time), Twitter has had stock appreciation of over 7% annually. If you didn’t snatch up any IPO shares and bought in at its closing day one price ($44.90), you’ve had almost no return. Dropping the recent Elon meme-induced buzz, the return drops to negative. In terms of returns to investors – Kevin O’Leary, aka "Mr. Wonderful" of Shark Tank fame, leveled this nuanced take on Twitter’s performance, "You know there’s Dante’s Hell, and at the very bottom of that is Twitter." Facebook, Instagram, Tik Tok, and other social media peers have far exceeded Twitter's performance because they have focused on diversifying their offerings, freshening their platforms, and investing in R&D – all characteristics of growth engines. Operating your family business as an economic growth engine for future generations requires a different attitude toward risk, investment, and innovation than "store of value" or "source of lifestyle" businesses. Growth engine companies take advantage of investment opportunities and focus on the future. Musk sees that Twitter has failed to do that. We understand that for many enterprising families, a greater focus on capital preservation and current income provides a better fit. In any event, the same general rule applies: Family businesses should make capital allocation decisions that fit their company’s meaning. For example, is your company in a mature manufacturing space with a shareholder base focused on dividends? Then don’t finance a risky acquisition with debt that restricts returns to shareholders. Remembering what the family business means to the family keeps your decisions grounded within a framework that ultimately benefits the company and its shareholders.Where Can We Unlock Value?Beyond the more grandiose ideas of free speech and censorship, Musk is a savvy investor and wants to buy Twitter because he thinks it is poorly run. The world’s richest man sees locked-up value in the business, but management and leadership won’t get out of the way. Sound familiar? We hope not.Family business directors: Where would Musk see opportunities to run your family business better?Give one of our family business professionals a call today for help with unlocking value for your shareholders today.

Values Up, Valuations Flat?

As the Inventory Shortage Persists, Dealers Are Getting More Credit for Their Outperformance

Pre-COVID and chip shortage, it would be no surprise if Blue Sky multiples remained stable over numerous quarters for many brands. As seen in the charts later in this post, multiples normally don’t tend to shift dramatically on a quarterly basis. Multiples are dependent on numerous factors, though brand desirability is chief among them. This is usually tied to product lineup and the overall effectiveness of the OEM.In 2020, the economic shock to the economy borne by the COVID-19 pandemic caused Blue Sky multiples to oscillate in near lockstep, regardless of brand. While multiples changed on a quarterly basis throughout 2020, notably, so did the earnings stream to which buyers applied the Blue Sky multiples. As the chip shortage and lack of inventory have persisted into 2022, auto dealers are getting more credit for recent outperformance as earnings rise steadily.According to Haig Partners, buyers have historically focused on adjusted profits from the last twelve months, which has been viewed as the best indication of expectations for the following year. Since the onset of the pandemic, as expectations have been much more dynamic, the earnings stream to determine ongoing expectations has shifted.Throughout most of 2020, Haig’s Blue Sky multiples were applied to 2019 earnings as these were viewed as the best indication of a dealership’s “run rate” prior to any negative COVID impact. When profitability improved and uncertainty began to decline around June 2020, multiples applied on these 2019 earnings rebounded. Throughout the latter half of 2020, it became clear that the pandemic positively impacted earnings. Most dealers significantly outpaced pre-COVID results, despite a month or two of nearly stand-still operations.In late 2020 and into 2021, Haig reports that buyers were using a three-year average of adjusted profits from 2018, 2019, and LTM ’20 or ’21, or two years of pre-pandemic results and one year of outperformance. The prevailing thought was that the outperformance due to COVID would eventually normalize, and buyers didn’t want to overpay for dealerships that may not be able to repeat these earnings in the future.Now in 2022, Haig reports that buyers are ready to acknowledge that not only have earnings continuously increased, but the inventory shortages show no signs of abating. As we’ve noted for months, industry players have continuously said the situation should normalize in the next 6-9 months. But they’ve been saying that since about February 2021, or 14 months ago.If you only look at the Blue Sky multiples from the Haig reports, you’re missing the bigger picture because valuations (multiples) may be flat, but values are up.As we sit here today, the outlook is still uncertain, but I personally wouldn’t have extreme confidence to say operating conditions or earnings will normalize in 2022. The lead time to meaningfully increase microchip production is clearly long, and with record profits for dealers and manufacturers, OEMs aren’t necessarily incentivized to change the status quo. Demand for personal vehicles is certainly more inelastic than the market previously indicated.If you only look at the Blue Sky multiples from the Haig reports, you’re missing the bigger picture because valuations (multiples) may be flat, but values are up. With earnings steadily increasing, Blue Sky values have followed the same path. That’s why it’s important to understand what level of earnings are being applied to the multiple.Illustrative Example: HondaTo show the path of Blue Sky values since the onset of the pandemic, we’re going to take pre-tax earnings for average import dealerships as reported by NADA and apply them to the appropriate multiple. Last year, we did this analysis for Lexus, so we’re switching from Luxury to Mid-Line Import. We also thought earnings would normalize, yet it has gone the opposite direction in the past year. Unfortunately, due to licensing issues, NADA no longer posts monthly dealer financial data on its website, so our analysis is only based on what we had previously saved, and we must use some extrapolations.In Q4 2019, Haig Partners reported a Blue Sky multiple range of 5.5x to 6.5x for Honda dealerships (tied with Toyota for the highest multiple for import dealerships). With 2019 pre-tax earnings of $1.66 million for the average import dealership, the implied Blue Sky value for the average Honda franchise would range between $9.1 million and $10.8 million. In Q1 2020, the multiple declined by 0.50x on the top and bottom end, dropping implied Blue Sky values to a range of $8.3 million to $9.9 million.By year-end 2020, multiples and earnings each increased significantly, and Honda was up to a range of 6x-7x, or $11.1 million to $12.9 million based on a 3-year average pre-tax earnings of $1.84 million. Through a tumultuous year, the multiple landed a half-turn higher than Q4 2019, and earnings were up 39.9%. Even using the 3-year average, “ongoing” earnings at year-end 2020 were up 11.2% from 2019. As seen on the chart above, Honda’s reported Blue Sky multiples have been unchanged since Q3 2020 at a range of 6x-7x. But from Q3 2020 to Q3 2021, earnings more than doubled, and 3-year average earnings increased 51% from $1.67 million to $2.52 million. Multiplying by the mid-point of the range, Blue Sky values increased from $10.9 million to $16.4 million. In Haig’s Q4 2021 report, ongoing earnings are now expected to be based on 2019, 2020, and 2021 earnings. With 2021 performance more than double 2018 earnings for import dealerships, this change in methodology further increases ongoing earnings. Based on our estimate of 2021 earnings, the average Honda dealership would fetch $18.6 million in Blue Sky or double its value from Q1 2020. While the mid-point multiple has only increased from 5.5x to 6.5x, ongoing earnings increased from $1.66 million to $2.86 million.Even in what has been perceived as a seller’s market, buyers of auto dealerships have likely done pretty well in their first year of ownership.We consider a hypothetical transaction to further illustrate how Blue Sky values have exploded. If a Honda dealership was sold in January 2021 at the prevailing mid-point Blue Sky multiple of 6.5x applied to 3-year average earnings of 2018, 2019, and 2020, the seller would’ve received just under $12.0 million in Blue Sky. The buyer’s first year of earnings in 2021 would be an estimated $4.44 million, way above the “ongoing” expectation. While nobody expects 2021 performance to be earnings into perpetuity, the implied Blue Sky multiple of that transaction was only 2.7x, or lower than any reported Blue Sky multiple range. While few could predict what would happen in 2021, the hypothetical buyer above was a clear winner. While there are numerous doomsday scenarios for dealers these days about longer-term perspectives, I would think twice before selling my largest investment while at peak cash flows that I felt I had some control over if I wasn’t getting well compensated. Even in what has been perceived as a seller’s market, buyers of auto dealerships have likely done pretty well in their first year of ownership. Below, we observe how Blue Sky multiples have changed over the past five years. However, as we’ve illustrated above, the recent lack of movement is not indicative of stagnant Blue Sky values.Blue Sky Multiples: Luxury BrandsAfter three straight quarters of changes in 2020, not a single luxury dealership saw a change in its multiple range, though as highlighted above with imports, dealership values have taken off. After years of only reporting a value range due to a lack of profitability, Cadillac dealerships are now reported at a range of 3x-4x and will be included in future graphs. This multiple range is in line with Acura as the lowest for luxury dealerships. Despite being luxury brands, 3-4x is the lowest reported multiple range, in line with VW and Mazda, which have had their fair share of struggles in recent years.Blue Sky Multiples: Mid-Line Import BrandsFour of the eight Mid-Line Imports multiples improved in the second half of 2021. In Q3 2021, Kia and Hyundai multiples increased 0.5x to 3.75x-4.75x, further distancing these dealerships from the lower half of the mid-line imports (VW, Mazda, and Nissan) though as seen in the graph below, still well below Toyota, Honda, and Subaru. Nissan’s multiple also ticked up 0.25x in Q3 2021, making it slightly more desirable than VW and Mazda.Toyota was the only brand to see a change in its multiple in Q4 2021, modestly increasing its lead at the top of the group at 6.5x-7.5x. Toyota dealerships now fetch just higher valuations than Audi and Jaguar-Land Rover dealerships. While they don’t sell luxury vehicles, Toyotas are definitely viewed as dependable vehicles which consumers can appreciate. Toyota has also taken a balanced approach in terms of EV adoption, which makes sense for the company that really pioneered the hybrid approach with its Prius in the early 2000’s.Blue Sky Multiples: Domestic BrandsDomestic franchise multiples have not changed in the past year, all generally above the lackluster mid-line imports but well below other players. One would think that supply chain constraints would negatively impact import brands more than their domestic counterparts. However, the past year has demonstrated that even domestic brands rely heavily on the global supply chain for their inputs, particularly microchips.In the last five years, Stellantis dealerships have seen their multiples modestly improve, while Ford, Chevy, and Buick-GMC are all down. Only Audi shows a decline in the past five years while Acura, Honda, and Mazda are unchanged and everyone else has seen their multiples increase. While domestic dealerships have not received high Blue Sky multiples, they have been well positioned for the shift from cars to trucks, and heightened earnings across the board is likely to lead to greater return on investment for dealerships that trade at lower multiples.ConclusionBlue Sky multiples provide a useful way to understand the intangible value of a dealership. These multiples provide context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t directly determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. The resulting price they are willing to pay can then be communicated and evaluated through a Blue Sky multiple. If a dealer feels they are being reasonably compensated, they may choose to sell. As demonstrated in this post, earnings expectations can be significantly different from actual results.For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key value drivers. We also help our dealer clients understand how their dealership may or may not fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Wealth Management Trend Lines May Be Rolling Over

After a Great Year, Higher Rates and Weaker Markets Threaten Continued Growth

While wealth management continues to benefit from demographic trends in the U.S. and the general accumulation of investible assets during the pandemic, 2022 is proving to be somewhat more difficult for the sector, and sentiment among investors in wealth management firms has dimmed.Public firms with substantial operations in the wealth management space have been underperforming alt asset managers and the broader market, and aggregator models like Focus Financial and CI Financial (whose share prices currently trade at 52-week lows) will need organic growth to overcome sluggish financial markets, fee pressure, and higher interest rates. Recent market activity is a strong contrast to the uptrend seen for much of 2021. Prices for aggregator models accelerated into December of last year, peaking as transaction activity in the space hit a fever pitch, fueled by higher multiples and the threat of changes in tax law that would make selling after year-end potentially disadvantageous. The annual Schwab survey of wealth management firms confirmed this bullish sentiment, with advisors generally more optimistic about industry growth prospects than they were a year earlier.Source: June 2021 Schwab Advisor Services Independent Advisor Outlook StudyIt’s noteworthy that the survey represents sentiment in mid-summer. In the nine months that have transpired since the survey was taken, the market has had to digest higher inflation, a new uptrend in global interest rates, the Federal Reserve shrinking its balance sheet, and the war in Ukraine. The survey to be taken in 2022 could prove less sanguine.Despite all of the media attention given to consolidation activity in the wealth management sector, it’s noteworthy that the advisors surveyed by Schwab saw ample opportunity to grow their firms organically, with less than 10% of expected growth coming from recruiting or M&A.Also noteworthy is a generally positive look back at the impact of the COVID pandemic on the wealth management industry, with most firms reporting better performance working remotely than expected. Many firms found opportunities for efficiency in video calls, better staff utilization by cutting staff community times, and expense saving opportunities by cuts in travel costs and office space.Technology investment is a continued theme in the wealth management space, as firms look to new resources for investment management, client management, and firm management to improve service and efficiency. Most firms expect technology spending to increase in 2022, and some view it as a way to overcome staffing challenges presented by tremendous growth in clients and lack of available talent.By the spring of 2022, many of the industry trends facing and favoring wealth managers started to shift, threatening margins and valuations.Higher interest rates are undermining valuations in both debt and equity markets, taking an unusually strong toll on everything from U.S. treasuries to tech stocks. This shift creates a downward gravitational pull on assets under management, and therefore revenue, for wealth management firms. At the same time, inflationary forces are pushing up on both labor and non-labor expenses for RIAs. The consequence could be challenging for margins in 2022 and could deflate some of the positive influences on profitability that have provided a tailwind to RIA valuations for several years.Valuations may ultimately suffer as well because of higher interest rates, as other income producing assets provide an alternative to investing in RIAs, and the cost of capital increases on both the equity and debt sides of the equation for leveraged consolidators of wealth management firms.

Oilfield Water Markets

Update, Trends, and the Future

The Oilfield Services (“OFS”) industry has long been known for its cyclicality, sharp changes in “direction” and demand-driven technological innovation. One segment of the OFS industry that is among those most subject to recent, rapid change is the Oilfield Water segment – including water supply, use, production, infrastructure, recycling and disposal. In this week’s Energy Valuation Insights blog, we look to key areas of the Oilfield Water segment – oilfield water disposal and oilfield water recycling – and address both recent trends and where the segment is going in the near-future.Oilfield Water DisposalThe oilfield water disposal (saltwater disposal) industry remains dynamic with numerous forces driving change. Key among those forces are volume demand, growth in water recycling and rising seismic activity in key shale basins. With the rebound in oil prices since 2020, demand for oilfield water disposal has rebounded as well. While oilfield water recycling continues to grow rapidly in volume, there remains a very significant imbalance between produced water and recycling volumes. The portion of produced water that is being recycled was estimated at 20%, per Dr. Chris Harich, Chief Operating Officer at XRI during his presentation at the recent Oilfield Water Markets Conference (“OWMC”).Additional recent factors impacting the saltwater disposal (“SWD”) industry, particularly in prominent U.S. shale plays in Oklahoma, Texas and New Mexico, is the distinct increase in seismic events that are attributed to oilfield production and waste disposal activity. In September 2021, the Texas Railroad Commission initiated added reporting, permitted volume reductions and even cessation of operations of certain SWDs near high seismic activity areas, referred to as seismic response areas (“SRA”). As a result of the rising demand for oilfield water disposal capacity and reduced disposal availability in certain areas, Kelly Bennett, CEO & Co-Founder of B3 Insight, expects (i) disposal capacity to remain far below produced water volume through 2026, (ii) increased demand for additional SWD facilities and a race for development of shallow SWDs, (iii) more produced water being transported outside of production areas for disposal, and (iv) a resulting rise in water management costs to producers.In regard to the use of shallow SWD wells, one OWMC panel (including Gauri Potdar, SVP Strategy Analytics at H2O Midstream; Laura Capper, President of Energy Makers Advisory; Max Harris, Director at EIV Capital; and Ken Nelson, President & Co-Founder of Blue Delta Energy) noted that shallow depth SWD activity can interfere with production activity in the immediate area, inherently leading area producers to push back against shallow SWD development projects.Finally, how to finance projects providing additional oilfield water disposal capacity comes with challenges not faced in many other industries. Bennett noted that as a dynamic industry that seems to be becoming even more dynamic, financing considerations are becoming even more complicated in recent years.Oilfield Water RecyclingOn the recycling side of oilfield water management, the complications aren’t any easier to deal with. While demand for oilfield water recycling is certainly on the rise, the headwinds to providing recycling services are many and naturally push upward on the cost of recycling services. However, as with most challenges in the oilfield services industry, new technology and innovation are expected to drive industry participants to overcome the inherent barriers.Notable among the oilfield water recycling headwinds are cost, lack of detailed information as to needed recycling volumes, the need for disposal of certain by-products of recycling, and landowners that are economically predisposed against recycling. The cost of recycling services likely needs no explanation; however, the logic as to the other headwinds may not be quite as obvious.The OWMC’s panel on the Mechanics of Recycling at Scale (including Jason Jennaro, CEO of Breakwater Energy Partners; Dr. Chris Harich; David Skodak, SVP Water Treatment at CarboNet; Ryan Hassler, Senior Analyst with Rystad Energy; and Joseph De Almeida, Director Water Strategy & Technology at Occidental Oil and Gas), noted that currently there are no oilfield water recycling reporting requirements. As such, potential recycling project developers have to deal with somewhat rough estimates as to demand volume, rather than a more concrete indication as to the recycled water volume potential in a particular production area. As with any potential investment, less specificity as to the potential market for services is “read” as greater risk, thereby providing greater uncertainty to project investment.As to byproducts of oilfield water recycling, one only has to go as far as the industry name for the liquid being recycled – saltwater. Yes, by volume, salt is logically one of the primary byproducts of saltwater recycling. In the Permian Basin, already known for its high produced water to oil cuts, salt content is higher than found in other basins resulting in higher recycling costs due to the sheer volume of salt byproduct and driving up the cost of capital for development.The last headwind referenced is the economic motivation of landowners in the production area. The OWMC’s panel on Engaging Landowners (including Rick McCurdy, VP-Innovation & Sustainability at Select Energy Services; Brian Bohm, Sustainability Manager with Apache Corp; Nate Alleman, HSE and Water Infrastructure Specialist at ALL Consulting; Matthias Bloennigen, Director – Consulting with Wood Mackenzie; and Jason Modglin, President of Texas Alliance of Energy Producers) noted that landowners are often compensated to supply water for oilfield exploration and/or production use, or for use of their property in the disposal of saltwater. As such, these landowners naturally aren’t in favor of the development of water recycling projects that are viewed as cutting into the fees they are being paid under existing contracts.Recycling SolutionsDespite the abundance of recycling headwinds, expectations are that all will be successfully addressed and overcome by the innovation of industry participants. Costs can be reduced by various means including the extraction of certain rare metals commonly found in produced water, use of flare gas as an inexpensive energy source for recycling operations, the development of recycling equipment that can be readily relocated, and greater cooperation in water management asset “sharing” between basin operators. In addition, increased recycling reporting requirements can assist in reducing some of the risk inherent in recycling projects and landowners can be educated as to recycling being a complementary service to existing water supply and disposal operations, thereby decreasing the natural resistance to recycling projects.ConclusionAs has always been true of the OFS industry, change brings challenges – and that is no different in the Oilfield Water segment. The dynamics of oilfield water disposal and oilfield water recycling continue to evolve, but the OFS industry has a long history of addressing and conquering its challenges, and there’s no reason to doubt the current challenges will also be conquered.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers, and Big 4 Auditors. These energy-related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Is Redemption a Four-Letter Word?

As recently noted in the Wall Street Journal, large public companies are announcing share repurchase programs at a record pace. And, yes, the article includes the usual hand wringing about whether buybacks are “good.” We tend to think that – for public companies – share repurchases are neither good nor bad in themselves. Individual share repurchases may, of course, be ill-advised if, for example, the repurchase price proves to be too high, the resulting leverage imperils the company’s future, or the repurchase crowds out other uses of capital that would generate a superior return. But there is nothing inherently good or bad about share repurchases as such. Repurchasing shares is one of two options companies have for returning capital to shareholders and doesn't need to carry any philosophical or emotional weight beyond that. For some reason, we don’t recall ever seeing articles bemoaning the level of dividends being paid by public companies.For both public and private companies, share repurchases occupy the same place in the cash flow waterfall, as depicted in Exhibit 1 below. The operating cash flow of any business (after being either supplemented or depleted by net borrowings or repayments of debt) will be used to do one of three things: (1) add to the company’s cash reserves, (2) be reinvested in productive capital assets, or (3) provide a return of capital to shareholders. The relative proportions of these three uses depend on many company-specific factors including the risk tolerance of the shareholders, the available capital investment opportunities, and the return preferences of shareholders. Whether paid as a dividend to all shareholders, or used to repurchase the shares of some, both strategies are essentially a return of capital. As the news stories consistently point out, share redemptions compete for cash flow with capital investment and cash accumulation. So do dividends. Like many issues, what is straightforward for public companies becomes a bit more complicated for family businesses. Two factors in particular increase the degree of difficulty for family businesses. First, the motivation for redemptions can be complicated by personal relationships. Second, price is not a given as it is for public companies.Motivation for RedemptionsWho is the villain here? Too often, families assume that a redemption transaction is a sign of failure and that if there is a redemption there must be a “bad guy.” This does not need to be the case. Shareholder redemptions are not a sign of failure, they are a sign that different family shareholders have different economic profiles, risk tolerances, and return preferences. While those differences are occasionally rooted in some lingering irrational emotional baggage, our experience is that such cases are less common than one might assume. Those circumstances grab the headlines, but most redemption transactions are far more mundane.Shareholder redemptions are not a sign of failure, they are a sign that different family shareholders have different economic profiles, risk tolerances, and return preferences.As family businesses mature and shareholders multiply, it is only natural that being a member of the family doesn’t necessarily mean it makes sense for someone to be a shareholder. Taking the emotion out of redemption transactions is the first step to arriving at a healthy outcome: a share redemption is a targeted return of capital that allows family businesses to provide a better “fit” to the economic characteristics of family shareholders. No shame in that.Price, Value, and the Art of the PossibleThe terms of any shareholder redemption transaction include, at a minimum, the number of shares to be redeemed and the price per share to be paid. For public companies, the price is uncontroversial, because the market provides the price every day. The company is no different than any other buyer. In fact, sellers don’t even know if they are selling their shares to another investor or back to the company. And they don’t care.Without the daily market mechanism, family businesses face a bigger challenge in setting prices. Not only is there no market transparency regarding the value of the company, but the absence of a liquid market for the shares means that the value of the shares to the shareholder is different than the value of the shares to the company.All else equal, investors prefer ready liquidity. From the perspective of individual minority shareholders in the family business, such liquidity is lacking, which means that the value of those shares to them is impaired relative to the value if the company were publicly-traded. We refer to this decrement to value as the marketability discount, and these discounts are often on the order of 20% to 40% of the “as-if-freely-traded” value of the shares. But the family business is not just any other buyer for the shares – unlike individual family shareholders, the corporate treasury doesn’t really bear the economic burden of illiquidity. So, the shares are effectively worth more to the company than they are to the selling shareholders. Viewed positively, this opens up a range for fruitful negotiations; viewed negatively, this opens up a range for family dysfunction.A qualified business valuation can establish the range, but it cannot identify the right price for the transaction.A qualified business valuation can establish the range, but it cannot identify the right price for the transaction. It is up to the family business and the selling shareholders to identify the optimal price within the negotiating range at which to execute a share redemption that accomplishes the goals of the redemption transaction. This moves the discussion from the “science” of valuation approaches, methods, and inputs to the “art” of the possible.In a future post, we will offer some thoughts on the “art” of the possible, but for now, it will have to suffice to say that successful share redemptions in family businesses are not as rare as you might think, but do require a heavy dose of good faith, a short memory for personal slights (real or perceived), and the ability to keep the end goal in mind throughout the process.

March 2022 SAAR

The March 2022 SAAR was 13.3 million units, down 5.3% from 14.1 million in February and down 24.4% from March 2021's SAAR of 17.6 million units. This drop in the SAAR is a product of several factors, one being the low magnitude of the seasonal adjustment. The seasonal adjustment in this month's SAAR is minimal compared to adjustments made in January and February, as March is typically a bigger selling month in the automotive industry (See below for unadjusted total sales numbers).Also pulling the SAAR down is production stoppages, as the production of new cars and trucks continues to be limited in the wake of ongoing supply-chain issues and global shocks from the war in Ukraine. More detail on the specifics of auto supply-chain headlines is included later on in this post.Seasonal AdjustmentTotal unadjusted sales over the past month were certainly low compared to previous years, except March 2020 when the COVID-19 pandemic shook up the world economy. Declining sales are not due to a lack of consumer demand, which has been elevated since mid-2021. In fact, consistently heightened demand for vehicles has kept incentive spending low (all-time low of $1,044/Vehicle) and average transaction prices high (March record of $43,737) over the last month.High sticker prices have increased the average monthly vehicle payment to $658, up 12.4% from this month last year. Rising interest rates in the last several months have compounded the issue, making the purchase of a new vehicle that much more expensive for consumers. Vehicle payments have not increased at quite the rate of sticker prices due to higher trade-in equity values, up 81.3% per vehicle from March 2021.These conditions come as no surprise. When asked about the last month prior to the SAAR data release, Thomas King, president of the data and analytics division at J.D. Power, commented, "Typically, March is a high-volume sales month with elevated promotional activity because it marks the end of the fiscal year for some manufacturers and the close of the first quarter for others. In March 2021, consumers purchased almost 1.4 million new vehicles at retail. This year, with fewer than 900,000 units in inventory, it will be impossible for the sale pace to even approach last year's level. Given the strong demand and extremely constrained inventory situation, it should be no surprise that manufacturer discounts are at their lowest level ever, while prices and profitability set records for the month of March."Industry-wide inventory balances for February were released this month, and they revealed virtually no change from the status quo. The industry Inventory/Sales ratio saw a modest increase, but the uptick was primarily due to decreased sales rather than increased inventory. When looking into the individual components of auto inventory in the U.S., domestic auto production and the number of imported vehicles both decreased, making for an all-around lack of vehicles available to auto dealers and their customers.The War in Ukraine and the Auto Supply ChainRussia's invasion of Ukraine and the resulting economic sanctions and reverberations are the latest global events to rock supply chains. The United States government has talked of reeling back globalization in an effort to reduce dependencies on China and Russia in a number of strategically important industries. President Biden has also announced a release of 180 million barrels of oil from U.S. reserves in response to rising fuel prices, given Russia's place in the oil and gas industry. Furthermore, microchip facilities are under construction across the U.S. as the country makes a concerted effort to become less dependent on off-shore micro-chip producers, which pre-dates the Russian invasion of Ukraine but is certainly relevant. As we've discussed before, there is a long lead time to producing microchips, meaning it will still take a while to increase domestic production meaningfully.Some analysts are projecting around 1.5 million lost units in 2022 as a result of shutdowns, while others are projecting up to 3 million lost vehicles.To focus on the auto industry in particular, automakers are facing their third supply-chain crisis in the past three years. On a global scale, European auto manufacturers like Volkswagen are being forced to shut down facilities. The company released a statement saying that "With the extensive interruption of business activities in Russia, the executive board is reviewing the consequences of the overall situation during this period of great uncertainty and upheaval." The fallout is not limited to Europe either, as Toyota, Ford, and Hyundai shut down plants in response to the conflict and have echoed sentiments of uncertainty. According to the Wall Street Journal, some analysts are projecting around 1.5 million lost units in 2022 as a result of these shutdowns, while others are projecting up to 3 million lost vehicles. The point is that visibility is very low.European OEM facility shutdowns are not the only repercussion of the conflict in Ukraine. Dozens of auto parts makers shut down facilities in the country as well, setting up a ripple effect that could impact automotive plants in every corner of the globe. For example, Ukraine has become a key supplier of electrical wiring assemblies. Western Ukraine is an attractive location for making wiring harnesses and cable assemblies because of the local workforce's relatively high quality and low cost (it is a labor-intensive activity). It is also geographically situated as a hub between manufacturing plants in Germany and Asia. Likewise, many raw materials used in the production of vehicles are sourced from Ukraine. Oil (used in countless processes) and neon gas (used in the production of microchips) are the two most relevant newly restricted raw materials in the automotive industry.There is no reliable estimate as to when these supply lines will be re-opened, and the timetable seems long and uncertain to say the least.Logistical issues have also been magnified amid the invasion. Train, plane, and boating connections have been disrupted or halted in the region, adding additional costs to an already elevated logistics pricing environment. There is no reliable estimate as to when these supply lines will be re-opened, and the timetable seems long and uncertain to say the least.Another consideration relevant to the automotive industry has to do with trade policy and the global presence of automakers. Since the invasion began, several OEMs like General Motors have gotten out of Russia (financially and physically). The decision to back out of the country came as several corporations across many industries (seemingly) came together to sanction and exclude Russia from economic activity. Many of these companies probably viewed their Russian investments as losing bets once the war started. These actions by OEMs raise an important question: will the doctrine of globalization in auto finally decline after the dust has settled? If that turns out to be the case, will any automakers move back into Russia after the war is over to seize an opportunity?April 2022 OutlookMercer Capital's outlook for the April 2022 SAAR is pessimistic and consistent with the last several months. Industry supply chain conditions continue to worsen and are expected to decline before they get better. Sales volumes will likely continue to be closely tied to production volumes as vehicles leave lots within days of arrival. Elevated profitability across the entire industry will likely continue as high prices boost margins on vehicle sales. Stay tuned for more updates on next month's SAAR blog.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Private Oil Company Values Are Readying For Take Off: While Publics Remain On Runway

As the term “energy security” comes back into the public lexicon, the values of U.S. oil companies are rising. This comes at the delight of some and chagrin of others. Regardless, it represents a foreshadowing of a potential longer-term cycle; whereby U.S. oil production being able to meet energy demands will be increasingly important. Many believe the U.S. is now the world’s “swing” producer (although John Hess disagrees), and it is not due to government action (or inaction). Biden’s third SPR release in the last six months is largely symbolic and more of a political gesture than a meaningful macro-economic needle mover. Demand and supply were drifting apart before Russia’s invasion of Ukraine and this geopolitical dynamic has only widened that gap. The market participants best positioned to seize upon this unexpected gap are private U.S. operators.The current price expectations of oil make a lot of reserves economically attractive. The rate of return on capital deployed for drilling is going to (if not already) outstrip the demand for other capital deployment options such as dividends or debt repayment. However, most U.S. public companies are not shifting their strategies.Domestic Dynamics (Not Russia’s) Keeping Public Valuations Relatively GroundedAs I have written before, shareholders have demanded returns from oil companies for years now in forms other than production growth. Oil company valuation in its fundamental form is a function of the present value of future cash flows. Therefore, if capital available today is best served in drilling more wells tomorrow, then production growth is the most efficient path to a higher value. At historical prices from a year ago, the decision to return more capital to shareholders (as opposed to deploying it in capex) made sense. It doesn’t now. However, public companies have yet to change the courses they’ve been setting for the past several years. That’s partly why the public sector (using XOP as a proxy) only rose 62% in the past year while prices nearly doubled. Demand is strong with the anticipated depletion of Russian oil on world markets. U.S. capital budgets would have to quadruple by the end of 2024 for shale to replace Russian oil exports to continental Europe according to Wells Fargo. In addition, break even prices in most basins for new wells are still around where they were a year ago according to the Dallas Fed Survey. That cost is going up and will continue to, but there is still lots of room for profitability at over $100 per barrel. Also, as I have mentioned before as well, DUC wells continue to shrink. In summary, there are a lot of signals to public companies to “drill baby drill”, yet they aren’t. To be fair there are some caution signs on the horizon that should be considered and are baked into these public valuations. First, the futures curve is still backwardated, meaning that prices are anticipated to fall in the future (not rise). However, even the long-term NYMEX curveis still over $70 in four years, which is still profitable for a lot of reserve inventory. Second, new wells drilled today appear to be less productive. The EIA’s drilling productivity report shows that new well production per rig is going down (although they acknowledge that metric is “unstable” right now). Lastly oilfield services markets have become very tight: “ Labor and equipment shortages, along with inflation in oil country tubular goods and shortages of key equipment and materials, will limit growth in our business and U.S. oil production. In particular, truck drivers are in critical shortage, perhaps due to competition from delivery services.” – Dallas Fed Survey RespondentPrivate Companies Take To The FrontEnter the private oil companies. If forecasts suggest the U.S. can add between 600,000 and 800,000 barrels of oil by the end of the year (EIA says this can be 760,000) then the path to get there will be through the drill bits of private and private equity backed producers. According to an Enverus Report cited by Hart Energy, these types of operators have assumed the vast majority of new rig activity since the summer of 2020. With fewer external concerns, less ESG pressure, and lower regulatory costs, the private sector’s flexibility and nimbleness allow it to surge in front in search of the growth that the fundamental economics suggest is lurking.As an example, Mercer Capital’s latest merger and acquisition discussion focused on the Eagle Ford shale suggested that the market have signaled to potential buyers that the time was right to increase their footprint in southern Texas while conversely providing for an exit for sellers who could either capitalize on the prospect of a continued upswing in energy prices or redeploy capital elsewhere.Whatever the exact incentives may have been that drove the M&A activity, the result was ten deals closed, mostly by private buyers or small-cap producers such as SilverBow Resources.These implied valuation metrics in the table above suggest that there are outsized returns to be made on incremental new wells at the present time. Lots of eyes are turning to watch U.S. production, not only in the Permian, but South Texas, Oklahoma, and the Bakken as well. What they are seeing right now is public companies remaining grounded with their capital, while private companies could be leaving them behind - and quickly.Originally appeared on Forbes.com.

Alt Managers Best the Market and Other Types of RIAs During a Rocky Twelve Month Stretch for the Industry

Access to cheap financing and favorable market conditions spurred significant gains for private equity firms and hedge fund managers during 2021. These tailwinds reversed course in the first three months of this year, and now many of these businesses are in bear market territory. Such volatility is typical for the alt space, which often relies on leverage to enhance returns on its underlying fund investments.Other classes of RIAs didn’t fare so well as the market downturn in January and February erased all their gains over the prior nine months. A closer inspection of the first quarter shows all classes of RIAs down 20% or more at the end of February when the S&P was only off 8%. Investors are likely anticipating lower margins for the RIA industry as AUM and revenue falls with the market while labor costs continue to rise.RIA aggregators also had a rough start to the year. Because the aggregator model is levered to the performance of the wealth management industry generally, the recent downturn for RIA stocks has impaired consolidator valuations too. While the opportunity for continued consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising interest rates and leverage ratios which may limit the ability of these firms to continue to source attractive deals. Performance for many of these public companies continues to be impacted by headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded RIAs, while larger asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance over the last year has generally been better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts. As valuation analysts, we’re often interested in how earnings multiples have evolved over time since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and first quarter of 2021, LTM earnings multiples for publicly traded asset and wealth managers declined modestly in the back of last year before dropping nearly 20% last quarter, reflecting investor anticipation of lower revenue and earnings as the market pulled back in the first two months of the year.Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with closely held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products.In contrast to public asset/wealth managers, many smaller, private RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.Notably, the market for privately held RIAs remained strong in 2021 as investors flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity for these businesses continued to be significant in 2021, and multiples for privately held RIAs tested new highs due to buyer competition and shortage of firms on the market. As these dynamics continue into 2022, the outlook for continued multiple expansion and robust deal activity remains favorable assuming interest rates and market conditions stabilize in the near future.

FreightTech Update

Automated Trucks, VC Frenzy, and the Rise of Brokerages

The COVID-19 pandemic brought economic hardship to many. The second quarter of 2020 might go down as one of the quickest economic downturns ever recorded. However, in an effort to protect the economy, the Fed created an extremely hospitable environment for venture capital, and with the glaring supply chain issues, FreightTech became a cushy landing place for investor’s money. We have written about venture capital and FreightTech before, and it has only gotten bigger since then.

Practical Considerations for Operating in an Inflationary Environment

In recent months, inflation has overtaken labor market measures as the most headline-grabbing macroeconomic indicator in the financial press. Inflation typically moves the needle more than other economic measures because of its effects not only on businesses of all sizes but also on consumers.The current inflationary environment has contributed to shifts in consumer behavior thus far in 2022, and it is important that family businesses build responses to changing consumer behavior into their budgeting and forecasting processes. In this week's post, we take a look at key considerations family businesses should be thinking about in their response to the current inflationary environment.Current Inflation and Consumer Spending DataThe U.S. Bureau of Economic analysis revealed in its March 31 news release that U.S. household spending rose 0.2% in February from the previous month, down from January’s revised rate of 2.7%. While consumer spending on services such as dining out, hotel stays, air travel, and recreation increased 0.9% in February given the significant decline in COVID-19 infections, consumer spending on goods dropped by 1% in February after increasing by 6.5% in January. The recent slowdown in consumer spending on goods is likely attributed to inflation. Consumer prices in February rose 0.8% from the previous month and 7.9% for the year ended February 2022 as measured by the Bureau of Labor Statistics consumer price index, representing a new 40-year peak. With these recent spending and inflation measures in mind, it is crucial for family businesses to be able to integrate an effective response to the current environment into the forecasting and budgeting process—both in the short-run and for the long-run.Short-Run ConsiderationsShort-run considerations and consequences of inflation are more straight forward than the long-term impact (discussed below). Many of our clients have enacted price increases over the past six months aimed at combating rising input costs and protecting margins. For consumers, inflation has led to brand switching, both out of pricing concerns and availability due to ongoing supply-chain issues.While these are the “headline symptoms,” perhaps one overlooked consideration for family businesses is the need for continuous, real-time budgeting and forecasting. In an ever-changing pricing environment, simply compiling quarterly and annual operating forecasts may not be sufficient. More advanced modeling tools, such as what-if scenarios and Monte Carlo simulations, can help management and finance teams plan for any number of inflationary situations and be aware of the potential implications for operating results under a variety of different scenarios. Constant vigilance is now more important than ever in allowing family businesses to respond to inflationary pressures in a timely and adroit manner.All that to say, recent inflationary pressures have made the already difficult task of preparing operating budgets even more complex. Maintaining a greater degree of discipline in updating operating budgets and awareness of the various scenarios that could unfold is one practical step that family businesses can take in the short-run to head off potential inflationary pressures at the pass.Long-Run ConsiderationsWhen thinking about long-run consequences of inflation on the capital budgeting process, family businesses should look beyond the simple fact that a new piece of machinery, equipment, etc. is more expensive today than it was last month or last year. While this is true, family businesses must also consider the effects of inflation on the cost of capital, which is the minimum return that an investment must generate to create value (for more information on the cost of capital and capital structure, see Mercer Capital’s “Capital Structure in 30 Minutes” whitepaper). A business’ cost of capital is comprised of two components: a cost of debt and a cost of equity. The most readily observable effects of inflation on a company’s cost of capital bear themselves out in the cost of debt, which is the effective interest rate that a company pays on its long-term debt obligations.With the Federal Reserve’s stated goal of using interest rates hikes to combat inflation in mind, the effect of inflation on the cost of debt then becomes clear. Increases to the fed-funds rate enacted by the Federal Reserve flow through to most interest rates in the U.S. economy. For simplicity and reference, we’ll look at the Moody’s Seasoned Baa Corporate Bond Yield, which is a good approximation of the cost of debt for many private companies. At year-end 2021, the observed yield on this debt instrument was 3.37%. The yield had crossed 4% by mid-February and reached 4.51% on March 15 when the FOMC announced that it would raise the benchmark rate for the first time since 2018 in an effort to combat the persistent inflationary environment.The practical implication of this policy stance is an increase to the cost of debt via Fed policy actions, raising the return threshold that capital investments must cross to generate a positive net present value. On the flip side, current fixed debt instruments appear more attractive as dollar payments needed to cover borrowing costs decline on a real inflationary basis (i.e., fixed rate debt payments avoid inflation). While there are countless other considerations and factors that affect a company’s cost of capital, family businesses should consider inflation as it relates to long-term capital needs and financing decisions.For privately held family businesses, inflation has greater consequences than paying an extra dollar per gallon at the pump or the price of a loaf of bread increasing by a few cents. Family business managers and directors should be pursuing active long and short-term strategies aimed at mitigating the effects of inflation, as this pervasive macroeconomic phenomenon can have greater implications than immediately meets the eye.

Meet The Team

Scott Womack, ASA, MAFF

In each “Meet the Team” segment, we highlight a different professional on our Auto Dealer Industry team. This week we highlight Scott Womack, Senior Vice President of Mercer Capital and the leader of the Auto Dealer industry team.While Scott has provided valuation services for clients in a wide variety of industries, he has significant experience in the auto dealership industry. He provides clients in the industry with valuation and financial advisory services for purposes including gift and estate tax valuation, litigation support, corporate valuation, ESOPs, and financial reporting.The experience and expertise of our professionals allow us to bring a full suite of valuation, transaction advisory, and litigation support services to our clients. We hope you enjoy getting to know us a bit better.What attracted you to a career in valuation?Scott Womack: Initially, I knew I wanted to be in a career involving numbers and problem solving. My introduction to the valuation profession came from my college roommate's father, who is a pioneer in the industry. Ironically, that college roommate and his father are now two of my colleagues at Mercer Capital, Bryce and Don Erickson. After 20+ years in the industry, I still enjoy the challenge of determining the qualitative and quantitative factors that impact the value of businesses.What attracted you to a career in litigation support?Scott Womack: I started doing divorce work about 13 years ago. Personally, I find this work to be very rewarding. Divorce clients are very appreciative and I believe I am making a difference as their Trusted Advisor throughout the process, but especially in mediation or during the trial. Often the non-business (or "out-spouse)" is not directly involved in the couple’s business and doesn’t know the value of the business or understand the process of valuation. These clients look to us to educate them and guide them through the process. Business owners (or the "in-spouse") also see us as a value-add to the process, as they may have not gone through the business valuation process during their ownership of their company.What type of cases gives rise to your involvement in litigation matters?Scott Womack: More often than not, I am involved in family law/divorce cases. The cases generally involve high-wealth individuals and those who own businesses or business interests. In addition to the valuation and forensic work, I also participate in mediation to assist the client in an attempted settlement. If mediation is not successful, I generally submit a formal report to the Court and do testimony work at trial. Other litigation projects include breach of contract or shareholder disputes.How has the valuation industry evolved since you started?Scott Womack: Early in my career, the industry was comprised mostly of valuation generalists. In the early 2000s, financial statement reporting and valuations took on a whole new life of their own with purchase price allocations and stock-based compensation. At this point, the valuation profession kind of exploded to become more specialized. We have people that now specialize in a specific service – be it, say, divorce or financial statement reporting – or a particular industry. So, the movement from generalization to specialization within the industry is the most pronounced change I have witnessed. Especially for growth in your career, specialization is a great avenue for advancement because you are able to become an industry or service line expert.What influenced your concentration in the Auto Dealership Industry?Scott Womack: I had a partner at a prior firm who had several auto clients and I often got to work on those engagements. Some of those engagements were related to divorce so I was able to see what litigation-related valuation is all about. The Auto Dealership industry has some unique characteristics in its financial statements and operations. After being exposed to these differences I saw an opportunity to make an impact in this industry. I am able specialize in this area in order to provide the best valuation services possible.What are a few unique characteristics of the Auto Dealership Industry?Scott Womack: The financial statements are pretty unique in the Auto Dealership industry. Dealers have to submit monthly financials to manufacturers, and each manufacturer statement looks a little different, almost like trying to solve a puzzle. Due to the specialization and profit centers of the various departments, these statements have a lot of detail. They are very informative pertaining to not only the major categories like assets, liabilities, and revenues, but you can also determine the size of the service department or how many used vehicles they sold, what they’re selling them for, or how much inventory they have on the lot. Not only do auto dealerships have to submit monthly statements, but some also report a thirteenth month statement. The thirteenth month takes the twelfth month with added year-end tax adjustments, normalization adjustments, etc. Furthermore, there is unique terminology in this industry. An example would be “Blue-Sky,” which is the goodwill value of the dealership. It can encompass a number of factors and the Blue Sky value is often very meaningful to a dealer requesting a valuation. There are also nuances in ownership and management that are important to know, as well as different valuation techniques and methodologies that are preferred. Someone specializing in this industry is better equipped to know what a client is looking for. My experience valuing auto dealerships has given me an advantage in knowing what to look for and what questions to ask.What types of Auto Dealership engagements do you work on?Scott Womack: Most privately owned auto dealerships are owned in a similar fashion – the operating dealership held in one entity, and the real estate utilized for the dealership location in another entity. I perform valuations of both types of entities for a variety of purposes including estate planning and litigation. We have performed valuations of auto dealerships in numerous states around the country and have been involved in litigation engagements in multiple jurisdictions.What is one thing about your job that gets you excited to go to work every day?Scott Womack: I have always enjoyed that the valuation and consulting business is project-based. On a project basis, you are able to work with different owners and different industries all across the board. One of my favorite parts of a project is conducting the management interviews and site visits. While the financial statements paint a picture and supply the quantitative results of operations, the management interviews provide much of the qualitative factors and allow you to gain an understanding of the company, the industry, and the risk factors that they face. I enjoy meeting different business owners and learning about their successful companies and history.

Modest Production Growth for Eagle Ford

With More on the Way

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. In this post, we take a closer look at the Eagle Ford.Production and Activity LevelsEstimated Eagle Ford production (on a barrels of oil equivalent, or “boe,” basis) increased approximately 4% year-over-year through March. This is in line with the production increases seen in the Bakken and Appalachia (4% and 5%, respectively) but lags behind the Permian, where production increased 14% year-over-year.There were 56 rigs in the Eagle Ford as of March 25, up 75% from March 19, 2021. Bakken, Permian, and Appalachia rig counts were up 162%, 48%, and 21%, respectively, over the same period. One may wonder why the Eagle Ford has lagged the Permian in production growth despite a larger increase in rigs. The answer has to do with legacy production declines and new well production per rig. Based on data from the U.S. Energy Information Administration (“EIA”), the Eagle Ford needs ~40-45 rigs running to offset existing production declines, and only recently (starting in January) had more rigs running than this maintenance level. The Permian has generally been operating with more than the maintenance level of rigs, so it has seen a higher level of production growth despite a smaller increase in rigs. However, with 56 rigs now running in the Eagle Ford, more production growth should be on the way.Commodity Prices Rise Amid Geopolitical TensionOil prices generally rose through the first two months of the quarter as increased demand was met with continued producer restraint. While the shale revolution had largely put geopolitics in the back seat as a key driver of commodity prices, geopolitics once again became front and center as Russia launched its invasion of Ukraine. In response, Western nations launched a series of economic sanctions against Russia. While the sanctions generally included carve-outs for energy exports, issues with financing and insurance, as well as the exit of Western oil companies and oilfield service providers from Russia, have resulted in a substantial decline in oil exports from the country. Russia was the third-largest producer of petroleum and other liquids in 2020, according to data from the U.S. Energy Information Administration, behind the U.S. and just shy of Saudi Arabia. The potential for that much oil to no longer be available for global markets has led to a high degree of volatility in oil prices. West Texas Intermediate (WTI) front-month futures prices began the quarter at ~$75/bbl and reached $120/bbl in March. Prices have swung dramatically based on actions in Ukraine and the progress of peace talks.Natural gas prices did not exhibit the same level of volatility as oil prices, given the more localized nature of the commodity. However, natural gas is becoming more globalized as Europe grapples with how to replace Russian imports. One obvious source is the United States, as President Biden pledged to boost LNG exports to Europe, despite these same exports being demonized by Democratic Senator Elizabeth Warren just a few short months ago. Administration officials aim to increase European LNG exports to 50 billion cubic meters annually, up from 22 billion cubic meters exported to the E.U. last year.Financial PerformanceThe Eagle Ford public comp group saw relatively strong stock price performance over the past year (through March 28). The beneficial commodity price environment was a significant tailwind to smaller, more leveraged producers like SilverBow and Ranger, whose stock prices increased 326% and 147%, respectively, during the past year, outperforming the broader E&P sector (as proxied by XOP, which rose 62% during the same period). Larger, less leveraged EOG was a laggard, with its stock price rising 61%, slightly behind the broader E&P sector.Survey Says Eagle Ford Wells Among Most EconomicAccording to participants of the First Quarter 2022 Dallas Fed Energy Survey, Eagle Ford wells are among the most economic in the nation.Survey respondents indicated that the average WTI price needed to break even on existing Eagle Ford wells was $23/bbl. This is below the average breakeven in the Permian ($28-$29) and other parts of the U.S. ($30+). While the economic advantage diminishes somewhat for drilling new wells, the Eagle Ford also had the lowest average breakeven for new development, with producers needing WTI at $48/bbl to profitably drill new wells, besting the Permian ($50-51) and other parts of the country ($54-$69).The Eagle Ford’s economic advantage comes from both its geology and geography. The basin’s proximity to Gulf Coast refining and export markets gives it a leg up relative to more inland basins.ConclusionEagle Ford production growth was relatively muted over the past year as capital discipline led to producers running rigs largely at maintenance level. However, with the recent surge in commodity prices, producers are finally starting to bring more rigs online, which should lead to more production growth. However, this growth can’t fill the void left by Russian exports, so commodity prices will likely remain volatile until there is some sort of resolution in Ukraine.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

April 2022

In this issue: Statutory Fair Value vs Fair Market Value (and Fair Value): Not So Subtle Differences

Medtech and Device Industry Newsletter - Q2 2022

E&P Second Quarter 2022

Permian Basin

Permian Basin // Both oil and gas commodity prices rose in the second quarter of 2022, with WTI and Henry Hub front-month futures prices floating around $121/bbl and $9/mmbtu in mid-June, as Russia launched its invasion of Ukraine in late February.

Transportation & Logistics Newsletter

Second Quarter 2022

Purchase Price Allocations for Asset and Wealth Manager Transactions

In recent years, there’s been a great deal of interest in RIA acquisitions from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. Due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer, these acquirers have been drawn to RIA acquisitions. Following these transactions, acquirors are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.A purchase price allocation is just that—the purchase price paid for the acquired business is allocated to the acquired tangible and separately-identifiable intangible assets. As noted in the following figure, the acquired assets are measured at fair value. The excess of the purchase price over the identified tangible and intangible assets is referred to as goodwill. Transaction structures involving RIAs can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset and wealth management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fees, profit margins, etc). It is important to understand how the characteristics of the asset management industry in general and those attributable to a specific firm influence the values of the assets acquired in these transactions. Because most investment managers are not asset intensive operations, the majority of value is typically allocated to intangible assets. Common intangible assets acquired in the purchase of private asset and wealth management firms include the existing customer relationships, tradename, non-competition agreements with executives, and the assembled workforce.Customer RelationshipsGenerally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.Due to their long-term nature, relatively low attrition rates, and importance as a driver of revenue in the asset and wealth management industries, customer relationships often command a relatively high portion of the allocated value. We can see this in the public filings of RIA aggregator Focus Financial. Between 2017 and 2021, Focus completed 130 acquisitions of RIAs. Of the aggregate allocated consideration for these transactions, a full 51% was allocated to customer relationships. Most of the remainder (48%) was allocated to goodwill.TradenameThe deal terms we see employ a wide range of possible treatments for the tradename acquired in the transaction. The acquiror will need to decide whether to continue using the asset or wealth manager’s name into perpetuity or only use it during a transition period as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on a number of factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the asset/wealth manager’s existing client base. In any event, for most relatively successful small-to-medium sized RIAs, the tradename has some positive recognition among the customer base and in the local market, but typically lacks the “brand name” recognition that would give rise to significant tradename value.In general, the value of a tradename can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the tradename value.Noncompetition AgreementsIn many asset and wealth management firms, a few top executives or portfolio managers account for a large portion of new client generation. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current employees of the company. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement (for example, if the individual is a beneficiary of an earn-out agreement or received equity in the acquiror as part of the deal, the probability of competition may be significantly lessened).Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in relationship-based industries like asset and wealth management, getting a new portfolio manager or advisor up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. The ability of employees to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network may often command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the value of a assembled workforce is valued as a component of valuing the other assets. Under current accounting standards, the assembled workforce value is not recognized or reported separately, but rather is included as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset or wealth manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for RIA acquirors, we frequently see earnouts structured into the deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional clients, assets, or product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer, while rewarding the seller for meeting or exceeding growth expectations. Earnout arrangements represent a contingent liability for the acquiror that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation and transaction work for the investment management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.

First Quarter 2022 Review: Volatility Resurfaces

The first quarter of 2022 marked the most volatile period since the first quarter of 2020.The quarter began with significant deterioration in the market’s outlook for growth stocks, particularly those lacking demonstrable earning power.Then, a geopolitical crisis, building for some time, intensified with the invasion of a European country, roiling markets ranging from commodities to equities.Last, the Federal Reserve announced, as expected, a 25 basis point change in its benchmark rate and telegraphed six more rate increases in 2022, taking the Federal Funds rate to nearly 2.00% by year-end 2022.In a speech on March 21, 2022, though, Chairman Powell suggested a greater likelihood that future Fed moves may occur in 50 basis point, rather than 25 basis point, increments to combat inflation, which mirrors the position taken by Governor Bullard in dissenting to the Fed’s 25 basis point rate change at the mid-March meeting.The following tables summarize key metrics we track regarding equities, fixed income, and commodity markets leading up to the invasion of Ukraine on February 23, 2022 and thereafter.Equity IndicesIndex data per S&P Capital IQ ProBroad market indices contracted through February 23, 2022, driven by valuation concerns for growth stocksBank stocks remained stable through February 23, 2022, as valuations remained reasonable relative to historical normsSince February 23, 2022 bank stocks have experienced modest pressure, primarily among larger banks that may have some exposure to RussiaWhile markets were volatile after the Ukraine invasion, broad market averages reported a robust recovery in the week of March 18, 2022 and continued gaining into last weekTreasury RatesTreasury yields per FRED, Federal Reserve Bank of St. LouisTreasury rates increased during 1Q22, with a greater share of the expansion occurring prior to February 23, 2022The yield curve flattened in 1Q22Yields on 3- and 10-year Treasuries were virtually identical as of March 24, 2022, relative to a 55 bps spread as of year-end 2021Debt SpreadsCorporate Credit Spreads per FRED, Federal Reserve Bank of St. Louis CMBS spreads per ICE Index PlatformCorporate debt and commercial MBS option-adjusted spreads widened in 1Q22Prior to the Ukraine invasion, high yield bond spreads widened to a similar degree, regardless of rating.However, since the invasion, BB-rated issuers have outperformed B- and CCC-rated issuers1Q22 spread widening in BBB-rated corporate bonds (40 bps) is the largest since 1Q20Although commercial real estate may appear somewhat more insulated from geopolitical considerations than the corporate bond market, CMBS spreads widened to a greater degree than corporate bond spreads in 1Q22CommoditiesOil price represents West Texas Intermediate; WTI prices per FRED, Federal Reserve Bank of St. Louis Corn & wheat prices per BloombergCommodities experienced higher price appreciation than other asset classes in 1Q22Wheat prices, already rising prior to the invasion, leapt after it.This reflects potential production disruptions in Ukraine, sanctions on Russia, and transportation issues in the Black SeaOil prices dropped in the weeks after the invasion of Ukraine but still notched a 49% increase in 1Q22Our agriculturally-oriented banks still expect U.S. farmers to fare well in 2022, despite higher input prices and difficulty obtaining some supplies like fertilizerResidential MortgagesThe 30-year mortgage rate, as reported by Freddie Mac, exceeded 4.00% in the week ended March 18, 2022.This is the first time the mortgage rate has exceeded 4% since May 2019.For the week ended March 25, 2022, the 30-year mortgage rate climbed higher to 4.42%Mortgage rates widened to a greater extent than long-term Treasury rates in 1Q22UWM Holdings, the largest wholesale mortgage lender, in its March 1, 2022 earnings release projected that 1Q22 originations would decline by 24% to 40% from 4Q21 originations.Mortgage rates have increased further after it provided this estimate

Nine Characteristics of Successful Family Wealth Plans

Recently we had the opportunity to attend (virtually) the Johns Hopkins All Children's Foundation 24th Annual Estate, Tax, Legal & Financial Planning Seminar. This year's keynote speaker was Pamela Lucina, Chief Fiduciary Officer and head of the Trust & Advisory practice for Northern Trust Wealth Management, one of the country's largest trust companies. Her keynote presentation highlighted the characteristics of successful families and provided practical strategies to avoid mistakes commonly seen in the administration of multigenerational wealth plans and trust structures. We summarize Ms. Lucina's nine key observations below.1. Don't Buy Into Shirtsleeves to Shirtsleeves in 3 GenerationsEchoing what we've said and highlighted at the Family Business Director, the saying "Shirtsleeves to Shirtsleeves in 3 Generations" is less fate and more myth. Family companies and trusts that operate from a place of fear ("We will fail unless we do something") often fail to make sound, long-term decisions and revert to more short-sighted thinking. Focusing on the positives of the family business (long-term focus, generational wealth creation) induces better decision-making and outcomes.2. Resist Ruling from the GraveWealth creators and first-generation founders often find themselves, usually with the best intentions, attempting to ensure that they will continue to control the business or assets of their beneficiaries from the grave. This manifests itself in incentive trust structures and strict rules-based criteria for distributions or asset allocation. Ms. Lucina warns against this thinking. Beyond creating animosity and resentment, if beneficiaries are solely focused on checking boxes created by others (i.e., get a degree, hold a job, sign a pre-nuptial agreement), they will often do the bare minimum to meet the standard. Instead of relying on such extrinsic motivation, families and trust documents should aim to effectuate the grantors' intent while tapping into the intrinsic motivations that will cause beneficiaries to genuinely thrive.3. Consider a Statement of IntentThe best family businesses and trust structures contain a statement of intent. The purpose of the statement of intent is to clarify the purpose of the trust. Statements of intent provide guardrails for the trust and help keep the beneficiaries and trustees on the same page. From this view, the modern estate planner's job is, in part, to serve as amanuensis for the grantor or wealth creator, turning the desires of the trust grantor into a prudent and workable plan. Having a statement of intent can often demystify the seeming ambiguity of trust language and best effectuate the grantor's wishes.4. Attend to ConcentrationsDiversification is a common topic on the Family Business Director blog. Ms. Lucina notes that strong families aim to address concentrations within trusts and long-term wealth plans. This can come in the form of having outside investment management of trust assets or the sale of concentrated, long-held stock. A common pitfall for families arises when the grantor of beneficiaries becomes "attached" to stocks, whether because they are what created the family's wealth or provide income to meet beneficiary needs. On the flip side, a trust may have been created, in part, to maintain a family's ownership in a private business. Understanding that goal can provide clarity to the beneficiaries and help them to level expectations on asset allocation and distributions in the future.5. Clarify Roles and ResponsibilitiesJust as it is important to have clear roles and responsibilities for family members in your family business, families need to clarify each member's responsibilities in their long-term planning and trust structures. Trustee and administrative roles need to be specific, and families should identify possible pain points in trust structures. This includes avoiding ambiguous language and providing clarity to the who, what, where, and why. Clarifying roles can help to stave off future family squabbles and tough conversations.6. Provide for an Exit and AutonomyTrusts are often put in place as a means to achieve tax efficiency and maintain family wealth. They also can act to maintain family harmony and togetherness when the grantors are no longer in the picture. This can be achieved through annual family meetings or owning common private assets (private company stock, a vacation home). However, Ms. Lucina notes that creating an exit mechanism and establishing autonomy at outset of the long-term wealth plan is key to family harmony. Similar to shareholder redemptions in your family business, you need to understand the 'outs' for beneficiaries in your trust structure to prevent family resentment and feelings of entrapment.7. Develop CompetenciesStrong family businesses educate the next generation not just in the family business, but the intricacies of their family's trust structure and broader wealth plan. Working to build key competencies, either through education from advisors or real-life learning opportunities (participating on investment committees, overseeing donor advised funds, etc.) gets beneficiaries involved and prepares them for their future role as primary stewards of the family's wealth.8. Cultivate the Entrepreneurial SpiritFamily wealth often comes about through the entrepreneurial spirit of the founders of a family business. Successful families inculcate this spirit and encourage each generation to contribute to the overall wealth of the family. Families can act as the 'family bank' and underwrite investment ideas and business ventures or create new divisions or entities to house these ventures.9. Communicate, Communicate, CommunicateMs. Lucina's final takeaway is one we are all familiar with: the importance of communication. We have discussed how much you should communicate with your family shareholders previously, but how do you handle discussions on wealth from a holistic family perspective? Often, mum is the word regarding high-net worth families and their wealth. Second and third generation members may know there is wealth, but not understand how it fits into the family wealth plan or what governs their access to it. This silence is often motivated by a desire to not corrupt children or disincentivize their work ethic. However, not communicating with family about your business or wealth planning can seriously damage the trust of family members. While every family is different, we tend to lean to the side of over-communication regarding family wealth planning conversations.Family businesses and advisors would be wise to keep a number of these practical rules in mind when crafting or advising family wealth plans and documents. As valuation professionals, we aim to be a helpful partner in the tax planning process alongside estate attorneys and other advisors for businesses and high-net-worth individuals. Give us a call to see what we can bring to your estate planning team.

Public Auto Dealer Profiles: AutoNation

As we discussed in previous installments of this blog series, there are six primary publicly traded auto dealers that own approximately 923 new vehicle franchised dealerships as of year-end, or approximately 5.5% of the total number of dealerships in the U.S. The proportion of the total U.S. dealerships that these publics own demonstrates how fragmented the industry continues to be, despite recent consolidation. For example, in the back half of 2021, there were three significant acquisitions made by public dealers that captured headlines. (Check out our blog from October to explore how these acquisitions might matter to your dealership).Our goal with the Public Profiles blog series is to serve as a reference point for private dealers who may be less familiar with the public players, particularly if they don’t operate in the same market. Larger dealers may benefit from benchmarking to public players. Smaller or single point franchises may find better peers in the average information reported by NADA or more regional 20 Group reports. However, they might still value staying plugged into public auto dealers’ performance. Public auto dealers also give dealers insight into how the market prices their earnings, the environment for M&A, and trends in the industry.AutoNation OverviewAutoNation is the largest automotive retailer in the United States. As of December 31, 2021, the company owned 339 new vehicle franchises from 247 stores located in the U.S. At year-end, the company also owned and operated 57 AutoNation-branded collision centers, 9 AutoNation USA used vehicle stores, 4 AutoNation-branded automotive auction operations, and three parts distribution centers.LocationsAutoNation’s stores are primarily set in the Sunbelt region, but the company has a presence in 17 states. A map of all states that the company operates in with associated percentages of total revenue is included below:Source: AutoNation Investor Deck Fourth Quarter 2021 BrandsThe company sells 33 different new vehicle brands, with 90% of its revenue coming from Toyota (including Lexus), Honda, Ford, General Motors, FCA, Mercedes-Benz, BMW, and Volkswagen (including Audi and Porsche). Comprehensive brand selection is important to AutoNation, as it hopes to provide customers with a broad range of products to choose from. Profit amongst these brands has remained relatively stable over the company’s history. However, in recent years the company has seen a slightly greater profit mix towards selling and servicing higher-margin, luxury vehicles.The company is seemingly brand agnostic, which makes sense given its massive scale and complications with franchise agreements, where OEMs don’t want too many dealerships to be controlled by one company. A breakdown of income by brand from AutoNation’s Q4 2021 investor presentation can be seen below:Source: AutoNation Investor Deck Fourth Quarter 2021 Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if the store and unit-level economics remain similar. Despite these fundamental differences, we should still take a look into some of the financial metrics and trends that AutoNation has observed in its operations over the past few months.There are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer.In the fourth quarter of 2021, AutoNation observed a 13.8% increase in total revenue and a 34.3% increase in gross profit compared to the same period last year. This asymmetric growth can be attributed to margin expansion as rising vehicle prices have benefitted the company’s selling operations. Remarkably, while sales prices have increased faster than the cost of the vehicles, OEMs are also more profitable, which demonstrates why public players want some of the status quo to remain the same once the chip shortage abates. AutoNation’s net income and EPS margins have expanded as well, with net income increasing by 78.3% over the year and EPS increasing by 137%. Changes in the individual components of the company’s income statement are broken down below:Source: AutoNation Investor Deck Fourth Quarter 2021 Like most of its public and private counterparts, AutoNation has achieved an impressive financial performance in the midst of lower retail units sold and historically low numbers of units on lots. Day Sales Outstanding is an appropriate metric to show the magnitude of the inventory shortage’s effect on AutoNation. Throughout 2021, the company’s Days’ Supply dropped from 42 to 9, which is even more notable considering that sales volumes are also declining, which all else equal raises Days’ Supply. Used vehicles bridged some of the gap for AutoNation; as new retail units declined 20% due to manufacturer supply shortages, used vehicles increased by 21%.AutoNation’s finance and insurance department also performed well in 2021, as higher margins on service contracts and increased product penetration resulted in gross margin expansion in the business segment. Parts and Service also saw an increase in gross profit, primarily due to growth in customer pay, internal reconditioning services, and the sale of wholesale parts.Across AutoNation’s four revenue segments, margin structure differences allow for variability between each segment’s revenue contribution and gross profit contribution, as can be seen in the company’s investor presentation and below:Source: AutoNation 2021 10-K AutoNation USAIn 2021, AutoNation’s capital allocation focused on its rollout of AutoNation USA, an exclusively pre-owned sales venture that the company is launching to target additional market share in the used vehicle market. Unlike Lithia that is actively acquiring new vehicle franchises, AutoNation, like Sonic, is investing in a network of used-only stores to compete with Carvana, Vroom, Shift, and other online retailers. They have the built in benefit of sourcing trade-ins when customers come to AutoNation’s new vehicle franchises as well as the scale of their vast dealer network. AutoNation is targeting to have over 130 AutoNation USA stores in operation from coast-to-coast by the end of 2026, and has already launched 5 pilot stores, all of which were profitable. Of the 130 targeted openings, 12 stores are expected to open in 2022. Given they only have 9 currently, getting to 130 will take a significant investment in 2023-2026. If they stick to these plans, there may not be significant capital allocated to acquiring more new vehicle franchises.Implied Blue Sky MultipleIn prior blogs, we’ve discussed how blue sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied blue sky multiple investors place on AutoNation. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then their Blue Sky value per share is approximately $109.55. Given recent outperformance, Haig Partners prescribes a 3-year average to determine ongoing pre-tax income. Using this methodology and applying the 24.1% effective tax rate implied by AutoNation’s financials, its ongoing pre-tax earnings per share would be $9.20 or 9.05x Blue Sky.Source: AutoNation Investor Deck Fourth Quarter 2021 While this is relatively in line with all of its public counterparts, it is relatively high compared to import or domestic dealerships likely due to its size and growth potential and its tilt towards luxury brands.ConclusionAutoNation is a good proxy for the entire auto dealer industry in many ways. While the company is regionally clustered in Florida, California, and Texas, it has a presence in and is a product of several unique markets across the entire United States. Its presence in these states also isn’t random; these are three of the four most populous states in the country. AutoNation also sells almost all of the major domestic, import, and luxury brands, further emphasizing the very broad nature of its operations. Financially, the recent historical performance of AutoNation follows many of the same trends that privately held dealerships have been seeing over the past year.At Mercer Capital, we follow the auto industry closely to stay current with trends in the marketplace. Surveying the operating performance, strategic investment initiatives, market pricing of the public new vehicle retailers gives us insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

How to Approach a Target and Perform Initial Due Diligence

This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Business is good for many middle market operators and investment capital is generally plentiful. Are you an investor whose capital is industry agnostic, or does your capital need to be targeted at add-on investments that build on a pre existing business platform? All business investors are “financial” investors - the real question is how “strategic” is their ability to leverage the assets of the target. Providing practical guidance on approaching a business target and conducting initial due diligence depends on the investor’s criterion, competencies, and execution bandwidth. In this article we assume you have identified a target or group of targets and you are attempting to learn enough about the target to determine whether to proceed with developing a meaningful indication of interest. Of course, an active seller is likely prepared for the sale process and represented by an advisor who is postured to provide the financial and operating information necessary for investors to quickly determine the suitability of a deal (i.e., a pitchbook and defined protocols for communication and information access). However, many desirable targets may not be seeking a sale because business conditions are favorable, and their businesses have been managed to provide options to the owners regarding continued independence and turn-key ownership and management succession. If the former, you, as a prospective buyer may have already pinged on the radar of the seller, and if the later, you have mined for target opportunities and are ready for the next step to accomplish an acquisition. Our focus here is to summarize some practical considerations for approaching and vetting an identified target.First ContactM&A is not easy. For every transaction that is announced a very long list of items for both the buyer and seller were satisfactorily addressed before two parties entered into a merger or purchase agreement. For the acquirers, first impressions matter a lot. There are no second chances to make a good first impression.How a target is contacted can be pivotal to achieving receptivity and obtaining a critical mass of information. In cases where market familiarity or professional collegiality already exist, it can make sense for an investor’s senior leadership to make direct contact with the target’s senior management and/or owners.In cases where the target is not familiar to the investor, then following a respectful and empathic set of protocols is key. Investors using professional advisors and/or who involve their senior decision makers are likely to be taken seriously by the target. Peer-to-peer contacts too far down the chain of command are more likely to be dismissed.Owners and senior managers are keen to prevent the rumor mill from derailing business momentum and disturbing internal calm. A mindful and considerate process of first contact and initial discussions that is highly sensitive to the discrete nature of exploratory discussions will increase the probability that initial discussions and diligence can proceed to the next phase as a relationship based on trust develops.In our experience, contacting a target through a financial advisor has an important signal function that the potential acquirer is serious and has initiated a process to prioritize and vet targets. Diligence procedures will be thorough and well organized; deal consideration and terms will be professionally scrutinized. Alternatively, some business owners and investors who initiate a process may be perceived as canvassing to see what sticks to the proverbial wall. This can inadvertently serve to inflate seller requirements and expectations assuming the initial inquiry is successful.Initial Due DiligenceOnce the initial contact is established, it is important to follow-up immediately with an actionable agenda. Actions and processes include:Non-disclosure agreement;Information request list;Clear set of communication protocols involving specified individuals;A centrally controlled and managed information gateway;Establishment time frames and target dates for investigative due diligence, IOI, LOI, pre-closing due diligence, deal documentation, and ultimately closing. Organization begets pace and that pace culminates in a go or no-go decision.Preliminary ValuationProcedurally, our buy-side clients typically request that we perform a valuation of the target using a variety of considerations including the standalone value of the target and potentially the value of the target inclusive of expected synergies and efficiencies.A properly administered valuation process facilitates an understanding of the target’s business model, its tangible attributes, its intangible value, its operating capacity, its competitive and industry correlations, and many other considerations that investors use not only for the assessment of target feasibility but as an inward-looking exercise to assess the pre-existing business platform.For first-time buy-side clients, our services may also include building leverageable templates and processes for future M&A projects. Additionally, our processes may also be critical to the buyer’s Board consents, the buyer’s financing arrangements, and other managerial and operating arrangements required to promote target integration.Concluding ThoughtsConducting target searches, establishing contact, and performing initial due diligence are critical aspects of successful buy-side outcomes. In general, there are as many (if not more) consequential considerations for buyers as there are for sellers.Some buyers covet the conquest and go it alone without buy-side advisory representation. Conversely, even seasoned investors can benefit from third-party buy-side processes. Unseasoned acquirers may find their first forays into the M&A buy-side world untenable without proper guidance and bench strength.As providers of litigation support services, we have seen deals that have gone terribly wrong as if predestined by inadequate buy-side investigation. As providers of valuation services, we have valued thousands of enterprises for compliance purposes and strategic needs. As transaction advisors, we have rendered fairness opinions, conducted buy- and sell-side engagements and advised buyers concerning a wide variety of deal structures and financings. If you plan to take a walk on the buy-side, let Mercer Capital’s 40 years of advisory excellence guide and inform you.

How to Approach a Target and Perform Initial Due Diligence

This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. Our focus in this article is to summarize some practical considerations for approaching and vetting an identified target.

Does RIA Consolidation Work?

Show Me the Money

RIA group-think has been pro-consolidation for the past decade, and increasingly so. You've read the headlines about the pace of deals reaching a fever pitch last year and continuing into this year. We've been skeptical of the believed necessity for RIA consolidation in this blog in the past, and have yet to be dissuaded from our position. But opinions are only opinions, and facts are facts. This seems like an opportune moment to check our feelings against reality. How is RIA consolidation performing so far? The verdict from the public markets isn't very encouraging. We look at three publicly traded consolidators of wealth management businesses, Silvercrest, CI Financial, and Focus. Over the past five years, Silvercrest Asset Management Group (SAMG) showed cumulative share price appreciation of less than 65%, underperforming the Russell 3000 by over 2200 basis points. To be fair, SAMG pays a reasonable dividend, and its wealth management clients are probably not 100% invested in equities. Nevertheless, we think of RIA returns as being leveraged to the market, and in an era of strong markets a wealth management firm with organic growth plus an acquisition strategy should – in theory - be able to outperform broad indices. SAMG didn't beat the market, but it outperformed a couple of rivals. Focus Financial Partners trades less than 25% above its IPO price from the summer of 2018, in spite of a tremendous number of acquisitions and sub-acquisitions. Focus doesn't pay a dividend so 22% cumulative return is the total return for FOCS shareholders since going public. CI Financial has fared even worse, as the Canadian shop revered for its willingness to pay top dollar hasn't posted a positive return over the past five years, even if you count dividends. Keep in mind, all of the above happened in an era of strong equity markets and low interest rates – what should be optimal conditions to consolidate the RIA space.Obligatory Car StoryThe business climate of the late 1990s was one in which consolidation was rife in nearly every industry. Rollup IPOs were the SPACs of the day, newly minted dot-coms were trading their highly inflated equity currency for other companies' highly inflated equity currencies, and old economy manufacturers were teaming up to share branding, technology, and overhead. Sometimes this worked very well, and sometimes it didn't.It's often said that most M&A results in failure. The free-wheeling, mass-market managers at Chrysler could never agree on expectations with the hierarchical, engineering-led team at Daimler-Benz. The loveless marriage resulted in unfortunate offspring like the Pacifica crossover and the R-class. Less than a decade after the 1998 merger, Daimler unloaded Chrysler to Cerberus for about 25% of the $36 billion it had originally paid.At the same time, a more unlikely pairing actually worked. The 1998 sale of Lamborghini to Volkswagen's Audi division turned out to be wildly successful. Italian styling and German build quality make a good combination, and today Lamborghini sells almost fifty times as many cars annually as it did before Audi bought it. It hasn't caught up with Ferrari yet, but it's close enough to make the guys in Modena pay attention.Investment ThesisLooking back on the two auto industry transactions sheds some light on the expected performance of RIA deals. One way to compare Daimler-Chrysler and Audi-Lamborghini is to consider why they happened in the first place.Daimler-Chrysler was a bulking-up, bigger-is-better, merger-of-equals. The logic was driven by internally-focused economies of scale, and it wasn't clear who was in charge. That left an environment that was unusually hospitable to culture clashes that undermined opportunities, synergies, and (ultimately) sales.Audi-Lamborghini was product-focused, and it was clear from the beginning who acquired who. Huge increases in Lambo sales and the opportunity to equal or surpass their old rival with the Prancing Horse kept internal dissent at bay.Which transaction looks most like the typical RIA deal? The investment thesis for investing in RIAs (whether asset management or wealth management) is straightforward: sticky revenue and operating leverage produce a sustainable coupon with market tailwinds. In an era of ultra-low yields, it's the best growth-and-income trade available, and it's become a crowded trade with a diverse array of institutional investors and family offices. As we've said many, many times in this blog, it's easy to see why one would invest in investment management.Consolidation ThesisInvesting in RIAs is one thing; consolidating them is quite another. Still, the themes that drive industry consolidation are equally well-rehearsed:Scale. With 15,000 or so RIAs in the United States alone, solving for fragmentation seems like an obvious play. Consolidation wonks tout the financial leverage that comes with economies of scale, enhancing margins, distributions, and value.Access. Larger firms theoretically are able to source more sophisticated investment products, technology stacks, and marketing programs.Problem Solving. Sellers have to have an impetus to give up control over their own destiny, and consolidation is often seen as the solution for aging leadership (or at least aging ownership) without a compelling succession path.Financial Engineering with Debt. Covenant-light debt at low rates has made capital widely available for public and private acquirers alike. Banks will typically lend at 3x and non-bank lenders at as much as 6x. With Libor near zero, even premiums on the order of 500 to 600 basis points make LBOs compelling.Financial Engineering with Equity. Multiple arbitrages has been the handmaid of cheap debt. At one point, it was "buy at five to six times, sell at eight to nine times." Then the spread was 9 to 12. Then it was 12 to 15. Then it went further. The whisper numbers usually outpace reality, but the logic is the same. All the above is widely accepted in the industry, and it's easy to see why. But if Fed activity stalls equity, while at the same time raising the cost of borrowing, things could change abruptly. This wouldn't just threaten industry consolidation for financial reasons, it might also expose some flaws in the consolidation thesis.Diseconomies of ScaleIf you put ten RIAs together that each makes $5 million in EBITDA, your combined operation will make $50 million in EBITDA. Your holding and management operation, however, will probably need an executive team with a C-suite, an accounting department, a marketing department, legal, compliance, investor relations, and a couple of pilots for your jet. They'll all need office space in a nice building, even if they mostly work from home. The subsidiary level profitability will inevitably be eroded by monitoring costs.Some of this expense may be replacing functions that would previously have happened at the subsidiary RIA level, but not all of them. Is there enough expense synergy in consolidation to cover the overhead costs of a consolidator? I doubt it.In the asset management space, there is an argument that AUM can be added faster than overhead, and margins can expand almost infinitely (we've seen some big ones). In wealth management, it's a tough slough. When Focus Financial went public, we thought that, even with massive growth, it would be hard to get their adjusted EBITDA margin above 25% - the level we're very accustomed to seeing on a reported basis at wealth management firms of more modest proportions. A publicly traded consolidator might have more than 100 souls on board at the management company level. That's a lot of payroll to cover with subsidiary-level synergies.AccessibilityAre small firms disadvantaged when it comes to necessary products and services? With custodians eager to accommodate all manner of investment products, outsourced compliance, subscription-based tech, and scalable marketing, it's easier than it has ever been to compete as a sub-billion dollar RIA. Scale enables firms to have positions to manage these functions, but it doesn't provide the functions themselves. We aren't experts in RIA operations, but we haven't yet seen a small firm struggle because it couldn't get what it needed (or wanted).Exit and SuccessionConsolidators offer exit capital for RIA founders. In that regard, they can resolve the standoff between generations of leadership and pay senior members a price that next-gen staff either cannot or will not pay. But a cheaper source of capital (or greater appetite for risk) is not a surrogate for succession.Since most of the consolidators in the industry are relatively new, we don't know a lot about whether these models are sustainable. RIAs are not capital intensive, but they are highly dependent on staff to manage both money and relationships. Often the staff who will generate returns for the consolidator in the future don't get a lot of equity consideration in the transaction. And will the founding generation work as hard for their new boss as they did for themselves?These conundrums have led many consolidators to structure earnouts or develop hybrid ownership models that share equity returns in some form or other with subsidiary RIAs. One touts promising to never turn "an entrepreneur into an employee" – which sounds reasonable. Ultimately, though, the staff at subsidiary operations are sharing equity returns with the parent company, and the principal/agent dilemma is less a dichotomy and more of a spectrum.As such, the consolidator will be paying for a firm run by highly motivated founders and getting a firm that will ultimately be run by differently motivated successors. RIA consolidation is the act of simultaneously acquiring the operating asset and accepting the succession liability.Financial De-EngineeringMost RIAs, by far, operate on a debt-free basis. Usually, this is for the obvious reason that there isn't much of an asset base to finance, so why bother. Consolidators, on the other hand, frequently rely on debt financing and, as deal prices have increased, so have leverage ratios. Financing a cash flow stream that is in many ways leveraged to Fed activity works very well in the era of declining and low interest rates – as we have seen.Rising rates and falling (or stagnant) markets lead to higher debt burdens and lower cash flows to service that debt. Add to that the threat of inflation increasing payroll burden. In normal times, there would be enough equity cushion to protect against default. With higher deal multiples – based on highly adjusted EBITDA measures - and the massive leverage available from non-bank financing, we could be in for some nasty surprises.If coverage starts tightening, deal activity will fall off, and multiples will drop. If multiples drop, acquirers won't be able to exit on satisfactory terms. Without equity compensation as a carrot, producers will find an exit for themselves. The unfortunate reality of leveraged RIAs is that their assets get on the elevator, but the liabilities never leave.Climate ChangeI'm not calling it the end of the RIA consolidation trend. For many reasons, it could continue for years to come. But the performance of publicly traded consolidators has been lackluster, in spite of very favorable conditions in which those business models should thrive. Now that we have the prospect of RIA stagflation, it could become very difficult to maintain a land-grab mentality that operates as if the acquirer is valued on the basis of price-per-press-release.

Eagle Ford M&A

Transaction Activity Over the Past 4 Quarters

Deal activity in the Eagle Ford increased over the past year as energy prices recovered from a tumultuous 2020. As we noted in June of last year, production in the Eagle Ford remained relatively flat over the prior year despite 146% growth in the regional rig count, suggesting the significant increase in drilling activity was just enough to offset the decline in already-producing wells, but not economical enough to spur production growth meaningfully. This may also have signaled to potential buyers that the time was right to increase their footprint in southern Texas while conversely providing for an exit for sellers who could either capitalize on the prospect of a continued upswing in energy prices or redeploy capital elsewhere. Whatever the exact incentives may have been that drove the M&A activity, the result was ten deals closed in the Eagle Ford over the past four quarters, up from eight transactions closed in the prior four quarters.Recent Transactions in the Eagle FordA table detailing E&P transaction activity in the Eagle Ford over the last twelve months is shown below. The median deal value in the past four quarters ($370 million) was approximately $282 million higher than the median deal value from Q2 2020 to Q1 2021, excluding Chevron’s acquisition of Noble Energy in July 2020. The average deal value over the past year ($573 million) was more than double the average value ($274 million) over the prior year (excluding the Chevron-Noble Energy deal). Also notable, larger positions were transacted over the past year, with a median size of 45,000 net acres as compared to 26,500 net acres in the prior year (excluding Chevron-Noble Energy), and an average deal acreage of nearly 80,000 net acres this past year which was more than double the average of 34,775 net acres in the prior year.SilverBow Resources Builds Up Its Eagle Ford AssetsOn October 4, 2021, SilverBow Resources announced the closing of its purchase to acquire oil and gas assets in the Eagle Ford from an undisclosed seller in an all-stock transaction. The aggregate purchase price for these assets was $33 million, with the transaction consisting of approximately 1.5 million shares of SilverBow’s common stock. In late November 2021, SilverBow announced another transaction closed with its purchase of oil and gas assets from an undisclosed seller for $75 million, including $45 million in cash and approximately 1.35 million shares of SilverBow’s common stock.Of this second transaction, Sean Woolverton, CEO of SilverBow, commented, “This is the third acquisition we have closed in the second half of this year. This transaction represents SilverBow’s largest to date. As we look to 2022, the Company is set to grow production by double digits in part from the incremental development locations and a full year’s worth of contribution from the acquired assets. With greater cash flow and liquidity, SilverBow remains well-positioned for strategic M&A and further de-levering.”Callon Petroleum Divests Non-Core Eagle Ford AssetsOn October 5, 2021, Callon Petroleum – one of the upstream companies we follow regularly in our quarterly review of earnings call themes from E&P operators – announced it had entered into an agreement to sell non-core acreage in the Eagle Ford as part of its acquisition of leasehold interests and related oil, gas, and infrastructure assets in the Permian basin from Primexx Energy Partners. Total cash proceeds from the divestiture were approximately $100 million. The Eagle Ford properties included approximately 22,000 net acres in northern LaSalle and Frio counties. Net daily production from the properties was approximately 1,900 Boe/d (66% oil) on average in the third quarter through month-end August. Callon noted in its press release that the sale would eliminate approximately $50 million in capital expenditures related to continuous drilling obligations over the next two years, allowing for redeployment of capital to higher return projects.ConclusionM&A activity in the Eagle Ford has picked up over the past year in terms of both deal count and the amount of acreage involved. The ten deals noted over the past year were split evenly between property/asset acquisitions and corporate transactions, such as the Desert Peak Minerals-Falcon Minerals Corporation merger announced in mid-January of this year. This signals a notable increase in corporate-level activity as only one of the eight transactions in the prior year involved a corporate transaction, possibly foreshadowing greater industry consolidation in the Eagle Ford moving forward.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

WHITEPAPER | Community Bank Valuation

Key Considerations in the Valuation of Banks and Bank Holding CompaniesThis whitepaper focuses on the two issues most central to our work with depository institutions at Mercer Capital:What drives value for a depository institution?How are these drivers distilled into a value for a given depository institution?In this whitepaper, we dive into the more technical valuation issues, but at its core, value is a function of the following:A specified financial metric or metricsGrowthRisk

Succession Planning for Auto Dealers

Sorting Through the Madness

March is one of the best months on the sports calendar for avid and casual sports fans. Last week, the NCAA College basketball tournament began. Most of us have been checking our brackets to see which games we picked correctly and which upsets have destroyed our brackets. There’s a reason they call it March Madness. Who would have predicted that St. Peter’s would beat Kentucky? The tournament and the bracket challenges are an opportunity to unite friends, co-workers, and family members in a spirited competition. But, they can also be a source of frustration with stumbling blocks at unexpected terms. In many ways, succession planning can leave auto dealers with the same fears and confusion over the process and some of the decisions made along the way.What is succession planning? Succession planning is the transfer of value or leadership in a company or organization. For auto dealers, the dealership can represent a lifetime of efforts and relationships with key employees and customers. Hopefully, the dealership has also provided the owner with wealth and income over the years. These factors make the discussion of succession more complicated for auto dealers because of the deep emotions tied to the legacy that they have created.This post discusses some of the key factors involved in the succession planning process and why they are so critical.Cost of a Business Valuation One of the first steps in the succession planning process is to determine the value of the auto dealership. Often there can be a difference in the expectation of value. In other words, there may be a perceived difference in value when assessed by a third party versus the owning dealer. The cost of obtaining a business valuation can also be a stumbling block to the succession planning process. Most valuation professionals will offer different levels of service based upon the strength of the conclusion, the level of procedures performed and the information analyzed, and the style of the report. While it may be more cost-beneficial to engage a business valuation professional to perform limited procedures, a formal valuation is the better course of action. If decisions are ultimately made to transfer the auto dealership in some estate planning tool, a formal valuation will help protect the integrity of that transaction or transfer. In other words, if the transfer was ever to be audited or challenged by the IRS, a formal business valuation serves to justify the indication of value used in the estate planning process. Besides the formal event requiring the valuation, a business valuation can also benefit auto dealers for other reasons. A formal business valuation can be useful to an auto dealer when examining internal operations. While the business valuation represents an estimate of value at a certain point in time, the value can also be examined relative to the business over time. An auto dealer may use additional valuations to evaluate the performance of the dealership over time to assess its performance relative to a budget or long-term plan. Valuations can also give auto dealers insight into the value drivers of their dealership. Auto dealers can continue focus on areas of strength that contribute to value, while also addressing other areas of weakness that may be detracting from value. Finally, a business valuation could serve to evaluate the dealership relative to its peers and competition.Who Should Perform the Business Valuation? The selection of the business appraiser is critical to the succession planning process. A quality business valuation will not only determine the value of the dealership, but also provide a well-reasoned report to explain the basis of value and the underlying assumptions. Further, the valuation assists the auto dealer and their advisors in an understanding of how the dealership is valued. As we’ve written in this space before, dealers and their advisors should select a business appraiser that is properly qualified and credentialed. Additionally, the auto dealer industry is unique from other industries due to its unique financial statements, terminology, and specific valuation methods. When selecting a business appraiser, you should also seek a firm or individual that has experience in the auto dealer industry.Timing of Decision-Making Auto dealers have to face many daily challenges and operational decisions. Chief among them in the current environment, what is my new vehicle inventory and where am I going to obtain additional new and used inventory? Decisions that can be made tomorrow, such as succession planning, may be shifted to the back burner. However, these decisions should be made sooner rather than later. First, unexpected events can impact the value of your auto dealership or the succession planning process. We have focused more on the value of the dealership in this blog post, but succession planning also refers to the transfer of leadership with key employees. A life-changing event to the owner or the departure or thinning of key leadership over time can also impact the value of the dealership.In the current environment, the profitability and implied values of auto dealerships are at record highs.In the current environment, the profitability and implied values of auto dealerships are at record highs. Most prognosticators believe those trends will continue in the short-term due to inventory constraints. For auto dealers that have seen the value of their dealership climb in recent years and the expectation that those values could climb even further, why not consider transferring some of that value to your family? With annual gifting amounts being fixed, auto dealers could transfer more ownership at lower values today than retaining those shares in an appreciating climate. While there has been a lot of talk about estate planning and tax law changes since the change in administration, no material changes have been enacted as of yet. Changes could still be on the horizon.In addition to annual gifting, the lifetime estate and gift tax exclusion is set to sunset in 2026. The current exclusion allows for individuals to transfer $12.06 million ($24.12 million for a married couple) without being subject to estate taxes. These levels are set to drop by almost 50% in 2026. Auto dealers can transfer considerably more value under the current exemption levels today, than if those levels are reduced in 2026.Ultimate Decision The current environment in the auto industry has placed many auto dealers at a crossroads in terms of their ultimate decision: should they consider transferring the dealership to the next generation or should they sell? High profitability and high blue sky multiples for most franchises translate to heightened valuations. The evolution and adoption of electric vehicles forces many dealers to contemplate the additional expenses and challenges that will come with retailing and servicing these vehicles. Further, consolidation in the industry by the public companies and larger private auto dealership groups forces the smaller auto dealer families to compete with companies that have much larger resources and economies of scale. What decision should auto dealers make? Some of the decision revolves around the expectation of value discussed previously in this Blog. Does the dealer’s perception of value equal reality? If the dealership is worth less than what a dealer expected, perhaps it makes sense to retain the dealership and improve operations and improve certain value drivers to eventually increase the value of the dealership. If the dealership is worth more than the dealer expected, perhaps it makes sense to consider selling the dealership at a time of heightened value.High profitability and high blue sky multiples for most franchises translate to heightened valuations.The other critical factor to succession planning, and in this case, transferring the ownership of the dealership to the next generation or key employee, is to assess the existing leadership talent in the business. Is there a second generation of the family that is currently involved in the dealership and familiar with the operating environment? If not, is there a key employee that could step in and continue the legacy of the dealership? In either case, an auto dealer must consider whether either of these individuals would be approved by the OEM. The OEM has to approve the dealer principal of an auto dealership. This consent is not always guaranteed and presents another unique element to the succession planning process for auto dealers.ConclusionAt Mercer Capital, we perform valuations of auto dealerships for owners and advisors all around the country for a variety of purposes. Additionally, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. If you are contemplating succession planning with your dealership, contact a professional at Mercer Capital to discuss your valuation needs in confidence.

What Market Volatility Means for Your RIA

Is Volatility the New Normal?

It’s de ja vu all over again. The volatility from the onset of the pandemic two years ago has been creeping back up as investors grapple with the global implications of the war in Ukraine. At the end of last year, most RIA owners were enjoying peak AUM and run-rate profitability. Since then, these measures have likely taken a substantial hit as the S&P 500 and NASDAQ are down 12% and 19%, respectively. When this happened two years ago, the market made a sharp recovery in the preceding quarters, but looking forward, we don’t know where the bottom lies. Most RIA principals are likely grappling with a sizable decline in management fees and earnings for the next billing cycle.The VIX, which calculates the expected volatility of the U.S. Stock market, hit a new all-time high on March 16,2020, of 82.69. It gradually declined until Russia invaded Ukraine several weeks ago and has ticked back up ever since. If one thing has become more clear, it’s that market volatility is likely here to stay – at least for a while. In this post, we explore what this volatility means for you and your RIA.AUM, aka Revenue Base, Is More VolatileFor RIAs that charge fees on a quarterly basis, the fees charged on March 31, 2022, will likely be significantly lower than the fees charged as of year-end (barring any major advances in the market over the next week or so – which is not out of the question). Many RIAs have quickly adjusted to this new normal. Rather than charging fees quarterly, which makes them more susceptible to the large swings in the market, they have switched to charging fees on a monthly basis to smoothen the impact from a swift correction.Active Managers May Be Able to Exploit Mispricing in the MarketDuring times of increased volatility, active managers are generally able to take advantage of the swings in stock valuations away from fair value, allowing them to realize increased returns for their clients. This may be more difficult in the current market as the volatility today is not just driven by increased “fear” in the market, but a lack of liquidity in our financial system.Over the last few months, bid-ask spreads have widened, and trading volumes have generally declined. A lack of liquidity in market structure is associated with increased risk. In a less liquid market, it is more likely that you could get stuck in a losing position. Additionally, in less liquid markets, prices tend to overreact, making market moves less informative. While there are more winning opportunities presented to active managers, there are also more losing ones.Sector-Specific Managers Are Missing Out or Killing ItMuch of the decline so far this year has been driven by tech stocks, which outperformed most other sectors of the economy over the last few years. Conversely, energy sector fund XLE is up 34% year-to-date after underperforming the broader market for several years. Mean reversion has been a major force so far this year to the benefit and detriment of sector-specific asset managers.Internal Transactions Have Been Temporarily SidelinedMany RIA principals are more reluctant to sell at the pricing implied by recent valuations that consider the impact from the market fallout. Additionally, the next generation of leadership may be less inclined to take on the additional risk if their compensation also took a hit. We haven’t seen any evidence of this so far, but it could work its way through the system if these conditions persist over the next few quarters.External Transactions Might DeclineSince many debt-fueled purchases of RIAs rely on variable rate financing, many prospective external buyers will also be sidelined if borrowing becomes more expensive. Lenders could also get spooked by rising volatility and waning profitability for many RIA firms.Planning Is More Important Than EverDuring this time when the outlook for global markets and the economy is uncertain, many RIA principals are working to nail down the unknowns associated with business ownership. RIA principals are devoting more time to working on their buy-sell agreements in an effort to protect the working relationships with their partners and ensure they and their families are protected financially in the event of a divorce, partner dispute, disablement, or death.The current environment is ripe with uncertainty. This presents both challenges and opportunities for principals of investment management firms. As we all know, this will eventually pass, so most of our clients are focused on positioning rather than acting.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of March 15, 2022

Q4 2021 Earnings Calls

Inventory Shortages Continue to Dominate the Auto Dealership Operating Environment

There continues to be no end in sight for new vehicle supply constraints. In past posts we have noted how executives keep kicking the can down the road, guessing things will normalize in 6 months or so, which they’ve been saying for the past twelve months. Group 1’s management team was refreshingly honest on the situation as detailed in the quote below.“I have been unable to predict on [when inventories normalize] with any accuracy at all. I continue to be shocked. And every month seems to delay the recovery another month. Clearly, no one is building inventory still. […] It seems that there are some issues beyond chips as well now with COVID interruptions and shipping interruptions […] I can’t even keep track of all the stated reasons. But it would certainly seem the first half of the year is going to remain with severe new vehicle inventory shortages. I don’t know what will happen in the second half of the year.” – Earl Hesterberg, CEO of Group 1 AutomotiveInventory shortages are at the forefront of many of this quarter’s themes. While dealers across the country are looking to increase their new vehicle inventories, used vehicles are in greater supply. Numerous executives noted they are carefully managing this inventory to avoid getting burned on currently elevated prices. All the publics (except Lithia) explicitly mentioned a hope that inventories would increase to a new normal, that is below pre-pandemic inventory levels. Executives also seem to generally believe that GPUs will normalize with inventories, though a push for market share by industry participants may further shrink GPUs once inventory is available.On February 15, Edmunds released research indicating 82% of car shoppers paid above sticker price in January. While there have been reports of dealers charging above the manufacturer’s suggested retail price (“MSRP”) since mid-2021, the practice has proliferated and analysts sought comment on the topic this quarter, which was generally denounced for various reasons, again with Lithia being the exception.M&A was not as big of a topic of conversation as in prior calls, though it does still come up. The current M&A market for dealerships is similar to the market for the vehicles they sell: values are elevated above historical norms. As a result, dealer principals may be more interested in testing the waters on what they could get for their dealership. Most executives and dealer principals acknowledge that recent strength in new vehicle grosses should normalize whenever inventories normalize (we’re still waiting). Still, if dealers think the price is right, they may be willing to sell if they can get anywhere near a “normal” multiple on these heightened profits.Private dealers testing the waters on the Blue Sky for their dealership reminds me of Zillow’s “Make Me Move” feature that they recently discontinued. Homeowners on the fence about selling used to be able to post a high price, and if they got traction, they may decide to sell, avoiding the potential penalty of having your home listed for a significant amount of time, which leads to price concessions or actually discourages would-be buyers assuming something “must be wrong” with the house. Bringing it back to vehicles, I recently tested what offer I’d get on my 11-year old vehicle and was pleasantly surprised as it was considerably above its pre-pandemic value.When it comes to M&A for the public automotive retailers, they continue to focus on brand and geographic fit. An interesting nugget came from Sonic that may be interesting to smaller market dealers. While 2021 was the year of the mega-deal, Sonic noted its large RFJ acquisition (which was one of the mega-deals) primarily operates in smaller markets. While the company previously would not have been interested in buying such dealerships, the success they’ve seen thus far means they are open to more tuck-in acquisitions of dealerships in smaller markets, a welcome development for such dealer principals.A couple of other interesting pieces didn’t quite make their own theme. Penske threw cold water on the adoption of EVs, noting that 98% of its sales have been ICE over the past three years, and while OEMs have committed to more EV models, Penske believes it will take “longer than people expect” for widespread adoption, largely due to costs of EVs. Regarding discussions about direct-to-consumer sales, he also called attention paid to startups like Rivian “overblown.” Penske also holds more used vehicle inventory than Asbury, AutoNation, Group 1, and Sonic.Lithia also holds more used vehicle inventories than its peers and as noted previously, and doesn’t have a problem with charging over MSRP. Curiously, its executives also began positioning the company for an environment without franchise laws as it suggests the industry could move towards an agency model with its manufacturers by 2035 (see page 18 of its investor presentation).Theme 1: While dealers are looking forward to more normal inventory levels, they believe there is something to be learned from the heightened profits in the last year: auto dealers are hoping “normalized” inventory levels will be considerably below pre-pandemic levels.“So we don't want 60-day supply inventory. We don't need more 45-day supply inventory. They could just get it back to the 20 and 30-day supply you got great demand, great margin, and it sets up '22 and really '23 for just to be fantastic years for the industry. – David Smith, CEO, Sonic Automotive“The OEMs have become more sophisticated in that regard. And they understand that too much inventory is bad for us and we're not going to take it. And it's bad for them too. And that lesson is really being driven home right now to the OEMs as to the cost of excess inventory. The distribution channels in both the US and UK have been overstuffed for a decade or more. And now that they get leaned out, you can see what it does for the OEM profits also. It's much better for them. And so I think we're going to be in a much better position going forward.” –Earl Hesterberg, President and CEO, Group 1 Automotive“I have to believe that given all the learning through the pandemic and supply and demand dynamics that we've recently seen and the clear messages coming from the manufacturers, we will not return to the excessively high inventory levels that depressed new vehicle margins for both the dealers and the OEMs. […] And the levels of profitability for both OEMs and dealers clearly show the benefits of selling vehicles at MSRP. And what a concept, right, selling at MSRP.” –Michael Manley, CEO, AutoNation“When you look at the floor plan support, you look at customer support, and you look at the incentives that are being paid over the traditional years where we had normal business, the OEMs are digging deep in their pocket. Now they’ve seen a real benefit by backing that off. In fact, I think that’s helping them look rationally down the road that will help them find the R&D that’s going to be necessary when we look at electrification. So hopefully, they got a taste of that. And that will be a slow return and they’ll keep the day supply in the 30 to 45 days and we won’t obviously be where we are today in single-digits. But I think we can manage that carefully brand by brand.” –Roger Penske, Chairman & CEO, Penske Automotive GroupTheme 2: Whenever vehicle inventories normalize, vehicle profitability is expected to normalize as well, though some executives cautioned an attempt to grab market share could further depress heightened GPUs. Notably, Lithia’s base case assumes vehicle profitability fully returns to pre-pandemic levels.“Well, I would hope no one would ever go over 50 days again. And, of course, historically the domestic has always had well over that because of these -- the big variation on the build combinations of full-size trucks and things like that. But for decades Toyota dealers have operated well below 30 days and never missed that much business as far as I could tell. So I think most brands can operate in 30 days to 40 days. And hopefully there will be a corporate memory that the OEMs also can see this benefit and try to manage that way as we go forward. However, any time these large auto companies start fighting for market share that's when the discipline can erode." – Earl Hesterberg, President and CEO, Group 1 Automotive“It's a competitive world and you never know what someone is going to do to try and gain market share and grow their business. I think everyone's learned from the concept that we can be effective with a lower days supply and everyone can benefit from that. Does that mean we'll stabilize at a 35, 40 days supply compared to a 65 or 70? I think it's too early to tell.” –David Hult, CEO, Asbury Automotive Group“Total vehicle GPUs returning to pre -pandemic levels. […] Every day it does seem like the window for increased elevated margins are probably there for longer than we all would like or our consumers would like, but it may be that they don't return to some normalized level” – Bryan DeBoer, President and CEO, Lithia MotorsTheme 3: Used vehicle prices have runup even as compared to the price increase of new vehicles. Public auto dealers are trying to avoid being left holding the bag as the company holding too much used vehicle inventory when the music stops."It's hard to tell but we see the values starting in November, December, have adjusted meaning that they're not growing exponentially as they were before. And until the inventory levels, our belief is until the inventory levels for new cars somewhat stabilize, the used car valuation is going to remain where it is right now. And I don't -- we don't believe that when there is a correction that it will be an immediate correction. It's going to be a gradual correction. So -- but we do believe that is going to be dependent on the new DSI.” – Daniel Clara, SVP and CFO, Asbury Automotive Group“We're sitting at a 36-days supply [on used vehicle inventory…] What you worry about is the rest of the market out there that might have a 60, 80, 90-day supply, they're still sitting on cars that they paid at the height of the market, they're going to have issues. […] It's the price point, right? That's pushing demand up for new cars really because the used car price points are so high and that's got to give. And it's going to give. I mean that's going to happen. Used cars are not -- like I said earlier, are not going to continue to appreciate. We do believe we're starting to see the depreciation cycle start, if the last six weeks are any indication of that.” –Jeff Dyke, President, Sonic Automotive“The used market obviously is super dynamic. We're able to keep the inventories at the level they are because of our -- we changed our sourcing model. And the good thing about the PRUs is, we manage our inventory very tightly. So, any changes in the pricing environment we can react very quickly. I don't know when it's going to change. I feel like it's going to change at some point this year, but I don't know when.” – Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 AutomotiveTheme 4: In the high-priced environment, more dealers are charging above MSRP or requiring customers to buy add-ons in order to get the vehicles they want. OEMs generally denounce the practice, as did some of the public auto dealers. Generally, the practice is viewed to leave consumers not trusting the dealer community.“We've seen a number of comments about vehicles being sold above MSRP, quoting the potential adverse impacts on brands and customers, which I understand. And by the way, last year, less than 2% of all the new vehicles sold by AutoNation were above MSRP. But this discussion on MSRP branded customers actually also adds to my optimism regarding new vehicle margins going forward. Because I think it's equally clear that significant discounting and high incentives can also damage a brand, which is another reason for our industry to balance appropriately supply and demand, and another reason why we may expect higher new vehicle margins than we have historically seen pre-COVID. […] I think where the issue is where you've got a short-term temporary disruption and your supply and demand curve in, what I would call, general market, mass market vehicles, where there is no history in these mass market vehicles of used prices going significantly above for a long period of time against new vehicles. And I think that is where you have to be incredibly careful.” – Michael Manley, CEO, AutoNation“We're pressing very hard for them not to bring inventory levels back to pre-pandemic levels. And so margins are going to stay high. The margins prior to the pandemic are low. We should be selling cars at MSRP. I mean this industry needs to get away from doing all the negotiating it’s a hell of a lot less complex, much easier, and it brings the right value for the vehicle. […] I just don't see margins coming back going back to pre-pandemic levels ever.” –Jeff Dyke, President, Sonic Automotive“However, our inventories are still tight and led to a majority of units being presold. As a reminder, our focus is on driving long-term relationships with our customers. We direct our stores to sell at MSRP. It helps to create the kind of sticky relationships that feeds our segment-leading aftersales performance. We realized it cost us some SG&A leverage in the short term. But for us, it's much more important to drive retention in the strongest part of our business which is aftersales.” –Daryl Kenningham, President, U.S. and Brazilian Operations, Group 1 Automotive“Our stores make those decisions in the field. And they do that based off their supply and what their competitors are doing. So yes, we do have some stores that are charging over MSRP. We don't have specific numbers because we don't specifically track it because we allow our network to make the decisions close as to what their customer base is and what the supply and demand is in that local market.” –Bryan DeBoer, President and CEO, Lithia MotorsConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

The Perils and Pleasures of Forecasting in Family Businesses

The list of forecasting cliches is long (thanks, Yogi Berra!), but we were recently reminded of a good one: there are only two kinds of forecasts – lucky and wrong. That reminder came from an article by Joachim Klement 10 Rules for Forecasting published on the CFA Institute website.Klement’s list is focused on macro level economic forecasting, but several of his rules apply equally well to the micro level of individual family businesses. In this post, we consider four of Klement’s rules in the context of family businesses.Rule #1 – Data MattersIf it is hard for professional managers at public companies to remain dispassionate when predicting the future, it is doubly hard for managers and directors at family businesses. Humans are story-seeking animals, but the desire to craft a simplistic narrative that both neatly explains the company’s historical performance and extrapolates that performance into the future may prove counterproductive. It’s not that narratives are bad, but the temptation to make the data “fit” a preferred story can be overwhelming. Far better to adjust one’s narrative to “fit” the actual data, even if elements of that story are uncomfortable. Allowing the data to tell the real story opens up the space needed for a meaningful conversation about where the real and preferred stories diverge, the sources of those divergences, and whether those divergences are permanent or capable of being closed.Rule #3 – Reversion to the Mean is a Powerful ForceOdds are that your family business is indeed special, but not that special. Twenty percent growth rates have a habit of eventually giving way to 10% growth rates, which in turn, eventually deteriorate to 5% growth rates. Likewise, lucrative profit margins tend to attract the sort of competition that corrodes lucrative profit margins. Outside of regulated utilities, business is competitive, and forecasts that assume existing – or new – competitors will stand idly by while you execute your strategic plan are not realistic. While past success may reveal what your family business has done well, one should be wary of simply assuming the formula that worked so well in the past will continue to work equally well in the future. As Amazon founder Jeff Bezos is reputed to have said about his competitors: “Your margin is my opportunity.”Rule #9 – Remember Occam’s RazorOccam’s Razor is the principle that in explaining a thing no more assumptions should be made than are necessary. Accuracy is a more desirable attribute in a forecast than precision. Identifying the appropriate level of complexity in a financial projection is one of the biggest forecasting challenges facing family business directors and managers. For what it’s worth, we tend to value parsimony a bit more when projecting operating expenses than revenue.A zero-base “build-up” approach for forecasting revenue can be a helpful corrective to overly optimistic trend extrapolation. Total revenue, whether for a segment, division, or the consolidated family business, can often be modeled as the product of unit volume and effective pricing. In other contexts, market share and aggregate market size can be useful benchmarks for forecasting revenue.Predicting growth rate trends for operating expenses is often a sufficiently reliable approach. Operating expenses are often somewhat fixed, and while individual expense categories may exhibit more volatile behavior, keeping an eye on implied operating margins can help in assessing the overall reasonableness of operating expense forecasts.Rule #10 – Don’t Follow Rules BlindlyKlement’s final rule is a good reminder for writers of blog posts about making forecasts. There is a genuine difference between helpful discipline and blind rigid adherence to any set of abstract forecasting rules. Hopefully, your family business is making forecasts for a business purpose, not simply for the sake of mastering the art of making forecasts. Keep that business purpose front and center, and feel free to discard the prescriptions and proscriptions of arm-chair quarterbacks when they undermine that purpose.ConclusionFollowing Rule #10, it may be important to distinguish between a goal and a forecast. Goals express what we want the future to look like, whereas a forecast presents an unbiased picture of what the future will look like. The rules that make sense when crafting a forecast may not be appropriate when setting goals for future performance. Goals serve a valuable purpose for family business managers and employees, but when making capital budgeting, dividend policy, and capital structure decisions that can affect the family for generations, directors need unbiased forecasts.Does your family business have a disciplined process for separating fact from fiction and developing actionable forecasts that your directors can rely on? Sometimes an outside perspective can be helpful when you need to prioritize data over hopeful narratives, instill respect for reversion to the mean, keep things simple, and distinguish discipline from blind devotion to a set of forecasting rules. Give one of our family business advisory professionals a call today to discuss your challenges in confidence.

Themes from Q4 2021 Energy Earnings Calls

Part 3: Oilfield Service Companies

Last month, we reviewed Q1 through Q3 2021 earnings call themes from oilfield service companies. Commentary regarding the progress of ESG efforts, whether initiated by the OFS companies themselves or in support of their customers' ESG programs, was prevalent throughout the year. OFS management teams also noted their anticipation of increased industry consolidation by way of M&A activity. Perhaps most poignantly over the first three quarters of 2021, OFS companies signaled increasing leverage in their ability to either start commanding higher prices of their customers, or the expectation they would be able to do so in the very near term.In Part 1 of our Themes from Q4 Earnings Calls, we examined key topics among E&P operators, including:Projections of moderate cost inflation, typically in the upper single digits;Shifting focus towards liquids, including crude oil and NGL streams; andIndustry headwinds stemming from macro energy policies in the U.S. In Part 2 of our Themes from Q4 Earnings Calls, key topics among mineral aggregators included:Greater scrutiny and discipline regarding the execution of M&A deals;Expectations of relatively stagnant production in the near-term; andGreater insulation from price inflation relative to the impact on E&P operators. With this background in mind, we focus this week on the key takeaways from the OFS operator Q4 2021 earnings calls.Macro HeadwindsLabor shortages and supply chain constraints have been a common topic in the daily news cycle regarding the macroeconomic environment in the U.S. Suffice it to say, the OFS industry has not been immune to these factors."You know the story of tubulars people are struggling to get the right tubulars on time. They are having to make substitutions. We are seeing some rig efficiencies begin to deteriorate, which is attributable to several factors. Part of that, of course, is the basins. Different basins have different efficiency profiles. But I think our view is activities at the rig side have slowed down, all things being equal, strictly because of problems with personnel breakdowns. I think the industry is a bit stressed right now." – Scott Bender, President & CEO, Cactus Wellhead"Beyond activity trends, we see a continuation of many of the same things from 2021. Operators will continue to look for ways to improve efficiency and sustainability. We see the current constraints in many critical areas such as labor, sand, and trucking also continuing for the near term." – William Zartler, CEO & Chairman, Solaris Oilfield Infrastructure"Productivity and efficiency was broadly encumbered by 2 significant factors. First, the tightening labor market we faced in the U.S. was exacerbated by COVID outbreaks in certain plants during the fourth quarter. As skilled workers recuperated safely at home, their work was performed by less experienced, less efficient crews or by other skilled workers working overtime. Labor shortages led to higher product costs and scheduling headaches. Second, our manufacturing scheduling headaches were compounded by component and raw material shortages and late deliveries from our vendors who are facing the same sort of challenges that we are. Some businesses report supply chain challenges are getting a little better, but mostly these disruptions are persisting or getting more challenging in the near-term." – Clay Williams, CEO, National Oilwell VarcoIndustry Consolidation through M&A ActivityIn our Q1 through Q3 2021 OFS earnings call themes post, we noted anticipation of greater M&A activity and industry consolidation in 2022. This continued in Q4, with the ongoing expectation of consolidation activity in the near future."We have not given up on industry consolidation. That's our number one priority. And importantly, I don't think the industry has given up on industry consolidation. Yes, the valuations are going to be higher today than they were this time last year, but our currency is also more valuable today than it was this time last year. I don't really consider that to be an impediment to getting a deal done. The impediment is finding the right deal. ... Private equity has decided maybe now is the time to monetize after they've probably given up hope over the last couple of years." – Scott Bender, President & CEO, Cactus Wellhead"As I've stated many times, I believe consolidation is very important for this industry. Through a combination of cash and stock consideration, we closed on the acquisitions of Complete Energy Services, Agua Libre Midstream, HB Rentals and UltRecovery during 2021. Additionally, we are set to close on the acquisition of Nuverra Environmental Solutions. In doing so, we've added nearly $300 million of run rate revenues to an already growing base business and acquired strategic portfolio of infrastructure assets, including gathering and distribution pipelines, disposal facilities, and landfill operations." – John Schmitz, President & CEO, Select EnergyESG ActivityThe Q4 OFS earnings calls were peppered with commentary regarding ESG, including recognition of OFS operator initiatives from outside the industry, the mitigation of environmental impacts on local communities at present, and projections of continued demand for ESG-focused services."We announced our science-based emission reduction targets, added 11 new participating companies to Halliburton Labs and were named to the Dow Jones Sustainability Index, which highlights the top 10% most sustainable companies in each industry." – Jeff Miller, CEO, Halliburton"Overall in 2021, we recycled 25 million barrels that produced water through our fixed facilities, and we expect to continue driving these volumes higher. This recycling alleviates demand for freshwater sources in water stress regions, while also limiting waste disposal which is particularly important in areas of seismicity concerns." – Nick Swyka, CFO, Select Energy"On the technology and sustainability front, we continue to advance our water recycling efforts. We've invested in six facilities during 2021 which are backed by long-term contracts. This sets the stage for a significant growth in our recycled volumes for 2022." – John Schmitz, President & CEO, Select Energy"We're busy upgrading Tier 2 fleets to Tier 4 dual fuel fleets that can utilize up to 85% natural gas. And we expect the pursuit of ESG-friendly operations, efficiency gains and the industry's existing tired fleet of equipment will lead to continued demand for such rebuilds." – Jose Bayardo, CFO, National Oilwell Varco Mercer Capital has its finger on the pulse of the OFS operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the ancillary service companies that help start and keep the stream flowing. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

Hot Inflation and Cold Markets: RIAs Hit With a New Storm Front

So much for transitory: February's CPI growth came in at 7.9% year-over-year (the highest level in recent memory), and the ongoing Ukraine conflict portends further supply chain challenges that could drive prices even higher. The front-end of the yield curve has shifted higher as market participants reason that rising inflation will force the Fed to raise rates sooner and by a greater magnitude than had been previously anticipated.Historically, a flattening yield curve has signaled an end to a growth cycle, and so far in 2022 that certainly seems plausible. Markets are down and valuation multiples have declined significantly, particularly in high-flying tech stocks. So, what does all of that mean for the RIA industry?Revenue Impact on RIAsAlmost all wealth management and asset management firms employ a revenue model where fees are based on a percentage of AUM. Such a model is unique in that it’s not directly linked to the cost of doing business. In many other industries, there is a far more direct link between pricing and the cost of doing business. If a widget manufacturer’s cost of making a widget goes up, it raises prices to compensate. If a bank’s cost of borrowing goes up, it raises interest rates. And so on.For RIAs, revenue changes with the value of client assets, not the cost of doing business. While larger accounts are often more complicated (and costly) to manage than smaller accounts, the relationship between the cost to manage an account and the value of an account is not linear. If, for example, a $20 million account decreases to $10 million, the cost of managing that account is unlikely to drop by half. The consequence is margin pressure.The percentage of AUM revenue model works well for the RIA industry because it aligns interests between clients and advisors (fees increase when the value of a client’s assets increases). In times of rising markets, the percentage of AUM revenue model is an enviable one: market growth can drive revenue growth that is largely decoupled from the cost of doing business, which has allowed significant margin expansion and profit growth in the industry.This operating leverage is the secret sauce of RIA margin expansion. In recent years, market growth alone has contributed to 10-15% annual revenue growth at many firms—far outpacing formerly modest inflation effects. Even many firms with negative organic growth have seen growing revenues and profitability as market growth has more than offset client outflows.Current market conditions, however, demonstrate the downside of the “percentage of AUM” revenue model. Through March 8th, the Russell 3000 index was down over 14% year-to-date. For all but the most rapidly growing RIAs, organic growth will have done little to offset the market decline this year. Tiered fee structures may help mitigate the impact (the first dollar of AUM lost is often at a lower fee rate than the firm’s overall rate), but run-rate revenue for many RIAs has likely still taken a significant hit so far this year. RIAs often bill on a quarterly schedule, so the impact of the current market downturn may not have been felt yet, but it will soon absent a significant turnaround. Operating leverage works both ways.While RIAs have little control over market movement, they do have control over their fee schedules and fee discipline. If there were ever a time to increase fees, now would (theoretically) be the time. Everyone is experiencing rising costs across nearly every aspect of their lives, so price increases are to be expected. But RIAs are in an awkward spot when seeking to raise their fees—the whole point of the “percentage of AUM” revenue model is that the fees paid scale with the value of the account.Informing clients of increasing fee schedules at a time when their account value is down significantly is unlikely to be well received despite the familiarity of price increases elsewhere. When you combine that with the secular trend of declining fees in the investment management industry, we think that the ability of firms to raise their fee schedules is somewhat limited. For new clients, there may be more flexibility to remain disciplined on stated fee schedules in order to more closely align the price of investment advice with the cost of delivering it.Cost Structure ImpactAt the same time that revenue is declining, the fixed cost base for RIAs is facing significant upward pressure. Tech and software vendors, landlords, professional service firms, and the like are all raising prices at the fastest pace in decades to reflect their own higher costs of doing business and strong demand. While it takes time for these price increases to make their way to an RIA’s P&L, rising costs seem unavoidable for many RIAs unless inflation retreats significantly. With rising costs and declining revenue, the potential for margin compression if the current environment continues is very real.Most significantly, compensation costs (the largest component of an RIA’s cost structure) are under pressure given the extremely tight labor market and record turnover. RIAs will need to balance increasing compensation costs in order to retain key employees with firm profitability. We’ve said it often in the past, but compensation mechanisms that directly link employee pay to firm profitability (e.g., through a variable bonus pool or equity compensation) not only help to attract and retain key employees, but also help to preserve margins when revenue declines. How to best structure compensation packages to weather environments like today’s is a topic for another blog post, but it suffices to say here that we see firms with well-structured compensation packages that balance short term (salary), medium term (bonus), and long term (equity) incentives as having a competitive advantage in tight labor markets and volatile financial markets alike.M&A and Deal ActivityM&A activity and consolidation in the RIA industry is driven largely by long-term, secular trends like aging founders, lack of succession planning, and gaining access to the benefits of scale and broader service capabilities. As such, the longer-term trends in deal activity are likely to continue. In the short run, however, we could see an impact on M&A deal volume and pricing depending on the duration of continued inflation and the current market downturn. If revenue declines and margin contraction persists, we may see sellers delay going to market in order to wait for performance to rebound. For deals that do occur, multiples at the top-end of the current range may come under pressure without the backdrop of a market updrift to rationalize premium pricing.Further, there is the potential for RIA aggregator models (which account for a significant portion of total industry deal activity) to come under pressure if the current market environment continues. These firms typically rely on floating rate debt and high leverage to acquire RIAs, leaving them particularly exposed if the performance of the underlying firms deteriorates or if interest rates increase.So far, we haven’t seen any downturn in deal activity. Fidelity’s monthly Wealth Management M&A Transaction Report listed 13 transactions in February, a record level for the month. But, as we saw in 2020, there can be a lag between market activity and a noticeable impact on deal volume due to the multi-month process between deal negotiations, signing, and close. Recent market pricing of public RIA aggregators isn’t terribly encouraging; their cost of capital is going up rapidly – but that too is a topic for another post.There’s still much uncertainty about the duration of the current market environment and the ultimate impact it will have on RIA performance. The upshot to all of this is that revenue growth in recent years has far outpaced the cost of doing business for most firms, allowing margins to expand to healthy levels. As a result, many firms today are well positioned for a potential downturn given their robust margins and ample cushion to absorb possible revenue declines while remaining profitable.

Identifying Acquisition Targets and Assessing Strategic Fit

Many observers predict that the market is ripe for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity.Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth. For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition.This article is the first in a series on buy-side considerations that we will share over the next few months. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.Our first topic starts at the beginning – identifying and assessing acquisition targets.Identifying Acquisition Targets and Assessing Strategic FitWith aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations.With labor tightness, supply chain disruptions for capital goods, and financing costs fluctuating in real time, buyers and sellers are increasingly strategic in their mindset. Inflation and interest rates represent potential headwinds, but pent-up demand and plentiful war chests are likely to fuel elevated M&A activity in the foreseeable future. More than a few baby boomers have held on to their business assets making ownership succession and liquidity significant concerns.Additionally, many middle market business assets are churned by financial investors with defined holding periods. Large corporate players and private equity buy-out groups generally have their own corporate development teams. However, small and mid-market companies, occupied with day-to-day operations, often find themselves with limited bandwidth and a lack of financial advisory resource to identify, vet, and develop a well-crafted strategic M&A rationale and then execute it.This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.Motivation and ObjectivesA rejuvenated appreciation for optimal capital structures and fine-tuned operations has largely debunked the oversimplified notion that bigger is always better. However, right-sizing is about achieving a proper, often larger scale at the proper time for a supportable price. A classic question in strategizing to achieve the right size is that of "buy" versus "build."Many acquisitions are as much about securing scarce or unavailable hard assets and labor resources as they are about expanding one’s market space.Whether your investment mandate is to alleviate scarcities or to achieve vertical or horizontal diversification and expansion, tuning your investment criterion and financial tolerance to motivations and objectives is key.These collective questions, among others, help address the who and the what of recognizing potential targets and assessing the pricing and structural feasibility of a business combination in whatever form that may take (outright purchase or merger in some form).Given our experiences from years of advising clients, we have learned that the most obvious or simple solution is generally best. Many buyers already know the preferable target candidates but lack the ability to assess and the capacity to engage those targets. Additionally, many well-capitalized buyers lack the financial discipline to score, rank, and sequence their target opportunities with the expertise employed by large, active corporate developers and private equity investors.Understanding the magnitude and timing of the returns resulting from your investment options is critical. Constructing financial models to study the options of now-versus-later and the interactive nature of deal pricing, terms, and financing is vital to the process. These technical and practical needs must be addressed competently to grant buyers the freedom of mind and energy to critically assess deal intangibles that often influence the overall decision to move forward with a target or not. Cultural fit, command and control for successful integration, brand and product synergies, and many other factors ultimately manifest in an investment’s total return on investment.Scoring opportunities by way of traditional corporate finance disciplines using NPV and IRR modeling as well as using various frameworks such as SWOT Analysis or Porter's Five Forces is highly recommended. However, blind ambition and soulless math may not result in the best choice of targets.One common sense and often overlooked assessment is how a seller’s motivations may have a bearing on the risk assessment of the buyer. A seller today may be alerting today’s buyer about future realities the buyer may experience. In some cases, sellers are motivated by a deficit of ownership and management succession. In other cases, a seller’s motive may be the result of industry dynamics and disruption that may one day be the concern of today’s consolidators. Get informed, get objective and be rational when assessing a target. If you cannot do that with in-house resources, get help. If you have in-house resources, have your mandates reviewed and your target analysis checked by an experienced advisor with the right balance of valuation and transaction awareness.Take a Walk in the Seller’s ShoesWe know that sellers often fear opening-up their financials and operations to certain logical strategic buyers. This may stem from generations of fierce competition or from a concern that not selling means the seller has revealed sensitive information that will compromise their competitive position or devalue the business in a future deal. Many sellers are extremely sensitive to retaining their staff and keeping faith with suppliers and customers. Buyers should understand that sellers require comfort and assurance regarding confidentiality.Being proactive with non-disclosure agreements and even better using a third party such as Mercer Capital to establish contact may facilitate a process of mutual assessment that is initially a no-go for many tentative sellers. Buyers that demonstrate empathy for the seller’s position and who employ a well-conceived process to initiate exchange are more likely to gain access to essential information.It is common for the seller’s initial market outreach to set the hurdle price for the winning buyer. That may occur as a result of the seller having reasonably skilled advisors who help establish deal expectations or through first-round indications of interest. As such, it should be no surprise for truly strategic buyers to be able to hurdle the offers of first round financial buyers or less optimal fringe buyers.Buyers should also be aware that third party deals must win against the seller’s potential ability to execute a leveraged buy-out with family members or senior managers, which may facilitate favorable tax outcomes versus the asset-based structures in open-market M&A processes. Of course, strategic buyers should be equally aware that many private equity or family-office buyers may also be strategic in their motivations and pricing capabilities based on pre existing portfolio holdings.Awareness of competing concerns for the target must be considered if you intend to win the deal. Buyers, with the help of skilled advisors, can actually help sellers address the balance of considerations that underpin a decision to sell. Having plans for human resource, communicating employee benefits and compensation structures, and laying the groundwork for a smooth integration process are part of walking the talk of a successful acquisition.Concluding ThoughtsWhether your motivations are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.Regardless of your past experiences and deal acumen, we recommend retaining a transaction advisory team familiar with your industry and possessing the valuation expertise to maximize transaction opportunities and communicate the merits your firm has to offer the target and all its stakeholders.Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

Identifying Acquisition Targets and Assessing Strategic Fit

Many observers predict that the market is ripe for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity. Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth. For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition. This article is the first in a series on buy-side considerations that we will share over the next few months. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.Our first topic starts at the beginning – identifying and assessing acquisition targets.Identifying Acquisition Targets and Assessing Strategic FitWith aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations.With labor tightness, supply chain disruptions for capital goods, and financing costs fluctuating in real time, buyers and sellers are increasingly strategic in their mindset. Inflation and interest rates represent potential headwinds, but pent-up demand and plentiful war chests are likely to fuel elevated M&A activity in the foreseeable future. More than a few baby boomers have held on to their business assets making ownership succession and liquidity significant concerns.Additionally, many middle market business assets are churned by financial investors with defined holding periods. Large corporate players and private equity buy-out groups generally have their own corporate development teams. However, small and mid-market companies, occupied with day-to-day operations, often find themselves with limited bandwidth and a lack of financial advisory resource to identify, vet, and develop a well-crafted strategic M&A rationale and then execute it.This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.Motivation and ObjectivesA rejuvenated appreciation for optimal capital structures and fine-tuned operations has largely debunked the oversimplified notion that bigger is always better. However, right-sizing is about achieving a proper, often larger scale at the proper time for a supportable price. A classic question in strategizing to achieve the right size is that of "buy" versus "build."Many acquisitions are as much about securing scarce or unavailable hard assets and labor resources as they are about expanding one’s market space.Whether your investment mandate is to alleviate scarcities or to achieve vertical or horizontal diversification and expansion, tuning your investment criterion and financial tolerance to motivations and objectives is key.These collective questions, among others, help address the who and the what of recognizing potential targets and assessing the pricing and structural feasibility of a business combination in whatever form that may take (outright purchase or merger in some form).Given our experiences from years of advising clients, we have learned that the most obvious or simple solution is generally best. Many buyers already know the preferable target candidates but lack the ability to assess and the capacity to engage those targets. Additionally, many well-capitalized buyers lack the financial discipline to score, rank, and sequence their target opportunities with the expertise employed by large, active corporate developers and private equity investors.Understanding the magnitude and timing of the returns resulting from your investment options is critical. Constructing financial models to study the options of now-versus-later and the interactive nature of deal pricing, terms, and financing is vital to the process. These technical and practical needs must be addressed competently to grant buyers the freedom of mind and energy to critically assess deal intangibles that often influence the overall decision to move forward with a target or not. Cultural fit, command and control for successful integration, brand and product synergies, and many other factors ultimately manifest in an investment’s total return on investment.Scoring opportunities by way of traditional corporate finance disciplines using NPV and IRR modeling as well as using various frameworks such as SWOT Analysis or Porter's Five Forces is highly recommended. However, blind ambition and soulless math may not result in the best choice of targets.One common sense and often overlooked assessment is how a seller’s motivations may have a bearing on the risk assessment of the buyer. A seller today may be alerting today’s buyer about future realities the buyer may experience. In some cases, sellers are motivated by a deficit of ownership and management succession. In other cases, a seller’s motive may be the result of industry dynamics and disruption that may one day be the concern of today’s consolidators. Get informed, get objective and be rational when assessing a target. If you cannot do that with in-house resources, get help. If you have in-house resources, have your mandates reviewed and your target analysis checked by an experienced advisor with the right balance of valuation and transaction awareness.Take a Walk in the Seller’s ShoesWe know that sellers often fear opening-up their financials and operations to certain logical strategic buyers. This may stem from generations of fierce competition or from a concern that not selling means the seller has revealed sensitive information that will compromise their competitive position or devalue the business in a future deal. Many sellers are extremely sensitive to retaining their staff and keeping faith with suppliers and customers. Buyers should understand that sellers require comfort and assurance regarding confidentiality.Being proactive with non-disclosure agreements and even better using a third party such as Mercer Capital to establish contact may facilitate a process of mutual assessment that is initially a no-go for many tentative sellers. Buyers that demonstrate empathy for the seller’s position and who employ a well-conceived process to initiate exchange are more likely to gain access to essential information.It is common for the seller’s initial market outreach to set the hurdle price for the winning buyer. That may occur as a result of the seller having reasonably skilled advisors who help establish deal expectations or through first-round indications of interest. As such, it should be no surprise for truly strategic buyers to be able to hurdle the offers of first round financial buyers or less optimal fringe buyers.Buyers should also be aware that third party deals must win against the seller’s potential ability to execute a leveraged buy-out with family members or senior managers, which may facilitate favorable tax outcomes versus the asset-based structures in open-market M&A processes. Of course, strategic buyers should be equally aware that many private equity or family-office buyers may also be strategic in their motivations and pricing capabilities based on pre existing portfolio holdings.Awareness of competing concerns for the target must be considered if you intend to win the deal. Buyers, with the help of skilled advisors, can actually help sellers address the balance of considerations that underpin a decision to sell. Having plans for human resource, communicating employee benefits and compensation structures, and laying the groundwork for a smooth integration process are part of walking the talk of a successful acquisition.Concluding ThoughtsWhether your motivations are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.Regardless of your past experiences and deal acumen, we recommend retaining a transaction advisory team familiar with your industry and possessing the valuation expertise to maximize transaction opportunities and communicate the merits your firm has to offer the target and all its stakeholders.Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

Identifying Acquisition Targets and Assessing Strategic Fit

With aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations. This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.

Family Business Director’s Reading Roundup

Here at Family Business Director, we are focused on the numbers of family business: measuring and assessing financial performance, establishing dividend policy, setting capital structure, making capital budgeting decisions, and structuring shareholder redemptions. We believe these topics are crucial, and that many of the conflicts that enterprising families experience are avoidable when these tasks are done well and communicated effectively to family shareholders. In our experience, well-informed shareholders are engaged shareholders.All that said, we also recognize that family business leaders face many other critical challenges. In this week’s post, we provide a quick roundup of some of the best pieces we’ve come across recently dealing with management succession, governance, attitudes toward wealth, family relationships, board dynamics, and more.Winning at management succession must be a priority for family businesses focused on long-term sustainability. In this article, John Ward and Stephen McClure of The Family Business Consulting Group offer a comprehensive list of 15 guidelines for family business succession.Family businesses aren’t always great at drawing boundaries. Family and business tasks can become intertwined, and the burdens of family governance can fall on too few shoulders. Marion McCollom Hampton and Nick DiLoreto of Banyan Global examine the effect of “Overloaded Structures” here.The pandemic may be easing, but the use of virtual platforms for at least some family meetings is probably here to stay. Katelyn Husereau of CFAR offers some timely tips, tricks, and best practices for on-line family meetings here.Inheriting wealth is very different from creating wealth. Coaching the next generation of the family on how to view, and become responsible stewards of, inherited wealth is a common concern of family business leaders. In this article, Sarah Schlesinger of Continuity Family Business Consulting identifies six ways members of the rising generation can productively integrate wealth into their lives.Genuine, healthy family relationships are based on solid connections among family members. Steve Legler writes about the need for enterprising families to look beyond the org chart to discern whether the right kind of human relationships are in place. Check out Steve’s insights here.Is your family business board having genuinely productive conversations featuring different perspectives, or does everyone just go along to get along? Allen Bettis explores the hidden costs of prioritizing artificial harmony in the board room in this article.Speaking of boards, recruiting and retaining quality independent directors that can help guide your family business to the next level is an investment. Are your expectations regarding compensation for directors reasonable for today’s market? Bertha Masuda, Bonnie Schindler, and Susan Schroeder of Compensation Advisory Partners summarize some key findings from their most recent survey on the topic here. Happy reading!

February 2022 SAAR

The February SAAR was 14.1 million units, down 6.4% from last month and 11.7% below this time last year. After last month’s SAAR of 15.0 million, the 2022 Q1 SAAR is expected to be the highest since Q2 2021 when the vehicle inventory shortage started to fully take hold. While the seasonally adjusted annual rate has certainly improved from the lows of late 2021, raw sales numbers tell a different story. Raw sales volumes in February were much lower than in previous years, as shown in the chart below. Seasonal adjustments in the early months of the year typically account for lower expectations in those months after lofty sales expectations in December, explaining the discrepancy between raw sales and the SAAR metric. Unadjusted figures show just how constrained inventories are.Source: Bureau of Economic AnalysisIn February, the new vehicles that were available to sell continued to fly off the lot. According to J.D. Power, the average time a new vehicle sat on dealer’s lots was 20 days, down from 54 a year ago but up from the record low of 17 days in December 2021. In response to this persistently high demand, OEMs are expected to reduce incentive spending even more in February to a per unit average of $1,246. To give some perspective, when shown as a percentage of MSRP, incentive spending is at an all time low of just 2.8%. Average transaction prices on new vehicles are expected to reach $44,460 this month, an all-time February record and an increase of 18.5% from a year ago.Used vehicles continued to appreciate throughout February. While the intrinsic value of these vehicles might be unchanged or lower than months prior, constricted inventories continue to prop up price increases. According to J.D. Power, the average amount of trade-in equity that consumers were able to cash in on was up 93% compared to this time last year.Source: Bureau of Economic AnalysisComing as no surprise to dealers, new and used vehicle inventories remained scarce over the last month. The industry’s inventory to sales ratio was 0.171 in February, the lowest recorded value since the Bureau of Economic Analysis started tracking the metric in 1993. Inventory shortages have been present for almost a year now, and the supply chain issues that have perpetuated the shortage are here to stay until 2023 at the earliest. For more discussion on production issues, check out our January SAAR blog.Parts and Service Outlook – Manufacturers, Competitors, and TrendsAuto dealerships have several sources of revenue, including sales of new and used vehicles, financing revenue from internal F&I departments, and parts and service revenue from on-site vehicle repairs. While all of these revenue streams are essential to a successful dealership, the margin structures of each department fundamentally differ. Most important for this blog, parts and service departments have the healthiest margins at an auto dealership, making these departments essential to profitability.Higher fixed operations margins combined with increasingly aged vehicle populations have made parts and service departments more and more important over the last year and into the early months of 2022. Check out our recent blog for an in-depth look into the importance of fixed operations for your dealership. In this blog, we seek to provide an update on the auto parts industry, including manufacturers, competitors, and expected ramifications on dealers’ fixed operations.Raw material increases and rising labor costs have soared for parts manufacturers around the country, leaving many operators asking themselves how they will offset increasing costs without getting price relief from OEMs.Auto Parts Manufacturers – There are Always LosersLately, auto parts supply chains have been the target of headlines. While most of the discussions in our weekly blogs have focused on supply chain disruptions’ impact on the production of new vehicles, these same issues also apply to individual parts. Namely, auto parts manufacturers have been experiencing cost issues over the last year. They must feel like they are getting left out of one of the most profitable periods in the auto industry’s history.Raw material increases and rising labor costs have soared for parts manufacturers around the country, leaving many operators asking themselves how they will offset increasing costs without getting price relief from OEMs. This relief has not materialized due to the contract structure that the industry has in place, as explained in further detail below.Contractual agreements between OEMs and parts manufacturers set prices for the entire length of a vehicle’s production cycle and are difficult to renegotiate without both parties’ goals aligning. In the past, OEMs have not always benefitted from the fixed nature of these contracts and are now hesitant to renegotiate terms, especially when they are on the winning end of the deal. General Motors President, Mark Ruess, recently said that “passing things through is not the way to create value for customers.” While this may be true, the statement would also make sense if dealers and OEMs replaced customers.Auto Parts Retailers – Direct CompetitionAuto dealers are obligated to purchase parts for their service departments directly from OEMs. This relationship ensures that standardized replacement parts are offered to consumers and that OEMs can control the prices paid for these parts. In this framework, however, auto parts retailers like O’Reilly Auto Parts and AutoZone become direct competitors of auto dealers’ parts and service departments. The key question is: “Can these retailers get generic replacement parts cheaper than OEMs?” and “Can auto parts retailers effectively siphon off market share from parts and service departments?”Auto parts are getting pricier, and demand for those parts is increasing, but well below the rate of vehicle prices themselves. As shown in the chart below, motor vehicle parts and equipment were 12.6% more expensive in January compared to a year earlier, while used-car prices increased 40.5% in that same time frame. With consumer demand for parts and services high, auto parts retailers have been able to capture success. For example, in 2021, Advance Auto Parts increased its operating margin for the fourth consecutive year. Likewise, O’Reilly Auto Parts and AutoZone also experienced margin growth. As 2022 gets into full swing, parts and service departments as well as auto parts retailers are both expected to get bigger slices of the growing auto industry pie. When it comes to your dealership’s parts and service department, it is unlikely that future competition between auto parts retailers and parts and service departments reaches the point where significant market share is at stake. However, further margin improvement is expected across the board as high auto prices keep existing vehicles on the road for longer, requiring more replacement parts with favorable margins priced in.As 2022 gets into full swing, parts and service departments as well as auto parts retailers are both expected to get bigger slices of the growing auto industry pie.Trends – Expectations in 2022Like new and used vehicle departments, auto dealers’ parts and service departments are poised to thrive in 2022. Increased mileage on an aging vehicle population is expected to keep the demand for auto parts high and dealerships fixed operations are expected to remain strong enough to prevent lost market share to retailers. Increased automation, digitization, and electrification may represent a tailwind as professionals are more likely to handle increasingly difficult repairs. Also, margins should remain healthy as parts manufacturers struggle to enforce desired price increases.On the other hand, some factors could be a drag on parts and service departments’ success over the next year. For example, increased vehicle leasing could encourage consumers to put off repairs on cars and trucks that they do not personally own. More reliable models also tend to need less work overtime, as procedures like oil changes happen less often. Electric vehicles, a growing segment, raise issues for dealerships in the short and long term as dealerships are experiencing a shortage of qualified technicians and equipment to conduct repairs on these types of vehicles.March 2022 OutlookMercer Capital’s outlook for the March 2022 SAAR is pessimistic. January and February are the two months that require the largest seasonal adjustment to the SAAR metric, hiding low volumes behind low expectations that accompany any year’s first two months. Vehicle sales in March are typically higher than January and February, meaning that continued record low inventory and sales volumes are likely to rear their head in next month’s seasonally adjusted annual rate.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Do RIA Investors Prefer Growth Over Value?

What Public Company and Transaction Data Multiples May Tell Us About RIA Investor Preferences

As valuation experts, we watch trading multiples closely in both the public and private markets. We diligently follow handpicked investment manager indexes, and we monitor publicly disclosed transactions as well as our own proprietary data collected through our hundreds of valuation engagements. In a valuation context, market pricing is often viewed as a test of reasonableness as to an appraiser’s conclusion of intrinsic value. As any investment management professional knows, the reason may elude public pricing from time to time, but in the long run, market pricing is the only true proxy for intrinsic worth. Studying how multiples change over time helps us contextualize industry trends and pervading sentiments.In recent years, market sentiment for publicly traded investment managers has lagged the optimism seen in the robust private markets for RIAs and other investment managers. This should sound counterintuitive. In most cases, publicly traded companies are priced at a premium to their typically smaller, less liquid peers. Theoretically, public companies enjoy the benefits of liquidity and heightened access to capital which in turn spurs growth. Additionally, publicly traded companies are typically larger and have demonstrated the aptitude to amass scale, institutional backing, and brand necessary for an IPO. To some degree, these trends do bolster public market valuations, which makes it all the more striking that public multiples should trail private market competitors.*Table represents Mercer Capital’s index of U.S. publicly traded investment management firms with under $100 billion in AUM, excluding those specializing in alternative investmentsWhile public companies traditionally warrant outsized multiples, transaction data to is often biased upwards. In most cases, and especially in the investment management industry, deals are made for the purpose of unlocking “transaction value.” This may arise from increasing profitability, growth, or reducing risk. For instance, in joining two firms, advisors may be able to increase margins by sharing overhead and management costs or by streamlining cost-effective operational platforms. In other instances, advisors may be able to tack on new service offerings or expand into more strategic geographies. Any value identified in a transaction above fair market value is referred to as a transaction premium and is often shared between the buyer and seller upon negotiated terms.Transaction premiums vary widely and are difficult if not impossible to quantify without already having determined a specific buyer. In the context of “fair market value” – the most common standard of value used in appraisals — we try to decouple any transaction premiums when relying upon transaction data. In many instances, however, transaction premiums cannot be identified in private transactions due to the inability of a third party to ascertain the value a unique buyer sees in their purchase. For this reason, appraisers are often cautious when using guideline transactions data. A common proxy for a transaction premium, albeit a rudimentary one, is an earnout. Earnouts are contingent money paid out to the seller over time based on future performance. The purpose of an earnout is to align the incentives of the buyer and seller after any transaction is closed. If we consider earnouts to be a decent proxy for a transaction premium, transaction multiples observed from private market data still indicate a premium of 6.4% enterprise value to revenue and 27.4% enterprise value to EBITDA (see table below). We believe there are multiple reasons for this discrepancy in pricing among public and private buyers. First, most publicly traded investment management firms can be categorized as asset managers, specializing in investment products and seeking to generate alpha, while the typical RIA often focuses on wealth management, specializing in a range of services to protect and grow client wealth. Over the past decade or so, asset managers have faced fee compression as passive investment products such as ETFs and index funds have outperformed actively managed funds in both fund flow and return. Wealth managers, on the other hand, have demonstrated exceptional client retention independent of market performance. Consequently, wealth managers are often valued at a premium to asset managers in the current market environment. This may explain to some extent why smaller transactions are trading at multiples above publicly-traded competitors, but probably not entirely. For instance, consider Silvercrest Asset Management Group, Inc. Despite its name, Silvercrest can be considered, for all intents and purposes, a wealth manager. According to Silvercrest’s most recent 10-k, the RIA boasts 98% client retention and promotes itself as a financial advisor offering family office services to ultra-high net worth individuals (net worth above $10 million) along with investment services to institutional investors. While investment research, portfolio construction, and implementation are performed in-house, Silvercrest benefits from the same higher margin, higher retention model of any wealth management firm. Despite the similarities to smaller wealth managers, Silvercrest was trading more or less in line with the median multiples observed among publicly traded asset management firms with assets under management below $100 billion. Compared to our proprietary transaction data, excluding contingent consideration, Silvercrest is valued well below private market indications. So, Who Is Correct?To understand the pricing discrepancy between public and private markets, it is helpful to look to the publicly traded RIA consolidators for perspective.The aggregator value proposition to investors can more or less be summed up as enhanced growth through RIA (typically wealth management) acquisitions done at multiples below the aggregator’s multiple (multiple arbitrages) and financed with cheap (for now) debt. RIA multiples have expanded significantly in recent years, which leaves growth as the primary driver of shareholder return. While the aggregator model may advertise streamlined platforms or expansive service offerings, the business model is more or less the same as those wealth managers they look to acquire. Multiples, however, tell a different story. As seen in the table above, median revenue and EBITDA multiples are well above those observed in our transactions data, suggesting a significant premium on growth in the RIA market.The premium investors place on growth in the RIA industry helps explain the discrepancy in multiples between the private and public markets. The private RIA market is dominated by a handful of aggregators, and the need to achieve growth to appease shareholders may be a primary reason for outsized valuations within the smaller, private markets. Additionally, smaller RIAs, like any smaller company, are able to achieve superior growth during the beginning of their life cycle, better attracting buyers and higher valuations. While in most industries the premium placed on outsized growth for smaller companies is typically offset by higher discount rates attributable to company specific risk, the RIA industry may place a higher premium on growth opportunities than other industries.As independent appraisers, our objective is to render an unbiased conclusion of value that is both aware of while also independent of general market sentiments. This is why it is essential to hire an appraiser with both deep industry knowledge and expertise in business valuation. If you are considering a valuation or a transaction, please contact a Mercer Capital professional.

Price vs. Value

How Can the Conclusion of Value for the Same Auto Dealership Be Different?

Do you first see a man playing the saxophone or the face of a woman? How can different folks viewing the same image see different things? These types of images are fun and there are the reasons that we see what we see which involve human psychology and how the brain works. In terms of a business valuation, how can the conclusion of value for the same auto dealership be different?Arriving at Different Conclusions of ValueWe have heard it said that if you have ten different business appraisers perform a valuation of the same auto dealership, they might arrive at ten different conclusions of value. That doesn't sound comforting. How is this possible? In the previous two-part blog series on Levels of Value (here and here), we discussed a few potential reasons.Values can differ due to the appropriate level of value for the intended valuation or due to the purpose of the valuation. Values can also differ because the valuation process is both an art and a science. The science of valuation includes the three valuation approaches (asset, income, and market) as well as the valuation process (due diligence and financial modeling). The artful part of valuation incorporates all of the underlying assumptions including the appraiser’s understanding, interpretation, and support for each.Valuations can also differ depending on the Standard of Value used in the valuation. The three most common standards of value are fair market value, fair value, and strategic/investment value. A brief definition of each is as follows:Fair Market Value – The price exchanged between a willing buyer and a willing seller, both being informed of the relevant facts, and neither being under compulsion to buy or sell (generally includes the application of discounts for lack of control and marketability where applicable)Fair Value – Generally assumed to be fair market value without consideration of discounts for lack of control and marketabilityStrategic/Investment Value – The value to a particular investor or buyer based on their individual requirements and expectations. Because certain investors are able to generate higher returns from the same assets due to strategic opportunities, they can pay a higher price than other potential buyers and achieve the same level of returnThe Difference Between Value and PriceThe difference can also be explained by the difference between price and value. For a public company, these terms are supposed to be synonymous. In other words, the value of a share of Apple stock is equal to the market price of the equivalent share on a given day. Then again, if the price of every public stock was exactly what it was worth, would Warren Buffet be a billionaire?While the terms price and value are often used interchangeably, their meaning may not be synonymous in the context of a private business, or in this case an auto dealership. In this post, we examine the differences between price and value.The Price of an Asset or BusinessConversely, the price of an asset or business is governed by the supply and demand for that asset. As demand for an asset increases, the price will increase. As supply for an asset decreases, the price will increase. We are seeing the negative impact when both conditions exist in our daily lives with the prices of new and used automobiles, along with most consumer goods. This is also true for auto dealerships themselves. In an increasingly digital world, some of the large public auto retailers are acquiring dealerships in order to increase their scale. This added demand has boosted the Blue Sky values of dealerships. And while there are plenty of headlines about large deals and high valuations, the environment has persisted because strong earnings have made some dealers reticent to let go of their primary asset during a period of record performance.The price of a dealership may also be impacted by circumstances unique to the dealer principal. Selling the dealership may mean the loss of a salary in addition to the residual earnings of the dealership. Given the stage of life and other considerations, some dealers may not be willing to give up the golden goose, meaning it would take a much higher price to compensate them to exit the investment, perhaps exceeding the “value” of the dealership.Price, particularly in the stock market can also be affected by mood, momentum, and sometimes irrational forces. These factors are often referred to as Behavioral Economics. A classic example is “loss aversion” when a person refuses to sell a declining investment to avoid recognizing a loss. In such cases, the person is hoping for a recovery in the price before selling, even if their capital could be better deployed somewhere else. With the GameStop craze last year, plenty of investors piled into the stock wanting to be part of the crowd, being overconfident, or not properly assessing potential risk and return with the investment. While this undoubtedly plays a role in the elevated price, the vast majority of people buying acknowledged the stock price was not in line with the Company’s intrinsic value.The Value of an Asset or BusinessThe value of an auto dealership, or any asset, is generally based on its fundamentals. Under an asset approach, the value of an asset is typically based on the condition, age, and creator of that asset. For an auto dealership, the adjusted balance sheet indicates the fair market value of the tangible assets of the dealership. When combined with the Blue Sky value for the franchise rights, the resulting indication represents the total fair market value of the dealership. Under the income approach, the value of the business is determined by three primary factors: earnings/cash flow, risk, and growth. As cash flow/earnings or growth increases, the resulting value increases. As risk decreases, the resulting value will also increase all other things held constant.While a valuation considers the asset, income, and market approach, the difference between price and value might best be understood through the lens of these approaches. The asset approach is the price of all the Company’s assets, minus the price of its liabilities. The market approach is the price someone else might be willing to pay, based on prices paid for similar dealerships. The income approach however is more of a value perspective. It is based on an expectation of future earnings, weighed against a required rate of return. The value indication is primarily driven by these return expectations, rather than a price an investor would be willing or able to pay.Price or Value in Auto Dealership Valuations?After analyzing the differences between price and value, let’s revisit some of the purposes and data points for an auto dealership valuation to determine whether the conclusion represents price or value.Wealth Transfer/Gift and Estate – VALUEThe valuations of auto dealerships for these purposes are compliance-based and serve to protect the integrity of the transaction or transfer. The valuations are based on the classical valuation models and the conclusions will generally illustrate value.Valuation for Strategic Planning for Dealer to Contemplate a Sale – PRICEIn this instance, the appraiser might consider specific factors of the investment or buyer in addition to the classical valuation models. The conclusion might consider cost savings to the eventual buyer or improvements that a larger or more sophisticated buyer could implement to improve current operations.General Litigation or Divorce – VALUEIn the context of most ligation settings, the appraiser is asked to determine the value of the auto dealership for the trier of fact. Likewise, these valuations are based on classical valuation models and the conclusion will generally illustrate value.Internal Transactions within the Company’s Stock – VALUE and PRICEIn the course of a valuation of an auto dealership, the appraiser will ask management if any recent transactions have occurred in the stock of the Company. Transactions typically consist of an owner buying into the Company or the Company or owner redeeming another owner. These transactions can serve as data points to the valuation. Often, the sophistication and motivation of the buyer and seller are unknown. Further, many of these transactions occur without a formal valuation. In many cases, these transactions will reflect price (how much the buyer can afford to pay) and not necessarily value (what a hypothetical disinterested third party might be willing to pay). Typically, an appraiser would seek to investigate the motivation of the parties and evaluate the conclusion in the context of other classical valuation models to determine if they are an appropriate indication of value.ConclusionAs we have discussed, price and value are terms that are often used interchangeably. In the context of privately held auto dealerships, the terms can represent different conclusions of value. Some define price as what you pay for an asset, while value is what you receive or what something is worth.Understanding the purpose for a valuation and the appropriate level of value can dictate whether the conclusion represents price or value. Understanding these terms and the other factors discussed in this post can also explain some of the differences in concluded values for the same auto dealership.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Understand the Asset Approach in a Business Valuation

What Is the Asset Approach and How Is it Utilized?

Mercer Capital’s Value Matters^® 2022-03

All in the Family Limited Partnership

Three Questions to Consider Before Undertaking a Capital Project

From time to time in this blog, we take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers.What are the most important qualitative factors to consider when evaluating a proposed capital project?Net present value analysis, internal rate of return, and other quantitative analyses are important tools for evaluating capital projects. While family business directors should be acquainted with these tools and generally understand how they work, it is just as important that directors understand the limitations of these tools.Quantitative capital budgeting tools cannot answer this question: should we undertake the proposed capital project?Specifically, these capital budgeting tools are ideal for answering this question: Is the proposed capital project financially feasible? Too often, however, we see these tools being used to answer what seems to be a related question, but one that the tools are simply not designed to answer: Should we undertake the proposed capital project? The first question opens the door to the second, but the tools of capital budgeting – no matter how sophisticated or quantitatively precise – cannot answer the second. To answer the second question, you and your fellow directors need to consider three qualitative factors, each of which can be framed in the form of a corresponding question.1. Market OpportunityThe market opportunity question is simply this: Why does the proposed capital project make sense? Management must be able to provide a simple, straightforward, and compelling answer to this question. The components of an acceptable answer to this question should focus on the customer need being addressed by the project and how the project is an improvement over how the market is currently meeting the identified customer need. Under no circumstances should the answer to this question reference a net present value or internal rate of return. If the minimum conditions of financial feasibility have not been met, the proposed project should not be in front of the board.2. Strategic FitOnce the market opportunity has been demonstrated and vetted by the board, the next question is this: Why does the proposed capital project make sense for us? In other words, how does the proposed capital project relate to the family business’s existing strategy? Does the proposed project represent an extension of the existing strategy, or does it deviate from the strategy?One temptation that family businesses can succumb to is modifying an existing strategy for the express purpose of justifying a proposed capital project that a key constituency really wants to do, which is inadvisable. Instead, the board should understand why a change in the company’s existing strategy is warranted and why the proposed change to the strategy is an improvement given current market and regulatory conditions, competitive dynamics, and opportunities. If the board determines that the proposed change in strategy is appropriate, then the discussion can move to whether the proposed capital project should be approved. If strategy is the driving factor, the proposed capital project may not necessarily be the best way to execute on the new strategy.Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.This discussion presupposes, of course, that the family business has a strategy that has been clearly communicated to management, employees, and shareholders. Absent a guiding strategy, capital budgeting can devolve into what one of our clients sagely referred to as “a race to the table.” If there’s no guiding strategy, the first manager to arrive at the board meeting with a financially feasible project is likely to receive approval, even if the project does not promote the long-term health and sustainability of the family business. Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.3. ConstraintsThe final question is this: Can the proposed capital project be done by us? Management's time and attention, infrastructure and systems, and human resources are limited. Will undertaking the proposed capital project divert scarce resources away from other areas of the business? In our experience, managers proposing capital projects tend to underestimate the impact a project will have on the rest of the business. While it is certainly true that some expenses are fixed in the short term, all expenses are variable in the long-run. Resource constraints can be overcome, but directors should be certain that the full cost of doing so has been contemplated and reflected in the capital budgeting analysis.ConclusionDoes your family business have a robust capital budgeting process that determines whether a proposed capital project is financially feasible? If it does, that’s great. But the approval process cannot end with a green light on the financial side. Family business directors need to be diligent to answer the qualitative questions identified in this post.Originally posted on Mercer Capital's Family Business Director Blog April 29, 2019

Acquire or Be Acquired (AOBA) 2022: Review & Recap

After going virtual in 2021, the Omicron waved peaked just in time for the Acquire or Be Acquired (AOBA) conference to resume its normal physical presence in Phoenix, Arizona during late January.The virtual sessions in 2021 lacked their normal impact, given the inability, through face-to-face communications, to delve deeper into emerging strategies and industry trends with peers and subject matter experts.The most common sentiment expressed this year was simply the gratitude that we could gather once again, connecting with existing industry contacts and establishing new relationships.AOBA’s emphasis has evolved.When we first attended the conference, the sessions emphasized acquisitions of failed banks to such a degree that presenters struggled to avoid overlapping content.Then, the conference shifted to emerging from the Great Financial Crisis and the transition to unassisted M&A transactions.We still remember the years that distressed debt buyers roamed the halls looking for unsuspecting bankers with loans to sell.More recently, the traditional financial services industry structure—with separate, and somewhat inviolable, silos for banking, insurance, wealth management—has been fractured by new challengers from the FinTech sector.Armed with venture capital funding, a willingness to tolerate near-term losses, and a mindset not shackled by traditional operating strategies, the FinTech challengers have sought product lines prone to automation and homogeneity, like consumer checking accounts and small business lending.However, while seeking to disrupt the banking industry, FinTech companies also need the banking industry for compliance expertise, funding, access to payment rails, and the ability to conduct business across state lines.AOBA 2022 sought to unify several discordant themes.The first theme is fracturing and convergence.While FinTech companies seek to challenge the traditional banking industry, they rely on the industry and, indeed, have entered into M&A transactions to acquire banks.The second theme is threat and opportunity.Banks face challenges from FinTech companies for certain customer segments, but FinTech products and partnerships offer access to new products, new markets, and more efficient operations.For fans of price/tangible book value multiples, though, AOBA 2022 still offered plenty of perspective on recent bank M&A trends.We’ll cover four themes from AOBA 2022.1. FinTech Competitors/Partners & the Nature of CompetitionFinTech’s presence continued to increase at AOBA, both in terms of conference sponsors and mentions throughout the conference.The most popular breakout session we attended was entitled “Crypto/Digital Assets – A Threat or Opportunity for Your Bank,” although it is difficult to ascertain whether the attendance reflects mere curiosity or a leading indicator that more banks will enter the Crypto space.One common thread of FinTech-related presentations is that bankers should take a more expansive view of their competitors.Three FinTech-related companies would rank among the twenty largest U.S. banks, as measured by market capitalization, including Paypal Holdings (#4), Square (#9), and Chime (#12, based on the value implied by its last funding round).One speaker encouraged banks to adopt an “ecosystem” strategy instead of an “industry” strategy, noting that families often have 30 to 40 relationships with financial services providers, defined broadly.1Thus, banks’ strategies should not be defined by traditional boundaries but rather embrace the entire financial “ecosystem” in which a range of competitors seek to displace banks from their traditional roles.In this view, banks compete for customers from the “inside out,” while FinTech companies challenge from the “outside in.”It remains difficult to quantify the direct impact on community banks from the current crop of non-bank competitors.Nevertheless, banks’ strategic plans should evolve to reflect the growing population of well-financed non-traditional competitors, for which the pandemic has in some cases accelerated customer adoption.The last FinTech theme related to “partnerships.”This term has evolved towards a somewhat expansive definition this millennium, with seemingly any relationship (even as a customer/vendor) deemed a “partnership.”Certainly, many banks are evaluating FinTech products, with an eye on both expanding revenues and increasing efficiencies.Others are becoming more intertwined with FinTech companies, either as investors or as the banking platform used by the FinTech company itself.There is some evidence that banks more closely allied with FinTech companies are being warmly received by the market, given their potential revenue upside.When evaluating “partnerships,” we suggest deploying a risk/reward framework like banks use in evaluating other traditional banking products.The lower risk/lower reward end of the spectrum would entail limiting the “partnership” to a particular FinTech product or service, such as for opening consumer checking accounts or automating a lending process.The higher risk/higher reward part of spectrum would include equity investments or facilitating the FinTech’s business strategy using the bank’s balance sheet, compliance expertise, and access to payment rails.Like with any bank product, different banks will fall in different places along this spectrum, given their histories, management and board expertise, shareholder risk tolerance, regulatory relationships, and the like.2. Traditional Bank M&A:Tailwinds & HeadwindsMercer Capital provided its outlook for bank M&A in the December 2021 Bank Watch.Naturally, the investment bankers at AOBA are bullish on bank M&A in 2022.This optimism derives from several sources, including the pressure on revenue from a low interest rate environment and the technological investments needed to keep up with the Joneses.Several headwinds to activity exist though:Some transactions initiated prior to the COVID-19 pandemic in March 2020 were placed on hold throughout 2020, but negotiations resumed in 2021.These transactions likely enhanced the reported level of deal activity in 2021, but this deal backlog now has likely cleared.With the banking industry consolidating, fewer potential buyers exist.Smaller banks or banks in more rural areas may face a dwindling number of potential acquirers.Meanwhile, the remaining acquirers may seek to focus on larger transactions in strategic markets.This could lead to a supply/demand imbalance, although non-traditional buyers—read credit unions—could fill the void.After the drama over the FDIC’s leadership, many observers are expecting a more rigorous regulatory review of merger applications, such as around competition issues or fair lending compliance.In the near term, navigating the regulatory thicket would appear most fraught for larger buyers.Another trend to watch is M&A activity involving non-traditional buyers.Mercer Capital’s Jay Wilson presented a session on credit union acquisitions of banks, focusing on the perspective credit unions take when evaluating potential acquisition targets.In a reversal of roles, FinTech companies now have entered the scene as acquirers.In February 2022, SoFi completed its acquisition of Golden Pacific Bancorp, and several other precedent transactions exist.3. Subordinated Debt:Act Now?The subordinated debt market has been quite active, with bank holding companies issuing debt typically with a ten-year term, a fixed rate for the first five years and a variable rate tied to SOFR for the second five years, and a call option in favor of the issuer after five years.Pricing tightened throughout 2021.Through early 2022, pricing of newly-issued subordinated debt has remained stable in the 3.50% range, despite rising Treasury rates.This implies that the spread between the fixed rate on the subordinated debt and five-year swap rates has tightened, falling to levels even below those observed in 2021.Subordinated debt counts as Tier 2 capital at the bank holding company level but can be injected into the bank subsidiary as Tier 1 capital.If bankers expect rising loan volume as the economy continues to recover from the pandemic, then it may behoove institutions to issue subordinated debt now and lock in a low cost source of capital.4. The Regulatory Wild CardSome attendees expect greater regulatory enforcement and rule making activity in certain areas, with the most likely suspect being fair lending.However, leadership at some regulatory agencies remains in flux, such as at the OCC where President Biden’s nominee was withdrawn in the face of Senate opposition.This would not be a constraint, though, at the CFPB, which has a Senate confirmed director who appears ready to take a more active stance on fair lending matters.Interestingly, many larger banks have moved to limit overdraft and insufficient funds charges, even absent any actual (as opposed to hinted at) regulatory changes.Tightening practices around overdrafts appears to be another risk to community banks, which may lack the revenue diversification that permits larger banks to absorb a loss of consumer banking fee revenue.ConclusionWe sense that AOBA is moving into a new era, as it did when the Great Financial Crisis passed.Attendees and sponsors are, to an ever greater extent, coming from outside the traditional banking industry.This mirrors the banking industry itself, with its widening set of non-traditional competitors targeting different customer niches.Future conferences will reveal the extent to which traditional and non-traditional competitors converge.Regardless of what happens with the intersection of banks and FinTech companies, we can only hope that we’ve attended our last virtual conference.1 See Ronald Adner, Winning the Right Game, How to Disrupt, Defend, and Deliver in a Changing World, The MIT Press, 2021.

Themes From Q4 2021 Energy Earnings Calls

Part 1: E&P Operators

In Part I of our Themes from Q3 Earnings, topics included increased global demand for U.S. LNG exports and the divergence in the value proposition of E&P operators. Some opted to focus on using free cash flow to either pursue share repurchase programs and/or increase dividends instead of seeking out acquisition opportunities.On the other end of the spectrum, Continental Resources announced an agreement to purchase Delaware basin assets from PioneerResources to the tune of $3.25 billion. Technically, this acquisition was announced in Q4 (on November 3rd), but Continental’s management team made a point of mentioning it in the Q3 earnings call. Still, some companies, like EOG Resources, signaled setting their sights on pursuing more organic, exploration-driven growth and footprint expansion.In the last round of earnings calls for 2021, cost inflation was discussed with a bit more granularity than in recent quarterly calls, strengthening oil prices sparked a shift in focus towards the liquid hydrocarbon streams, and commentary regarding macro policies targeting hydrocarbons were prevalent in E&P management discussions.Cost InflationIn our Q1-Q3 2021 Themes From Oilfield Service Company Earnings Calls post from late January, we noted that OFS operators were likely hitting an inflection point in mid- to late-2021, with greater command of the prices they charged their E&P customers than in recent history. While service cost inflation was certainly on the minds of some E&P operators, costs for various industry inputs were mentioned in the Q4 earnings calls.“On the service side, on the rig and the frac crew side, because the way that we've contracted those services we've been somewhat isolated so far, in any kind of cost inflation along those lines. Where we've seen the bulk of the inflation so far in our business has been materials, particularly with respect to steel related material. Probably half of the inflation that we’ve baked into our '22 forecast [5% to 10%, year over year] is almost entirely in either steel or tubular. The rest of it, would it be spread across the multitude of materials that we use in our business." – Chad Griffith, Chief Operating Officer, CNX Resources“Our drilling and completion capital budget of $675 million to $700 million reflects an impact of approximately 5% from service cost inflation. This inflation includes the net benefit of expected sand savings from our regional sand mine.” – Paul Rady, President & CEO, Antero Resources“On the cost side, structural operating efficiency gains in 2021 continue to drive our average cost per foot down by approximately 7% on average, year-over-year. In our 2022 budget, we expect modest cost inflation.” – Jack Stark, President, Continental ResourcesShifting Focus Towards LiquidsIt is not newsworthy at this point to say energy prices bounced back over the course of 2021 as compared to the subdued levels seen over 2020. However, despite the significant increase in U.S. natural gas production (with no countering decrease in gas prices), several E&P management teams noted a shift back towards liquids in the latest earnings calls.“While our 2022 lease operating cost per barrel-oil equivalent guidance is modestly above our 2021 level, this reflects our pivoting towards greater oil activity…” – John Hart, CFO, Continental Resources“My comments today will focus on our current view of the liquids markets, more important than ever given we are fully unhedged on all oil and NGL production as of the start of 2022. The past few months, we have seen crude prices reaching their highest levels since 2014, with Brent and WTI touching these 7-year highs supported by global supply concerns and geopolitical tensions across several key regions. At the same time, demand has surprised to the upside and market demand forecasts have been revised upward, primarily due to the more muted impact of Omicron on global consumption compared to previous COVID variants. NGL prices have also benefited in the current bullish price environment.” – David Cannelongo, Vice President – Liquids Marketing & Transportation, Antero ResourcesPolicy HeadwindsIn our Energy Valuation Insights coverage of Appalachia, we noted a strongly worded letter sent from Massachusetts Senator Elizabeth Warren to natural gas E&P operators for the purpose of “turning up the heat on big energy companies who are gaming the system by raising natural gas prices for consumers to boost profits and line the pockets of executives and investors.” Controversy regarding the perception, whether real or imagined, that the U.S. E&P industry holds enough power to materially or unilaterally guide global energy prices is nothing new. However, several comments made in the Q4 earnings calls suggested a deeper underlying sentiment from E&P management teams that certain industry headwinds are the direct result of certain national policies.“We are proud to play our role in supporting U.S. energy security, which protects the U.S. consumer and serves as a powerful tool of foreign policy providing options for both the U.S. and our allies. We must take on the dual challenge of meeting the world's growing energy needs while also prioritizing all elements of our ESG performance, including efforts to address climate change. This is not an either/or proposition and failure on either front is not acceptable. However, our approach must be pragmatic and grounded in the free market, innovation and an ‘all of the above energy’ approach. We are unfortunately experiencing firsthand the impacts of misguided energy policy and the dramatic role it can play on energy affordability as well as geopolitical stability.” – Lee Tillman, President & CEO, Marathon Oil“I may add one other thing that I know you would have seen some of the comments from the Federal Reserve, if I can, this morning about, ‘Do you want to go and target industries?’ [We note that the referenced comments from the Fed could not be readily verified], and so I think that's why you're seeing us and probably the industry at large being very focused on getting that net debt down, because there is potentially a targeting of this industry to not be friendly toward lending money term.” – Bill Berry, CEO, Continental Resources“What you've got right now, not just within Appalachia, but nationally, is a policy that is designed basically to not have a natural sort of [pipeline] investment occur to match something like the supply of natural gas to the demand centers. I don't know if, at last, we're starting to see some problems manifest with respect to that type of policy.” – Nick Deluliis, CEO, CNX ResourcesMercer Capital has its finger on the pulse of the E&P operator space. As the Oil & Gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

Value Adrift?

If You Don’t Know What’s in Your Buy-Sell Agreement, You Don’t Know What You Own

A couple of weeks ago, the crew of a ship known as The Felicity Ace noticed smoke coming from the cargo hold. Below deck were 4,000 cars being ferried from Europe to Rhode Island, including at least 2,000 Volkswagens, 1,100 Porsches, and nearly 200 Bentleys. The fire spread quickly and the 23 members of the crew were evacuated by a Portuguese military helicopter. The ship was left to drift several hundred miles off the coast of the Azores; bad weather has made it difficult to reach The Felicity Ace and tow it to port. The ultimate fate of the ship and its cargo are still unknown, but it’s certain to be a mess.I was reading about The Felicity Ace while we were publishing our recent blog series on buy-sell agreements (here, here, and here). The former is a decent metaphor for the latter. When RIAs are formed, they often enter into some kind of shareholder agreement whereby the parties agree upon rules to buy or sell ownership interests under given circumstances. No one thinks much about it because the expectation of a terminal event – like the sale of the business or the retirement of a member – is so far off in the future. It’s like loading 4,000 cars on a ship and sending it out to sea, assuming that, at the end of the journey, the cargo will be reliably delivered and offloaded in good condition. No one thinks about the ship while it’s on the way from one destination to another until a fire breaks out.Our consistent experience is that few RIA owners review their buy-sell agreements until something UN-expected happens. The partners argue over the future of the business. Someone gets divorced. Someone gets in trouble with the SEC. Someone dies suddenly. At that point, the buy-sell agreement goes from being a forgotten afterthought to the only thing on everyone’s mind. And, unfortunately, that one thing may be subject to interpretation.Our consistent experience is that few RIA owners review their buy-sell agreements until something UN-expected happens.The biggest problem we see in shareholder agreements: pricing mechanisms.If a buy-sell is triggered and a 25% shareholder is to be redeemed, what’s the transaction price?I probably don’t have to tell you what we think of formula pricing. Is the formula a multiple of trailing, current, or forward earnings? Are appropriate multiples reflective of long term averages, current market pricing, good times, bad times? Meant to represent a change of control multiple? To a financial buyer or a strategic buyer? Rational buyer looking for ROI or irrational buyer making a land grab? Pricing reflective of highly synergistic deal terms (use our vendors, sell our products, adopt our brand) or on a stand-alone basis? Sale of actual equity interests or a hybrid instrument that asymmetrically shares upside but protects the buyer against downside?We had one situation where the agreement called for pricing an interest based on “prevailing market value.” What does that mean? Current prevailing market conditions work something like this: RIA with reported EBITDA of $5 million and adjusted EBITDA of $7 million at the time of negotiating the LOI, and reported EBITDA of $6 million and adjusted EBITDA of $8 million at the time of closing, sells for upfront consideration of $40 million plus the potential to get an additional $20 million in earnout if profits grow by 25% in three years. What’s the multiple? Is it:5x (upfront consideration as a multiple of adjusted EBITDA at closing)?6x (total possible consideration as a multiple of hurdle EBITDA at the time the earnout is paid)?7x (upfront consideration as a multiple of reported EBITDA at closing)?5x (total possible consideration as a multiple of adjusted EBITDA at closing)?8x (upfront consideration as a multiple of reported EBITDA at negotiation)?9x (total possible consideration as a multiple of adjusted EBITDA at negotiation)?10x (total possible consideration as a multiple of reported EBITDA at closing)?12x (total possible consideration relative to reported EBITDA when negotiated)? Naturally, the seller wants to believe they sold for 12x, and the buyer wants to tell his capital providers he paid 5x. It does no good to ask parties what multiple was paid. We find that when people whisper deal multiples they tend to go for the highest number possible – in most cases the maximum transaction proceeds possible as compared to a trailing measure of reported earnings. This makes more than a bit of sense, because it’s also self-serving. The seller gets to brag about what he was paid – and we all value psychological rewards. The investment banker brags about what a good job she did – and she probably did do a good job. And the buyer gets a reputation for paying up so the potential sellers will return his call. All of this is good for the deal industry, but not especially revealing as to valuation.We find that when people whisper deal multiples they tend to go for the highest number possibleAbsent some reliance on formula pricing or headline metrics, you can hire an appraiser…like us…but even that’s complicated. Do you pick a valuation specialist or an industry expert? Valuation people characteristically rely on DCFs that might be more expressive of intrinsic value than market. That’s not me engaging in professional self-loathing – it’s just how my tribe is wired. Then there are industry experts – usually investment bankers – who’s perspective leans heavily on the best deal they’ve heard of recently with a highly-motivated and over-capitalized buyer and a pristine target company with strategic relevance.If you hire a valuation expert with ample amounts of relevant industry experience (like us), you should get a balanced approach to the pricing of your transaction. But even the best resources out there (like us) have to deal with pricing expectations set long before we are involved. A buyer who wants something akin to intrinsic value and a seller who wants the high bid from a strategic buyer in a competitive auction are going to have a hard time coming to terms with the result of any valuation exercise. That situation is more common than not.I’ll offer two closing pieces of advice on crafting the valuation mechanism in your buy-sell agreement:Get your RIA valued on some kind of regular basis. If you have a smaller firm, a valuation every few years may suffice. If you have a larger firm, you might need it more than once per year. What this manages, more than anything, is expectations. The psychological bid/ask spread I describe above is much more narrow when the parties to an agreement are accustomed to seeing particular numbers, methodologies, and metrics used to determine the value of their interest. This is the main function of regular valuations. Buy-sell valuations are five-figure exercises. Buy-sell disputes are seven-figure catastrophes.Don’t draft your pricing mechanism to intentionally privilege either the buyer or seller at the expense of the other. We’ve seen estate situations where the company was compelled to redeem a 25% stake for about 45% of the value of the business. The resulting dilution to the remaining shareholders put a huge strain on the business model, ownership transition, and sustainability of the company. We’ve seen shareholder squeeze-outs where a group of shareholders were entitled to kick out a partner for minimal consideration. There’s no virtue in democracy when two lions and one lamb vote on what to have for dinner. Regardless of what you think your RIA is worth, if you aren’t intimately familiar with the terms of your buy-sell agreement, you don’t know what your interest in your RIA will net you in a transaction. Pull your agreement out, and read it. If it seems at all confusing as to how it will function when the buy-sell mechanism is triggered, it will be worse than you expect. There has been considerable speculation as to what sort of cars are in the hold of The Felicity Ace. Are they all conventional internal combustion engine cars with a minimal amount of gasoline in their tanks, or are some of them EVs carrying highly combustible lithium-ion batteries? Whichever the case, it’s too late now to do anything about it. Don’t wait until your ship is adrift and on fire to check your buy-sell. If business is good and your partners are happy – consider this your opportunity.

A Primer on a Growing Breed of Bank Acquirers

Credit Unions & FinTech CompaniesWhile still making up a small proportion of overall deal activity (<10% of total deal volume in 2021), acquisitions of banks by both Credit Unions and FinTechs have been increasing in recent years.The first credit union to acquire a bank occurred in 2011/12.Since then, approximately ~55 whole bank transactions have been announced with the peaks occurring in 2019 (14 transactions) and 2021 (13 transactions announced).The first announced FinTech acquisition of a bank was Green Dot’s purchase of a small bank back in 2010 for $15 million. There were also several online brokers that acquired banks from the late 90s to mid-2000s. In 2021, there was a marked increase with six announced transactions whereby FinTechs announced acquisitions of banks.This emerging breed of bank acquirers (CUs and FinTechs) provides bank sellers with an additional pool of potential buyers to consider when evaluating strategic options and liquidity events.Mercer Capital's Jay D. Wilson and Honigman's Michael M. Bell presented this session at the 2022 Acquire or Be Acquired Conference sponsored by Bank Director.

WHITEPAPER | Understand the Value of Your InsurTech Company

InsurTech companies are an emerging and fast-growing sector of the financial services industry. Against a backdrop of robust fundraising numbers and high profile exits via SPAC or IPO, many of these companies begin as start-ups and a few exciting years later, are able to raise millions of dollars in hopes of becoming the next “unicorn”. While this business trajectory may seem simple and attractive, these companies usually have a highly complex ownership structure made up of many investors of different origins, including venture, corporate, and/or private equity, all with different preferences and capital structures.Valuing an InsurTech company can be complicated and difficult, but carries important significance for employees, investors, and stakeholders for the company. While all InsurTech companies have differences, including what niche (distribution, claims, benefits, etc.) they operate in or what stage of development the company is in, understanding the value of the business is critically important.

Breaking Up Is(n’t) Hard to Do

Kicking off with the inspired lyrics, “Down dooby doo down down,” Neil Sedaka assured legions of teenage girls in 1962 that “Breaking Up Is Hard to Do.” Sixty years later, the actions of the Follett family are telling family business directors that maybe breaking up is not so hard after all.Tracing its roots to a Chicago area used bookstore opened by Charles Barnes (who later partnered with Clifford Noble) in 1873, the Follett Corporation has been owned by the Follett family since 1923. Soon thereafter the company began to focus on the educational market, with publishing, wholesaling, and retail operations on college campuses. Continued expansion over the decades culminated in the operation of three business segments:Follett School Solutions, a K-12 software and content companyBaker & Taylor, a distributor of physical and digital books and services to public and academic librariesFollett Higher Education, an operator of collegiate retail storesStarting in 3Q21, the Follett family began to “break up” the family business, selling each of its three operating divisions to a different buyer.In September 2021, Follett announced the sale of Follett School Solutions to Francisco Partners.Two months later, Follett announced the divestiture of Baker & Taylor through a management buyout.Earlier this month, Follett announced the sale of Follett Higher Education to an investor consortium led by a family office, Jefferson River Capital.We don’t know what motivated the decision of the Follett family to exit its legacy businesses. Whatever the cause, the series of transactions over the past six months provides a timely reminder that to thrive, businesses need the right owners. Even though the broad theme of books and education would seem to have provided better "glue" for the three business units than many conglomerates we see, the businesses were sold to three different buyers. Although no financial terms were disclosed for any of the transactions, we can only assume that selling the divisions to different owners generated greater net proceeds to the Follett family than a selling to a single buyer would have. What are some possible explanations for that? Why do different businesses sometimes need different owners?Risk ProfilesSome businesses are inherently riskier than others. All else equal, selling large-ticket discretionary items that consumers can easily defer or substitute is riskier than selling staple items that consumers need regardless of economic conditions. That is why the beta (a general measure of risk for public companies) of General Motors is 1.20x while that of General Mills is 0.50x. Return follows risk, and some shareholders are better equipped than others to stomach greater risks in hopes of earning greater returns. That is why some investors own General Motors while others own General Mills. Owning a General Motors-type business while having General Mills-type family shareholders is not a sustainable situation. Both the business and the family are likely to suffer.Return PreferencesShareholder returns come in two forms: current income and capital appreciation. Some investors seek current income, while others desire capital appreciation. Some businesses are better positioned to provide current income, while others more naturally provide capital appreciation. As with risk profile, if the return attributes of your family business don’t “fit” with the return preferences of your family shareholders, there is likely trouble ahead.Capital NeedsBusinesses are either in “planting” or “harvesting” mode. Businesses with a strategy for tackling a large market opportunity often require more investment capital than the operations of the business can provide. As a result, they need to seek out external sources of capital, whether debt or equity. For many families, owning these businesses can be challenging if there is a reluctance to undertake significant borrowings or to admit non-family investors into the shareholder group.On the other hand, some families are flush with capital that needs to be put to work and can grow restless with mature businesses that are perpetually in “harvest” mode. Pushing incremental capital into a business that cannot use it effectively can also breed serious problems for enterprising families.Portfolio CompositionFinally, some businesses may be worth more to a particular investor because of the composition of the rest of that investor’s portfolio. The traditional “strategic” acquirer scenario is the most obvious case, but not the only one. Even what are typically classified as “financial” acquirers often seek out certain types of companies, as illustrated by Francisco Partners, the acquirer of Follett School Solutions. The press release for that transaction notes that “FSS will join Francisco Partners’ growing portfolio of K-12 education-focused businesses and technologies, including Renaissance Learning, Discovery Education, Freckle, myON and Mystery Science.”A legacy operating business often demands – and receives – the lion’s share of the family’s attention, but it is important for family business leaders to occasionally step back and take a broader portfolio view of the family’s wealth. Taking an inventory of the overall wealth of the family can help leaders to assess what businesses make sense for the family to own and which businesses might make more sense for someone else to own.Conclusion: Getting Back to WhyWhy is your family in business together? From an economic perspective, what does your family business mean to your family? Breaking up may be hard to do, but for some family businesses it may be the right thing to do. Selling a family business – or a piece of the family business – does not mean that the broader family enterprise is failing. There are plenty of other businesses to be acquired and/or philanthropic objectives to be pursued. The Follett family illustrates this point well, as described in the press release for the Follett Higher Education sale: “The Follett family and its Board of Directors have enjoyed being part of improving the world by inspiring learning and shaping education for the past 150 years and the Follett family will continue to drive education through advocacy with future projects. The next steps for the Follett Family legacy will be to enhance its effects with future family business education and the Follett Educational Foundation.”Do your family businesses have the right owners? Does a careful analysis of risk profile, return preferences, capital needs, and portfolio composition reveal a good “fit” between your family shareholders and the various businesses your family owns? If not, do you have a strategy for moving toward a better fit? Your enterprising family’s long-term sustainability may depend on it.

LOV(E): Why Getting the Level of Value Right Is So Important to Auto Dealers

Part II

In this two-part series (the first post dropped on Valentine’s Day), we are covering a topic near and dear to the hearts of business valuation analysts. LOV – or the “Levels of value” – refers to the idea that while “price” and “value” may be synonymous, they don’t quite mean the same thing. A nonmarketable minority interest level of value is very different from a strategic control interest level of value.Last week's post and this week's post were adapted from a piece written for Mercer Capital’sFamily Business Director Blog.Part I of this two-part series described the Levels of Value and why the concept is so important to auto dealers. We present the Levels of Value chart below for reference. This week, we discuss four potential transactions in which selecting the appropriate level of value is critical and explain why: 1) estate planning, 2) corporate development, 3) divestitures, and 4) shareholder redemptions. Engagement administration and engagement planning are two steps in the valuation process that don’t garner much of the spotlight. However, defining the scope of the engagement is critical to the success of a valuation project. The scope and eventual engagement letter are often described as a road map for the project to follow. One of the great strengths of a family business is the ability to take the long view. Unburdened by the quarterly reporting cycles of publicly traded companies, family businesses can make investing and operating decisions for long-term benefit without worrying about the effect on the next quarter’s earnings. One of the foundations of this long-term perspective is the stability of ownership within the family. With an indefinite holding period, why does the value of the family business even matter? While the family may have an indefinite holding period, the fact of mortality means that individual shareholders do not. So, even for committed families, transactions will occur and valuations will matter. Let's consider four potential transactions in which selecting the appropriate level of value is critical.1. Estate PlanningMany family shareholders determine that transferring wealth to heirs while still living is advantageous. Regardless of the specific technique used, the value of shares in the family business is a cornerstone of the estate planning process. Under the IRS’ definition of fair market value, the appropriate level of value depends on the attributes of the block of shares being transferred. Since estate planning almost always involves transactions of minority interests in the family business, the nonmarketable minority interest level of value is relevant.There are also elements of estate planning that are unique to auto dealers. All dealerships must be operated by a Dealer Principal approved by the OEM. Any succession plan must consider whether the next generation would be approved as a Dealer Principal by the OEM. This approval is not always guaranteed. When desiring to transfer ownership to the next generation, dealers would be wise to consider a family choice that has been active in the dealership or has industry experience.Any succession plan must consider whether the next generation would be approved as a Dealer Principal by the OEM.Measuring the value of shares in the family business at the nonmarketable minority interest level of value is a two-step process. First, we consider what the shares would be worth if they were traded on an exchange (i.e., the marketable minority level of value). Second, we determine an appropriate discount to apply to that value to reflect the unfortunate side effects of owning a minority interest in a private company. The magnitude of that discount depends on factors like the expected duration of the holding period until a liquidity event, the level of interim distributions, and the expected pace of capital appreciation. When combined with an assessment of the risks facing the investor, these factors determine the marketability discount, which, in turn, defines the fair market value of the shares on a nonmarketable minority interest basis.2. Corporate DevelopmentFamily businesses have two basic pathways for growth: organic growth through capital expenditures (“build”) or non-organic growth through acquisitions (“buy”). The pathways are not mutually exclusive. Some families are culturally averse to acquisitions, while for others a disciplined acquisition strategy is part of the family’s business DNA. As we have discussed in this space in prior blogs, the prospects for organic growth for dealers are somewhat constrained. While dealers can improve Fixed Operations and Used Vehicle Operations, they are limited to selling more vehicles from their OEM on the new vehicle side of operations. Those growth opportunities have been more constrained over the last two years due to inventory shortages and the microchip crisis. For more desired growth, dealers must consider adding additional rooftops or acquiring other dealerships.For more desired growth, dealers must consider adding additional rooftops or acquiring other dealerships.For family business acquirers, developing an appropriate valuation of the target is essential. As one of our colleagues is fond of saying: “Bought right, half right.” Regardless of the strategic merits of a proposed acquisition, the overpayment will weigh on the returns available to future generations of the family. When formulating a bid price for a potential target, acquirers should seek to answer two questions.What is the business worth to the existing owners? Selling their business to you means that the existing owners will be giving up the future cash flows they expect the business to generate under their stewardship. This reflects the financial control level of value, which as we noted in last week’s post, is probably not much different from the marketable minority value.What is the business worth to us? To answer this question, acquirers need to carefully evaluate how the target “fits” with their existing business. Will the combination of the two businesses generate revenue synergies (i.e., 2 + 2 = 5)? Or are there duplicative costs that can be eliminated as a means of generating higher margins for the combined entity? Perhaps the combination will reduce the risk of the family business, or perhaps the family has access to lower-cost capital than the existing owners. In any event, family business acquirers should develop forecasts for the pro forma combined entity using well-supported inputs that reflect the strategic case for the acquisition to determine what the business is worth to them. Forecasts are less seldomly used in the valuation of auto dealerships, but the concept of determining the anticipated future earnings is the same. Auto dealers will generally evaluate the last two to four years of operations to arrive at that conclusion. Due to heightened profitability over the last two years, this exercise can be more difficult. We are seeing many dealers consider an average of several years of operations as an indicator of expected future operations. The difference between these two values defines the “space” over which negotiations will center. The ultimate purchase price will reflect the relative bargaining power of the two parties. As illustrated in Exhibit 1, bargaining power is a function of the number of likely buyers for the target, and whether the target represents a generic or unique opportunity for buyers.To avoid overpaying, savvy family business acquirers focus not just on what the target could be worth to them, but also what the target is worth to its current owners, along with a careful assessment of the factors that influence the relative bargaining power of the parties.3. DivestituresAt some point, many families transition to being enterprising families. In other words, they are defined by the fact that they pursue economic opportunities together, rather than by continued ownership of the legacy family business. In pursuit of broader portfolio management objectives, enterprising families may sell businesses from time to time. In this case, the dynamics described in the preceding section are reversed.In the auto dealer space, we generally see divestitures occurring for one of two reasons in recent times. First, smaller single-point dealers are facing more pressures to compete against larger auto groups in terms of online platforms, imaging requirements, and the fear/threat of electric vehicles being introduced into their models. Secondly, dealers that do not have an identified succession plan or successor Dealer Principal candidates are apt to consider selling. Heightened profits and heightened blue sky valuation multiples are also making the decision to sell more attractive in the current environment.As the seller, you won’t have direct access to what your business could be worth to the buyer. However, knowing how your industry is structured and how your business operates, you should be able to estimate potential revenue synergies and cost-saving opportunities available to the buyer.In order to achieve a sales price closer to the value of your business to the buyer, it is important to identify the attributes of your business that differentiate it from other potential acquisition targets available to buyers. Further, generating interest from a larger pool of buyers is essential to reaping greater proceeds from a divestiture.4. Shareholder RedemptionsA shareholder redemption is a purchase by the family business of shares from a family shareholder. As with our corporate development and divestiture examples from last week’s post, shareholder redemptions reflect an inherent tension between buyers and sellers, as illustrated in Exhibit 2. Unfortunately, we often see these events occur in litigation because of the differing perspectives described below. It’s common for dealers to incentivize key employees and management with an ownership stake as part of an employment agreement. These ownership interests become the subject of redemption if the employee resigns or is terminated from the dealership. In a shareholder redemption transaction, the buyer and seller do not share the same perspective.The selling shareholder owns an illiquid minority interest in a private business. As a result, the fair market value – the amount that a hypothetical willing buyer would pay – reflects a marketability discount. In other words, the nonmarketable minority level is relevant.However, in a shareholder redemption transaction, the buyer is not a hypothetical party, but the company that issued the shares in the first place. The family business is not burdened by the illiquidity of the shares in the same way a shareholder is. As a result, the value of the shares to the family business is consistent with the marketable minority level of value. It strikes us as a bit perverse to evaluate transactions between family shareholders and family businesses in terms of relative negotiating leverage. Instead, we prefer to frame the decision in terms of family business objectives: What is the purpose of the redemption? The “correct” price at which to conduct a shareholder redemption transaction is always a bit ambiguous. Consider the alternatives:Nonmarketable Minority Level. This seems straightforward – after all, that is the fair market value of what the shareholder owns. Why should the family business pay any more than that?Marketable Minority Level. On the other hand, this is the value of what the redeeming company is acquiring. Why should the departing shareholder accept any less than that? From an economic perspective, redemption at the nonmarketable minority level is accretive to the non-selling shareholders. Redeeming at the marketable minority level provides a windfall to the selling shareholder relative to the fair market value of their shares. There is no simple escape from this dilemma. The ambiguity around the level of value in these instances generally exists for engagements for internal and strategic planning purposes. If these events result in litigation, the levels of value are typically defined in the applicable standard of value or case laws of the jurisdiction governing the matter.If the family business wants to discourage redemption requests, the nonmarketable minority level of value may be preferable.If the family business is designing a shareholder liquidity program with a view to promoting positive shareholder engagement, it may be desirable to conduct redemptions at the marketable minority level of value. However, in such cases it is essential to set limits on the amount of redemption requests the family business will honor in a given period; otherwise, the liquidity program could trigger a “run on the bank,” crowding out corporate investments critical to the long-term sustainability of the family business.If the objective of the redemption is to “prune” the family tree of unwanted branches, it may be necessary to pay a redemption price at the marketable minority / financial control level of value. Depending on state statute, it may be a legal necessity. In any event, the departing shareholders are likely to demand such pricing to exit the family business.ConclusionYour family business has a different value at each level of value because of differences in expected cash flows and risk factors. Considering four common corporate transactions, we have illustrated why the level of value matters to family businesses:When transferring minority interests among family members in furtherance of estate planning objectives, the fair market value of the interests transferred is properly measured at the nonmarketable minority level.When considering a potential acquisition, family businesses should evaluate both the marketable minority / financial control level of value (what the target is worth to the existing owners) and the potential strategic control level of value (what the target is worth to the family business). These two values for the target define the relevant range for negotiating a transaction price.When divesting a business, the dynamics are reversed. The relevant negotiating range is set by the difference between the marketable minority / financial control level of value (in this case, what the business is worth to the family) and the strategic control level of value (what the business is potentially worth to the buyer). The family can improve its negotiating leverage in these situations by differentiating the business from other available targets and exposing the business to multiple motivated buyers.Finally, shareholder redemptions can occur at either the nonmarketable minority or marketable minority /financial control levels of value. The appropriate level for a given transaction should be selected with a view to the objectives of the redemption for the family business. These transactions can have profound and long-lasting economic implications for the family business and its shareholders. When the stakes are high, it’s a good idea to measure twice and cut once. When your dealership is preparing for any of these transactions, give one of our valuation professionals a call.

Oilfield Services 2022

The Rise of the OFS Bulls

In our Energy Valuation Insights post from last week, Bryce Erickson focused on Oilfield Services (OFS) company valuations. This week we follow the same OFS theme, but with a focus on OFS “expectations” and the question: “Has the OFS industry turned the corner to a more prosperous outlook?”Enthusiasm Among ExpertsOne can’t come away from a review of current OFS industry musings without feeling that, in the endless battle between OFS Bulls and OFS Bears, the Bulls have gained the advantage and are on the rise.From Bloomberg Intelligence – and under the noteworthy heading of OFS Recovery to Reach Cruising Altitude in 2022 – we find that oilfield services industry revenues are expected to grow by ten to fifteen percent in 2022, compared to nearly flat revenue growth in 2021. North American OFS is expected to lead the way with likely 20% revenue gains.Representatives of investment banking firm Evercore’s E&P and OFS groups noted in a recent Natural Gas Intelligence piece that the E&P and OFS groups’ expectations for 2022 remain bullish as they believe we are in the early stages of a long, strong, multi-year E&P spending upcycle.In its recent industry outlook, Zacks noted that the OFS industry is bright again and that the business environment for E&P activities has shown drastic improvement. That improvement is reflective of oil prices having returned to the “glorious days,” thereby leading drillers to return to the oil patch, resulting in significantly improved demand for oilfield services.Many more significantly optimistic references are available, but suffice it to say that expectations for the OFS industry (due to E&P industry activity) have changed a lot, for the better, in the last year.Basis for OptimismSo, what are the industry experts seeing that is leading to this optimism? In short:oil demand rising as the Covid pandemic recedes and the world begins the return to normal levels of activities that require energy use,significant potential for an oil supply shortage, andrecent under-investment in the new production needed to sustain supply.In light of the factors above, industry analysts are detailing some very positive expectations for the OFS industry. Such as: The Energy Information Administration (EIA) forecasts that global consumption of petroleum and liquid fuels will average 100.6 million b/d for all of 2022, which is up 3.5 million b/d from 2021 and more than the 2019 average of 100.3 million b/d. On top of which the EIA forecasts that global consumption of petroleum and liquid fuels will increase by 1.9 million b/d in 2023. So, for the first time since Covid reared its head in early 2020, global oil consumption is expected to rise to a level materially higher than pre-Covid consumption.Mizuho Securities USA LLC indicates in a January 2022 NGI article (U.S. E&Ps, OFS Players Expected to Reset in 2022, with Eyes on Inflation, Supply Chains) that in order to generate sustainable oil volumes through 2022 based on current production volumes, the rig count across the five major U.S. oil basins would have to increase by 100 rigs, compared to a 178 rig increase since January 2021.Mizuho further indicated that the rate of completions in the major U.S. basins is probably sufficient to support growth. However, the drilled but uncompleted (DUC) inventory is at a historically low level, so more drilling activity will be required. Otherwise, the needed 2022 growth in the U.S. supply could be materially held-back.Early Indications Favoring the BullsAs to early evidence supporting those expectations, Baker Hughes’ most recent North American rig count is at 854, a level not seen since the onset of the Covid pandemic in March 2020.According to Bank of America, due to the draw-down in global oil inventories in 2021, the oil market is anticipated to move from a steep deficit to a more balanced market. With that in mind, BofA is predicting that WTI and Brent will average $82 and $85 over the course of this year.Other industry analysts, including Goldman Sachs Group, are indicating that oil prices could reach $100 during 2022, while forecasting average 2022 oil prices at $85.Employment in the U.S. oilfield services and equipment sector rose by an estimated 7,450 jobs in December, according to the Houston-based Energy Workforce & Technology Council.Zacks Equity Research summarized how all this ties in to the OFS outlook: “The price of West Texas Intermediate (WTI) crude is trading higher than $89 per barrel, marking a massive improvement of more than 50% in the past year. Strong fuel demand across the world and ongoing tensions in Eastern Europe are aiding the rally in oil prices. The massive improvement in oil price is aiding exploration, production and drilling activities. This, in turn, will boost demand for oilfield service since oilfield service players assist drillers in efficiently setting up oil wells.”Potential HeadwindsOf course, there are also headwinds for the OFS sector that will have to be dealt with, including inflation being a key consideration. As detailed in our January 14, 2022 Energy Valuation Insights post, industry analysts are projecting over 30% average OFS revenue growth in 2022, although average EBITDA margins are expected to edge downward from 13% toward 12%. Inflationary factors are pushing up OFS costs, but such increased costs are expected to only partly be passed through to their E&P clients.In addition, the Biden Administration is clearly adamant about getting the country moving rapidly away from hydrocarbon-based energy, despite the public already complaining mightily about fast-rising energy prices and more general inflationary pressures. Where those political winds will carry the matter is anyone’s guess.In SummaryAs indicated, the companies that comprise the OFS segment – at least those that survived 2020 – experienced some stabilization in 2021, and are now facing what appears to be a market that has the industry analysts feeling fairly bullish. Influenced by rising oil demand, an existing shortage, and recent E&P investment well below the sustainable level, expectations have moved from OFS stabilization to strong multi-year OFS growth in 2022 and likely beyond.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers, and Big 4 Auditors. These energy-related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Additional Considerations for Your Buy-Sell Agreement

Following up on last week’s post (Three Considerations for Your RIA’s Buy-Sell Agreement), we offer four additional considerations that you should be addressing in your firm’s buy-sell agreement. We’ve seen each of these issues neglected before, which usually doesn’t end well for at least one of the parties involved. A well-crafted buy-sell should clearly acknowledge these considerations to avoid shareholder disputes and costly litigation down the road. We highly recommend taking another look at your buy-sell agreement to see if these issues are addressed before something comes up.1. Formula Pricing, Rules-Of-Thumb, and Internally Generated Valuation Metrics Don’t Withstand TimeSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is a substantial incentive to try to shortcut that part of the process. However, non-professional valuation methods, such as formula pricing, rules-of-thumb, and internally generated valuation metrics are often key reasons for costly disputes or disruptions down the road. The investment management space is particularly fraught, and not too long ago, investment manager valuations were thought to gravitate toward about 2% of AUM.We have written extensively about the fallacy of formula pricing. No multiple of AUM, revenue, or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM (typically expressed in percentage terms) does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.The example below demonstrates the problematic nature of this particular rule of thumb for two investment management firms of similar size, but widely divergent fee structures and profit margins.Both Firm A and Firm B have the same AUM. However, Firm A has a higher realized fee than Firm B (100 bps vs 40 bps) and also operates more efficiently (25% EBITDA margin vs 10% EBITDA margin). The result is that Firm A generates $2.5 million in EBITDA versus Firm B’s $400 thousand despite both firms having the same AUM. The “2% of AUM” rule of thumb implies an EBITDA multiple of 8.0x for Firm A—a multiple that may or may not be reasonable for Firm A given current market conditions and Firm A’s risk and growth profile – but which is nevertheless within the historical range of what might be considered reasonable. The same “2% of AUM” rule of thumb applied to Firm B implies an EBITDA multiple of 50.0x – a multiple which is unlikely to be considered reasonable in any market conditions.Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.We’ve seen rules of thumb like the one above appear in buy/sell agreements and operating agreements as methods for determining the price for future transactions among shareholders or between shareholders and the company. The issue, of course, is that rules of thumb do not have a long shelf life, even if they made perfect sense at the time the document was drafted. If value is a function of company performance and market pricing, then both of those factors have to remain static for any rule-of-thumb to remain appropriate. This circumstance, obviously, is highly unlikely.But the real problem with short cutting the valuation process is credibility. If the parties to a shareholder’s agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.2. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the date appropriate for the valuation matters. If the buy-sell agreement specifies that value is established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about.Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm, and there is concern about losing clients as a result of the departure. After an adequate amount of time, the impact on firm cash flows of the triggering event becomes apparent. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.3. Appraiser Qualifications: Who Will Perform the Valuation?Once you decide to engage a professional to value your firm, you’ll need reasonable criteria to decide whom to work with. Often, partners in investment management firms feel they are equipped to value their own business as investment management firms (unlike many other closely held businesses) have ownership groups with ample training in relevant areas of finance that enable them to understand financial statement analysis, cash flow forecasting, and market pricing data.What insiders lack, however, is the arms’ length perspective to use their technical skills to determine an unbiased result. Many business owners suffer from familiarity bias and the so-called “endowment effect” of ascribing more value to their business than what it is actually worth simply because it is well-known to them or because it is already in their possession. On the opposite end of the spectrum, some owners are prone to forecast extreme mean reversion such that they discount the outperformance of their business and anticipate only the worst.Partners with a strong grounding in securities analysis and portfolio management have a bias to seeing their business from the perspective of intrinsic value, which can limit their acceptance of certain market realities necessary to price the business at a given time. In any event, just as physicians are cautioned not to self-medicate and attorneys not to represent themselves, so too should professional investment advisors avoid trying to be their own appraiser.Over time, we have reviewed a wide variety of work product from different types of service providers - but have generally observed that there are two types of experts available to the ownership of investment management firms: Valuation Experts and Industry Experts. These two types of experts are often seen as mutually exclusive, but you’re better off not hiring one to the exclusion of the other.Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry.There are plenty of valuation experts who have the appropriate training and professional designations, understand the valuation standards and concepts, and see the market in a hypothetical buyer-seller framework. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Both require extensive education and testing to become credentialed, along with continuing education. Also well known in the securities industry is the Chartered Financial Analyst designation issued by the CFA Institute. While it is not directly focused on valuation, it is a rigorous program in securities analysis.There are also a number of industry experts who are long-time observers and analysts of the industry, who understand industry trends, and who have experience providing advisory services to investment management firms.However, business valuation practitioners are often guilty of shoehorning RIAs into generic templates, resulting in flawed valuation conclusions that don’t square with market realities. By contrast, industry experts are frequently guilty of a lack of awareness concerning the use and verification of unreported market data, the misapplication of valuation models, and not understanding the reporting requirements of valuation practice.We think it is most beneficial to be both industry specialists and valuation specialists. The valuation profession is still, for the most part, populated with generalists. But as the profession matures, an increasing number of analysts are realizing that it isn’t possible to be good at everything. Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry. Because our firm has specialized in valuing financial institutions since the day we opened for business in 1982, it was easy to pursue this to its logical conclusion. Ultimately, you want an expert with both professional standards and practical experience.4. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement. If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake.Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and having a valuation prepared will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.

Review of Key Economic Indicators for Family Businesses

Family business directors are often afforded a luxury that their publicly traded counterparts are not: the ability to focus on and plan for the long term rather than solely the next quarter’s earnings report. While this dynamic can provide some respite from having to keep the TV tuned to CNBC theatrics all day, it is important that family business directors not totally insulate themselves from the surrounding macroeconomic environment outside of their industry. Family business directors should be aware that their operations are subject to the same macroeconomic effects that often steer the results of the public companies in their respective industries.While family businesses may not have the in-house economists and research departments of the larger public, it is crucial for the management and boards of family businesses to keep tabs on the overall economic environment in which they operate, as an understanding of the metrics and trends driving or hampering growth in the economy can inform effective and relevant strategic, tactical, and operational planning and decision making aimed at maximizing long-term shareholder returns. With that, we take a look at a few of the broad trends that bore themselves out in the U.S. economy through the end of 2021 and the first months of 2022.GDPAccording to advance estimates by the Bureau of Economic Analysis, GDP growth in the fourth quarter of 2021 measured 6.9% over the third quarter. This increase was driven by gains in private inventory investment, exports, personal consumption expenditures, and nonresidential fixed investment. Mitigating factors to the increase in GDP were decreases in government spending (federal, state, and local) and imports, which increased and act as a deduction from the national income and product accounts. Overall, GDP increased 5.7% in 2021, which compares favorably to the 3.4% decline in GDP in 2020 and growth of 2.3% in 2019.Overall, GDP increased 5.7% in 2021. Economists expect GDP growth to continue into the next two quarters.Economists expect GDP growth to continue into the next two quarters. A survey of economists conducted by TheWall Street Journal in January reflects an average GDP forecast of 3.0% annualized growth in the first quarter of 2022, followed by 3.8% annualized growth in the second quarter. The forecasted growth in GDP of 3.0% in the first quarter of 2022 is down from previous estimates from the October survey, in which forecasters surveyed by the Journal estimated first quarter GDP to be 4.2%. This downgrade in expectations was the result of higher-than-expected inflation in the final months of 2021, ongoing supply chain constraints, and concerns surrounding the spread of the Omicron variant, which threatened to put a dent in consumer spending and exacerbate labor shortages, as workers are forced to call in sick.Click here to enlarge the imageInflationEstimates from the Bureau Labor Statistics released last week reveal that the Consumer Price Index (“CPI”) increased 0.6% in January 2022 on a seasonally adjusted basis. On a year-over-year basis, the CPI increased 7.5% from January 2021 to January 2022. This annual increase was the largest since February 1982 and was well above the December year-over-year increase of 7.0%. For context, in the pre-pandemic days of 2019, the CPI increased at an annual rate of 1.8%. Economists generally agree that the recent record increases in inflation reflect not only supply constraints in the goods market, but also still elevated levels of demand for goods and services from U.S. consumers. The Wall Street Journal survey reveals expectations for some tapering in the annual rate of inflation, as economists surveyed forecast the year-over-year increase in June 2022 to be 5.0% and the December increase to be 3.1%.The Wall Street Journal survey reveals expectations for some tapering in the annual rate of inflation.The Producer Price Index (“PPI”) is generally recognized as predictive of near-term consumer inflation. While January 2022 estimates for the PPI were not available at this writing, the PPI increased 0.2% in December 2021 and 9.7% in 2021, which is the largest annual increase in PPI since the data were first calculated in November 2010. The most practical application of the current inflationary environment for family business owners and directors is the potential for price increases (perhaps in excess of those already no doubt put in place in 2021) aimed at protecting margin.Labor MarketsTotal nonfarm employment rose by 467,000 in January 2022, and the unemployment rate (U-3, total unemployed, seasonally adjusted) measured 4.0% according to the Bureau of Labor Statistics’ January release. For context, the unemployment rate was 6.4% in January 2021 and 4.7% in September 2021.The unemployment rate was 4.0% in January 2022 (6.4% in January 2021 and 4.7% in September 2021).The January 2022 employment figures outperformed expectations, as hiring demand continued to be high even as the Omicron variant surged. Still, the variant put a dent in the January employment figures. Nonfarm employment would have risen even higher if not for the surge in Omicron cases, as the Labor Department reported that nearly two million workers were prevented from looking for a job in January due to the rise in cases. With unemployment falling and wages increasing on inflationary effects, Fed watchers expect the FOMC to stay the course with regard to the potential for interest rate increases in 2022, which we discuss below.Monetary Policy and Interest RatesThe FOMC met for the first time in 2022 in late January. Since the beginning of the pandemic in March 2020, Fed officials have pledged to hold interest rates near zero until inflation was forecast to moderately exceed 2% and labor markets returned to conditions consistent with maximum employment. In the aftermath of the January meetings, Fed officials signaled that these conditions have been met and that interest rate increases would begin in March. In his press conference following the meeting, Fed Chairman Jay Powell stated, “This is going to be a year in which we move steadily away from the very highly accommodative monetary policy that we put in place to deal with the economic effects of the pandemic ... I think there’s quite a bit of room to raise interest rates without threatening the labor market.” These remarks led investors in interest-rate futures markets to fully anticipate a March rate increase of at least one-quarter of a percentage point. The CME Group also forecasts a nearly 70% chance of a second interest rate increase the Fed’s meeting in early May. If both of these rate increases come to pass, it will be the first time since 2006 that the Fed has raised rates at consecutive meetings.The cheap financing environment of the past two years may be coming to an end.As we saw earlier, inflation has easily surpassed the 2% target set out by the FOMC in recent months, but the sharp drop in the unemployment rate and widespread wage gains in labor markets have created greater urgency by the Fed to raise rates sooner than previously anticipated. With the conditions for rate increases achieved, family business directors and management should be keenly aware that the cheap financing environment of the past two years may be coming to an end. Various interest rates already reflect the prospect of increases to the fed funds rate, as the yield on 20-year treasury bills measured 2.37% last week, which is up from 1.77% at the beginning of December. Corporate borrowing rates have also increased in recent weeks, as the Moodys Baa Corporate Bond Yield measured 3.94% at its last reading. This is up from approximately 3% in early December.ConclusionThe broader economic environment has certainly been more, shall we say, active, in recent months than even at times during the height of the pandemic. Now more than ever, family businesses directors and management must make informed decisions in the context of overall economic conditions. We hope this piece, and future posts, can be a resource and tool for doing just that.

LOV(E): What Are the “Levels of Value" and Why Does It Matter to Auto Dealers?

Part I

In the spirit of Valentine’s Day, we are covering a topic near and dear to the hearts of business valuation analysts. LOV – or “Levels of value” – refers to the idea that while “price” and “value” may be synonymous, they don’t quite mean the same thing. In this week’s post, we adapt a piece written for Mercer Capital’sFamily Business Director Blog, and how it specifically relates to auto dealers. This will be the first part of a two-part blog series.Levels of Value OverviewShareholders are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.Business valuation experts use the term “level of value” to refer to these differing perspectives. As shown in Exhibit 1, there are three basic “levels” of value for a family business. Each of the basic levels of value corresponds to different perspectives on the value of the business. Let's explore the relevant characteristics of each level.Marketable Minority Level of ValueThe marketable minority value is a proxy for the value of your family business if its shares were publicly traded. In other words, if your family business joined the public ranks of Lithia, Sonic, Asbury, etc. through an IPO, what price would the shares trade at? To answer this question, we need to think about expectations for future cash flows and risk.The marketable minority value is a proxy for the value of your family business if its shares were publicly traded.Expected cash flows. Investors in public companies are focused on the future cash flows that companies will generate. In other words, investors are constantly assessing how developments in the broader economy, the industry, and the company itself will influence the company’s ability to generate cash flow from its operations in the future.Public company investors have a lot of investment choices. There are thousands of different public companies, not to mention potential investments in bonds (government, municipal, or corporate), real estate, or other private investments. Public company investors are risk-averse, which just means that – when choosing between two investments having the same expected future cash flow – they will pay more today for the investment that is more certain. As a result, public company investors continuously evaluate the riskiness of a given public company against its peers and other alternative investments. When they perceive that the riskiness of an investment is increasing, the price will go down, and vice versa. So, when a business appraiser estimates the value of your family business at the marketable minority level of value, they are focused on expected future cash flows and risk. They will estimate this value in two different ways.When a business appraiser estimates the value of your business at the marketable minority level of value, they are focused on expected future cash flows and risk.Using an income approach, they create a forecast of future cash flows, and based on the perceived risk of the business, convert those cash flows to present value, or the value today of cash flows that will be received in the future.Using a market approach, they identify other public companies that are similar in some way to your family business. By observing how investors are valuing those “comps,” they estimate the value of the shares in your family business. Many novice investors are aware of Price-to-Earnings ratios, and there are plenty of valuation multiples that can be gleaned from public auto dealers. While these are two distinct approaches, at the heart of each is an emphasis on the cash flow generating ability and risk of your family business. We start with the marketable minority level of value because it is the traditional starting point for analyzing the other levels of value.Control (Strategic) Level of ValueIn contrast to public investors who buy small minority interests in companies, acquirers buy entire companies (or at least a large enough stake to exert control). Acquirers are often classified as either financial or strategic.Financially motivated acquirers often have cash flow expectations and risk assessments similar to those of public market investors. As a result, the control (financial) level of value is often not much different from the marketable minority level of value, as depicted in Exhibit 1. Imagine a private equity buyer with no other auto dealership investments. They’ll pay for the right to earn the cash flows you’ve been generating, but other than some creative financing, they may not be able to meaningfully increase cash flows above what the current dealer principal can achieve.Strategic acquirers, on the other hand, have existing operations in the same, or an adjacent industry. These acquirers typically plan to make operational changes to increase the expected cash flows of the business relative to stand-alone expectations (as if the company were publicly traded). For example, two adjacent auto dealers can likely run with a leaner management team.Strategic acquirers may be willing to pay a premium to the marketable minority value if they can achieve revenue synergies but, given relationships with OEMs, there may be fewer synergies in automotive retail than some other industries.The ability to reap cost savings or achieve revenue synergies by combining your family business with their existing operations means that strategic acquirers may be willing to pay a premium to the marketable minority value. However, given relationships with OEMs, there may be fewer synergies in automotive retail than some other industries.Of course, selling your family business to a strategic acquirer means that your family business effectively ceases to exist. The name and branding may change, employees may be downsized, and production facilities may be closed. It also reduces a significant source of cash flow, as future earnings are accelerated to a lump sum payment up front. Many auto dealers have looked to exit with blue sky values high, but it’s also hard to walk away during a time of record profits in a business that can operate throughout the business cycle.Nonmarketable Minority Level of ValueWhile strategic acquirers may be willing to pay a premium, the buyer of a minority interest in a family business that is not publicly traded will generally demand a discount to the marketable minority value. All else equal, investors prefer to have liquidity; when there is no ready market for an asset, the value is lower than it would be if an active market existed.The buyer of a minority interest in a family business that is not publicly traded will generally demand a discount to the marketable minority value.What factors are investors at the nonmarketable minority level of value most interested in? First, they care about the same factors as marketable minority investors: the cash-flow generating ability and risk profile of the family business. But nonmarketable investors have an additional set of concerns that influence the size of the discount from the marketable minority value.Expected holding period. Once an investor buys a minority interest in your family business, how long will they have to wait to sell the interest? The holding period for the investment will extend until (1) the shares are sold to another investor or (2) the shares are redeemed by the family business, or (3) the family business is sold. The longer an investor expects the holding period to be, the larger the discount to the marketable minority value. Imagine you own a 5% interest in a dealership that you’re looking to sell. If a potential buyer knows the dealer will “never sell to one of the big guys,” that will impact how much they’ll pay you for your interest.Expected capital appreciation. For most family businesses, there is an expectation that the value of the business will grow over time. Capital appreciation is ultimately a function of the investments made by the family business. Public company investors can generally assume that investments will be limited to projects that offer a sufficiently high risk-adjusted return. Family business shareholders, on the other hand, occasionally have to contend with management teams that hoard capital in low-yielding or non-operating assets, which reduces the expected capital appreciation for the shares. All else equal, the lower the expected capital appreciation, the larger the discount to the marketable minority value. Auto dealerships tend to have pretty strong cash flows, and relatively limited opportunities to reinvest in the business. While the OEM has imaging requirements every so often, the opportunity to meaningfully expand operations tends to be tied to adding on more rooftops.Interim distributions. Does your family business pay dividends? Interim distributions can be an important source of return during the expected holding period of uncertain duration. Interim distributions mitigate the marketability discount that would otherwise be applicable. High levels of distributions may be common for minority investors in auto dealerships. However, minority investors cannot compel these distributions themselves, and we’ve seen many cases where the cash simply builds on the balance sheet. As noted above, this can drag on returns.Holding period risk. Beyond the risks of the business itself, investors in minority shares of public companies bear additional risks reflecting the uncertainty of the factors noted above. As a result, they demand a premium return relative to the marketable minority level. The greater the perceived risk, the larger the marketability discount. A strong capacity for distributions and opportunities to be sold to a strategic buyer can push down marketability discounts for auto dealerships. Conversely, sporadic distributions and cash buildup can lower expected returns. And while dealerships must send monthly factory statements to the OEM, these don’t commonly get shared on a regular basis with minority investors who may not have a good pulse for how their dealerships are performing.ConclusionYour family business has a different value at each level of value because of differences in expected cash flows and risk factors. Hopefully, we’ve illustrated the “why” behind the various levels of value. In our next post, we’ll cover why getting the Level of Value correct is so important, and we’ll discuss numerous instances where a dealer may encounter the value of their store from different levels.

Oilfield Service Valuations: Dawn Is Coming

Most people who know me know that I have loved movies most of my life. One favorite is 2008’s The Dark Knight, where Harvey Dent proclaims hope to a skeptical media, “The night is darkest just before the dawn. And I promise you, the dawn is coming!” This comes to mind as I observe valuations and prospects for oilfield service companies. It has been tough sledding for OFS companies during COVID. Many shuttered their doors, equipment, or people. At the end of 2020, rig counts were around 350 and DUC counts were high.However, as we’ve been talking about for the past several weeks, things have changed for the positive as far as the industry is concerned, and it’s going to get better according to people like Marshall Adkins of Raymond James, who spoke at the NAPE Global Business Conference in Houston. The current U.S. rig count is now at 613 and, according to Mr. Adkins, may be heading to 800 this year if OFS companies can fill a real labor shortage gap.However, when it comes to valuations, assuming oilfield service companies will join the recovery has not always been true in the shale era. That said – this time may be different.What’s Old Is New: Cycle Could Be PivotingOFS is well documented to be one of the most cyclical industries. Financial performance tends to lag customers in the E&P sector. As an example, despite the expectation for strong revenue growth in 2022, analysts project that EBITDA margins are expected to actually decline slightly from a year-end 2020 median forecast of 12.8%, to a current figure of 12.2%. However, what if that growth continued beyond 2022 and into the following years? Many think this will be the case as global demand for oil and gas continues to grow amid the surge in renewables. Industry research analysts at IBISWorld project growth of 2.4% compounded for the entire $85.4 billion revenue industry (that’s over $2 billion of revenue growth every year for the next five years). Adkins sees this as the beginning of a multi-year bull run for energy on the tail of sector underinvestment, low supply, inflation, and demand growth rising to pre-COVID levels.Past Oilfield Service PerformanceOilfield service providers, drillers, pumpers, and equipment providers enabled E&P companies to ramp back up. So, where do they stand today? One lens through which to view things is the OSX index–a popular metric to track sector performance.Since the end of 2020, the OSX index has bounced around but has generally moved back up as demand has risen. In addition, this will almost certainly go higher if rig counts go back up to 800, which hasn’t been the case since 2019. From Adkins’ perspective, his question is: will the OFS industry be able to handle getting back up to 800 rigs? This is particularly acute from a labor perspective. The oilpatch has long been challenged to attract workers because of seasonality, remote operations, camp life, and the expectation that you will continue working regardless of the weather. It compensated with high wages, interesting and challenging work, and endless opportunities for advancement in a growing industry. But that’s not the case in 2022. The young generation that the industry has always managed to attract is increasingly urban, pampered, and has grown up in a society that has a negative impression of fossil fuels and is produced by an industry that some perceive to have no future. All the while the demand grows. Part of the reason for this growing demand is the steady depletion of drilled but uncompleted (DUC) well inventory in the past year or so. DUCs will eventually deplete to the point that more new wells must be drilled, thus increasing demand for OFS. E&P companies will, out of necessity, rediscover great respect for their suppliers. And the service sector will enjoy rewards for surviving the past seven years – perhaps not bigger, but certainly much better.Current Oilfield Service PerformanceHigher oil prices, coupled with competitive breakeven costs for producers, are making drillers, completers and a host of other servicers busy. Capex budgets for E&P companies, known as lead indicators for drillers and contractors, have cautiously been increasing, even amid the capital discipline drumbeat over the past several years.IHS Markit released a report early this month titled, “The Great Supply Chain Disruption: Why It Continues in 2022.” In the introduction, Vice-Chairman Daniel Yergin wrote, “There is no recent historical precedent for the current disruption in the modern highly integrated global supply chain system that has developed over the last three decades … [resulting in] delays and disruptions for manufacturers and deliveries on a scale never recorded in our 30 years of PMIs (Purchasing Managers’ Index).”In the meantime, the oil patch will need its supply chain to be working. According to Rystad Energy, the average productivity of new wells in the Permian Basin is set to hit a record high in 2022, breaching past 1,000 BOED due to a surge in lateral well length. The only way that this can be done is with more OFS services.Valuation TurnaroundNow that utilization rates and day rates are both trending upward, valuations should logically respond and by certain aspects, they are.Take, for example, a selection of guideline company groups: onshore drillers and pressure pumpers (fracking companies). One way to observe the degree of relative value changes is to look at enterprise value (sans cash) relative to total book value of net invested capital (debt and equity) held by the company or “BVIC”. Any multiple over 1.0x indicates valuations above what net capital investors have placed into the firm, which for drillers and pumpers is a notable threshold.In 2019-2020, with a multiple well below 1.0x, investors didn’t expect to get an adequate return on the capital deployed at these companies. However, in 2021 and continuing in early 2022, that trend has reversed. This suggests that the market is recognizing intangible value again for assets such as developed technology, customer relationships, trade names and goodwill. For pressure pumping and fracking concentrated businesses, which are more directly tied to DUCs, the trend is clear. Intangible asset valuations have grown even faster, more heavily weighted towards pumpers’ developed technology that is driving demand for these companies’ services.ConclusionOverall rig counts have shifted downward since 2014 and are currently nowhere near levels back then, however, this cycle may resemble pre-shale eras when fundamentals like inflation, supply issues, and related factors pushed commodity prices upward for extended periods. Oil and gas are fundamental economic building blocks in the world economy. If the longer-term cycles are pivoting towards the direction they appear, values of OFS companies may be increasing for a longer cycle this time.

Three Considerations for Your RIA’s Buy-Sell Agreement

Working on your RIA’s buy-sell agreement may seem like an inconvenience, but the distraction is minor compared to the disputes that can occur if your agreement isn’t structured appropriately. Crafting an agreement that functions well is a relatively easy step to promote the long-term continuity of ownership of your firm, which ultimately provides the best economic opportunity for you and your partners, employees, and clients. If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion below.Decide What’s FairA standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all the parties in the agreement. That’s easier said than done because fairness means different things to different people. The stakeholders in a buy-sell scenario at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. It is nearly impossible to be “fair” to that many different parties, considering their different motivations and perspectives.Clients. Client relationships are often the single most valuable asset that an asset or wealth management firm possesses, and avoiding internal disputes is crucial to maintaining these relationships. Beyond investment advice, clients pay for an enduring and trusting relationship with their investment manager. As the profession ages and ownership transitions to a new generation of management, we see a well-functioning buy-sell agreement and broader succession planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded).Founding owners. Aside from wanting the highest possible price for their interest in the firm, founding partners usually want to have the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as winding down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn requires consideration of the other stakeholders in the firm.Subsequent generation owners. The economics of a successful investment management firm can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is a symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply.The firm itself. The company is at the hub of all the different stakeholder interests and is best served if ownership is a minimal distraction to the operation of the business. Since handwringing over ownership rarely generates revenue, having a functional shareholders’ agreement that reasonably provides for the interests of all stakeholders is the best-case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to focus on maximizing the performance of the company while at the same time avoiding costly disputes over ownership.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of stable and predictable ownership. The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that at the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available, and the firm may need to be sold to perfect the agreement. At relatively low valuations, the internal transition is easier, and business continuity is more certain, but the founding generation of ownership may be perversely encouraged not to bring in new partners, stay past their optimal retirement age, or push more cash flow into the compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an investment management firm is always a balancing act, but one which is typically best done intentionally.Define the Standard of ValueStandard of value is an abstraction of the circumstances giving rise to a particular transaction. It imagines the type of buyer, the type of seller, their relative knowledge of the subject asset, and their motivations or compulsions. Identifying and clearly defining the standard of value in your buy-sell agreements will save time and money when triggering events occur.Portfolio managers are familiar with certain perspectives on value, such as market value (the price at which a company’s stock trades) and intrinsic value (what they think the security is worth, based on their own valuation model). None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value, among others.Identifying and clearly defining the standard of value in your buy-sell agreements will save time and money when triggering events occur.In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The benefit of the fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.For most buy-sell agreements, we would recommend one of the more common definitions of fair market value.The standard of value is critical to defining the parameters of a valuation. We would suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of an ambiguous or home-brewed definition can be severe. For most buy-sell agreements, we would recommend one of the more common definitions of fair market value.The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario clearer.Define the Level of ValueValuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. From a practical perspective, the “level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value. Given the potential for valuation disputes regarding the appropriate level of value, buy-sell agreements function best when they memorialize the parties’ understanding of what level of value will be used in advance of a triggering event occurring.Most portfolio managers and financial advisors will already be familiar with the concept of “levels of value,” but they may be unfamiliar with the terminology used in the valuation profession to describe these levels. A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. This is known as the “marketable minority” level of value in the appraisal world. Portfolio managers usually think of value in this context until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company and the value achieved in a strategic acquisition is commonly referred to as a control premium.Closely held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the investment management firm and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most investment management firms, the owners joined together at arms’ length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise-level valuation.In any event, the buy-sell agreement should consider the economic implications to the investment management firm and specify what level of value is appropriate for the buy-sell agreement.Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Typically, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation-specific. Whatever the case, the shareholder agreement needs to be very specific as to the level of value.Does the pricing mechanism create winners and losers? Should value be exchanged based on a control level valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing.There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the firm's continuity. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to retain their ownership longer and force out other shareholders artificially. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.ConclusionKeeping the above considerations in mind when drafting or updating your buy-sell agreement will help create a document that promotes the sustainability and orderly ownership transition of the firm while balancing the interests of the firm’s various stakeholders and the firm itself. However, this is far from an exhaustive list of things to consider when constructing your buy-sell agreement. In next week’s post, we’ll discuss additional parameters that should be addressed when constructing your buy-sell agreement.

January 2022 SAAR

SAAR reached a seven month high in January, totaling 15.0 million units on an annualized basis. SAAR was up 20.0% from last month but down 10.4% from January 2021. While the SAAR certainly improved, raw sales volume in January was the lowest since April 2020. January is typically the lowest selling month for dealers each year, so the seasonally adjusted nature of the metric can make it difficult to compare with other months; it puts a lot of faith in the math required to annualize sales. The bar chart below shows raw sales numbers in January 2022 compared with raw numbers in January since 2015.Source: Bureau of Economic Analysis Unsurprisingly, many of the same trends that have dominated over the last year have persisted into early 2022. Auto manufacturers continue to prioritize retail deliveries over fleet deliveries. Sales continue to be held back by limited inventories. Light trucks continue to dominate, reaching 79.8% of all light vehicle sales over the last month. Within this popular category of vehicles, pickups and SUVs gained market share while the popular crossover segment’s market share remained flat from December. Vehicle sales prices and profitability remained high. After reaching an all-time high of $45,743 in December, the average transaction price of a new vehicle is expected to cool slightly to $44,905 while still notching an all-time January high.Due to these persistently high prices, trade-in equity also remains high for consumers, with average trade-in equity up 88% from this time last year. Incentive spending continues to fall. In January, average incentive spending per unit was $1,319, down from $1,598 last month and $2,163 a year ago, down more than 50%.Source: Bureau of Economic Analysis Reported beginning-of-month January inventory balances remained low but showed a marginal improvement from last month. Improvements aside, the industry’s inventory to sales ratio remained well below its long-run average of 2.45x, emphasizing the fact that supply chain and production recoveries still have a long way to go.Production Update – Stumbling Out of the Gate in 2022After inventory shortages constricted sales volumes throughout 2021, the biggest question for auto dealers and manufacturers going into 2022 has been “when is the production process going to recover?”. Optimists have been predicting that recovery would come in the second half of the new year, but marginal inventory decrements in November and December did not encourage those following the industry that a full recovery is likely in 2022. Over the last month, a couple of manufacturers have released production updates that emphasize the magnitude of these struggles, at least in the short run.January started off well, with no reports of any auto manufacturing plants experiencing problems in the early days after the holiday break. However, it didn’t take long before Ford reduced scheduled production at its Flat Rock, Michigan, Oakville, and Ontario plants due to chip shortages. Toyota Motor Corp. followed suit by cutting its worldwide February output forecast by 150,000 vehicles. In February, Toyota North America alone was reported to lose 25,000-35,000 vehicles to production cuts.Domestic chip-manufacturing plants are not set to produce chips until 2023 at the earliest.These types of announcements from manufacturers are not going away anytime soon, as domestic chip-manufacturing plants are not set to produce chips until 2023 at the earliest. While it seems the chip issue has been going on forever, we note it takes even longer to meaningfully increase chip production. Until that time comes, domestic manufacturers are going to have to continue to rely on international supplies of microchips, likely making for choppy conditions over the next year.The Biden administration announced its intention to take action on the current microchip shortage in October, releasing a statement:“As you know, we’ve been working on the semiconductor shortage since day one of the president’s administration and it’s time to get more aggressive. […] There are bottlenecks across the economy, mostly due to COVID. There’s a disruption in the supply chain. Some of it will work itself out naturally but others like semiconductors will require investments so we make chips in America again. We have to make investments now so that never happens again.”Furthermore, at a September convening of semiconductor industry participants, the Commerce Department announced the launch of a Request for Information (RFI) that asked all parts of the supply chain – producers, consumers, and intermediaries – to voluntarily share information about inventories, demand, and delivery dynamics. The results of this RFI, which included 150 companies across several industries, were released on January 25th.The Commerce Department concluded that "there is a significant, persistent mismatch in supply and demand for chips, and respondents did not see the problem going away in the next six months." The report also said that median inventory for consumers for key chips has fallen from 40 days in 2019 to less than 5 days in 2021. The hope is that this report will give legislators a more informed view as they consider taking action. For those that have lived through these daily struggles, the conclusions of this report are unsurprising, so hopefully, nobody was holding their breath.It is projected that several chip manufacturing facilities abroad will come online by the summer of 2022.It is projected that several chip manufacturing facilities abroad will come online by the summer of 2022 and take some pressure off of existing facilities to meet the current level of demand. An uptick in supply would certainly be welcome and perhaps the latter half of 2022 will bring some inventory relief. In either case, LMC Automotive forecasts 86 million chips will be manufactured in 2022, an improvement of 6.2% from the 81 million estimated to have been produced in 2021. It remains to be seen how those will be allocated to vehicle manufacturing, but multiplying the anticipated increase in chip production by 2021 volumes, vehicle sales in 2020 would only be 15.8 million.Auto Forecast Solutions has aggregated vehicle production data following the chip shortage and its impact on auto manufacturing throughout the last month. The chart below shows the number of vehicles cut from production so far this year next to the full-year 2022 production cut projection: From an auto dealer’s perspective, not much has changed. Promises of structural changes to where microchips are produced and how many are available to auto manufacturers will take some time to follow through on, with the summer seeming like the absolute earliest that significant inventory relief might come. More updates should surface as the first quarter of the year is now in full swing.February 2022 OutlookOur outlook for February 2022 is that vehicle inventories will remain low and demand will remain high. Incremental inventory improvements are expected to accumulate eventually, but many of those improvements are not expected in the next several months. Also, the persistent Omicron variant of the COVID-19 pandemic could continue to affect supply chains and production facilities in the coming months as well, adding to the uncertainty.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

What Publix Supermarkets Can Teach Family Businesses

When something as innocuous as a grocery store has a cult following, sometimes it is helpful to pay attention. When that store also has net income margins 2x to 3x those of its peers, you should definitely pay attention.Barron’s recently featured Publix Super Markets. Founded in 1930, Publix operates about 1,300 stores and more than 800 of them in its home state of Florida. And as Barron’s points out, if you are chomping at the bit to own the stock, you’ll have to grab a green apron: Publix is privately held and is owned by employees, board members, and the founding Jenkins family. According to Barron’s, Publix had a valuation in November 2021 of approximately $45 billion.Other than enjoying the free cookies (which my daughters insist upon as we enter the parking lot), what can we take away from Publix? While there are likely dozens of lessons to be learned from Publix, family business owners and leaders should consider three areas key to Publix’s success over the last 90 years: long-term planning, smart diversification, and strong family culture.Long-Term PlanningManagement succession is often a hiccup in a family business’s long-term planning. Estate plans may be in order and stock secured in tax-advantageous trust entities, but who is actually going to drive the boat once current leadership cycles out of the captain’s chair? We highlighted previously that the majority of family businesses have no succession plan at all.What about Publix? Its CEO, Todd Jones, started with Publix 41 years ago and began as a store clerk. Jones has a reputation as a workaholic and exhibits many of the values of the family and the company. Additionally, Jones is the first CEO not to be a member of the Jenkins family. It is apparent the Jenkins family and ownership have fostered a management program that builds its leaders from within while maintaining the company’s long-term vision. While many family businesses may struggle with handing control over to a non-family CEO, Publix and its shareholders appear to have a solid understanding of what the business means to them and have decided having a Jenkins family member at the helm is not a requirement for the family.Smart DiversificationSo how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business means to the family, the potential for diversification benefits may take priority over absolute return.Part of Publix’s success is owed to its ownership of a considerable amount of real estate, including its distribution centers and manufacturing facilities, signaling a priority on diversification over absolute expected returns. While real estate may not be a “core competency,” holding many of its facilities and hard assets diversifies its fortunes away from its operating grocery business. This has been accomplished while building a strong balance sheet: virtually no debt, $2 billion in cash, and over $13 billion in investments.Strong Family CultureAn unfortunate myth that has perpetuated itself regarding family businesses is the “shirtsleeves to shirtsleeves in three generations” adage damning the fate of family businesses. Josh Baron and Rob Lachenauer, whose Harvard Business Review | Family Business Handbook we reviewed previously, illuminate a number of findings that fly in the face of this axiom. You can read the full article here, but to simplify, “The data suggests that, on average, family businesses last far longer than a typical public company does.”So it would appear family businesses may have an advantage over their publicly traded counterparts regarding longevity. As we have repeatedly highlighted on Family Business Director, while public companies plan for the next quarter, successful family businesses plan for the next decade.So what is Publix doing to maintain a strong family culture? One, over 90% of the company’s 225,000 employees own stock through its ESOP (something we here at Mercer Capital, an employee-owned company, understand well). Shares are granted annually to staff, and employees can also purchase shares from the company. And while Publix does not share its average employee ownership, the figure is estimated at more than $150,000 in stock, adjusting for the $8.8 billion stake reportedly held by the Jenkins family. Many longtime staff members are millionaires. The company’s ownership structure is conducive to multi-generational value creation, aligning employee incentives with long-term thinking. Despite having outgrown “mom-and-pop” status years ago, the business still exhibits characteristics typical of smaller family businesses that keep the focus on the long haul.Final LessonsThe share price is many times seen as the ultimate “scoreboard” for a company. Publix’s stock price (per internal reporting) has risen from $47.10 in November 2019 to $66.40 in November 2021, a 41% increase over the period. This, coupled with its quarterly dividend of $0.37 cents a share ($1 billion of annual payments to shareholders), large cash and investment balance, and little debt, gives a strong case that whatever they are doing at Publix appears to be working. Family businesses have multiple areas to consider when looking at the Publix success story. It would be wise to heed some of the characteristics they exhibit. Give one of our professionals a call today to discuss how we can help you guide your company to long-term value creation.

Meet The Team

Bryce Erickson, ASA, MRICS

In each “Meet the Team” segment, we highlight a different professional on our Energy team. This week we highlight Bryce Erickson, Senior Vice President of Mercer Capital and the leader of the oil and gas industry team. The experience and expertise of our professionals allow us to bring a full suite of valuation, transaction advisory, and litigation support services to our clients. We hope you enjoy getting to know us a bit better.What attracted you to a career in valuation?Bryce Erickson: There are a lot of things appealing about valuation, and I feel fortunate to have been a part of it for over 20 years. Looking back, for me, three things stand out. First, I sort of grew up in the profession. My dad entered valuation in 1972, and I would hear the conversations at the dinner table about the cost of capital, customer lists, and comparables. Secondly, the economic and analytical disciplines at the center of what I do align well with how my brain functions and how I approach problem solving. That’s fun. Lastly, it allows me to serve clients in a way that, if done well, will lead to a long career whereby I have a lot of ability to chart my own course. That’s a great incentive.What does your personal practice consist of?Bryce Erickson: Sort of like the Generation X member that I am, my practice is a mix of a lot of things. When I started in valuation in the late ’90s, most firms and groups had not specialized (that has changed). I got exposed to a lot of industries and service lines as a result. I have touched a bit of everything in my career and still do in many respects. However, as my career has progressed, I have developed a few specializations. One is in energy, particularly upstream oil & gas, as well as minerals. That has been a big part of my career in the past 10+ years. Another has been professional sports (NFL, NBA, MLB, NHL), where I have had the opportunity to value teams I grew up watching or rooting for as a kid. That has been a real thrill. Again, I touch them all as far as service lines, but the two areas I have spent the most time on have been tax-driven and litigation-driven work. In addition to valuation, I have done a lot of economic damage-driven work and have testified nearly two dozen times now. Litigation is intense by its nature, and that intensity is useful in other areas of my practice, helping me give the best service I can to all clients.What types of oil & gas engagements do you work on?Bryce Erickson: As I’ve already mentioned, in addition to exploration and production company valuations, I do fairness opinions and quite a bit of mineral and royalty interest valuations. These come in many different scenarios, from tax to financial reporting to litigation. At this point, we have probably worked in just about every major oil & gas basin in the U.S. and several international projects as well. I also do some work with oilfield service clients.What is unique about Mercer Capital’s oil & gas industry services compared to your competitors?Bryce Erickson: I believe what is unique about our oil & gas group is our blend of industry expertise that we have gained over the years alongside the depth and knowledge of the valuation space. It is a powerful combination for our clients and they like it a lot. On the industry side, we are able to connect with clients and speak their language as far as reserves, basins, structures, and economics are concerned. On the valuation side, we speak the language of the audiences we are addressing as well, whether that’s a judge in a courtroom, an IRS engineer in a tax matter, or an auditor for a financial reporting issue. Our competitors may have one or the other of those two skill sets, but rarely both.As a Forbes.com contributor, what types of issues do you cover in your column?Bryce Erickson: I address industry developments, economic trends, and the impact on valuation for companies operating in the Permian, Eagle Ford, Bakken, and Marcellus & Utica regions, among others. Additionally, I cover these issues as they pertain to mineral rights and royalty owners. It is a fun column to write. It also allows me to stay tied into the industry as well as keep current.What is the one thing about your job that gets you excited to work every day?Bryce Erickson: That’s simple. Solving problems and serving clients. It scratches itches and is so satisfying for me. I am excited I get to utilize so much of my education and experience on each engagement so that Mercer Capital can do excellent work for our excellent clients.

February 2022

In this issue: Acquire or Be Acquired (AOBA) 2022: Review & Recap

March 2022

In this issue: First Quarter 2022 Review: Volatility Resurfaces

Meet the Team – Z. Christopher Mercer, FASA, CFA, ABAR

In each “Meet the Team” segment, we highlight a different professional on our Family Law team.

Mercer Capital’s Value Matters^® 2022-02

Bear Market Silver Lining? An Estate Planning Opportunity

BOOKLET | Navigating Tax Returns: Tips and Key Focus Areas for Family Law Attorneys and Divorcing Individuals / Business Owners

Knowing how to navigate tax returns can be very useful in divorce proceedings. This booklet was written to help the reader do just that.

Buy-Sell Agreement Basics for Wealth Managers

The Importance of Buy-Sell Agreements for Wealth Management Firms, and Why It Might Be Time To Revisit Yours

Over the next several weeks, we will be publishing a series of blog posts discussing the importance of buy-sell agreements and other adjacent topics for RIA owners. Ownership is perhaps the single greatest distraction for advisors looking to grow with their firm, but it can also be an opportunity to align interests and ensure continuity of the firm in a way that is accretive for the firm’s founders, next generation management, and clients. As highlighted in the Charles Schwab 2021 RIA Benchmarking Study, planning for a successful transition of ownership — whether through internal succession or a strategic sale – continues to be a key differentiator among top RIA performers.Most wealth management firms are closely held, so the value of the firm is not set by an active market. They are typically owned by unrelated parties, whereas closely held businesses in other industries are often owned by members of the same family. In recent years, the profitability and value of many wealth management firms have increased substantially as assets under management have risen with the markets and a proliferation of capital aimed at the wealth management sector has bid up multiples. As a result of these dynamics, there is usually more than enough cash flow to fund the animosity when disputes arise, and what might be a five-figure settlement in some industries is a seven-figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms, the more compelling reasons revolve around transitioning ownership to perpetuate the firm and provide liquidity for retiring partners. Clients increasingly seem to ask us about business continuity planning—and for good reason. In times of succession, tensions can run high. Having a clear and effective buy-sell agreement is imperative to minimizing costly and emotional drama that may ensue in times of planned or unplanned transition.Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes a process by which shares of a private company transact. Ideally, it defines the conditions when the buy-sell agreement is triggered, describes the mechanism by which the shares are priced, addresses the funding of the transaction, and satisfies all applicable laws and regulations.A buy-sell agreement establishes a process by which shares of a private company transact.These agreements aren’t necessarily static. In wealth management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to assign who gets what if the partners decide to go separate ways.As the business becomes more institutionalized, and thus, more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of a dispute or other unexpected changes in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, as well as a degree of certainty for shareholders that allows them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then an event occurs that invokes the buy-sell agreement, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized because now they are not simply co-owners with aligned interests but rather buyers and sellers with diametrically opposed interests.Triggering EventsBuy-sell agreements govern the process and terms of a transaction if certain defined events occur. These “triggering events” can stem from voluntary or involuntary circumstances. Many buy-sell agreements call for an independent appraisal upon a triggering event to establish the price at which shares will transact. In cases where ownership is more fluid, some agreements require an annual appraisal to establish the price at which all transactions will take place.Voluntary CircumstancesAt any point in time, one generation of business owners is preparing for retirement, having planned (or frequently not planned) for a successful ownership transition from one generation of business leaders to the next. A buy-sell agreement is one of the most important steps to ensure a successful, planned transition of ownership, and as such, it should complement your succession plan.A buy-sell agreement is one of the most important steps to ensure a successful, planned transition of ownership.An effective succession plan could call for the sale of the retiring partner’s stake to current management or an outside investor group or may require the sale of the entire firm to a strategic buyer.If your exit strategy includes a sale to an insider, it should specify the terms and define the process for determining the price that shares are transacted at as an owner exits to retire. This is often a point of contention as young partners and retiring partners have inherently opposed objectives. A retiring partner will want to exit at the highest share price possible while the continuing partners are ultimately financing this repurchase.Because many wealth management firms are highly valuable, successors are often financially stretched to take over the founder’s interest in the firm. By establishing the process through which price is determined and the terms at which the shares will be transacted, a buy-sell agreement mitigates any potential drama. As such, a buy-sell agreement is foundational for your firm’s succession plan.If your exit strategy is to sell your firm to an outside buyer, you should be aware of your opportunities and make it explicitly known to your firm that this is your intention. For example, you should know the different incentives of potential buyers and what options exist with financial or strategic buyers.You should make sure that your buy sell agreement makes sense in the context of your other operating agreements. A buy-sell agreement should specify the process by which a sale to an outside investor group is agreed to. We once worked with a client whose operating documents required unanimous consent to bring on a minority partner, as this required an amendment to the operating agreement, while the sale of a majority of the Company just required the consent of a super majority.Knowing your exit strategy options will help clarify what is needed from your succession plan and your buy-sell agreement going forward.Involuntary CircumstancesBuy-sell agreements guard against undesirable transitions in ownership from a potential partner to an unaffiliated party; they also define a set price per share to ensure a fair transaction. In the case of death, disability, divorce, and bankruptcy, current partners will ultimately need to redeem the shares of their colleague.For instance, in the event of the death of a shareholder, a buy-sell agreement can protect the deceased’s family, ensuring such shares are bought at a fair price and in a timely manner. It can also protect your company from the inheritors of a deceased owner, who may want to benefit from the firm’s earnings but are not able to contribute to the growth of the business. Life insurance policies for owners are advised to protect your firm in case of an untimely death or a disabling scenario. A life insurance policy will secure your firm’s ability to repurchase shares in the case of the death or disability of an owner.A buy-sell agreement will outline the process through which a price is set and the transaction is financed.Additionally, if an owner files bankruptcy, the firm will need to repurchase his or her stake to avoid the shares being acquired by the owner’s creditors. In the case of a divorce, an owner’s shares may legally transfer to his or her spouse, in which case ownership would be seeded to the ex-spouse. A buy-sell agreement will outline the process through which a price is set and the transaction is financed.Our RecommendationWe recommend revisiting your buy-sell agreement to ensure that it makes sense in the context of your firm’s vision and in partnership with its other governing documents. If you do not currently have a buy-sell agreement in place, we highly encourage you to draft one with the help of legal counsel and an independent valuation expert. Doing so will help ensure the continuity of you firm, align incentives, and may even help avoid costly litigation down the road. If you plan on reviewing your buy sell agreement and other governance matters, please give us a call.

Transaction Outlook 2022

Dealmakers logged record levels of merger and acquisition activity in the middle market (deal values between $10 million and $500 million) in 2021. In this post, we highlight a few of the trends that bore themselves out in middle-market M&A activity in 2021 that family business owners and directors should keep in mind when evaluating potential transactions in 2022.1. Widespread Liquidity2021: One of the key factors that drove M&A to levels observed in 2021 was companies’ elevated liquidity positions and cash balances relative to pre-pandemic levels. Both public and private companies built up large cash balances in 2020, as large discretionary capital spending projects were often deferred until the uncertainty initially brought on by the pandemic was resolved. Many companies also generated better-than-expected earnings and cash flows throughout 2020 and 2021, adding to the already accumulating war chests on corporate balance sheets. Many companies put these inflated cash balances to work pursuing M&A opportunities in 2021, as the practical difficulties (in-person diligence, etc.) associated with closing deals in 2020 were generally alleviated in 2021. 2022: We expect this trend to continue into 2022, as cash-rich companies will continue to look for favorable M&A opportunities that competitors could otherwise potentially pursue. While some observers believe pricing for deals in the middle market is at an unsustainably high level, growing corporate cash balances may well continue to support elevated deal values and multiples in 2022. These dynamics are likely to extend the favorable environment for sellers in the middle-market that has persisted for the past several years.2. Ease of Financing2021: Companies that chose to finance deals rather than pay cash in 2021 benefitted from historically low interest rates thanks to continued quantitative easing pursued by the Fed in response to the pandemic. “Easy money” policies accelerated the use of debt across the middle market, as seen in the chart below. Total debt to EBITDA multiples in the third quarter of 2021 reached 4.1x, the highest level over the past two years. 2022: As the economy continues its recovery and inflationary pressures persist, Fed Chairman Jay Powell has signaled that the Fed plans to raise interest rates by 25 basis points at least three times in 2022. While these increases will still leave rates at relatively low levels, buyers looking to take advantage of the current credit environment may look to accelerate deals - closing sooner rather than later in 2022.3. Increased Levels of Private Equity Activity2021: As seen in the chart below, private equity (financial) buyers were increasingly active in 2021, and we expect that the data from the fourth quarter of 2021 will show a continuation of this trend when released. During 2021, the prospect of an increase in capital gain tax rates loomed large over the middle market. This helped bring some corporate assets to market, as sellers looked to take advantage of the current tax environment. Private equity firms deployed capital across the middle market, capitalizing on the buying opportunities brought on uncertainty surrounding future tax policy.2022: Private equity buyers are expected to remain active in the middle market in 2022. According to S&P Global Market Intelligence, PE firms ended 2021 sitting on record amounts of dry powder (committed, but unallocated capital). We expect PE firms to be anxious to deploy this capital in 2022, which will increase competition for deals and could drive multiples even higher.The trends outlined above contribute to a continued positive outlook for potential sellers of well-positioned businesses in 2022. Elevated levels of liquidity, relatively cheap debt financing, and increased levels of private equity activity all signal that the seller’s market of the past several years will likely persist in 2022. While we believe these trends to be instructive as to the potential transactional climate in the middle market in 2022, we also recognize that every family business has a unique “meaning,” which we have outlined on this blog before. When pursuing a transaction on either the buy side or the sell side, it is crucial for family business owners and directors to first develop consensus regarding what the family business means to the family. In short, what may be a favorable transactional opportunity for one family business could turn into a boondoggle for another. Evaluating M&A opportunities on both the buy side and the sell side through the lens of your family business’ “meaning” is crucial to creating value for your family business through M&A. As seasoned advisors participating on both front-end and post-transaction processes, we understand that every deal is unique. Give us a call if you want us to take a look at an acquisition target or LOI from a potential acquirer of any part of your family business.

Don’t Turn a Blind Eye to Fixed Operations

A Look at the Importance and Stability of Fixed Operations

The phrase, “don’t turn a blind eye,” refers to the idea that one should not ignore something they know to be real and significant. The phrase is said to originate from an 1801 English naval battle – the Siege of Copenhagen – where two admirals disagreed over battle plans. Legend has it that the second admiral in charge, Horatio Nelson, was ordered to withdraw but pretended not to see the flagship signals of the ranking admiral because he put his looking glass up to his eye that had been blinded in an earlier battle.As auto dealer headlines continue to be dominated by shortages of new and used inventory and record profitability, it’s easy to focus on the variable side of operations, including the sale of new and used vehicles. But, auto dealers and their trusted advisors should not turn a blind eye to the fixed operations of the dealership, which generally includes service, parts, and the body shop.While fixed operations may not be grabbing any of the current headlines, auto dealers should remain focused on their importance and stability to the overall success and profitability of a dealership. In this blog post, we analyze the recent historical contribution of fixed operations to overall dealership metrics, analyze several key indicators of future performance, and explore several myths and the changing landscape of the service department and customer relationship.Recent Historical Performance of Fixed OperationsLike all aspects and departments of an auto dealership, fixed operations or “fixed ops” have been impacted by COVID-19 and the initial lockdowns, plant shutdowns, chip shortages, and changing consumer behavior. Nonetheless, fixed operations have always provided a high margin portion of the business to an auto dealer while also connecting the customer to that particular dealership over the life of the existing vehicle and hopefully future vehicles to come.To gain a historical and current perspective on the impact of fixed operations on the total dealership operations, we have analyzed the Dealership Financial Profiles for an Average Dealership historically published by NADA. Specifically, we have analyzed year-end data from 2019 and 2020, along with the most recently published data from October 2021. This time period provides some insight into the impact and trends caused by the pandemic and indicates signs of recovery.In 2020, the average dealership had approximately $7.06 million in fixed ops sales, down 7.8% from the $7.65 million achieved in 2019. Through the first ten months of 2021, this figure was $6.41 million, which, if we annualize to twelve months, would be about $7.70 million, or just above 2019 levels. While this appears to be a full recovery, fixed operations pales compared to the performance dealers have achieved in variable operations as new and used vehicle sales, and margins have exploded despite/due to inventory shortages.As seen in the graph below, the gross profit margin on fixed operations has steadily improved, from 46.6% of fixed operations sales in 2019 to 47.0% in 2020 and 47.2% in the first ten months of 2021. Over this same time period, fixed operations sales as a percentage of average total dealership sales have steadily declined from 12.4% to 12.0% to 10.9%.Gross Profit Margin on Fixed OperationsSource: NADADespite modestly improving pricing power in fixed operations (orange line in the graph above), it appears to be declining modestly in importance to dealerships from a revenue standpoint (blue line). While fixed operations have always contributed less revenue to dealerships than variable operations (due to the high sticker price of vehicles), fixed operations have typically contributed a significant portion of total dealership gross profit. In 2019, fixed operations contributed 12.4% of sales but 50.5% of total dealership gross profit. This is because gross profit margins on new and used vehicles were 5.5% and 11.3%, respectively, compared to the previously noted 46.6% gross margin on fixed ops sales.In 2020 and 2021, this historical norm has been flipped on its head. In 2020, fixed operations only contributed 46.1% of total dealership gross profit. Through the first ten months of 2021, fixed ops contribution to total gross profit declined all the way to 36.5%.Fixed Ops Contribution to Total Gross ProfitSource:NADATwo of the primary causes of these trends are the huge increase in margins from variable operations and the lack of vehicle miles driven, which we have covered in a prior blog and will re-examine later in this blog. What may not be clear from these figures: fixed operations provide consistent, high margins to the dealership as evidenced by the departmental gross profit margin steadily, albeit modestly improving over this period. While it may not get all the headlines of variable operations, fixed operations continue to support dealerships and will continue to do so once vehicle margins normalize.Key Indicators of Future PerformanceVehicle miles traveled (“VMT”) is defined as the number of miles driven and has been tracked since 1971. The rolling 12-month average identifies the current run rate of this metric at any given point in time. An increase in VMT indicates more cars are on the road logging more miles, which eventually will require parts and service and eventually purchase a new vehicle either from new or used vehicle inventory. The rolling 12-month VMT drastically reduced at the start and during the early months of the pandemic due to temporary lockdowns and staying at home. In fact, the VMT dropped below 3.2 trillion miles in March 2020, and the rolling 12-month VMT declined every month before finally starting to rebound in March 2021.VMT has enjoyed a gradual monthly increase and returned above the 3.2 trillion figure for the first time in November 2021. It will be interesting to monitor whether the rolling 12-month VMT will continue to rise each month, just as it did pre-pandemic. The metric and the graph below indicate that consumers are traveling by car at rates not seen since before the pandemic.Moving 12-Month Total Vehicle Miles TraveledSource: FRED Economic Data A second metric that serves as a key indicator for the future performance of fixed operations is the average age of a car on the road in the United States. Like VMT, as the average age of a car increases, the need for service and eventually the purchase of a new vehicle alternative increases. According to IHS Markit and the Bureau of Transportation Statistics, the average age of cars on the road has generally increased from 1995 until 2021. Specifically, the average age of a car on the road has climbed from 8.4 years to 12.1 years.Average Age of Cars on the Road - U.S.Source: IHS Markit and Bureau of Transportation Statistics Coupled with the actual age, the average mileage of these cars is much higher than in prior years. While it wasn’t that uncommon for cars to have over 100,000 miles in years past, now many cars in service have 200,000 miles or greater. Based on a survey performed by iSeeCars, nearly 16% of Toyota Land Cruisers on the road have at least 200,000 miles on them.Fixed Operations Myths and Changing landscapeMyth 1: Auto Dealers make more money in Variable Operations than Fixed OperationsIn order to assess the validity of this statement, we must clarify a few parameters. Variable operations have always generated more gross or raw sales dollars than fixed operations for most dealers. The adage of making money usually centers around the profitability or margins provided by certain segments of the total auto dealership. Prior to the conditions of the last twelve months caused by inventory and chip shortages, fixed operations have provided a greater, or at least equal, contribution to total gross margin for a dealership as detailed earlier in the blog. Further, the specific gross margin on fixed operation sales has always been greater than the gross margins on new and used vehicles. While the transitory conditions have shifted more of the overall contribution of total gross margin to variable operations, fixed operations remain a vital, high-margin component of dealership operations.Myth 2: There is not much value in a service customer to my DealershipAs we just examined, the service customer is certainly valuable to a dealership if merely analyzed for the financial impact of their existing service requirements. In reality, fixed operations allow for ongoing touchpoints between a dealership and a customer. Touchpoints have been a common term used by executives of publicly-traded auto dealerships. Not only does that customer relationship have value during the life of the current vehicle, but the hope is that there will be future loyalty to that dealership in the decision to purchase the next vehicle. For these reasons, dealers should improve the overall customer experience, including efficiency and technology.2 out of every 3 service visits do not occur at a dealership.We have demonstrated both the financial and behavioral benefits of fixed operations to the dealership. Despite these gains, dealers have ample opportunities to improve the focus and market share of this element of the dealership. According to a 2021 survey conducted by Cox Automotive, only 34% of consumers prefer dealership service centers to general repair shops. While this figure represents a 1% gain in market share by auto dealers over the last three years of the survey, it still leaves 2 out of every 3 service visits that do not occur at a dealership. These overall figures mask the early years of a new vehicle's lifespan, where most service visits that fall underneath the warranty almost certainly occur at the dealership where the vehicle was purchased.The survey cites several reasons why consumers choose general service centers over dealership service departments: costs and location. Dealers must fight against the perception that dealership service costs are overpriced compared to similar services at a general service center. Additionally, consumers choose service centers closer to home than the original dealership. As we’ve discussed in prior posts, the future of the auto retailing landscape is changing. If fewer vehicles are kept on lots for the long-term, this may enable dealers to invest in real estate that is more proximate to consumers, which could increase market share for fixed operations.An additional component for the service department to monitor in the future will be the ability to service electric vehicles.An additional component for the service department to monitor in the future will be the ability to service electric vehicles (EVs). In last week’s blog, we discussed the future of auto dealerships and the impact of EVs on shaping the future of automotive retail. The Cox Automotive Survey cited that 66% of their current survey responders offer some level of EV service work. Additionally, 30% of responders plan to service EVs within the next year.ConclusionFixed operations have always provided stable, and high margin returns to an auto dealership's overall profitability and success. Particularly for single-point dealers with only one brand, dealers can see lagging sales if product offerings from the OEM don’t engage consumers, oftentimes for numerous years. However, fixed operations can get these dealers through the ebbs and flows of the business or product cycle.While recent trends have shifted the contribution and focus to variable operations, fixed operations continue to benefit dealers in the form of financial performance and bolster the customer relationship and loyalty to the dealership. Auto dealers must stay focused and adapt to these trends regarding their fixed operations despite persisting obstacles of consumer behavior and retail preferences. While 2022 may result in declining trends to the high wave of variable operations over the last twelve months, the future looks bright for the fixed operations of auto dealers. With fewer vehicles being put on the road than in years past, the average age of vehicles should increase and lead to more service work. Now it’s up to the dealers to pull in their share of these opportunities.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Q1-Q3 2021 Themes From Oilfield Service Company Earnings Calls

Nuances of the Upstream PerspectiveAs our readers are well aware, Mercer Capital tracks and reviews themes from the quarterly earnings calls of E&P operators and mineral aggregators, providing key insights into the upstream perspective on U.S. oil and gas. In this post, we look at oilfield service (OFS) company earnings calls for the first three quarters of 2021. Looking forward, we will likely incorporate OFS earnings calls in our quarterly survey of themes from the public oil and gas sector, using this post as a reference point for the upcoming round of Q4 2021 calls.We typically review earnings calls for 3 to 8 companies among the E&P operators and mineral aggregators each. Likewise, we look forward to reviewing calls for a roster of approximately 7 OFS companies that operate in the primary onshore U.S. basins covered by Mercer Capital. In this inaugural survey, however, we focus on Q1 through Q3 earnings calls for just two OFS companies – Halliburton and Ranger Energy Services. We follow the earnings call themes for these two companies, who represent some of the largest and smallest (by market cap) public OFS companies, through the first three quarters of 2021 to get a sense of how OFS industry dynamics have evolved over the past year.Promoting ESG InitiativesIn our review of Q1 2021 earnings call themes among E&P Operators, we saw a continued trend (from Q4 and Q3 2020 E&P operator earnings call themes) of emphasizing and discussing the progress of various ESG initiatives. This theme was absent in the Q2 2021 E&P earnings calls, and not a significant theme in the Q3 2021 E&P earnings calls. However, OFS operators were clear to point out their contribution towards various ESG initiatives throughout the first three quarters of 2021.“We're excited about the progress of Halliburton Labs, our clean-energy accelerator. In the first quarter, we announced Halliburton Labs' inaugural group of participating companies. They are working on solutions for transforming organic and plastic waste to renewable power; recycling of lithium-ion batteries; and converting carbon dioxide, water, and renewable electricity into a hydrogen-rich platform chemical.” – Jeff Miller, President & CEO, Halliburton [Q1]“We have successfully completed gas processing jobs for both dual fuel and e-frac fleet and anticipate more to come. There are several rewarding attributes to this transition. We are tangibly contributing to the ESG efforts of our industry.” – Darron Anderson, CEO, Ranger Energy Services [Q1]“On the Processing Solutions side, we continue to expect our customers' ESG mandate to drive an uptick in both the traditional flare gas capture use and newer fracturing dual-fuel and e-fleet generation fuel supply. We continue to have pilot program success on fuel supply projects, but have yet to sign that elusive long-term contract. Stay tuned here as stronger commodity pricing, incremental flare gas, emission regulation and the build-out and adoption of dual fuel and electric frac fleet are all tailwinds for our Processing Solutions segment.” – Bill Austin, Interim CEO & Chairman, Ranger Energy Services [Q2]“In the third quarter, Halliburton completed an all-electric pad operation on a multi-year contract with Chesapeake Energy in the Marcellus Shale.” – Jeff Miller, President & CEO, Halliburton [Q3]Opportunistic Acquisitions & Increased Consolidation of Smaller OperatorsWhile mineral aggregators were active on the M&A front in Q3 2021, with a favorable sentiment towards expanding their holdings since Q1, E&P operators were relatively quiet in the Eagle Ford and Appalachian basins, a bit more active in the Bakken, and chomping at the bit in the Permian. OFS operators, particularly those for whom incremental expansions carry more weight, kept their eyes on the horizon over 2021.“Our acquisition strategy has been fixed and simple. We are focusing on potential counterparties with top-tier assets, who have a reputation for best-in-class service quality. We are looking at both bolt-ons to our existing service lines and complementary service lines that extend our current core service offerings. Tactically, we believe in being opportunistic.” – Darron Anderson, CEO, Ranger Energy Services [Q1]“As we said in the prepared remarks, many of these small operators, frankly, we believe, lived and died on the PPP. They priced things that keep them alive and trade dollars. We think by signaling, and more than signaling that there's consolidation, and we think there'll be other players that will try to consolidate.” – Bill Austin, Interim CEO & Chairman, Ranger Energy Services [Q2]Leverage to Increase Service PricingThe greatest theme of 2021 from the perspective of E&P operators and mineral aggregators was the upward trajectory out of the crude abyssfrom 2020. What a difference a year makes, both in hindsight and for the road ahead. This was probably most present with OFS operators, which likely hit an inflection point from riding the wave as price-takers to potentially commanding the wave as price-makers in the near-term or at least being able to take more than what they can just get.“Service pricing improvement is the final step. We're not there yet, but we see positive signs of market rebalancing that should drive future pricing improvements. Total fracturing equipment capacity has limited room to grow in the current pricing environment.” – Jeff Miller, President & CEO, Halliburton [Q1]“I believe equipment availability will tighten much faster than most people think. In multiple product lines, we believe that equipment supply will fall behind anticipated demand. Today, both drilling and completions equipment are nearing tightness in North America.” – Jeff Miller, President & CEO, Halliburton [Q2]“Our primary near-term objective is driving margin expansion. Our largest near-term lever here is pricing.” – Bill Austin, Interim CEO & Chairman, Ranger Energy Services [Q2]“I'll give you two anecdotes. One customer was a smaller customer, that we went and said that these need to be the new rig rates for us to continue, working beyond what we had committed to. They were pretty upset. Used some pretty colorful language. And we said, we're going to okay, well, we will finish up our jobs that we committed to, and we'll walk away. Half an hour, they call back and agreed to it, right? So clearly, our view is that they got on the phone, called around, and realized that there wasn't anything available. And another one with a much bigger customer said that they wanted to add additional rigs. They were trying to use that as a bargaining chip for basically a volume discount. We very quickly said we'll talk about additional rigs only, until we get our first pricing, basically the first wave of price increases. It's been a multiple conversation event, but I think we’re getting there.” – Stuart Bodden, President & CEO, Ranger Energy Services [Q3]ConclusionMercer Capital has its finger on the pulse of the oil and gas sector. As upstream operators, mineral aggregators, and the OFS operators that support them regain their footing, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team.

WHITEPAPER | Understand the Value of Your Logistics Company

There are many reasons why a logistics company can be worth more or less than a standard rule of thumb might imply, and many reasons why a particular interest in a logistics company can be worth more or less than the pro rata value implied by that rule of thumb.This whitepaper provides useful information as to how logistics companies are valued and what impact that might have on their owners.The whitepaper breaks down basic concepts that must be defined in every valuation and goes into depth about three commonly accepted approaches to value. Financial and market considerations are discussed as are the differences between public and private companies as well as public and private logistics companies.

2022 Credit Market Outlook for Family Businesses

In this week's Family Business Director, we feature Jeff K. Davis, CFA, Managing Director of Mercer Capital’s Financial Institutions Group, a veteran banking analyst, and an editorial contributor to SNL Financial. He regularly is featured in American Banker, Bloomberg News, and other industry outlets.Barring a change in the economic backdrop, the availability of debt financing for most family businesses in 2022 should be good; however, the cost of borrowing probably will rise in 2022. Market participants are highly certain the Fed will raise short-term policy rates to address high inflation that massive growth in monetary aggregates since March 2020 unleashed on financial markets initially and now the broader economy.As shown in the chart below, the yield on two-year and ten-year US Treasury (“UST”) notes have been trending higher for some time. The two-year note is sensitive to short-term policy rates the Fed sets (e.g., the rate the Fed pays banks for reserves that are deposited with it). It has rapidly increased in yield (i.e., the price has declined) since last September when it became obvious that inflation was not “transitory” and the Fed faced a political as well as economic issue of having not acting sooner. Click here to expand the chart below.Source: Market Yield on U.S. Treasury Securities at 2-Year Constant Maturity (DGS2) | FRED | St. Louis Fed (stlouisfed.org)The yield on the 10-year UST is not directly tied to where the Fed sets short-term policy rates. Theoretically, the rate reflects economic growth expectations, inflation, and a term premium for long lending. If short-term policy rates are kept too low, then all else equals the yield on the 10-year would be expected to increase as growth and inflation expectations rise. Conversely, once the Fed starts hiking, long-term UST rates initially tend to rise less than the Fed hikes and later often decline as investors wager the Fed will hike until something breaks.This is what occurred in 2018. The yield peaked in October and fell sharply as investors concluded the anticipated December rate hike would be ill-advised. The yield on the 10-year continued to trend lower in the first half of 2019 before the Fed was forced to reduce short-term policy rates three times to about 1.50% during the third quarter.Since late March 2020, short-term policy rates have been near zero when the Fed cut rates to address illiquidity in markets and the economic shock from policy actions taken in response to the COVID-19 pandemic.It is these short-term policy rates that are now poised to increase, which in turn impact short-term benchmark rates banks and other lenders use as a base rate to charge businesses, most notably 30-day and 90-day LIBOR and now the secured overnight funding rate (“SOFR”) for floating rate borrowings. (Note: LBIOR is in the process of being phased out and will be replaced by SOFR, AMERIBOR, and other less well-known overnight borrowing rates.)Even with rising rates, competition will likely remain intense and preclude much if any increase in the margin over the base rate in 2022.Fixed borrowing rates that track UST and swap rates for various maturities have already begun to rise somewhat and will increase further in 2022 provided UST yields continue to track higher.Competition among lenders determines the margin over the base rate whether short-term floating or intermediate-term fixed the borrower will be charged. Even with rising rates, competition will likely remain intense and preclude much if any increase in the margin over the base rate in 2022.As shown below, market participants are pricing in about four 25bps hikes in short-term policy rates by the Fed given about 100bps of increase in 30/90-day LIBOR based upon rates that are observed in the highly liquid Eurodollar market. Likewise, the forward SOFR curve also is pricing in about 100bps of increase over the next year. Over the next two years, the market is pricing in about 175bps of hikes, which would equate to seven 25bps hikes by the Fed compared to nine during the last hiking cycle that ended in December 2018.If market expectations are fully realized, borrowing rates for family businesses should remain very low by historical standards, just not as low as 2020 and 2021. Our sense is that most businesses will not be materially impacted given the market projects' low terminal rate. Higher rates will only be an issue if the borrower’s industry or broader economy falls into recession.An unanswered question is whether financial markets can stand the prospective increase given the massive leverage employed for speculation and to fund “carry trades” in which leverage is used to increase the amount of income produced from low-yielding bonds. If markets cannot tolerate much increase, then the question will become at what point will the “Fed put” or “Powell put” be triggered in which further hikes are precluded or even reversed?No one knows, but this link provides an interesting perspective on the accuracy of forwarding curves. Since the Fed experimented with very low policy rates in the early 2000s when the Fed Funds rate was set at 1%, market participants have projected hikes would commence sooner than occurred. Also, once hiking cycles began, market participants projected less hiking than occurred.In effect, investors believed rates were too low once reduced to near zero; and once the hiking began, the Fed did not have as much latitude as it thought it had to raise rates given the build-up of debt in the economy and markets.

The Future of Auto Dealerships

How Inventory Shortages and Electric Vehicles May Shape the Future of Automotive Retail

Just as December is a good time to look back and reflect, January is a good time to look forward, to 2022 and beyond. When we value auto dealerships, we look back at performance in prior years because this helps to inform reasonable expectations for future performance. Prior to the pandemic, the directly preceding twelve months of performance may have been a reasonable proxy for ongoing expectations. However, throughout 2020 and 2021, discussions about when things will return to “normal” or whether we’re in the “new normal” have taken center stage.In order to look forward, we must also consider the past, or as Shakespeare’s Antonio would say, “What is past is prologue.” In this post, we look at two key trends in 2021 (inventory shortages and electric vehicles/direct selling) and how they may inform how automotive retailing will look in the future.Inventory ShortagesIn case you’ve been living under a rock (or working from home and refusing to turn on the news), new vehicle inventory has been tight, reducing availability and raising prices. While a lack of necessary microchips has stolen headlines, general supply chain issues are also at play (labor shortages, plant shutdowns due to COVID, etc.). From Econ 101, we know low supply leads to higher prices. And even though operating expenses have increased 16.3% for the average auto dealership in the U.S., pre-tax profits more than doubled in the first nine months of 2021.This inelasticity of demand affords greater pricing power to dealers and manufacturers than they’ve previously achieved.For years, retail has been obsessed with discounts. Think 10% for signing up for a mailing list, free shipping for orders over $25, or straight to the point: Black Friday/Cyber Monday. Automotive retailing is no exception, with incentives reaching above $4,500 per vehicle prior to the pandemic. As discussed last week, incentives have plummeted in the low inventory environment. Unlike knick-knacks bought in the Christmas season, many car buyers don’t have a reasonable substitute. When their car breaks down, they need a vehicle and can’t wait months for inventory levels to normalize. This inelasticity of demand affords greater pricing power to dealers and manufacturers than they’ve previously achieved.Auto dealers and their manufacturers are much more profitable under the current operating environment while producing fewer vehicles, reducing execution risk. It’s easy to chalk up these good times to temporary dislocations caused by COVID that will eventually normalize. But in a capitalist society, economic downturns tend to bring back the phrase attributed to Winston Churchill around World War II, “never let a good crisis go to waste.” OEMs will look at how they’ve adapted since March 2020 and look to keep profits higher with more efficient operations.Once the pandemic is finally in the rear view mirror, we think the level of inventories held on lots will be lower than pre-pandemic levels. While there is still a value to testing out the product before purchasing, we’ve seen other retail industries that hadn’t yet succumbed to ecommerce where certain buyers are now willing to buy sight unseen (see mattresses in a box). This shift in auto will reduce floor plan costs for dealers who can also downsize their real estate holdings or convert it to more service areas if they can find the technicians to fill the bays they already have. Smaller real estate requirements may enable dealerships to move to more cost-effective locations.But the main concern from dealers we’ve talked to is this: what if prevailing supply conditions fundamentally change the franchised dealer model?History of Dealer FranchisingTo understand the status quo of automotive retailing, we start at the beginning, when automotive manufacturer franchising of dealerships began in 1898. Back then, there were numerous methods of selling vehicles, including franchise locations, direct sales from factory-owned stores, traveling salesmen, wholesalers, retail department stores, and consignment arrangements. As automobiles proliferated, manufacturers preferred outsourcing sales to the franchise model, so they could focus on their core competency of manufacturing vehicles. They would rely on entrepreneurs to understand their local market in terms of which models were popular and where best to situate the dealership within the market. This also lowered investment for the manufacturers who could instead plow those resources back into product development.The franchise agreements were perceived as shifting risk downward to dealers and rewarding upwards to the manufacturers.Once this investment was made by numerous “mom and pop” shops throughout the country, dealers lobbied to protect their investment. It was deemed unfair for the Big Three (Ford, GM, Chrysler) to be able to sell directly to consumers in lieu of through its dealers. Manufacturers already operate from a position of power as the sole provider of new vehicles to its franchisees, a risk known in valuation as “supplier concentration.” OEMs can unilaterally determine production levels, and according to a 1956 Senate Committee report, franchise agreements of the 1950s typically did not require the manufacturer to supply the dealer with any inventory and allowed the manufacturer to terminate the franchise relationship at will without any showing of cause. Manufacturers could overproduce and force dealerships to accept the cars with the threat of no inventory in the future. This occurred with Ford during the Depression. Thus, the franchise agreements were perceived as shifting risk downward to dealers and rewarding upwards to the manufacturers.For perspective, restaurants don’t have similar franchise protections. For example, McDonald’s has both corporate owned and operated locations as well as franchise locations (approximately 93% of locations are franchisees). In this industry, there is heavy competition and franchisors often test out new products in their own locations before rolling them out to franchisees. This is quality assurance and also gives franchisors the ability to point to the success of a product so franchisees don’t feel like they’re being forced into something that may not appeal to their customers.While dealers made numerous lobbying efforts at the Federal level in the 1930s to 1950s, they made little headway. In fact, a 1939 Federal Trade Commission report found that manufacturers pitting dealers against each other actually led to an intense retail competition which ultimately benefitted consumers. To get the protections they sought, dealers turned to state legislatures, which is why franchise laws are largely handled at the state level. Today, all 50 states have laws that protect dealers, though the strength and terms of these laws varies by state. Common terms include the prohibition of forcing dealers to accept unwanted cars, protection against termination of franchise agreements, and restrictions on granting additional franchises in a dealer’s geographic market area. As many dealers today know, the OEMs still have significant bargaining power in these latter two areas.Direct SellingThe current market dynamic has prevailed for generations through numerous business cycles. Today, dealers are concerned that manufacturers may use electric vehicles (“EV”) as a means to skirt dealer franchise laws. Tesla has been very successful, particularly if you look at their share price, with its direct-to-consumer electric vehicle sales. OEMs naturally would like a piece of this (or anywhere near their valuation multiple).While Tesla has encountered legal troubles with its direct selling model, it’s important to note the difference between Tesla and other manufacturers. Tesla never pursued a franchise dealer model. Therefore, direct selling cannot disadvantage dealers of its vehicles since they don’t exist. Tesla offers a luxury product and has yet to reach a meaningful scale. Unlike OEMs of the early to mid-1900s, their product has not garnered mainstream demand, and they can therefore be competitive in their niche by keeping few parties in between the manufacturer and the consumer. While the below graphic is instructive, the OEM tends to play the role of plant, distributor, and wholesaler, meaning there’s really only one extra layer between manufacturer and consumer in this industry. Dealers naturally contend that direct-to-consumer EV sales should not be allowed as it could be a slippery slope to allowing the sale of all vehicles directly. There is nothing inherently different about the manufacturing and selling process as it relates to the powertrain of the vehicle. Tesla’s exception is not electric; it’s the lack of an existing dealer network. However, one of the benefits of the current dealership model is that consumers can return to the dealership to service their vehicle. If EVs deliver on their promise to require less maintenance than internal combustion engine (“ICE”) vehicles, maybe the need for this dealer network will be diminished in some regard. For now, electric vehicles are too expensive to be mainstream, but significant progress has been made on lithium batteries which have lowered costs. Still, massive investments in infrastructure will be necessary to make EVs practical. Electric vehicles are only 2.9% of the market, though combined with hybrids, alternative powertrains amount to 9.5%, with the remaining being internal combustion engines. While this is a relatively small piece of the market, it will likely grow over time.Source: NADA Market Beat December 2021ConclusionGiven the complexity of manufacturing automobiles and the heterogeneous preferences of consumers, we don’t think the recent shift to “just-in-time” delivery out of necessity will last. We believe electric vehicles will compose a much more meaningful market share, though we are less certain on the timing. While there are various proclamations of carbon-neutral by 2050 and the like, we think the market will determine when and how much electric vehicles hit the mainstream. If improved technology reduces costs and fears of range anxiety, EVs could be on the same playing field or even advantaged over ICE vehicles with higher upkeep costs (service and gas).We don’t believe electric vehicles will meaningfully change dealer franchise laws. However, we believe the trends we’ve seen of smaller stores being gobbled up by increasingly larger auto groups will continue, which is partially due to the threat of direct selling. However, smaller dealers are also getting out with valuations peaking, tax policy uncertainty, and increasing capital requirements to invest in digital platforms, automated systems, and the infrastructure to support electric vehicles rather than the direct selling of these vehicles.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

A B2B Fintech in the RIA Space Races to Market

Dynasty IPO Ticks a Lot of Boxes, and Begs a Few Questions

Two economists are walking along, and one of them says, “Look, there’s a hundred dollar bill on the sidewalk.” The second economist says, “It can’t be a hundred dollar bill; if it was, somebody would have picked it up by now.”Most economists believe in market efficiency. This belief requires a healthy dose of skepticism, which some see as cynicism. That characterization is unfair.Real Versus RareMy family was staying at the Grove Park Inn a few years ago when we spotted what looked exactly like a Porsche 904 GTS in the motor court (photograph above). It looked just like the mid-60s racing legend, with a short wheelbase, a very low roofline, and a detachable steering wheel (to assist getting in and out of the driver’s seat). Convincing, but I knew it couldn’t be real; highly unlikely that anyone would drive such a rarity to dinner (about 100 were built), even on a beautiful day in the mountains of North Carolina. A little research revealed it to be a kit car made by Chuck Beck – also rare but considerably more accessible than the original.Last week we were surprised by an equally rare sighting, an S-1 filed by a prominent player in the RIA community. Dynasty Financial Partners seeks to raise $100 million in a public offering. The mercifully terse prospectus is less than 250 pages, and is recommended reading for anyone who swims (or fishes) in this pond.The mercifully terse prospectus is less than 250 pages, and is recommended reading for anyone who swims (or fishes) in this pond.As most of the readers of this blog know, DFP is the ten-year-old brainchild of Shirl Penney, Edward Swenson, and Todd Thomson. The company provides a variety of services to both foundling and established RIAs, but principally engineered a plug-and-play back office for RIAs, sifting through the myriad of technology vendors needed for wealth management and organizing them on a proprietary platform called the Dynasty Desktop.The pitch for potential clients is self-evident: RIAs of any scale can access the tech stack of a big firm on a subscription basis. Dynasty stays on top of tech developments better than (most) in-house teams.Complementing this is a TAMP and access to growth capital. Being a Dynasty Network firm situates wealth management shops in a broader community of firms with similar interests, needs, and requirements. Client firms get to focus on what wealth managers do best: stay at the front of the house, developing their business, while Dynasty manages the back of the house, supporting their business.Great narrative. DFP’s financials are promising, if lighter than expected. Dynasty’s PR group is to be commended: the firm has developed an outsized prominence in the industry relative to its actual size.Dynasty has a recurring revenue stream (most of its services are priced as basis points on AUA) and the scale of the business has more than quadrupled in the past five years. Nevertheless, in the nine months ended September 30, 2021, Dynasty reported a bit less than $50 million in revenue and only $12 million in adjusted EBITDA. While adjusted financial metrics sometimes warrant criticism, Dynasty’s reported EBITDA was only off $750K or so for the same period.While full year financials aren’t yet available, we estimate run rate revenues of $75 million or more, with adjusted EBITDA approaching $20 million. Dynasty’s unit economics are enviable, with a growth-plus-margin metric, so often cited by SaaS investors, of nearly 75% (period-over-period revenue growth of 50% plus an EBITDA margin of 24%).What’s Not to Like?As available investment opportunities go, Dynasty looks great except for one thing: it’s available. Why is this hundred dollar bill on the sidewalk? More specifically, why is a firm with this story and size not being funded by private equity?There’s no shortage of private equity investors in the B2B, fintech, or RIA space; Dynasty should appeal to them. As a B2B, Dynasty has a track record of attracting and retaining demanding RIA clients with their platform. As fintechs go, DFP is certainly more interesting than the myriad of buy-now, pay-later startups that seem to attract nearly limitless capital these days. Compared to the many PE-backed serial acquirers in the RIA space, this is an actual business…with products. Surely, selling picks and shovels to RIAs is less speculative than being an RIA.Surely, selling picks and shovels to RIAs is less speculative than being an RIA.Why would management want to go public? Running a public company is no walk in the park, and most management teams don’t choose that path instead of PE backing, especially with less than $100 million in revenue. As such, we have a few questions:Is the Dynasty Desktop a comprehensive, proprietary technology solution for RIAs, or middleware that is easily replicable? The answer may depend on the client, but if it’s the latter, Dynasty is at risk of being exposed to more competition if the market for their platform becomes more visible. Their offerings could be featurized by custodians or custom-engineered by developers. The more success they achieve, the more competition they’ll attract.Is Dynasty’s fee schedule sustainable?We don’t have enough information to infer what Dynasty has been able to charge for their services over time, but current returns suggest a realized fee across all of their segments (tech stack, TAMP, etc.) of about 11 basis points. The S-1 suggests that fees are negotiable, and larger RIAs probably pay fewer bps than small ones. At the same time, Dynasty probably earns most of its profits from larger clients, because the base cost of service won’t be that different for a $200 million RIA and a $2 billion RIA.If the wealth management industry experiences fee compression, what does that mean for Dynasty? RIAs have the option of paying a consultant a one-time or infrequent fee to build a tech stack instead of regular subscription fees. Smaller RIAs have an obvious incentive to get someone like Dynasty to handle the back-of-the-house stuff so they can focus on wealth management. Larger RIAs can disintermediate and build their own margin with direct vendor relationships.What is normalized profitability for this company? Under the right circumstances, SaaS can throw off huge margins. Here, the margin opportunity is hard to assess, although the potential for operating leverage is obvious. Dynasty currently serves 46 firms with 75 employees. How much additional headcount would it take to service 80 firms, and how specialized would those additional staff be? We suspect that DFP’s move to Florida was part of an effort to right-size its cost structure. While many rue the outflow of financial businesses from New York, we see it as both prudent and inevitable. Being public, on the other hand, has costs of its own, and DFP will have to outgrow those costs to make the IPO worthwhile.What is the cost of remaining relevant in this space? It’s easy for in-house tech specialists to fall behind the competence curve. When they do, companies lose opportunities, fall victim to malware, and profits suffer from inefficiency. Outside tech providers can offer the latest and greatest and are pros at keeping themselves and their clients current. But remaining current is expensive, and one wonders if a company the size of Dynasty can handle the tradeoff between the margin they make from today’s products and services and the cost of developing tomorrow’s products and services. Dominant technology companies are either very niched or very large. The Dynasty S-1 is mostly routine, except for one section outlining their efforts to remedy problems with their internal controls. It’s probably nothing, but we’re surprised by this, as competent management of back-office issues is what DFP is supposed to be selling to RIAs. If Dynasty could have waited a bit on their IPO, they could have cleaned up and avoided the disclosure.Price Versus ValueSo what’s the verdict? It all comes down to price. We know Dynasty wants to raise $100 million, and we estimate they have nearly $20 million in EBITDA. How much of that EBITDA will $100 million buy? We’ll soon find out.It all comes down to price.The Beck 904 is faster, more comfortable, and more drivable than an original Porsche 904. It’s not “real,” but it’s real cool. And the Beck is much cheaper than the original, priced at less than 5% of the auction value of the Porsche. At $75K for a fully outfitted Beck and $2 million for the Porsche, each priced to reflect the underlying value of the car.

Desert Peak to Go Public via Merger With Falcon After IPO Attempt

Desert Peak Minerals and Falcon Minerals Corporation recently announced an all-stock merger, forming a pro form a ~$1.9 billion mineral aggregator company. This comes in the wake of Desert Peak’s attempted IPO in late 2021. In this post, we look at the transaction terms and rationale, the implied valuation for Desert Peak, and implications for the mineral/royalties space.Transaction OverviewThe merger will combine Falcon’s ~34,000 Eagle Ford and Appalachia net royalty acres with Desert Peak’s ~105,000 acre Delaware and Midland position, resulting in a combined company with ~139,000 net royalty acres. Approximately 76% of the company’s acreage position will be in the Permian, with 15% in the Eagle Ford and 9% in Appalachia. Pro forma Q3 2021 production was 13.5 mboe/d, which moves Falcon from the smallest (by production) publicly traded mineral aggregator in Mercer Capital’s coverage to number four, leapfrogging Dorchester and Brigham.The transaction is expected to close during the second quarter of 2022, at which time legacy Falcon shareholders would own ~27% of the company, while legacy Desert Peak shareholders would own ~73%. The combined company will be managed by the Desert Peak team and headquartered in Denver.Going forward, one of the key strategies of the company appears to be M&A. The company seeks “to become a consolidator of choice for large-scale, high-quality mineral and royalty positions” and touted its “strategic, disciplined, and opportunistic acquisition approach” in presentation materials.The company also highlighted its ESG credentials, noting the diversity of its workforce and structural economic disincentives for flaring gas. However, most ESG discussions focused on the often-neglected G – governance. Management incentive compensation is expected to be 100% in the form of equity with an emphasis on total shareholder returns, rather than relative returns or growth metrics.Desert Peak Implied ValuationDesert Peak was pursuing an IPO in late 2021, looking to raise $200 to $230 million at an implied enterprise value of $1.2 to $1.4 billion, based on Mercer Capital’s analysis of Desert Peak’s S-1 filing. However, the deal was postponedin November and ultimately withdrawn in January.Based on Falcon’s stock price immediately preceding the announcement, the merger terms imply an enterprise value of $1.4 billion for Desert Peak, slightly higher than the valuation implied by the top-end of the IPO range. However, Falcon’s stock price has slid since then, bringing Desert Peak’s implied valuation back in line with the mid-point of the IPO range.Implied valuations and relevant multiples are shown in the following table.IPO stock price reflects midpoint of $20 to $23 range indicated in Desert Peak’s S-1. Merger stock price reflects Falcon's closing stock price as of 1/11/2022 (immediately preceding merger announcement). Current stock price reflects Falcon's closing stock price as of 1/19/2022.IPO shares pro forma for anticipated IPO offering. Other figures reflect the number of Falcon shares to be issued to Desert Peak.IPO net debt pro forma for anticipated transaction proceeds, as indicated in Desert Peak’s S-1. Other figures reflect net debt as disclosed in the transaction press release.Metric per transaction press release (as of 9/30/2021).Metric per transaction presentation (as of 9/30/2021). Multiple calculated on a dollar per flowing barrel equivalent basis ($/boe/d).Metric per Desert Peak S-1 (pro forma as of 12/31/2020). Multiple calculated on a dollar per barrel equivalent basis ($/boe).Metric per Desert Peak S-1 (pro forma as of 12/31/2020).Metric per transaction presentation.ImplicationsDesert Peak's inability to complete its IPO highlights the lack of appeal of oil & gas assets among generalist investors, which is not welcome news for an industry facing capital headwinds and a dearth of IPO activity. However, Desert Peak was able to structure a new deal at essentially the same valuation should give mineral and royalty owners confidence that logical buyers can be found.ConclusionWe have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Portfolio Valuation: Private Equity and Credit

First Quarter 2022

FEATURE ARTICLESolvency of the SponsorAlso in This IssueUpdated Metrics forPrivate Credit and EquityPublicly Traded Private CreditVenture Capital

Solvency of the Sponsor

2021 was a spectacular year for leverage finance, a once obscure area of the capital markets that has morphed into a stand-alone asset class and money machine for the banks that arrange it. According to S&P Global Market Intelligence, leverage loans issued topped $800 billion with over $600 billion absorbed by institutional investors while high-yield bond issuances exceeded $460 billion. Both totals were records, though a significant amount was used to refinance existing debt.

Middle Market Transaction Update Second Half 2021

In this issue of Mercer Capital’s Middle Market Transaction Update, we take a look back at the trends that drove middle market deal activity to record levels in 2021 and whether we expect these trends to continue into 2022.

Auto Industry Trends to Monitor in 2022

Less Is More?

With the start of NFL playoffs and our third accumulating snowfall in three weeks, we are once again reminded that the calendar has flipped over to a new year. No doubt if you watched any games from Super Wild Card weekend, you were also reminded that the auto manufacturers and beer producers are two industries that have become synonymous with advertising in the NFL. One such beer producer had a longtime advertising campaign where they debated whether their beer “tastes great” or is “less filling.” While consumers continue to weigh that debate, that same beer producer ended some of their commercials with the line “everything you always wanted in a beer. And less.”That slogan could easily have described the state of the auto industry in 2021. Some industry experts have referred to it as “less is more,” others as “the new abnormal.” There is no debate that the auto industry faced numerous challenges but was able to adapt and turn in one of its most profitable years on record in 2021.What trends can we expect to see in 2022 for the auto industry? What trends will we see “less” of? What trends will we see “more” of?In this blog post, we examine some of these trends and offer some predictions for industry conditions in 2022.Less: Incentives from the ManufacturerHistorically, OEMs have offered incentives to auto dealers on certain makes and models for stocking the companies’ products and promoting sales. As the supply of new units was diminished since the onset of the pandemic due to plant shutdowns and then ultimately a shortage in microchips, the demand to buy the limited number of units outweighed supplies and incentives have diminished for most makes and models. The following chart from JD Power/LMC Automotive displays the average incentive spending per unit and the percentage of incentives to the average Manufacturers’ Suggested Retail Price (MSRP) from December 2019 through December 2021. Specifically, average incentive spending per unit has declined by approximately $3,000 per unit from December 2019 to December 2021, representing a 65.3% decline. Incentives as a percentage of average MSRP has also declined from 11.0% to 3.5%. With continued inventory supply challenges expected to persist for most of 2022, expect OEM/Dealer incentives to continue to be lower than historical levels. Quite simply, the demand for inventory will outpace supply in the continuing months.More: SAAR/Total Retail Units SoldAs we reported in last week’s blog, the December SAAR totaled just 12.44 million units. The total number of units retailed for the year has been estimated at 14,926,900. Volumes were negatively impacted by the same conditions that impacted manufacturer incentives – plant shutdowns, chip shortages, and supply chain issues. Despite the success achieved by auto dealers over the past two years, the total number of retail units sold has lagged behind the prior five-year average. Many analysts that cover the industry would estimate that demand for the annual SAAR should hover around 17 million units. In fact, the average SAAR for the period from 2015 through 2019 averaged 17.24 million units. As seen in the graph below, the decline in sales for the last two years has created a deficit of approximately 5.08 million units. Some of this deficit may get offset or replaced by consumers that have either delayed their next purchase or shifted to purchasing a newer used vehicle rather than a new vehicle. With fewer vehicular miles driven, some of these retail volumes may be permanently “lost.” In any event, there is pent-up demand from consumers due to the inventory shortages over the last two years. The market will need to absorb this pent-up demand as more inventory becomes available. Several industry experts have weighed in on their SAAR estimates for 2022:Kevin Roberts – Car Gurus: 15-16 millionJonathan Smoke – Cox Automotive: 16 millionPatrick Manzi – NADA: 15.4 million SAAR will most certainly increase in 2022 out of necessity from demand from the prior two years. Full recovery to the 17 million unit historical levels will continue to be challenged by the inventory conditions from the OEMs. If the OEMs are able to produce more units in 2022, auto dealers will be able to increase the number of units sold from the prior two years.Less: Number of Models AvailableGiven the challenging industry conditions, OEMs have been forced to prioritize which models they produce. Most OEMs have had a difficult time producing their full lineup of vehicles. Specifically, two segments that are among the hardest hit are the luxury market and cars (as opposed to crossovers and pickup trucks). In normal production years, luxury cars are more limited in supply than other brands, but those are being more impacted in 2021 and are being the hardest hit with seller markups. Cars and sedans are also seeing a reduction in the number of units produced. Consumer behavior, in addition to inventory shortages, is to blame for this phenomenon. According to a recent article in Newsweek, trucks and SUVs compromise nearly 81% of the total vehicles manufactured.OEMs will continue to prioritize the production of models based upon:units dealers are selling the most frequentlyunits for which necessary parts and microchips are availableunits achieving the highest margins. Like many industry experts, we anticipate the number of models from each OEM will continue to be limited in 2022.Less: Features on VehiclesAs we all learned in 2021, many of the accessories and features on our vehicles are powered through microchips. The microchip shortage has caused production delays and shortages. Some analysts have estimated that the global microchip shortage has cost the auto industry millions of lost vehicles and billions in lost revenue in 2021. How long are conditions expected to persist?Most automobiles can be built in 15 to 30 hours, while a microchip takes nearly five months to be produced.Most auto manufacturer plants can operate two production shifts five days a week or a total of 10 shifts per week. In times of high production needs, auto manufacturers can increase the total number of shifts to 21 shifts per week. In contrast, semiconductor plants are expensive, slow to build, and more complex to operate. For example, most microchip plants operate 24 hours per day, 365 days per year, so there is no room to increase production in existing plants to make up for any shortfalls. Further, the life cycle of a microchip plant from breaking ground on the facility to the start of production can take up to five years, compared to the six-month lead time at an auto manufacturing plant. Most automobiles can be built in 15 to 30 hours, while a microchip takes nearly five months to be produced, packaged, and shipped to an OEM for installation on a vehicle.So while companies such as Taiwan Semiconductor Manufacturing Company (TSMC) and others are making the investment to build new chip factories, it’s going to take considerable time to meet current demands. TSMC began building a new factory in Arizona in June, and Samsung is planning a new chip plant in Texas.Given supply constraints, OEMs can either produce fewer vehicles with the same number of features, the same number of vehicles with fewer features, or a combination of the two (smaller reduction of both vehicle volumes and features). As we saw in 2021 and anticipate into 2022, the auto industry will continue to suffer from the microchip shortage. Consumers will see the impact materialize in fewer accessories and features on the new vehicles produced in 2022.Less: Number of Electric Vehicles (EVs) on the MarketIn last week’s blog, we also commented on the OEMs participation and activity in the electric pickup truck race. The activity isn’t just limited to Ford, Chevrolet, and Tesla as newer manufacturers such as Lordstown Motors, Bollinger, and Atlis Motors are also entering the market.The demand for battery-electric vehicles doubled during the first half of 2021.While EVs only account for a fraction of the new vehicle sales in the United States, the demand for battery-electric vehicles doubled during the first half of 2021. Just last week, representatives from NADA, General Motors, and the United Auto Workers testified in a House hearing on the impact of EVs on rural communities. Many dealers indicate the desire and energy to participate in the direct sale of EVs once they are rolled out from production from the OEMs. Auto dealers wish for traditional state franchise laws to be upheld that govern the licensing and regulation of distribution and the sale and service of EVs. Specifically, auto dealers in rural or non-metropolitan areas want to make sure they are not excluded from participation due to a lack of technological innovations. Similar to other advancements such as electrification, broadband, and telephone service, rural area auto dealers want to ensure that they will be given the same priority and attention as their urban dealer counterparts.Consumer behavior and preference may also play a key role in the increased number of EVs on the road. According to a 2022 State of the American Driver Report from Jerry, 47% of millennials are interested in buying an EV as their next vehicle. Gen Z and Gen X also show strong interest in EVs at 41% and 38%, respectively.ConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

2022 Tax Update for Estate Planners and Family Businesses

Where Are We With Tax Policy?Entering 2021, tax worries and changes in tax policy were at the forefront of discussion in the political, business, and estate arenas. Changes including removing the step-up in basis on capital gains at death, increasing the corporate tax rate, eliminating valuation discounts, neutering GRATS, increasing the capital gains rate on high incomes, and lowering the gift and estate tax exemption were all on the table as part of the Biden Administration’s agenda upon taking office.As 2022 kicks off, tax policy largely remains unchanged from a year ago. President Biden’s Build Back Better (“BBB”) Act went through numerous iterations over the year and was politicked down from a headline program cost of $3.5 trillion to $1.7 trillion before ultimately being kiboshed by Senator Joe Manchin (D-WV) publicly pulling his “Yea” from the bill in late December.But where does that leave estate planners and family businesses? There are three things estate planners and business advisors need to keep top of mind regarding tax policy in 2022.1. Major Tax Overhaul Less Likely…A short column from Bloomberg Tax highlighted the President’s herculean task of resurrecting BBB heading into a contentious 2022 midterm election cycle, with multiple purple state Democrat Senators not named Joe or Kyrsten facing tougher reelection battles. The likelihood of major tax changes diminishes as the calendar approaches November 2022, and the polling would suggest Democrats may be less willing to pass sweeping changes in the face of a ‘red wave’ in the midterm elections. Watch closely: if nothing transpires early in the legislative calendar, the likelihood of major tax changes will likely dissipate until at least January 2025.According to a report from The Hill, Democratic aides say the BBB bill won't be ready for floor action any time soon and predict the wide-ranging legislation may have to be completely overhauled. Senate Majority Leader Chuck Schumer (D-NY) informed colleagues the Senate will begin focusing on voting rights legislation in the New Year, further signaling a shift from tax policy. After a year of tax consternation, it might be nice to ring in the new year with less tax anxiety immediately on the horizon.2. Changes Still LurkingSpeaking during a radio interview, Senator Manchin offered a path to revive a skinnier version of President Biden’s BBB bill. Senator Manchin said the legislation should go through Senate committees in order to examine any economic impacts and focus on rolling back the 2017 Tax Cuts and Job Act (“TCJA”) tax cuts.What parts of TCJA is Senator Manchin referring to? Hard to say, but the largest changes in the TCJA included a decrease in individual income tax rates, a decrease in the federal corporate income tax rate from 35% to 21%, and the qualified business income deduction to pass-through entities. The law also increased the estate tax exemption for single and married couples (discussed below) to their current schedule.Senator Manchin has also indicated he is willing to support some version of a tax targeting billionaire wealth via a wealth tax mechanism, a cause generally supported by the more progressive wing of the Democrat party. While this may not affect as many readers here, it does reflect the Senator’s willingness to entertain more aggressive tax increases (while maintaining his issue with the spending programs outlined in BBB). While less vocal moderate Democrats are likely concerned with voting on any tax increase in 2022, this may be the President’s only shot to pass broader tax policy changes if a ‘red wave’ does transpire in 2022.3. Remember the Transfer Tax Law SunsetFor family businesses and estate planners, while the transfer exemptions remain at current levels, they are still set to drop by 50% on January 1, 2026 (as well as current income tax rates). Per The National Law Review, the Treasury Department has confirmed the additional transfer tax exemption under current law is a use it or lose it benefit. If a taxpayer uses the “extra” exemption before it expires (by making lifetime gifts), it will not be “clawed back” to cause additional tax if the taxpayer dies after the exemption is reduced.As we’ve written previously the current estate and gift tax exclusion is an opportunity for privately held and family businesses to accelerate their gifting strategies. In 2022 the gift and estate tax exemption increased to $12.06 million ($24.12 million for a married couple), allowing families and estate planners to maximize lifetime gifts in a tax advantageous environment. As an added bonus, federal tax laws allow for an annual exclusion that avoids the estate/gift tax exemption entirely. This level was set at $15,000 per recipient for 2021 and will increase for inflation to $16,000 in 2022.ConclusionAs we have written previously in Family Business Director, don’t let the tax tail wag the business dog. Estate tax planning efforts should be opportunistic while remaining focused on the bigger goal, which is ensuring a successful transition of the ownership of the family business from one generation to the next in a way that promotes the long-term sustainability of the family and the business.Keeping a semi-regular eye on Washington D.C. can be beneficial to estate attorneys and family businesses looking to avoid legislative pitfalls that can torpedo an estate plan. Just remember that predicting the future is perilous: the BBB act may be mortally wounded, but like any good political drama, you have to remember the evil twin brother who has been lurking out of frame. Contact a professional at Mercer Capital with your valuation needs in support of your estate planning.

Alt Managers Best the Market Along with Other Types of RIAs During a Strong Year for Investment Management Firms

Alternative asset managers fared particularly well during favorable market conditions for the RIA sector. Access to cheap financing and heightened market volatility spurred significant gains for private equity firms and hedge fund managers during 2021. Other types of investment management firms also benefited from another solid year in the equity markets as traditional asset managers and RIA aggregators outperformed the S&P 500 with 30% to 40% gains on average. Drilling down into the most recent quarter, we see more mixed results with positive gains for all sectors, but traditional asset managers and aggregators lagged the market as investors weighed the impact of the omicron variant and rising inflation on the sector’s prospects. Alt managers continued to benefit from higher allocations to risky assets despite some weakness across all sectors during the back half of the quarter. RIA aggregators exhibited outsized volatility during the quarter but ended on a positive note with the stock market in the last week of the year. Because the aggregator model is levered to the performance of the RIA industry generally, recent volatility for RIA stocks has triggered mixed investor sentiment towards the RIA aggregator model. While the opportunity for consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising competition for deals and high leverage at many aggregators which may limit the ability of these firms to continue to source attractive deals. Performance for many of these public companies continues to be impacted by headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded RIAs, while larger asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance over the last year has generally been better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts. As valuation analysts, we’re often interested in how earnings multiples have evolved over time since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and first half of 2021, LTM earnings multiples for publicly traded asset and wealth managers declined moderately during the most recent quarter, reflecting the market’s anticipation of lower or flat revenue and earnings as the market pulled back modestly in September and November. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately-held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products.In contrast to public asset/wealth managers, many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.Notably, the market for privately held RIAs remained strong in 2021 as investors flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity for these businesses continued to be significant in 2021, and multiples for privately held RIAs tested new highs due to buyer competition and the shortage of firms on the market. As these dynamics continue into 2022, the outlook for continued multiple expansion and robust deal activity remains favorable.

What a Difference a Year Makes: Part II

Analyst Projections

In our prior Energy Valuation Insights post – What a Difference a Year Makes – Mercer Capital’s Bryce Erickson dug into the key aspects of the energy industry during 2021, including oil and gas pricing, stock price performance, rig counts, production levels, capital spending, and LNG facility development. It’s well worth a read!In today’s post, we continue the “what a difference a year makes” theme, but now with a focus on analyst projections, then-and-now (then being as of year-end 2020, and now being as of year-end 2021) and energy stock valuation multiples.For the purpose of our analysis, we utilized the Capital IQ system and identified publicly traded energy companies, trading on the NYSE and NASDAQ exchanges, and operating in three broad areas – exploration and production (E&P), oilfield services (OFS), and midstream.The resulting pool included 44 E&P, 32 OFS, and 29 midstream companies1,227 forward (i.e., for the next year) revenue estimates were included in the analysis – 666 as of year-end 2020, and 561 as of year-end 20211,735 forward EBITDA (earnings before interest, taxes depreciation and amortization) estimates were included in the analysis – 854 as of year-end 2020, and 881 as of year-end 2021Potential survivor bias was eliminated by including the same set of companies as of both year-end 2020 and 2021So, What Are the Analysts Expecting?Exploration & ProductionWe’ll start at the drill bit end of the industry – the E&P companies. Revenue growth expectations (233 and 201 analyst estimates as of year-end 2020 and 2021, respectively) actually didn’t change significantly. As of year-end 2020 the median estimated 1-year revenue growth was 25.8%, with only a small increase to 29.7% as of year-end 2021. An improvement certainly, but by no means earth-shaking. A bit more significant for the E&Ps was a 7.5 percentage point increase in the median estimated EBITDA margin, from 57.7% to 65.2%. The real “move” in E&P estimates came from the combination of slightly improved revenue growth estimates and EBITDA margin estimates, buoyed by the rise in commodity prices. Those two estimates “teamed-up” for a mere 17.0% median EBITDA growth estimate at year-end 2020, but a very significant 119.8% median EBITDA growth estimate at year-end 2021.Oilfield ServicesNext up we look to the service and machinery providers to the E&Ps – where we find a much more positive outlook today relative to a year ago. Last year’s median revenue growth estimates sat in negative territory at -6.3%. Sentiment was much improved at year-end 2021 with a median revenue growth estimate at 23.9%. However, OFS EBITDA margins paint a different picture. Despite the expectation for strong revenue growth, EBITDA margins are expected to actually decline slightly from a year-end 2020 median forecast of 12.8%,d to a current figure of 12.2%. This implies that while demand and utilization will be strong, pricing power for oilfield service companies will slip somewhat. The combination of revenue growth and EBITDA margin estimates, though, show a strong improvement in EBITDA growth expectations, from a median expected decline of 5.3% at year-end 2020 to a median expected growth of 34.0% at year-end 2021. This is not as strong as EBITDA growth expectations among the E&Ps, but a very welcome increase all the same. MidstreamMidstream operators of course are the “Steady Eddies” of the energy industry – that in large part is due to the very nature of the services provided and the more contractual/commitment orientation of the midstream business. As one would expect, the difference between 2020 and 2021 median analyst estimates are much less material for midstream companies. Median revenue growth estimates were quite low at only 1.0% at year-end 2020, but improved to a median growth estimate of 7.5% as of year-end 2021. EBITDA margin estimates actually declined a bit more than those for OFS companies, with a 3.3 percentage point dip from 42.5% at December 2020 to a 39.2% median at December 2021. In combination, the revenue growth and EBITDA margin estimates result in the median EBITDA growth estimate of 2.1% in December 2020 and a median estimated growth of 9.0% as of December 2021. Valuation MultiplesLastly, in our comparison of year-end 2020 and year-end 2021 within the energy industry we look to valuation multiples across the three energy sectors. Here we see how the combination of uncertainty of future operating results (risk) and growth expectations combine in the form of enterprise value multiples of EBITDA, on both a trailing (latest twelve months – LTM) and 1-year forward EBITDA basis. Starting with the midstream companies, we see that modest improvement in revenue expectations and slight reduction in EBITDA margins combine with risk perceptions for fairly modest changes from 2020 to 2021 LTM and forward valuation multiples. LTM midstream multiples edged up from 9.0x to 10.0x, while the Forward multiples showed an even more modest increase from 8.7x to 9.0x.The negative 2020 EBITDA growth expectations and much larger (than Midstream) 2021 EBITDA growth expectations result in a very different combination of 2020 to 2021 and LTM to forward OFS multiples. Here we see the median LTM multiple jumping 34% from 2020 to 2021, while the forward multiple decreased by 24%. That with 2020 forward multiples 32% greater than 2020 LTM multiples, and 2021 forward multiples 50% below 2021 LTM multiples.By far the largest swing in 2020 to 2021 and LTM to forward multiples comes from the E&P companies. With only modest EBITDA growth expectations as of 2020, the E&P LTM and forward multiples are quite similar at 5.8x and 5.2x, respectively. However, the 119.8% median estimated EBITDA growth at year-end 2021 results in a much larger LTM to forward differential of 6.7x – 9.7x LTM compared to 3.7x forward. That high level of EBITDA growth expectations in 2021, compared to the much more modest growth expectation as of 2020 results in a 3.1x differential between 2020 LTM multiples and 2021 LTM multiples (5.8x versus 9.7x). As with OFS forward multiples, the E&P forward multiples decreased markedly from 2020 to 2021, from 5.2x to 3.7x. In SummaryThe energy industry that was hammered in 2020 by the combined OPEC+ induced oil glut and COVID related oil demand decline showed a mixed bag of marginal and tepid operating result growth expectations at year-end 2020, but is showing much greater expectations as analysts look ahead into 2022. However, it is the energy industry – so, be ready for the next cycle shift.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers, and Big 4 Auditors. These energy-related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

What a Difference a Year Makes: Part I

Key Aspects of the Energy Industry in 2021

The close of 2021 marked the end of a long upward march for the energy sector. With oil closing up the year at $75 (compared to $48 at the end of 2020) and gas at nearly $4 per mmbtu (compared to $2.36 at the end of 2020), the commodity markets driving the energy sector were much more economically attractive to producers. Stock indices such as the XLE, which primarily tracks the broader energy sector, was up over 50% for 2021 and was by far the best performing sector. Rig counts, although with more cautious deployment than in the past, rose along with prices and increased by 235 for the year (586 at year-end 2021 vs. 351 at year-end 2020). Crude production rose to 11.7 million bbls/day with room to grow as inventories were about 7% below the five-year average. OPEC+ also has signaled it will continue its scheduled output growth.All of this growth is coming alongside the ascent of wind and solar. The Omicron variant raises uncertainty about the markets and took a cut into prices in December. However, while COVID may dampen demand growth, most analysts believe it won’t stop it.Prices & Production“We expect Brent prices will average $71/b in December and $73/b in the first quarter of 2022 (1Q22). For 2022 as a whole, we expect that growth in production from OPEC+, of U.S. tight oil, and from other non-OPEC countries will outpace slowing growth in global oil consumption, especially in light of renewed concerns about COVID-19 variants. We expect Brent prices will remain near current levels in 2022, averaging $70/b.” – EIA – December 7, 2021 The steady climb of prices in 2021 reflected a rebound in demand that exceeded earlier expectations. It also reflected a more cautious approach to bringing more production online and the curtailed capital environment as well. However, that may not last much longer as more estimates accumulate that suggest capital spending for upstream producers will pick up in 2022. Perhaps even more impactful for upstream producers has been the rise of natural gas prices in 2021 as well. After languishing for so long, prices not only exceeded $3.00 per mmbtu they rose to over $5.00 for a brief period.These price levels have been unseen for many years and are anticipated to remain near $4.00 mmbtu in 2022, however, volatility is expected to be higher as well. Production has increased, particularly in Appalachia and has now reached pre-pandemic levels. Perhaps in 2022 the restraint will come off on production efforts more than the past few years. According to the Dallas Fed Energy Survey 75% of companies surveyed plan to spend more in 2022 vs. 49% in the same survey given at the end of 2020. Cowen & Co. says the E&P companies it tracks plan to spend 13% more in 2022 vs. 2021 after significant drops of 48% in 2020 and 12% in 2019. Much of this growth vigor is fueled by smaller E&P companies that have struggled so much in recent years. However, there is still a lot of uncertainty with inflation and other issues which are keeping larger companies more conservative with their capital as reflected in comments like this: “Supply-chain issues continue to create logistical challenges, and it is difficult to plan and/or coordinate upstream operational activity. Labor shortages have contributed to this issue as well. Pandemic worries are definitely impacting the oil demand side, with resultant uncertainty with respect to commodity pricing and supply forecasting.” – Dallas Fed Respondent For larger companies, debt reduction and quality asset acquisitions are a higher priority as opposed to riding the drill bit.LNG Delays - But Rest Assured, It Is ComingOne of the outlets for production growth has been the development of LNG facilities along the Gulf Coast. At the end of 2020, there were five (5) facilities under construction. Unfortunately, as of the end of 2021, only one of those terminals got finished. There are still four (4) terminals under construction and no other approved terminals (there are 13 of those) have gotten going as well. This has inhibited production growth for natural gas as LNG is a major global demand growth outlet for U.S. production. The pandemic has delayed bringing online over eight (8) Bcfd of processing capacity. The Biden administration has also not made it any easier either. However, more should come online in 2022 which should help continue the growth trend for gas in the U.S.Regulatory PrognosticationsSpeaking of the Biden administration, last year around the election we were discussing some potential policy and impacts of a Biden administration. Several of those potentials have come to pass such as permit rejections, the stoppage of the Dakota Access Pipeline, and a decline in drilling on federal lands.One thing that has not borne out is the projection by some of a decline in oil production of as much as two million b/d by 2025. Production has held strong so far as prices increased in 2021. Considering the volatility in both regulation and markets, that’s pretty good in the prediction department.

WHITEPAPER | Understand the Value of Your Payment Company

When it comes to emerging sectors of the economy, FinTech companies remain in the spotlight. FinTech companies seek to improve inefficiencies in the financial services industry. COVID-19 accelerated these efforts as legacy problems became impossible to circumvent in the environment that the pandemic created.Valuing FinTech companies can be a complex exercise as their market opportunities can be evolving, and their cap tables are often complex.This complexity can be a result of venture capital, corporate, and private equity investors being cobbled together across a number of funding rounds.Throughout this whitepaper, we look into the payment industry’s place in the larger FinTech ecosystem, macroeconomic factors driving the industry, microeconomic factors pertaining to specific companies, and what valuation methods are most prudent when determining the fair market value of a payments company.

Asset Management Firms See Strong Performance in 2021

The asset management industry fared well in 2021 against a backdrop of rising markets and improved net inflows. Strong performance in equity markets was a major contributor to this performance. The S&P 500 index was up nearly 30% during the year, suggesting that many asset management firms saw significant increases in AUM driven by market movement and ended the year with assets (and run rate revenue) at or near all-time highs.As asset management firms are generally leveraged to the market, market movements tend to have an amplified effect on asset management firm fundamentals. Our index of publicly traded asset/wealth management firms reflected this in 2021, with the index generally outperforming the S&P 500 throughout the year and ending the year up just over 30%. While multiples saw modest improvement over this period, much of this outperformance was driven by rising fundamentals.Our index of asset/wealth management aggregators also improved significantly during 2021, ending the year up nearly 40% driven by strong performance in the underlying businesses in which aggregators invest. Alternative asset managers led the way, however, with this index increasing nearly 90% during 2021 driven by strong net inflows due to increasing investor demand for alternative assets.Return of Organic GrowthWhile market movement is often the dominant contributor to changes in AUM over a particular time period, it affects all asset managers in a particular asset class more or less equally and is (to some extent) outside of a manager’s control. Organic growth, on the other hand, can be influenced by the quality of a firm’s marketing and distribution efforts and can be a real differentiator between asset management firms over longer time periods.Many asset managers have struggled with organic growth in recent years, in part due to rising fee sensitivity and the influence of passively-managed investment products. Despite these headwinds, organic growth for our index of publicly traded asset/wealth management companies improved modestly during the nine months ending September 30, 2021 relative to the same period in 2020 (see chart below).In aggregate, these firms saw net outflows of $75 billion during the first three quarters of 2020, compared to aggregate net inflows of $49 billion during the first three quarters of 2021. While this improvement in organic growth is modest in absolute terms, the switch from net outflows to net inflows is a positive sign for the industry, indicating that these firms were able to grow AUM on an aggregate basis even in the absence of market movement.Fund Flows by SectorWhile overall organic growth improved in 2021, there were significant variances by asset class. Fund flow data from Morningstar (table below) shows that total inflows across active funds for the year ended November 30, 2021 were approximately $287 billion (relative to aggregate outflows of $188 billion in 2020). The aggregate inflows in 2021 were concentrated in fixed income, alternative assets, and international equity funds, while US equity funds shed nearly $200 billion in assets over the period. For perspective, all categories of actively managed funds except taxable bonds and municipal bonds saw net outflows in 2020.Notably, passively managed funds continued to outpace active funds in terms of net new assets in 2021. This trend will likely continue to pose a challenge for many types of active asset managers in attracting new assets.Improving OutlookThe outlook for asset managers depends on several factors. Investor demand for a particular manager’s asset class, recent relative performance, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing and on the performance of the underlying businesses.On balance, the outlook for asset managers has generally improved with market conditions over the last year. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. Modest improvements in organic growth are also a positive sign for active asset managers that bodes well for continued strong performance in 2022.

December 2021 SAAR

The December SAAR totaled just 12.44 million units, down 3.5% from last month and 23.7% from December 2020. Inventory shortages, supply chain issues, and consistently high demand have been commonplace in the auto industry since the summer. That being the case, December’s low SAAR should not surprise many.Several trends that have been observed in the industry over the last six months have continued to persist. For example, dealers continued to sell out inventories. According to J.D Power, the number of days that a new vehicle sat on the lot fell to a record low of 17 days, beating last month’s record of 19 days and even further down from 49 days a year ago.Transaction prices continued to climb over the last month as well. The average transaction price reached its own record of $45,743 in December, up from $44,000 last month and the metric’s first time above $45,000. Light trucks continue to dominate sales, accounting for 77.6% of all new light vehicle sales in 2021. This vehicle class includes crossovers, which accounted for 44.9% of all new light vehicle sales over the past year. Dealer incentives also remained low, falling to just $1,598 of incentive spending per vehicle, an all-time December low. All told, this past month was more of the same for auto dealers and manufacturers.According to J.D Power, the number of days that a new vehicle sat on the lot fell to a record low of 17 days.December inventory levels remained low. As a result, the industry’s inventory to sales ratio took another step down from 0.39 in October to 0.24 in November. There should be some incremental gains in inventory levels throughout 2022, but the exact point at which the supply chain tide will turn is still unknown. As far as auto sales are concerned, the pace remained red hot. High consumer demand for vehicles continued to empty lots around the country in December. In fact, in spite of the last six month’s conditions, 2021 new light sales totaled 14.93 million units, up 3.1% from 2020’s 14.47 million. When looking back at the past year in auto, it seems likely that 2021 sales of new light vehicles could have easily climbed to 17 million units in an unrestricted environment given the strong demand.Electric Pickup Truck Race Heats UpThe long-fought war between auto manufacturer’s pickup trucks has finally been pushed into the electric vehicle spotlight. As many manufacturers unveil their spin on an electric pickup, there are many questions that dealers and consumers have about brand loyalty and availability for these types of vehicles. The definitive answers to those questions won’t come for some time, but the conversation among consumers and those covering the industry has certainly started to heat up.Many major auto manufacturers have already announced plans to roll out electric pickup models. In December, General Motors released a video teasing an electric version of its GMC Sierra. This came one day after Toyota revealed its plans for an electric pickup in its near future. Nissan Motor Company showed off an electric pickup prototype in November called the Surf-Out, and newly publicly minted automaker Rivian, is taking preorders on its R1T and R1S electric truck and SUV.Ford announced that it has logged about 200,000 non-binding reservations for its F-150 Lightning, a battery powered truck that goes on sale this spring. The automaker has also announced its investment in a West Tennessee F-150 Lightning facility. Tesla announced its Cyber Truck in late 2019 but has recently removed information about production timelines from its website, implying a slower start to its electric pickup rollout than expected but perhaps still ahead of its competitors. There are several other manufacturers seeking to enter the market, including Lordstown Motors, Bollinger, and Atlis Motors.Moving on from the manufacturers and onto their customers, brand loyalty has always been more tangible in the market for pickup trucks than for any other class of vehicle. In years past, convincing a [insert name here] truck enthusiast to switch to another brand would have been harder than pulling teeth. However, the age of pickup loyalty may be on its way out due to high and rising sticker prices.A survey in 2019 conducted by used-vehicle shopping site CarGurus, found rising price sensitivity among truck owners, with more than two-thirds of respondents calling today’s pickups overpriced. We note price sensitivity is more likely to be apparent in used vehicle buyers, but brand loyalty was also found to be surprisingly fluid, with more than a third of Ford and Chevy buyers saying that they would consider the rival brand for their next pickup purchase. While these results may be true for gas powered pickups exclusively, the presence of deteriorating pickup loyalty makes for a blurry entrance into the electric market for dealers and manufacturers alike.The age of pickup loyalty may be on its way out due to high and rising sticker prices.With all these new models on the horizon, auto makers are hoping to gain an edge in a key battleground for the industry. Pickups are among the industry’s most profitable units, especially for U.S. automakers like GM and Ford where they account for a large share of global profit. If consumers embrace the shift to electric trucks, the segment’s early performance should inform dealers on how to respond and what works best on their lots. It will be interesting to see how OEMs are able to meaningfully scale production of these EVs in 2022 in light of tight inventories.January 2022 OutlookOur outlook for the first month of 2022 shows vehicle inventories remain low, and demand remains high. Incremental inventory improvements are expected to accumulate throughout the year, but many of those improvements are not expected in the next several months. Also, the persistent COVID-19 pandemic could further affect supply chains and production facilities in the coming months as well, adding to the uncertainty.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Deciding What to Decide

Capital Allocation in Family Businesses

Browsing through the archives of the Harvard Business Review, we recently discovered an article from 2013 that we had previously missed. In “Deciding How to Decide,” authors Hugh Courtney, Dan Lovallo, and Carmina Clarke advocate using a broader set of tools to make difficult capital budgeting decisions. While the entire article is well worth reading, we were especially struck by how the authors categorized the different types of capital budgeting decisions facing corporate managers.The authors identify five different types of capital budgeting decisions, distinguishable based on how familiar the decision is and how predictable the outcomes are.The easiest decisions are those that are familiar and have predictable outcomes. Because the company has a long track record of making similar decisions, there is a good understanding of what ingredients contribute to a successful outcome. In other words, the company has developed a reliable model for making the decision. Furthermore, the inputs to the model can be specified with confidence, resulting in a high degree of certainty as to the outcome. According to the authors, a domestic site selection decision by McDonald’s illustrates this type of problem.At the other end of the spectrum are novel decisions for which the company has little or no basis for predicting future outcomes. The company has no history from which to construct a good model, which is perhaps beside the point, since there are no reliable model inputs to be found anyway. The example cited by the authors for this type of decision is deciding how McDonald’s should respond to potential backlash over the fast-food industry’s role in obesity. There is no precedent action that managers can readily draw on to formulate a model, and it is nearly impossible to predict how consumers and society will respond to various actions. The authors then proceed to identify which capital budgeting tools are most appropriate for which situations. Their comments and suggestions are insightful and worthy of consideration by family business directors. For additional perspective on capital budgeting techniques, you can download our whitepaper “Capital Budgeting in 30 Minutes” here.... the most challenging part of capital budgeting for family businesses is not deciding “how” to decide so much as deciding “what” to decide.Yet, we walked away from reading the article with a nagging sense that perhaps the most challenging part of capital budgeting for family businesses is not deciding “how” to decide so much as deciding “what” to decide. In other words, what types of capital projects should be going into your capital budgeting funnel? For example, before deciding whether to lease or build a new distribution facility, family business directors must first – whether explicitly or implicitly – decide that enhancing distribution is a more appropriate use of family capital than acquiring a competitor, or investing in research & development, or securing supply, or any of a host of other potential decisions having varying degrees of difficulty.It is at this level of “meta” capital budgeting that we suspect family business directors could benefit from the decision classification scheme outlined by the authors of the HBR article. The “easy” capital budgeting decisions entail less risk, but also promise less return. Multi-generational business transformation arises from making “hard” capital budgeting decisions. What is the appropriate mix of “easy” and “hard” capital budgeting decisions for your family business? Net present value, internal rate of return, and the other traditional capital budgeting tools are not really equipped to answer this question.We suspect that deciding “what” to decide is yet another manifestation of what your family business “means” to your family.In our experience, there are four basic “meanings” a family business can have for a family. Knowing what your family business “means” maybe the best path toward deciding “what” to decide.For some families, the business exists to drive economic growth for future generations. With this forward-looking perspective usually comes a desire for higher absolute returns and a willingness to accept more risk. For these families, the ideal mix of capital budgeting decisions is likely tilted more toward the types of transformational capital budgeting decisions having low degrees of familiarity and predictability.Other family businesses serve as a mechanism by which to preserve the family’s capital. A prominent concern for these families is that all their economic eggs are in a single basket, so they want to build a stout fence around that basket. As a result, they will be best served by focusing on capital budgeting decisions having a high degree of familiarity and predictability.In contrast, other families respond to the “single basket” problem by seeking to find more baskets. The focus for these families is maximizing the harvest from the family business to enable family shareholders to store some eggs in different, uncorrelated, baskets. These families may be more willing to accept risk once an acceptable number of other baskets have been filled. Making a large volume of “easy” capital budgeting decisions that serve only to increase the size of the existing basket is not a suitable meta-capital budgeting strategy for these families.Finally, some families view the business principally as a source of lifestyle. The primary concern for these families is maintaining the current level of real, per capita distributions. Depending on the biological growth of the family, doing so is likely to require making some capital budgeting decisions that are either less familiar or have less predictable outcomes. How are you and your fellow directors deciding what to decide? Is there consensus around the economic meaning of your family business to your family? Gaining consensus around the meaning of your family business can be a crucial first step to making all the strategic finance decisions you make line up with one another.

RIA M&A Q4 Transaction Update

Aggregators Continue to Drive Deal Volume in 2021

Deal count is projected to reach new highs in the fourth quarter of 2021 as market activity continues to gain momentum, likely rounding out another record-breaking year for the RIA industry. In keeping with the rest of 2021, deal volume was driven by secular trends and supportive capital markets. As market activity remains robust, competition for deals continues to favor RIA aggregators such as Mercer Advisors, Mariner Wealth Advisors, Wealth Enhancement Group, and Focus Financial Partners (FOCS), to name a few. The RIA aggregator model largely developed in the wake of the RIA boom after the Great Recession and has since culminated into nearly a dozen firms, each with their own vision of how to marry the independence and client experience of an RIA with a national brand. Over the past couple of years, aggregators have gained private equity sponsors which have fueled their dealmaking capabilities. As we discussed in last quarter’s RIA M&A Transaction Update, this trend has only gained momentum in 2021, with private equity capital infusions at all-time highs. Aside from branding, industry consensus suggests some legitimate tailwinds encouraging consolidation in the RIA industry, which likewise supports the aggregator model. One such trend is a lack of succession planning by RIA founders, which we have written about extensively in prior posts. With immense experience and resources, aggregators offer a streamlined deal process and post deal integration, making many aggregators a convenient solution for principles looking to exit. While all aggregators offer liquidity solutions, each aggregator offers a slightly different value proposition to potential sellers. Consolidators such as Mercer Advisors, Wealth Enhancement Group, Mariner Wealth Advisors, and Goldman Sachs would largely be considered strategic buyers. Strategic buyers acquire firms in order to unlock value through synergy. Systemic issues such as fee compression in the asset management space or the growing cost of operational platforms and overhead in the wealth management space are solved by scale. Integrating with any one of the aforementioned firms should theoretically unlock value for buyers through higher profit margins and growth, but a strategic buyer may be a poor fit for a seller looking for a clean exit. Firms such as Focus Financial Partners lean towards the financial acquirer category in which acquisitions are primarily financially motivated investments. However, even aggregators like Focus provide many in-house back-office solutions and additional service offerings to their partners.Leading RIA AggregatorsBelow are a handful of RIA aggregators that have led M&A activity in 2021.Mercer Advisors. Mercer Advisors was founded in 1985 as a planning-focused RIA and in the last ten years has become an industry leader in the trend towards consolidation, acquiring a total of 45 firms and nine in 2021 alone. Mercer Advisors looks to integrate partnering firms intimately within the Mercer Advisors ecosystem to provide a homogeneous wealth management platform to clients. The Mercer Advisors deal team is led by David Barton, JD – former CEO and current Vice Chairman. Mr. Barton’s transition in 2017 highlights the firm’s aggressive M&A strategy and has since culminated in the majority of the firm’s acquisitions to date. The firm’s sale to private equity group, Oak Hill Capital, in 2019 has further bolstered the firm’s dealmaking activity.Mariner Wealth Advisors. In April 2021, Mariner sold a minority stake to private equity group, Leonard Green & Partners, which has since propelled the firm into 11 acquisitions. Similar to Mercer Advisors, Mariner seeks to integrate investment teams within a larger ecosystem, potentially allowing partners to exit entirely over time. In 2020, CEO Marty Bicknell announced a partnership with Dynasty Financial Partners creating Mariner Platform Solutions which looks to onboard advisors seeking independence from wirehouses and larger RIAs as well as partner with existing wealth management firms. Back-office services such as marketing, technology, compliance, and administrative support are handled by Dynasty Partners.Wealth Enhancement Group. On July 31, 2019, Wealth Enhancement Group was acquired by private equity firm, TA Associates, which has resulted in 13 acquisitions in 2021 alone. Wealth Enhancement Group offers a full suite of wealth management services across a single platform, much like Mariner and Mercer Advisors.Goldman Sachs Personal Financial Management (PFM). While Goldman Sachs did not make any direct RIA acquisitions in 2021, speculation remains high regarding the investment bank’s intentions to move into the wealth management market at scale. The purchase of United Capital in 2019, an RIA aggregator with 34 direct acquisitions to date, marked Goldman’s interest to become a leading RIA acquirer. Since the acquisition, Goldman Sachs has not leaned into the aggregator model as many had anticipated, but speculation rebounded in 2021 when Goldman hired former TD Ameritrade executive, Craig Cintron. The move suggests further development of Goldman’s burgeoning custodian services. Goldman Sachs’ historic brand and scale would make the firm a formidable competitor if it should choose to enter the RIA M&A ecosystem.Focus Financial Partners (NASDAQ: FOCS). The Focus umbrella includes over 80 partner firms (550+ principals) and over $300 billion in assets under management, making it the largest RIA aggregator by any metric. Focus self-proclaims to “preserve the autonomy of every partner firm who joins the Focus team,” and as such, would likely be a poor fit for principals looking for a clean exit. For those looking to remain post-acquisition, Focus provides a pay-out along with an operational scale for partners seeking to grow their firm or perhaps make acquisitions of their own. Accordingly, more partners who have joined Focus have made an acquisition than those who have not.In 2021 alone, Focus Financial Partners made 21 acquisitions, nearly double its deal count in 2020. Looking forward, Focus’s future is seemingly tied to its ability to continue to make deals upon more favorable or convenient terms than anyone else, and its prospects are tied to the backdrop of continued deal availability, pricing improvement, or entry into international markets.Implications for Growing Consolidation in the RIA M&A MarketThe arms race for deals, catalyzed and perpetuated by RIA aggregators, favors experienced buyers who have dedicated deal teams and capital backing. For perspective, the typical advisor operates with eight employees and approximately $341 million in AUM compared to Focus’s +$300 billion in AUM and staff of +4,000. Focus currently staffs a team of about 80 transaction-related professionals responsible for fielding acquisition targets and for integrating RIAs within the Focus Financial Partners ecosystem. Nearly all aggregators have extensive capital backing, either through private equity sponsorship, public capital markets, or both.As aggregators continue to bid up multiples, the sustainability of current M&A trends remains in question. While scale might favor a buyer’s ability to make deals, the verdict is still out on whether the RIA industry benefits from economies of scale. Despite consistent increases in M&A activity over the past decade, the number of RIA firms continues to grow, a fact that perhaps generally contradicts the aggregator investment thesis. However, the ever-increasing number of RIAs may continue to add fuel to current deal volume over the near future.

Is Your Family Business READY for 2022?

Our family business clients naturally want to know what their business is worth today. But an even better question asked by many of them is what they can do today to make their family business more valuable tomorrow. While the specifics of value creation are unique to each business, we like to use a common framework to help our clients identify pathways for creating value.The framework was developed many years ago by the founder of our firm, Chris Mercer. Chris has an inordinate affection for acronyms rivaled only by his enthusiasm for pickleball. So, with a big hat tip to Chris, we’ll use this first post of the year to ask whether your family business is READY for 2022.Risk. Investors don’t like risk. Given the choice between two investments that offer the same reward, investors will always choose the one with less risk. The best way for investors to manage risk is through diversification, but family shareholders are often not very well diversified. As a result, family business directors need to be especially vigilant about managing risk within the family business. The most common risks facing family businesses relate to concentrations, which can take many forms: management, customer, supplier, geographic, product, etc. What strategies are available to reduce the risk of your family business in 2022?Earnings & cash flow. Investors like cash flow. In fact, investments are valuable because of the expectation that they will generate cash flow, whether in the next week or the next decade. Cash flow is rooted in earnings. Earnings depend on revenue and margin. Revenue measures how much business your company is doing, and margin measures how efficiently your company conducts its business. While earnings are the wellspring of cash flow, they are not cash flow. Among the most important decisions family business directors make is how to allocate earnings between cash flow to shareholders today and reinvestment to fuel greater cash flow to shareholders tomorrow. Is your family business profitable enough to provide current cash flow to shareholders and make appropriate investments for the benefit of future generations?Attitudes, aptitudes & activities. Investors like discipline. Founder-led businesses can be highly profitable, but not necessarily very valuable if the “secret sauce” is tied up in the personality and unique gifts of the founder. Family businesses that have successfully converted the unique attributes of the founder into repeatable and transferable business processes are worth more than those that cannot, or do not, make that leap. Do you have the right people in the right places doing the right things over time? To borrow an overused cliché from the popular business press, how “scalable” is your family business?Driving growth. Investors like growth. Yesterday’s earnings and cash flow are, strictly speaking, irrelevant to investors, who care only about the future. The value of your family business is determined by the view through the windshield, not the rearview mirror. What are you and your fellow directors doing to prepare for the future? Does your family business have a disciplined process for identifying, evaluating, and paying for investment opportunities that will generate growth in future cash flows?Year-to-year comparisons. Investors like a clear story. Hollywood is obsessed with making prequels to satisfy the curiosity of moviegoers for the “backstory” of their favorite characters. Historical financial results comprise the “backstory” for your family business. Is there a coherent narrative arc from what your family business has been in the past to what you are planning for it to be in the future? This is where strategy becomes critical. What aspects of past strategies will you carry over into the new year? What pieces of your current strategy should be cast aside? What new strategies will be necessary for your family business to thrive in 2022? The new year is upon us whether we are READY or not. Give one of our family business professionals a call today to kickstart a conversation about how to increase the value of your family business in 2022.

January 2022

In this issue: Net Interest Margin Trends and Expectations

Mercer Capital’s Value Matters^® 2022-01

2022 Tax Update for Estate Planners and Family Businesses

E&P First Quarter 2022

Eagle Ford

Eagle Ford // Oil prices rose through the quarter as increased demand was met with continued producer restraint.

Transportation & Logistics Newsletter

First Quarter 2022

Demand for services in the logistics industry is tied to the level of domestic industrial production.

The Best of 2021

Energy Valuation Insights’ Top Blog Posts

After an extraordinarily challenging 2020, 2021 gave Oil & Gas companies some respite and (perhaps most importantly) some optimism going into 2022. As we enter the new year, we look back at to see what was popular with you – our readers. Below is a list of some of our top posts of 2021.Solvency Opinions: Oil & Gas ConsiderationsIn this post,David Smith covers key aspects of solvency opinions. Regardless of whether a company files for Chapter 11, is party to an M&A transaction, or executes some other form of capital restructuring – such as new equity funding rounds or dividend recaps – one fundamental question takes center stage: Will the company remain solvent?Recent SPAC Boom Largely Leaves Out Oil & Gas CompaniesWhile the mania around SPACs (special purpose acquisition companies) has subsided since its peak in early 2021, SPACs continue to be a key driver of capital markets activity. Alex Barry looks at oil & gas companies that were early adopters of the SPAC structure, the recent pivot of SPACs towards energy transition companies, and looks forward to see what the future might hold for the few remaining oil & gas-focused SPACs.Mineral Aggregator Valuation MultiplesAn important trend in the mineral and royalty ownership space has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership. Due to a variety of corporate structures and complex capital structures, mineral aggregator values pulled from databases are often missing meaningful components, leading to skewed valuation multiples. Mercer Capital has thoughtfully analyzed the corporate and capital structures of publicly traded mineral aggregators to derive meaningful valuation multiples on a historical and forward-looking basis. Look back at data fromMarch, May, August, andNovemberof 2021.The Evolution of E&P ESG ScoresWhile oil & gas and ESG (environmental, social, and governance) investing may seem at odds with each other, operators have increasingly included ESG talking points in their management commentary, signaling a proactive initiative rather than reactive response. Justin Ramirez discusses ESG criteria among E&P operators and looks at trends from 2016 to 2020.Upstream Producers Are Not Gouging–They’re Tentative. Here Are Three Reasons WhyAs commodity prices have risen and profits have rolled in, so have accusations of price gouging by oil & gas companies. Despite higher prices, producers haven’t materially increased production or announced aggressive drilling plans. Bryce Erickson identifies some of the reasons why, including supply and demand dynamics, rising costs, and capital headwinds.ConclusionWe look forward to 2022 and appreciate your interest in this blog. May you and your family enjoy a happy and prosperous year!

Bank M&A 2022 | Gaining Altitude

At this time last year, bank M&A could be described as “on the runway” as economic activity accelerated following the short, but deep recession in the spring. Next year, activity should gain altitude. Most community banks face intense earnings pressure as PPP fees end, operating expenses rise with inflation, and core NIMs remain under pressure unless the Fed can hike short-term policy rates more than a couple of times. Good credit quality is supportive of activity, too.Should and will are two different verbs, however.One wildcard that will impact activity and pricing is the public market multiples of would be acquirers. Consideration for all but the smallest sellers often includes the issuance of common shares by the buyer. When bank stocks trade at high multiples, sellers obtain “high” prices though less value than when public market multiples are low and sellers receive low(er) prices though more value.If bank stock prices perform reasonably well in 2022, after a fabulous 2021 in which the NASDAQ Bank Index increased 40% through December 28, then activity probably will trend higher as more community banks look to sell. MOEs may be easier to negotiate, too. If bank stocks are weak for whatever reason, then activity probably will slow.A Recap of 2021As of December 17, 2021, there have been 206 announced bank and thrift deals compared to 117 in 2020. During the halcyon pre-COVID years, about 270 transactions were announced each year during 2017-2019.As a percent of charters, acquisition activity in 2021 accounted for about 4% of the number of banks and thrifts as of January 1.Since 1990, the range is about 2% to 4%, although during 2014 to 2019 the number of banks absorbed each year exceeded 4% and topped 5% in 2019. As of September 30, there were 4,914 bank and thrift charters compared to 9,904 as of year-end 2000 and about 18,000 charters in 1985 when a ruling from the U.S. Supreme Court paved the way for national consolidation.Pricing—as measured by the average price/tangible book value (P/TBV) multiple—improved in 2021. As always, color is required to explain the price/earnings (P/E) multiple based upon reported earnings.The national average P/TBV multiple increased to 155% from 135% in 2020, although deal activity was light in 2020. As shown in Figure 1, the average transaction multiple since the Great Financial Crisis (GFC) peaked in 2018 at 174% then declined to 158% in 2019 as the Fed was forced to cut short-term policy rates three times during 3Q19 in an acknowledgment that the December and probably September 2018 hikes were ill-advised.Earnings—rather than tangible book value — drive pricing as do public market valuations of acquirers who issue shares as part of the seller consideration. Nonetheless, drawing conclusions based upon unadjusted reported earnings sometimes can be misleading.As an example, the national median P/E for banks that agreed to be acquired in 2018 approximated 25x, in part, because many banks that are taxed as C corporations wrote down deferred tax assets at year-end 2017 following the enactment of corporate tax reform. Plus, forward earnings reflected a reduction in the maximum federal tax rate to 21% from 35%.Also, the median P/E in 2021 fell to about 15x from 17x in 2019 and 2020 in part because the earnings of many sellers included substantial PPP-related income that will largely evaporate after this year.Buyers focus on the pro forma earnings multiple with all expense savings in addition to EPS accretion and the amount of time it takes to recoup dilution to tangible BVPS. Our take is that most deals entail a P/E based upon pro forma earnings with fully phased-in expense saves of 7x to 10x unless there are unusual circumstances.Public Market Multiples vs Acquisition MultiplesClick here to expand the image aboveFigure 2 compares the annual average P/TBV and P/E for banks that were acquired for $50 million to $250 million since 1997 with the SNL Small Cap Bank Index average daily multiple for each year. Among the takeaways are the following:Acquisition pricing as measured by the P/TBV multiple peaked in 1998 (when pooling-of-interest was the predominant accounting method) then bottomed in 2009 (as the GFC ended) and trended higher until 2018.Since pooling ended in 2001, the “pay-to-trade” multiple as measured by the average acquisition P/TBV multiple relative to the average index P/TBV multiple, has remained in a relatively narrow range of roughly 0.9 to 1.15 other than during 2009 and 2010.The reduction in both the public and acquisition P/TBV multiples since the GFC corresponds to the adoption of a zero interest rate policy (ZIRP) by the Fed during 2008 that has been in place ever since other than 2017-2019.P/E multiples based upon LTM earnings have shown little trend with a central tendency around 20x other than 1998 (1990s peak), 2018 (tax reform implementation) and 2020-2021 (COVID distortions).Acquisition P/Es have tended to reflect a pay-to-trade multiple of 1.25 since the GFC but as noted what really matters is the P/E based upon pro forma earnings with expense saves. To the extent the pro forma earnings multiple is 7-10x, the pay-to-trade earnings multiples typically are below 1.0 to the extent buyers are trading above 10x forward earnings.Click here to expand the image aboveClick here to expand the image abovePremium Trends SubduedPublic market investors often focus on what can be referred to as icing vs the cake in the form of acquisition premiums relative to the pre-announcement prices. Investors tend to talk about acquisition premiums as an alpha generator, but long-term performance (or lack thereof) of the target is what drives shareholder returns. Sometimes the market is suprised by acquisitions with an outsized premium, but in recent years premiums often have been modest.As shown in Figure 4, the average one-day premium for transactions announced in 2021 that exceeded $100 million in which the buyer and seller were publicly traded was about 9%, a level that was comparable to the prior few years excluding 2020. For buyers, the average day one reduction in price was less than 1%, though there are exceptions when investors question the pricing (actually, the exchange ratio). For instance, First Interstate (NASDAQ: FIBK) saw its shares drop 7.4% after it announced it would acquire Great Western for about $2 billion on September 16, 2021.About Mercer CapitalM&A entails a lot of moving parts of which “price” is only one. It is especially important for would be sellers to have a level-headed assessment of the investment attributes of the acquirer’s shares to the extent merger consideration will include the buyer’s common shares. Mercer Capital has roughly 40 years of experience in assessing mergers, the investment merits of the buyer’s shares, and the like. Please call if we can help your board in 2022 assess a potential strategic transaction.

Mercer Capital's 2021 Energy Purchase Price Allocation Study

2021: The Year of the Used Car

What Does This Mean for Dealers and Consumers?

2021 was an interesting year for many businesses, and it was certainly interesting for auto dealers. While automotive retailing may be an attractive space for purely financial investors, many dealerships are owned by the same folks that run the business. So while inventory shortages and other headwinds played a role in heightened profits in 2021, the return on investment achieved came with many operational headaches.Just about everyone we’ve talked to acknowledges that current performance is not indicative of ongoing expectations. The question has largely been focused on when we’ll revert to the mean, but this post touches on what things will look like when we return to a more “normal” operating environment. Specifically, what negative equity from used car buyers in 2021 may mean for dealerships.Used Car PricesIn a recent whitepaper, KPMG warned that used vehicle prices could fall abruptly and raise negative equity issues once new vehicle supply rebounds. Negative equity occurs when consumers owe more on their auto loan than the vehicle is worth. We’ve all heard about a vehicle losing value once you drive it off the lot and it's true. Compounding this problem is the expectation that values today will materially decline in a year or two which increases the likelihood of negative equity.Negative equity occurs when consumers owe more on their auto loan than the vehicle is worth.In April 2020, during the depths of the pandemic, 44% of trade-ins carried negative equity – more than double the amount seen a decade earlier. The average negative equity then was $5,571. A year later, vehicle prices increased significantly, but average negative equity only declined by a little more than $1,000. More importantly, the proportion of trade-ins with negative equity was relatively constant, meaning nearly half of buyers were looking at their trade-ins adding to the price of the vehicle they were looking to buy.According to our analysis of NADA data from 2011 to 2020, used vehicle retail prices increased at a compound annual rate of 2.7%, just above the 2.6% increase for new vehicles. In 2021, used vehicle prices lurched forward faster than new vehicles. New vehicle prices increased 7.5% in the last twelve months due in part to supply shortages. Consumers who couldn’t get the new vehicle they wanted or realized they needed a car, but prices were too high, may have turned to used vehicles, whose prices increased 19.1% due to increased demand.The ratio of used-to-new vehicle prices was 62.5% through October 2021, notably higher than the 56.5% observed in October 2020 and above the long-term average (2011 to 2020) of 57.1%. Used-to-new retail volumes were also 91.9% for the first ten months of 2021, higher than any full-year since at least 2011. Used vehicles have become increasingly important to dealers, as this figure has steadily increased from a recent low of 73.9% in 2015.What will happen if new vehicle supply is restored and used vehicle prices crater?As KPMG warns, what will happen if new vehicle supply is restored and used vehicle prices crater? Applying the long-term average used vehicle price appreciation of 2.7% to the $22,027 average used vehicle retail price in 2020, it would take until 2027 to reach $26,000. As of October 2021, the average retailed used vehicles cost $25,904. If used car prices revert to the long-term relationship of new car pricing (57.1% of $41,421 for new vehicles as of October ‘21), we would see a decline of 8.7%. KPMG indicated “a 20-30% plunge in used vehicles costs is within the playing cards.” This would almost certainly wipe out any consumer's equity who elected to finance their purchase.Consumers are able to buy more expensive cars when they get what they perceive to be a good deal on their trade-in, and higher used vehicle prices mean trade-ins are more valuable. However, this important source of cash for buyers will evaporate if used vehicle prices plunge, and negative equity just adds on to the price of a vehicle, putting pressure on how much consumers can pay up for a new vehicle. As noted previously, through April 2021, a significant number of buyers still had negative equity despite advantageous pricing on used vehicles. This could spike if prices crater.What It Means For DealersGiven the long life cycles of vehicles, dealership performance tends to ebb and flow with the economy. Executives of public retailers harp on the importance of touchpoints with the consumer, meaning they return to the dealership to get their car serviced. Dealers also hope customers return to their showrooms when it’s time for another vehicle, and the experience from the last purchase will likely play a big role.If consumers are unsatisfied with their purchase because prices were elevated when they bought in 2021 and decline significantly thereafter, they may feel aggrieved and choose to go with another dealership. While this situation is largely unavoidable for most dealerships, it could have negative ramifications down the line. Consumers may also choose to hold onto their vehicles longer to not recognize the loss by trading in. While it’s unclear how this will shake out down the road, dealers will need to prepare themselves for difficult conversations.Through the first ten months of 2021, the average dealership has already made nearly $3.4 million.As we alluded to previously, profits are up for dealerships in 2021. According to the NADA, the average dealership earned average pre-tax profits of $1.4 million from 2011 to 2020. Average pre-tax profits reached above $2.1 million in 2020, which was the first time above $1.5 million since 2015. Through the first ten months of 2021, the average dealership has already made nearly $3.4 million with two more months to add to these totals.The value of auto dealerships is communicated through Blue Sky values, which are based on a multiple of pre-tax earnings. While dealers aren’t likely to get a high multiple on peak earnings, we note both Blue Sky values and multiples are up since before the pandemic. However, once performance normalizes, dealerships may not be worth as much as they are now, much like the vehicles they sell. This would likely explain the record amount of M&A activity seen in 2021 with some of the largest dealer groups opting to sell.According to the Q3 2021 Haig Report, the average franchise has a Blue Sky multiple of 5.24x and adjusted pre-tax earnings of $2.08 million for a Blue Sky value of about $10.9 million, up 61% from year-end 2019 to all-time highs. At these prices, buyers must be optimistic that the good times will continue, multiples won’t crater, and/or the new normal of profits will be higher than historical levels.Source: Haig Partners Haig’s estimated pre-tax earnings of $2.08 million as an ongoing figure today is about 46% below current levels based on our calculations of NADA figures. However, according to NADA, it coincidentally represents a 46% increase over the 2011-2020 average for the average dealership. While that makes the ongoing figure appear reasonable, the chip shortage universally viewed as a temporary problem is far from “normal.” Suppose current estimates of ongoing earnings end up being overly optimistic, with an increased focus on recent outperformance. In that case, the values of dealerships, like the vehicles they sell, are likely to decline.ConclusionMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

A 2021 Review of Family Business Director

We hope you had a great Christmas and a happy holiday season. To end the year, we summarize some themes and most read pieces from Family Business Director you may have missed throughout the year.Tax PolicyThe more things change, the more things stay the same. Several themes from 2020 were back: COVID-19 was still a part of our lives, political divisions seemed to only widen, and Alabama is still in the college football playoff.Tax overhauls from Washington were on theme too: big plans, followed by horse trading, name calling, special elections, and an infrastructure bill. In January (and April, August, September, and October) we did our best at the Family Business Director to summarize and digest the numerous proposed tax changes. But, at the end of the day, as of this writing, the Build Back Better (BBB) omnibus bill appears dead on arrival. Senator Manchin (D-WV) has publicly pulled support for the bill, leaving capital gains taxes, removal of the basis step-up, estate tax changes, and income taxes unchanged from the beginning of the year. After a year of tax consternation, it might be nice to ring in the new year with less tax anxiety immediately on the horizon. But rest assured, the fight is not over.Lessons from the Public MarketsFamily Business Director featured several articles and studies on public market data and meaningful stories for family business owners and directors. We summarize your favorites below:The 2021 Benchmarking Guide for Family Business Directors – How small companies fared relative to large caps in 2020.Can You Hear Me Now? Lessons from a $20 Billion Family Business Fight – A made-for-TV family business drama… in real life.Getting to the Top – The top 750 family companies and how it impacts you.Sanderson Farms Case Study – Lessons from a family business acquiring a public company.Built Ford “Family” Tough – How Ford’s investment in Rivian can help us think about diversification.2021 Dividend SurveyThis summer, we partnered with Family Business Magazine to conduct our inaugural survey of dividend practices at family-owned businesses. We featured an article that we wrote for the magazine summarizing the survey results and presented the detailed results to survey respondents.A headline statistic from the survey indicated while about half of public companies pay dividends to shareholders, over 80% of the family businesses responding to our survey indicated that they do. However, nearly half of respondents reported not having a formal dividend policy. In other words, a significant group of family businesses are paying dividends, but they’re not sure why.Read more and check out our detailed write-up and summary results.That Is the Right QuestionFamily business owners don’t stay on top by having all the answers, but by having the ability to ask the right questions. Family Business Director posed a few questions to spark important conversations. Readers’ favorite questions include:Why Do Buy-Sell Agreements Rarely Work as Intended? – How you should think about your buy-sell to stave off potential pitfalls, litigation, and unhappy shareholders.How Long Will It Take to Sell My Family Business? – A short overview of the sales process for a family business.Family Business Director’s Top Ten Questions Not to Ask at Thanksgiving Dinner – Avoid family squabbles over turkey with these questions not to ask.Should Your Family Consider a Family Office? – What are the benefits of a family office, and should your family consider opening one?Five Questions with Paul Hood – Interview with long-time estate planner focusing on taxes and achieving good estate planning results.As we enter 2022, feel free to email anyone at Family Business Director with ideas, complaints, praise, or content ideas. We would love to hear from you, and we thank you for your continued readership.

‘Twas the Blog Before Christmas…

2021 Mercer Capital RIA Holiday Quiz

‘Twas the blog before Christmas, when all through the house Every laptop was purring, every keyboard and mouse; The stockings were hung by the chimney with care, So that backgrounds on Zoom calls wouldn’t look quite so bare;When out on the squawk there arose such a clatter, I refreshed my Bloomberg to check on the matter. Then what to my wondering eyes did appear, But a global growth manager outperforming its peer.With a ghostly old PM so lively and quick, I listened, engaged, to his every stock pick. More rapid than eagles his recommends came, And he whistled, and shouted, and called them by name:“Buy Bitcoin! Buy Apple! Buy Tesla and Google! ’Cause shorting the future will always prove futile! To the top of the charts, for the big money haul, Go long like you’ve never had a bad margin call!”As I drew down my cash, and was turning around, Down the chimney John Templeton came with a bound. He was dressed like he owned just a few private jets, Which compared favorably to my “work at home” sweats.A bundle of hundreds he had flung on his back, Like an entrepreneur with a new public SPAC. He spoke not a word, but went straight to his work, And filled all my orders, then added a perk:His eyes - how they twinkled! His dimples, how merry! As he talked a new strat that would guarantee carry! And out-money calls bought to cover the shorts, Bringing untold riches to long-only sorts.A wink of his eye and a twist of his head, Made me want to get all of his thoughts on the Fed – And vaccines and rates and bullion and more, But he rose and I followed him out my front door.A magical Gulfstream waited there in my yard, And up the air-stairs sprang the RIA bard. But I heard Sir John claim, as he flew out of sight - "Let your best winners run, and all will be right!"...How much do you know about the RIA industry? Put your knowledge to the test with our RIA Holiday Quiz. Fill out your contact information and if you get a perfect score you will win a prize. Good luck!(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src="https://widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd_2BAEZcRHJHwtJp1wzgq96QNl8Vvqh42MIevvuINzlilE.js",a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk"); Create your own user feedback survey

Appalachian Production Stable Despite Price Volatility

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. In this post we take a closer look at the trends in the Marcellus and Utica.Production and Activity LevelsEstimated Appalachian production (on barrels of oil equivalent, or “boe,” basis) decreased approximately 1% year-over-year through December. Production in the Permian and Eagle Ford increased 14% and 4% year-over-year, respectively, while the Bakken’s production declined 1%. Despite a much-improved commodity price environment, Appalachian production was very stable, driven by producers’ capital discipline and the fact that the region was largely unaffected by Winter Storm Uri that disrupted power supplies throughout Texas in February 2021. There were 41 rigs in the Marcellus and Utica as of December 10th, up 37% from December 4th, 2020. Bakken, Eagle Ford, and Permian rig counts were up 145%, 91%, and 74%, respectively, over the same period. One may wonder why Appalachia production has been relatively flat while the region’s rig count has increased. The answer has to do with legacy production declines and new well production per rig. Based on the U.S. Energy Information Administration (“EIA”) data, the Marcellus and Utica need roughly 37 rigs running to offset existing production declines. Relative to last year, most of Appalachia’s additional rigs came online in January and February. Since then, the total rig count has generally ranged between 36 and 40 (in line with the maintenance level). As such, production growth will likely be modest without additional rigs. Commodity Price Volatility ReturnsOil prices slowly and steadily rose through the first two quarters of the year as the vaccine rollout, and lower COVID case counts spurred economic activity. Oil prices were more volatile in the third quarter as the Delta variant caused an increase in COVID cases and concerns regarding the economic recovery. U.S. COVID cases peaked in early September, giving oil prices a boost during the latter part of the quarter. The net result is that WTI front-month futures prices began and ended Q3 at about the same place – approximately $75/bbl. In October, the upward price momentum continued in the fourth quarter as WTI futures prices nearly reached $85/bbl.This optimism was short-lived as the discovery of the new Omicron variant sent oil prices plunging in November. Prices rebounded in December as research has shown that, while highly transmissible, the Omicron variant typically results in less severe illness relative to previous variants. As of December 14th, WTI front-month futures price settled at $70.52/bbl. Going forward, the EIA expects prices to be flat to down in the near term as “growth in production from OPEC+, of U.S. tight oil, and from other non-OPEC countries will outpace slowing growth in global oil consumption, especially in light of renewed concerns about COVID-19 variants.” Natural gas prices steadily increased during the first three quarters of the year, which the EIA primarily attributes to “growth in liquefied natural gas (LNG) exports, rising domestic natural gas consumption for sectors other than electric power, and relatively flat natural gas production.” So far in the fourth quarter, natural gas prices have been relatively volatile as inventories are lower than recent averages. However, recent mild weather has resulted in less gas used for heating. Financial PerformanceThe Appalachia public comp group saw relatively strong stock price performance over the past year (through December 14th). The beneficial commodity price environment was a significant tailwind to smaller, more leveraged producers like Antero Resources and Range Resources, whose stock prices increased 230% and 155%, respectively, during the past year, outperforming the broader E&P sector (as proxied by XOP, which rose 59% during the same period). Larger, less leveraged players like EQT and Coterra (formerly Cabot) were laggards, with their stock prices increasing by 53% and 16%, respectively.Senator Warren Lashes Out Over High Natural Gas PricesMassachusetts Senator Elizabeth Warren wrote a strongly worded letter to eleven natural gas producers, including Appalachia E&Ps EQT, Coterra, Antero Resources, Ascent Resources, Southwestern, and Range Resources. According to Senator Warren’s press release, the purpose of the letter was to “[turn] up the heat on big energy companies’ greed as they jack up natural gas prices, exporting record amounts to boost profits while Americans foot the bill” despite the fact that natural gas producers are simply price-takers, selling a commodity into a competitive market with essentially no control over prices.It is true that LNG exports from the United States have increased dramatically over the past several years. However, that has been driven by the construction and completion of LNG export facilities, resulting in part by continued resistance to pipelines that would connect the Marcellus and Utica regions to East Coast population centers. And while Senator Warren criticized producers for their greed, “putting their massive profits, share prices and dividends for investors … ahead of the needs of American consumers,” she did not thank E&P companies for their previous largesse (or lack of capital discipline) in which natural gas prices were often below $2/mmbtu and numerous natural gas producers went bankrupt.EQT publicly responded to Senator Warren’s letter. Despite the recent run-up in natural gas prices “as the economic engines of the world have reignited,” the company cited that current prices are “significantly below the 20-year average of approximately $5.70 per Mcf.” As a result of the shale revolution, “the United States consumer has benefited from, and continues to benefit from, some of the lowest natural gas prices in the world.” The remainder of EQT’s response was primarily focused on natural gas’s green credentials. Toby Rice, EQT’s CEO, wrote that the United States led the world in CO2 emissions reduction from 2005 to 2020 largely as a result of replacing coal power plants with natural gas power plants. If the world wants to reduce emissions, there are no alternatives with the scale and speed of switching power generation from coal to gas. But with 91% of coal-fired power generation located outside the United States, the transition will require exports of U.S. natural gas to countries without their supply.ConclusionAppalachia production was largely unaffected by the wild commodity price ride we’ve experienced, driven by investor emphasis on capital discipline, the current rig count, and uncertainty. However, with higher natural gas prices, global demand for a lower-carbon alternative to coal, and political pressure, it will be interesting to see if Appalachia producers maintain their restraint.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America and worldwide. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

RIA Margins – How Does Your Firm’s Margin Affect Its Value?

An RIA’s margin is a simple, easily observable figure that encompasses a range of underlying considerations about a firm that are more difficult to measure, resulting in a convenient shorthand for how well the firm is doing. Does a firm have the right people in the right roles? Is the firm charging enough for the services it is providing? Does the firm have enough–but not too much—overhead for its size? The answers to all these questions (and more) are condensed into the firm’s margin.What Is a “Typical Margin”?We’ve seen a wide range of margins for RIAs. Smaller firms with too much overhead and not enough scale might see no profitability or even negative margins. On the other hand, an asset manager with rapidly growing AUM and largely fixed compensation expenses might see margins of 50% or more. The “typical” margin for RIAs depends on the context. As the chart below illustrates, different segments of the investment management industry typically have different margins based on the risk of the business model (among other factors). At one end of the spectrum are hedge funds, venture capital firms, and private equity managers. The high fees these companies generate per dollar invested can support very high margins, but the risks of client concentrations, underperformance, and key staff dependence are significant. Traditional institutional asset managers are somewhere in the middle of the spectrum. When these companies get it right, institutional money can pour in rapidly. A successful institutional asset manager may find themselves managing billions more in assets while staffing remains virtually unchanged. The additional fees flow straight to the bottom line, and margins can be robust as a result. But the risks are significant. Institutional money can leave just as quickly as it came if the manager’s asset class falls out of favor or if performance suffers. At the lower end of the margin spectrum are more labor-intensive disciplines like wealth management and independent trust companies. For these businesses, bringing on additional clients translates directly into increased workload for staff, which will ultimately translate into higher staffing levels and compensation expense as the business grows. While margins are lower, the risk is less. Key person risk is also less, because an individual’s impact is generally limited to the clients they manage, and not the entire firm’s investment strategy. Client concentration is less of a problem, because wealth management firms tend to have a large number of HNW clients rather than a few large institutional clients. Performance risk is generally less of a concern as well. Does a Firm’s Margin Affect What It’s Worth?A high margin conveys that a firm is doing something right. But what really matters from a buyer’s perspective is not what the margin is now, but what it will sustainably be in the future. Consider the three scenarios below. In Scenario A, the EBITDA margin starts relatively low (15%), but improves over time. In Scenario B, the margin starts at a higher level (25%) but remains constant. In Scenario C, the margin starts at 35% but declines over time. The sensitivity table below shows the buyer’s IRR in each scenario as a function of the multiple paid. For a given multiple, the IRR is highest in Scenario A (margins low but expanding) and lowest in Scenario C (margins high but declining). In Scenario A, the buyer can afford to pay a higher multiple and still generate an attractive rate of return (a 9.0x multiple results in an IRR of 32.8%). In Scenarios B and C, however, the buyer must pay a lower multiple in order to generate the same IRR, even though the initial margin is higher. The implication of the analysis above is that the prospect for future margins is much more important than the current margin when determining the appropriate multiple for an RIA. The market for different segments of the investment management industry tends to reflect this. Institutional asset managers – while they can have very high margins – tend to command lower multiples than HNW wealth managers, which often have lower margins. The reasons for this are many: asset managers are more exposed to fee pressure, trends towards passive investing, and client concentrations, among other factors. These factors suggest an increased likelihood for lower margins in the future for asset managers. HNW wealth managers, on the other hand, often have lower but more robust margins due to their relatively sticky client base, growing client demographic (HNW individuals), and insulation from fee pressure that has affected other areas of the industry. Margin and ValueHigh margins are great, but what really matters to a buyer is how durable those margins are. A variety of factors that affect this, some of which are within the firm’s control and some of which or not. Where the firm operates within the investment management industry (asset manager, HNW wealth manager, PE fund, etc.) is one factor that can affect revenue and margin variability.While a firm can’t easily change which segment of the industry it operates in, there are other steps that these businesses can take to protect their margins. For example, designing the firm’s compensation structure such that it varies with revenue/profitability is one way to protect margins in the event that revenue declines. See How Growing RIAs Should Structure Their Income Statement (Part I and Part II).Firms can also critically evaluate their growth efforts to ensure that additional infrastructure and overhead investments don’t outweigh gains in revenue. By structuring the expense base in a way that protects the firm’s margin if revenue falls and developing growth initiatives designed to support profitable growth, many RIAs can generate stable to improving margins in most market environments—and realize higher multiples when the firm is eventually sold.

Charlie Munger, Elon Musk, Kenny Rogers and Your Family Business

"He thinks he's even more able than he is and that's helped him. Never underestimate the man who overestimates himself. Some of the extreme successes are going to come from people who try very extreme things because they're overconfident. And when they succeed, well, there you get Elon Musk." - Charlie Munger"If the objective was to achieve the best risk-adjusted return, starting a rocket company is insane. But that was not my objective." - Elon Musk"You got to know when to hold 'em, know when to fold 'em, know when to walk away, and know when to run." - Kenny Rogers Long-time Warren Buffett confidant and business partner Charlie Munger was in the news this week for giving frank interview responses on a wide range of topics. Among his comments was the quote about Elon Musk's productive overconfidence cited at the top of this post. Return follows risk, and the only way to earn outsized returns is to take outsized risks. As Musk himself acknowledges, hewing to textbook notions of prudent risk management would have derailed SpaceX before it ever got off the ground (literally or figuratively). Attitudes toward risk are hard to quantify and are unlikely to be uniform across a family. It is reasonable to assume that investors in public companies have similar views of risk. After all, they all chose to be there. Family shareholders, on the other hand, likely have not designed their investment portfolios from scratch, and the family business often represents a far larger portion of the overall portfolio than modern investment management theory would deem prudent. Most mature family businesses that we know do not have an appetite for taking on the sort of outsized risks for which Mr. Musk is famous. Instead, they adopt a more cautious posture of calculated risk-taking like that espoused by the late, great Kenny Rogers in his immortal song, "The Gambler." Confidence and Capital BudgetingAs 2021 draws to a close, family business directors are busy evaluating capital spending plans for the coming year. Capital budgets are influenced by the availability of capital to invest in the future, the availability of projects in which to invest, and the willingness of shareholders to forego current returns in the hopes of greater future rewards.So, just how confident should family business directors feel when forecasting business results in 2022? The Organization for Economic Cooperation and Development, or OECD, publishes a Business Confidence Index ("BCI"), which is based upon survey responses related to developments in production, orders and stocks of finished goods in the industrial sector. Readings above 100 indicate increased confidence, while measurements below 100 correspond to a pessimistic outlook. After dipping into bearish territory in 2H19 and bottoming out in the early months of the pandemic, the measure has given an expansionary reading since July 2020.Chart 1: OECD Business Confidence Index (2019 - 3Q21) Responding to survey questions is one thing, cracking open the corporate checkbook is another. We examined capital investment data for small- and mid-cap public companies over the same period to get another perspective on corporate confidence. Chart 2: Capital Investments for Small- and Mid-Cap Public Companies (2019 - 3Q21) Corporate investment spending corroborates the OECD confidence index. M&A activity is more volatile, but corporate managers also slowed capital expenditures materially during the middle quarters of 2020. Circling back to the confidence of Elon Musk, we can track capital expenditures for Tesla over the same period. Chart 3: Tesla Capital Expenditures (2019 - 3Q21) In contrast to most of the companies examined above, Mr. Musk was hitting the accelerator on capital spending during the pandemic, spending 134% more on capital expenditures during the middle quarters of 2020 than in the same period of 2019. Clearly, Musk is a "unicorn" and most family businesses are not blessed (or cursed, depending on your perspective) with a personality like his. So what lessons can family business directors take from his confidence and disregard for normal risk management (as embodied by Mr. Rogers' Gambler)? No Blind "Confidence Premium"For public markets, share price performance is the ultimate scoreboard. As summarized in Table 4, confident investors (defined here as those companies that did not reduce capital expenditures during the middle quarters of 2020), on balance, did not fare as well as their more cautious counterparts. Knowing when to fold 'em appears to have paid off for most companies.Table 4: Post-COVID Stock Appreciation of "Confident Investors" Reality is messy, so easy answers don't work. The data in Table 4 suggests that closing one's eyes and being aggressive for the sake of being aggressive is not a great strategy. Our analysis of the data indicates that there is no automatic "confidence premium" available to more aggressive companies. For family business directors, this means that there is no substitute for careful analysis of the available investment opportunities. We have previously proposed that – in addition to the financial metrics that serve as a gating function for potential investments – directors carefully evaluate the market opportunity, strategic fit, and constraints associated with a potential capital investment. Rewarding ConvictionsThere may not be a "confidence premium," but there is a clear reward for maintaining one's investment convictions in the face of discouraging market returns. We wanted to see what impact, if any, prior stock price changes had on companies' willingness to invest during the pandemic. For the most part, the companies that invested the most during the pandemic had experienced favorable stock price movements during 2019. In other words, the "confident investors" were to some degree chasing momentum, as shown in Table 5.Table 5: Post-COVID Stock Appreciation of "Confident Investors"There are two notable exceptions to this momentum story. Shares of the most confident investors in the Consumer Staples and Information Technology sectors had underperformed those of their industry peers during the pre-COVID period. These "conviction" investors bucked the broader trends in post-COVID returns in Table 4, generating premium returns of 12% (Consumer Staples) and 43% (Information Technology), respectively.Contrarian investing requires thick skin and a steady stomach. In our experience, successful family businesses are often the best-suited players in their respective industries to invest at opportune times. Not being subject to the public stock market's reaction to next quarter's earnings release frees many family businesses to invest when others are holding back. Over generations, such enterprising families reap the rewards of investing with strategic conviction.So, where does your family business find itself during the current planning cycle? Are there investing convictions that your family business should double down on like Elon Musk, or is it time to follow the Gambler's advice and take some chips off the table? Sometimes an outside perspective can help bring clarity; call one of our family business professionals to discuss your investing outlook in confidence.

November 2021 SAAR

The November 2021 SAAR was 12.9 million units, down 0.7% from October and 19% from November 2020. This month’s SAAR came in below expectations as the industry experienced only slight inventory improvement from the historic lows of September and October. This seems like old news, as persistently limited inventory on dealer lots has affected the industry for months now and has been the principal issue concerning auto dealers. In this environment, vehicle prices remain elevated, with the average transaction price paid for a new vehicle reaching a November record of $44,000 this month. Light trucks continue to be red hot, representing more than 80% of all new vehicles sold and leaving dealer lots at a record pace. The average number of days a vehicle stays on the lot fell to a record low of 19 days in November, down from 48 days in November 2020. It is no secret that inventory issues at the dealer level are a consequence of production stoppages and supply shortages by OEMs. OEMs have all been subject to supply chain disruptions for some time, and these challenges have been met with a wide range of responses. Jeff Schuster, president of J.D Power’s Americas operations and global forecasts recently addressed these responses by saying: “The supply shortage is being managed in very creative ways, from building vehicles without certain content, to bringing chip development and production in-house for better supply chain visibility. However, the improvements in vehicle production are inconsistent around the world. China and India both saw stronger vehicle production in October, but North America and Europe remain constrained. Even as plants restart after being down for several weeks, they are not running near-normal levels. While the solutions are intended to minimize the disruption now or in the future, consumers will continue to find it difficult to purchase the exact vehicle they want for several months to come."At least partially as a result of these “inconsistent” conditions across countries, the market shares of certain manufacturers have fluctuated a bit over the last month. Toyota, Hyundai-Kia, Honda, Nissan, and Mazda are among the manufacturers that experienced market share growth in November, while American manufacturers Ford, Stellantis, and General Motors all saw market share losses. This trend in auto public equities has been around for a few months now, but it shouldn’t take long for American and European manufacturers to catch up with their counterparts in other parts of the world by establishing in-house microchip development and securing a consistent pace of production going forward.What Could 2021 Mean to the Industry’s Future?For the last SAAR blog of 2021, we thought it might be valuable to reflect on the unique year that auto dealers and manufacturers have had. This is not a comprehensive recap of a year, but instead a commentary on what seemed to work well in 2021 and what changes might be around for a while.2021 defied nearly everyone’s expectations.While 2020 presented its own set of challenges and opportunities, 2021 defied nearly everyone’s expectations. Analysts following the industry watched as OEMs and dealers reacted to unprecedented conditions in almost every phase of their businesses. We saw dealer principals shepherd their auto dealerships through a choppy market environment and thrive in the current pricing and inventory environments. As the second half of the year wound down, new records were being set every month relating to low stocks of vehicles, elevated, and persistently rising gross profits, and consumer demand for autos of all classes. We also saw a red hot M&A market, with elevated Blue Sky multiples and record-high earnings driving mass amounts of industry consolidation by the public auto dealers like Asbury, AutoNation, Group 1, and Sonic Automotive.The motivation behind a chunk of the sales volume in 2021 seems unique to the times.On the other side of vehicle-buying transactions, vehicle scarcity and inflated sticker prices have left many consumers feeling uncertain about the future of car-buying and when they may choose to make that big purchase. Prospective buyers on the margins may have decided to hold off on buying their next vehicle in the hopes that prices will fall as inventory levels normalize. Others have chosen to take the opportunity to cash in on high trade-in values for their used vehicles that won’t stick around for long. In either case, the motivation behind a chunk of the sales volume in 2021 seems unique to the times we are living through. Many consumers are under the assumption that when things “get back to normal” the car-buying experience will closely resemble what it was pre-pandemic. While that will surely be true for many aspects of the sales process, auto dealers and manufacturers would be remiss not to take the lessons learned in 2021 and make some of the changes permanent in how they do business going forward.We aren’t likely to see high margins on vehicle sales persist.Could pre-orders on many models become more commonplace as dealers find the perfect inventory balance on their lots? Absolutely. Could record low dealer incentives persist in an effort to assist dealers in competitively pricing their vehicles when sticker prices inevitably fall off? Perhaps. But for changes like these to stick, factors like test drive availability and matching model-specific production volumes with the pent-up demand that exists will have to be addressed. It is also important to note that many local, full-service dealerships seek to gain loyalty through providing as great a personal experience for the buyer as possible. Repeat customers and parts and service revenues are very important to these dealers, and making customers feel like they are getting gouged is not in anyone’s best interest. For that reason, we aren’t likely to see high margins on vehicle sales persist. However, dealers and OEMs certainly learned there’s been money left on the table in the past due to the relative inelasticity of demand for vehicles.ForecastWhile December is typically a big selling month for dealers, we don’t see much changing the supply issues in the next couple of weeks to close out 2021. From a dealer’s standpoint, inventories will most likely continue to be sold within days of arriving on the lot.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

Insurance Valuation Services for Financial Sponsors

In recent years, financial sponsors such as private equity, venture capital firms, investment companies, and family offices have taken a more prominent role in funding and growing firms in the insurance industry. From insurance brokerage/distribution to underwriting to InsurTech start-ups, there are many opportunities for investment in the insurance sector and transaction activity in the space has steadily been increasing.Mercer Capital has worked with financial sponsors in the insurance industry for years and we understand both the dynamics of the industry as well as the accounting and valuation issues that are likely to be encountered.Key areas where Mercer Capital can help include:Valuations of Shares/Units for 409A / ASC 718 Compliance - If you anticipate granting equity to founders or key management at acquired companies, using rollover equity as part of a growth strategy, or issuing options or RSUs as part of your employee compensation plans, supportable and defensible valuations are critically important.Valuations for Financial Reporting – Acquisitive growth strategies will likely necessitate ASC 805 purchase price allocations, earn-out liability measurements, and goodwill impairment testing.Financial Due Diligence – We provide financial due diligence and quality of earnings reports on target companies, including analysis/trending of the pro forma P&L, potential earnings adjustments, working capital assessments, unit economics analysis, and other areas of financial analysis.Financial Opinions (Fairness and Solvency Opinions) – Certain types of transactions, related-party issues, or fiduciary concerns can lead a board to seek an independent opinion of fairness or solvency as it pertains to a transaction involving the subject company. These situations might include going-private transactions, special dividends, and leveraged recapitalizations.Portfolio Valuation for ASC 820 Compliance – We provide a range of services to assist fund managers with the preparation and/or review of periodic fair value marks. These services are cost-effective and include a series of established procedures designed to provide both internal and investor confidence in the fair value determinations. To discuss any of these services in confidence, please contact a Mercer Capital professional today.

M&A in Marcellus & Utica Basins

Activity in 2021 Was Muted Relative to 2020

The three transactions in the Marcellus & Utica basins over the past year were just a trickle compared to the 16 transactions reported in the prior year for the Appalachian basins. The number of transactions in 2020 was more than double the seven transactions in 2019, driven in part by the relative price stability of natural gas as compared to oil which would naturally tend to favor M&A activity in these gas-heavy basins. One key observation of the transactions in 2020 was that companies were making critical decisions regarding where to operate on a forward-looking basis. Companies, such as Shell, took the position of divesting their Appalachia assets, while other companies, such as EQT, chose to augment their Appalachian footprint. The following table summarizes transaction activity in the Marcellus & Utica in 2020: Appalachia transactions announced so far in 2021 are shown in the following table: The decline in transaction activity in 2021 most likely indicates that anyone looking to get into or out of the Appalachian basins effectively did so in 2020, or was concerned with natural gas price volatility, which increased sharply in 2021 after several years of relative calm. However, that is not to say that the activity in 2021 was any less interesting. Notable changes in the statistics between the transactions in 2020 and 2021 include a sizable increase in the median and average deal values, price per acre, and price per production unit. Based on the much smaller sample size of 2021, the magnitude of these differences probably doesn’t mean too much. But one metric, production per acre (or MMcf/Acre), on an annualized basis, could be indicative of a greater focus on obtaining more productive assets in 2021 than the transactions observed in 2020. The following table summarizes the estimated annualized production per acre, including the median and average values, for the transactions in 2020 and 2021: Buyers in 2021 seemed to target producing rather than prospective, assets, as indicated by, as indicated by the median and average annualized MMcf/Acre metrics. Irrespective of the smaller transaction count (sample size) in recent history, the minimum production density metric in 2021 (0.71 MMcf/Acre) was nearly 9% greater than the maximum metric observed in the 2020 transactions (0.65 MMcf/Acre), and 52% and 82% higher than the median (0.47 MMcf/Acre) and average ( 0.39 MMcf/Acre) metrics, respectively, observed among the transactions in 2020. Again, this back-of-the-napkin statistical analysis may fall far short of being arguably significant, technically speaking, but it’s pretty interesting as far as an eyeball test is concerned. EQT Corporation Adds to Core Marcellus Asset BaseOn May 6, EQT Corporation (NYSE: EQT)announced that it entered into a purchase agreement with Alta Resources Development, LLC (“Alta”), pursuant to which EQT would acquire all of the membership interests in Alta's upstream and midstream subsidiaries for approximately $2.93 billion. EQT intended to finance the acquisition with $1.0 billion in cash, drawing upon its revolving credit facility and/or through one of more debt capital market transactions, and stock consideration consisting of approximately 105 million EQT common shares, representing $1.93 billion. The asset was comprised of approximately 300,000 core acres positioned in the northeast Marcellus region. Net production as of the transaction date was approximately 1.0 Bcfe per day, comprised of 100% dry gas. The transaction also included 300-miles of owned and operated midstream gathering systems and a 100-mile freshwater system with 255 million gallons of storage capacity. Toby Rice, President and CEO of EQT, stated that the acquisition represents an attractive entry into the northeast Marcellus while accelerating the company’s deleveraging path, providing attractive free cash flow per share accretion for EQT shareholders and adding highly economic inventory to the company’s robust portfolio. Mr. Rice also noted the transaction increases the company’s long-term optionality, and should accelerate its path back to investment grade metrics while simultaneously achieving its shareholder return initiatives.Northern Oil and Gas, Inc. Acquires Non-Operated Appalachian AssetsOn February 3, Northern Oil and Gas (NYSEAM: NOG) agreed to acquire certain non-operated natural gas assets in the Appalachian basin from Reliance Marcellus, LLC (“Reliance”), a subsidiary of Reliance Industries, Ltd., for total consideration of $175 million in cash and approximately 3.25 million warrants to purchase shares of NOG common stock at an exercise price of $14.00 per share. The transaction was expected to be funded through a combination of equity and debt financings and anticipated to be leverage neutral on a trailing basis and leverage accretive on a forward basis. At the effective date of July 1, 2020, the acquired assets were producing approximately 120 MMcfe/d of natural gas equivalents, net to Northern Oil and Gas. The assets were expected to produce approximately 100?110 MMcfe/d (or approximately 19,000 Boe/d) in 2021, net to Northern Oil and Gas, and consisted of approximately 64,000 net acres containing approximately 102.2 net producing wells, approximately 22.6 net wells in process, and approximately 231.1 net undrilled locations in the core of the Marcellus and Utica plays. Furthermore, an inventory of 94 gross highly-economic, work-in-progress (“WIP”) wells was slated for completion over the following five years by EQT. As of the transaction announcement, approximately $50 million of net development capital had already been deployed on the WIP wells, which was not subject to reimbursement by Northern Oil and Gas. The acquisition complemented Northern Oil and Gas’s then-existing approximate 183,000 net acreage portfolio in the Williston and Permian basins. As of year-end 2020, the acquired assets held an estimated 493 Bcf of proved reserves, of which approximately 55% were comprised of PDP reserves, with PV-10 of $269 million (at strip pricing as of January 20, 2021).Nick O’Grady, Northern Oil and Gas’s CEO, commented, “This transaction furthers our goal of becoming a national non-operated franchise with low leverage, strong free cash flow and a path towards returning capital to shareholders. With this transaction, we expect increased opportunities to efficiently allocate capital and diversify risk, our commodity mix and geographic footprint.”ConclusionM&A transaction activity in the Marcellus & Utica shrank in number in 2021 relative to 2020. However, the relatively greater magnitude of production density represented by the transactions in 2021 could prove to be a bellwether of more “transformational” transactions to come in 2022 as companies stake their claim in the gas and gas liquids rich basins of Appalachia.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Q3 2021 Earnings Calls

Third quarter earnings calls across the group of public auto dealers began with similar themes from the prior two quarters: record profits and earnings, record Gross Profits Per Unit (GPU) on new and used vehicles, and tightening inventory conditions. Additionally, the public franchised dealers continue to post large scale improvements in SG&A expense as a percentage of gross profit or revenues.Supply chain disruptions caused by the microchip shortages continue to impact inventory levels on new and used vehicles for all auto dealers. The public auto dealers are not immune from these conditions as well. Average days’ supply for new and used vehicles for the six public auto dealers as of September 30 are as follows: We have focused previous blogs on the conditions impacting new and used vehicles and their contribution to overall profitability. While those themes still existed for the Q3 earnings calls, we will focus on other areas of profitability for the public auto dealers, including Fixed Operations and Finance and Insurance (F&I). Additionally, the M&A market for the entire industry continues to accumulate transaction volumes at record levels. While much has been discussed regarding the pricing of those transactions in terms of multiples paid and which historical earnings to consider for ongoing performance, we will discuss some of the other factors public executives consider when making acquisitions. Will inflation be the next disruptive force to impact the auto dealer industry as we close out 2021 and head into 2022? Find out how public executives view inflation to the auto consumer and how that might affect new and used vehicle transactions. Finally, we will examine some of the themes and performance enhancements that public auto dealers continue to experience from the digital and omnichannel platforms outside the obvious digital transactions of new and used vehicles. Theme 1: Public auto dealers report improvements in Fixed Operations and Service stemming from recovery in vehicle miles driven post-pandemic. Customer pay has continued to improve while collision work has lagged. “Consumers are approving more work than they had in years past, and they’re spending more dollars per order […] We do see more opportunity to be more digital and be more engaged and transparent with the consumer […] and mainly our source is text messaging. We’re communicating through text message.” – David Hult, President & CEO, Asbury Automotive Group“The strong areas, obviously being areas of customer pay have continued to perform well versus both 2020 and 2019. The one area that continues to be a little bit of a laggard is collision, we do anticipate as miles continue to improve that will fully recover.” – Joe Lower, Chief Financial Officer, AutoNation“Our customer pay continues to ramp -up following a very strong first half of the year with 19% same-store dealership gross profit growth compared to the third quarter of 2019 […] despite continued headwinds in warranty and collision, both of which we believe will reverse in time.” – Daryl Kenningham, President U.S. and Brazilian Operations, Group 1 Automotive“Our service and parts […] it’s a huge tailwind for us. Our warranty was only off 9% […] our customer pay was up 21%” – Jeff Dyke, President, Sonic AutomotiveTheme 2: Public executives report strong results in the F&I department fueled by escalating transaction prices and low-interest rates. The lower volume of new vehicle units retailed is also affecting the mix of F&I revenue as penetration from product sales is outpacing warranty and reserve components.“Our strong, consistent and sustainable growth in F&I delivered an increase of $155 to $1,955 per vehicle retail from the prior quarter […] We like the fact that 70% of our F&I number is product sales and only 30% is reserve […] [regarding our recent acquisition] Larry Miller group has better penetration numbers than we do. So we’re certainly excited to learn from them and grow as well.” – Dana Clara, SVP of Operations, and David Hult, President & CEO, Asbury Automotive Group“The real driver for us [on F&I] has been increased penetration […] about two-thirds of F&I for us comes out of product versus financing.” – Joe Lower, Chief Financial Officer, AutoNation “22% increase in F&I income […] The adjacency that we are furthest along with is Driveway Finance or DFC […] Driveway Finance earns three times the amount earned than when we arrange financing with a third-party lender […] Driveway Finance can penetrate 20% of our financed retail sales.” – Bryan DeBoer, President & Chief Executive Officer, Lithia MotorsTheme 3: Supply chain disruptions have affected all industries including the auto dealer industry. Executives are watching how inflation and rising interest rates might impact the purchase of new or used vehicles in the coming months.“We’re watching inflation and the CPI […] what they’ve missed is the consumers are very happy with that pre-owned valuation that they own, that the 275 million vehicles on the road in America are worth more. That has made the consumer happy, not unhappy […] so once you see the other side of the coin, that consumers are not unhappy with this, they don’t consider it inflation [….] [consumers say] oh I made a pretty good investment […] it’s worth more. And if I want to sell it, I can get a nice check. And if I want to trade it, I have a reasonable difference. As soon as you realize that the consumer doesn’t view that as inflation, but as a win for them, then you understand our optimism and our confidence about the future of automotive.” – Mike Jackson,Chief Executive Officer, AutoNation“I don’t think there’s any doubt that inflation is a business factor […] I don’t think we can call it transitory or anything like that […] the costs are going to go up on everything, but the affordability of vehicles is more dictated by retail financing and leasing. And with high used car values, and low interest rates, I don’t see this inflation raining on the vehicle sales parade in the foreseeable future." – Earl Hesterberg, Chief Executive Officer, Group 1 AutomotiveTheme 4: M&A continues to dominate headlines. 2021 will see more transactions than any year in recent history. “I think fragmentation provides an opportunity for consolidation. With the investment required today, I think there’s a number of smaller dealerships that will become available. I think the deals that we see, the bigger deals are expensive. And many of them require CapEx and also then would provide some input from the standpoint of framework agreements with the manufacturers.” – Roger Penske, Chairman and Chief Executive Officer, Penske Automotive Group“So we visited all of the RFJ stores […] the entire management team is coming along for the ride […] we kind of walk into one of their stores and if feels like a Sonic store, they run their playbooks very similar to us. […] They are a fantastic leadership team. […] This is a perfect fit for us.” – Jeff Dyke, President, Sonic Automotive“[Regarding the Greeley Subaru, Kahlo CDJR, and Arapahoe Hyundai announced transactions] The brand mix is about 50% luxury and then mostly, import with one domestic store as well. It’s a really a very strong group with the right brand mix in a market that we’ve been trying to grow.” – David Hult, President & Chief Executive Officer, Asbury Automotive GroupTheme 5: Digital/omnichannel advancements are happening to meet consumer demands and enhance the retail experience. Improvements consisted of more than just unique digital visitors and increased online transactions. Improvements include average deal time, used vehicle procurement, headcount efficiency, and the ability to serve consumers with all credit scores.“I think the reason you are seeing higher credit scores and higher down payments on the tool [Clicklane] is it’s simplistically someone with a 750-Beacon score understands that they’re not worried about financing and understands that they can get what they want […] [we] certainly see [sic] lower credit scores as well on there […] there’s a broad mix, but again, the score average is certainly higher.” – David Hult, President & Chief Executive Officer, Asbury Automotive Group“We’ve demonstrated that we can operate the business at a lower relative cost than was done historically in large part by the deployment of digital tools that are making our sales and service associates far more effective […] we’ve been able to continue to operate with 3,000 plus fewer heads within the store environment on a same-store basis year-over-year.” – Joe Lower, Chief Financial Officer, AutoNation“We’ve increased the productivity of our salespeople by 30%, pre-Covid versus today […] selling 13 or more units a month instead of 10 […] nearly 40% of our customers are scheduling appointments online these days” – Earl Hesterberg, Chief Executive Officer, and Daryl Kenningham, President of U.S. and Brazilian Operations, Group 1 Automotive“The average Driveway consumer is averaging exactly 50 points lower on their FICO scores. So there are 671 versus 721 in Lithia […] We did finance a higher percentage of customers in Driveway at 75% and only financed 67% of Lithia customers.” – Bryan DeBoer, President & Chief Executive Officer, Lithia Motors“Omni-channel is just not selling vehicles. You think about service appointments, online payments – that is key.” – Roger Penske, Chairman and Chief Executive Officer, Penske Automotive Group“EchoPark is all about buy the car, transport the car, recon the car, merchandise the car and moving like 12 days to getting on the frontline, it’s gone […] EchoPark model is a one-to-five year old model under 60,000 miles” – Jeff Dyke, President, Sonic AutomotiveConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight into the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Five Thoughts on Turning Your RIA’s Success Into Momentum

Knowing why you’re successful is a key to sustaining success. Porsche made its mark in auto racing in the 1950s by turning the race for better power-to-weight ratios on its head. While most automakers focused on the numerator, building bigger cars with more powerful engines, Porsche worked to keep the car's light - not only to improve acceleration, but also braking and handling. The formula worked both on the track and in the showroom, and Dr. Ferry Porsche never lost sight of what made his cars competitive and sought after. On roads that are a monotonous sea of SUVs, the 8th generation 911 Carrera stays true to an identity that Porsche established in the 1950s with the 550 Spyder and the model 356. Although the weight has crept up over the years, power increased even faster. Engineering advances have added double-clutch gearboxes, all-wheel drive, four-wheel steering, ceramic-disc brakes, and (to the horror of the Porsche faithful) water-cooling to Porsches. However, the core identity of the product has remained intact and forms the intangible that Porsche has monetized for over 70 years. Today, the waiting list for a new one is impressive.Despite the recent volatility, it’s been another very good year for the RIA community. Markets, on the whole, are strong, tax rates didn’t skyrocket, margins are thick, and transaction activity continues unabated.Success, alas, can be fleeting. While some in the industry are focused on continued opportunities and upside in the years ahead, it’s hard to ignore calls that corporate earnings growth is slowing, the yield curve is flattening, commodity prices are worrisome, emerging markets are uneven, fee pressure is growing, and the world is bracing for another round of COVID. Whatever brings about the rollover in industry trend lines, we all know it’s coming at some point.So if, indeed, 2021 is the peak of the cycle for the investment management industry, what will you one day wish you had done now?1. Know What Got You HereThere’s an old proverb that says something to the effect of every ship has a good captain in calm waters. If your RIA has grown in AUM, revenue, and profitability over the past decade, you’re not alone. Think about why your firm grew. Did you add productive financial advisors to your wealth management practice? Did you add attractive asset management strategies? Did your assets under management increase because you broadened your appeal to a larger range of clients? Did you develop deeper relationships with existing clients? Did you grow organically or was most of your growth the result of acquisitions? Are your effective fees charged steady or increasing?Most revealing is to look at whether or not your AUM grew because of market tailwinds or because of new clients. Bull markets come and go, of course, so building the fundamental value of your investment management firm is really contingent on having an asset acquisition strategy (i.e. marketing) to bring in new clients and new client assets net of terminations and client withdrawals. You will always face some client terminations – you don’t want to do business with everyone anyway. Even good wealth management clients will eventually spend their money, and institutional asset management clients will reward your outperformance by rebalancing their commitment to you. We all know that some attrition is unavoidable and, ultimately, healthy. You just can’t rely on favorable markets to keep your revenue base stable or growing.2. What Will Your Firm Look Like in Five Years?Corporations can be perpetual, but the people who work at them eventually leave. Because investment management is necessarily labor-intensive, your firm is a function of the career cycles of your staff. Five years from now, everyone who is still at your firm will be five years older. Stop for a minute and think about what that looks like. The RIA industry is, as a whole, facing demographic challenges, and by some measures, there are more financial advisors in the career wind-down stage than there are in the career development stage.So what will your staff look like in five years? Will any of them have retired? Will any have new skills and/or credentials? How will titles, roles, and responsibilities change? What turnover are you likely to have? Will you need to replenish turnover from experienced hires or will you train people who are new to the industry? In other words, as you look at the changes that will likely happen to your staff over the next five years, will those changes grow your firm, maintain it, or are you at risk for attrition to your collective intellectual capital.3. Stress Test Your MarginsIt’s more than a little ironic and unfortunate that there are so many forecasting tools for individuals but so few for businesses. Just like wealth management firms run Monte Carlo simulations on portfolios to model likely outcomes for clients given different market scenarios, so too you need to think about how your firm will fare during unfavorable external circumstances.Profit margins have a very real business continuity function that is easy to forget after long stretches of upward trending markets. If your firm currently boasts a 25% pre-tax margin, for example, you could suffer the loss of a quarter of your revenue stream and, theoretically, not have to cut your expenses. This isn’t pleasant to contemplate, but if a sustained bear market cut your AUM by 20%, and then client financial stress caused a greater than usual rate of withdrawals, you could see a considerable decline in your top line. Since the only way to meaningfully reduce expenses in the RIA business is to cut staff, responding to unfavorable financial market conditions can have a long-lasting impact on the scale and value of your firm. It’s worth considering such a likelihood, and it’s much easier when you aren’t under the stress of the event itself.4. Consider Your Exit OptionsWith M&A on the rise, private equity increasingly interested, and new consolidation schemes emerging on a weekly basis, there has never been a more interesting time to consider how you might liquefy an interest in an RIA. Remember, though, that most ownership transitions in investment management firms are still internal because transacting staff, clients, and culture is difficult, even with favorable industry conditions. Outsiders don’t always “get it,” and insiders don’t want them.If you had to sell right now, how would you do it? If you don’t think your firm is ready to take to market, what changes need to be made? If you intend to transact internally, do you foster a culture of succession? There’s no room here for an exhaustive analysis of exit planning for RIA owners, but suffice it to say that you should always be aware of your possibilities. If you can’t find the door in good times, what will your plan be following the next correction?5. Remember That Long-Term Industry Trends Are FavorableAt some point, things are going to get rough, and the performance of your RIA is going to deteriorate. When market valuations tumble, clients get nervous, and staff stress rises, it can feel like at least your professional world is coming to an end. Broad industry trends, though are very favorable to the investment management community. New retirees make up the largest source of new clients for wealth management firms (and, in turn, asset managers), and the number of retired persons in the U.S. will continue its upward trajectory for decades to come. Assets continue to flow away from wirehouses and toward independent advisory practices. And last but not least, markets are – over time – upward drifting. None of that is going to change with the next bear market.So while the fundamentals of your firm may appear to deteriorate during bear markets, the fundamentals of the industry will continue to drive success for a long time. Today, the fundamentals of your firm are probably the best they’ve ever been. That’s why this is the perfect time to consider your formula for success, prepare for the next downturn, and build the competitive momentum you’ll need to ride the industry trends to greater success in the future.

5 Questions with Dennis Hinton

An Interview with the Managing Director of a Private Investment Firm Focused on Non-Controlling Equity Investments in Family Businesses

Previously on the Family Business Director Blog, we shared our prediction that the number of family businesses raising non-family equity capital will grow dramatically in coming years.In this week’s post, we share excerpts from a discussion with Dennis Hinton, Managing Director at North River Group, a private investment firm focused on non-controlling equity investments in family businesses. Mr. Hinton shares some common reasons family businesses seek non-family equity and how family business owners can achieve liquidity and diversification.Your firm, North River Group, makes non-controlling equity investments in family businesses. What are the most common triggers for the family businesses that are looking for non-family equity capital?Dennis Hinton: The most common trigger for a family business to get connected to us concerning non-controlling (minority) capital is around growth capital, or where the capital goes onto the company’s balance sheet to fund a specific initiative. However, this is not the ideal situation for North River Group. We seek to invest non-controlling equity capital into family businesses where they do not need capital. Stated differently, our capital is used for “liquidity,” or cash goes into the shareholder’s pocket. Most business owners, especially family businesses, do not know this is an option. They think their options are to either sell 100% of the company or do nothing. Selling less than 50% of a business provides a sort of “hybrid” liquidity event for a family-owned business.Do you find that family business owners are becoming more receptive to the idea of having non-family shareholders? If so, why do you think that is the case?Dennis Hinton: Yes and No. As traditional private equity becomes more mainstream, I think many family-owned businesses are uncomfortable with how they operate. Specifically, many family-owned businesses that have been around for a long time usually have done so through the avoidance of debt. Adding a lot of debt to a company’s balance sheet changes the dynamics of how a family-owned business operates. For example, many family-owned businesses pay their bills to their vendors as soon as they receive an invoice. However, a private equity owned, debt burdened business might view this as an opportunity to “squeeze” a bit more cash flow by delaying paying invoices for 30, 60, or even 90 days. Short term these gimmicks work but long term they lead to an erosion of trust with key stakeholders. Second, most entrepreneurs simply don’t like taking orders from others. While a strategic or private equity buyer talks about “partnering” with such a family-owned business, in reality, many times, this partnership turns into a dictatorship. Many times after an acquisition, a buyer will come in and micro-manage the prior owner operator(s). In a non-controlling equity investment transaction, these dynamics do not exist.What sort of governance rights do non-family investors typically require when they invest?Dennis Hinton: There are really only 3 governance provisions we require when doing these types of transactions:Agreement on annual CPA audit firm.Agreement on any family compensation increases above 2 or 3% annually.A Put Right or Redemption Right. Of the 3 provisions, the Put Right or Redemption Right is the only one that has any detail to it. While we never make a non-controlling investment intending to exercise such a Right, a preset and prenegotiated separation agreement is beneficial for both parties should a difference of opinion ever arise.Many families are leery of private equity funds because of their relatively short (4-7 year) investment horizons. Are there investors out there that are not tied to the fund cycle treadmill?Dennis Hinton: Yes, there are more and more investment firms with longer investment horizons. However, most are focused on the change of control investments or minority growth equity investments. We believe we are quite unique in that we don’t have any preset time horizons for investments. Additionally, we focus on providing family business owners liquidity by purchasing less than 50% of their business.What advice do you have for an enterprising family that is considering whether outside capital might be appropriate for them?Dennis Hinton: Chemistry matters. Specifically, when a family is deciding whether or not to partner with an investment firm in a minority capacity, there has to be a high degree of trust between both parties as it is a true partnership. While legal documents can provide high level parameters for how a partnership will operate post-closing, they can never include all situations that arise when running a business. When such a situation arises, both parties need to have confidence that the other party will work towards a fair and just outcome (which can sometimes conflict with one’s own financial interests). Finally, aside from business matters, we have always enjoyed working with business owners that we like personally – it makes the partnership much more fun. Mercer has experience working with family businesses to evaluate outside investment opportunities. Give us a call if you have an offer you want us to analyze alongside you.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of November 29, 2021

Upstream Producers Are Not Gouging–They’re Tentative. Here Are Three Reasons Why

The drumbeats have been building for a couple of months now. Finally, as commodity prices have risen and third quarter profit reports have rolled in, so have accusations of price gouging by oil and gas companies. Senator Warren recently said as much on MSNBC. She is wrong on this point, but certainly not alone by any means. Politicians have made oil companies a proverbial punching bag on numerous fronts. This is not news. They have been rhetorical targets for decades.However, it is true that U.S. upstream producers (both oil and gas) have yet to momentously hasten new production and aggressive drilling plans. It would make sense if they did, as it speaks to the core incentives of commodity-based businesses like oil and gas. Yet the U.S. industry remains tentative and reticent. In the meantime, the market remains in backwardation marked by continuing inventory draws and increasing prices. Why? The answer is found somewhere among supply and demand dynamics, rising costs, and capital headwinds.Supply & Demand Issues“We are encouraged by the restraint shown by U.S. upstream operators. By restricting capital expenditure, we are healing historic overproduction of both oil and natural gas. We believe investors will be attracted back into the E&P space if, as an industry, we continue on this path for at least a year or two more to deleverage balance sheets and return capital to investors.” -Fed SurveyRespondent It was a rough 2020, but producers have turned a corner on drilling discipline, and have restrained on the drill bit compared to years past. They also deleveraged balance sheets, and where possible, returned capital to shareholders. During 2021 traffic patterns have normalized, and apart from jet fuel, demand growth has bounced back to pre-pandemic levels. It is also creeping into winter and natural gas will be in season. That’s good news. Energy consumption is a bellwether for economic activity. However, that production discipline in both the U.S. and OPEC+ nations has resulted in crude oil inventories being 6% below the five-year average (2016-2020) overall. The Biden administration just announced a 50-million-barrel drawfrom the Strategic Petroleum Reserve. This imbalance started in Q3 2020 and has continued since, and is helping to keep prices high, though perhaps not for too long. The U.S. Energy Information Administration (EIA) projects this to come back into balance by Q2 2022. OPEC+ is slowly, but steadily adding production to the markets, while U.S. shale producers, although increasing activity, have been lagging this year. Futures markets suggest a similar outcome and prices are expected to steady according to NYMEX and EIA. As the futures curves tail out, the 60 month premium from a year ago is higher, but the near term spread is even wider, thus giving firms pause before diving in headlong with massive new production initiatives. (Not all share this outlook – Bank of America sees oil at $120 by June 2022). Still, producers went through a lot to discipline themselves, and expectations by investors have been clear for years now: less drills more bills. One other commodity that’s in demand which should impact oil and gas supply as well is the U.S. dollar. The currency is strengthening, and this brings downward pressure on prices too. Costs Labor is causing major problems in staffing for the increase in activity. Wages are up 20 percent, and companies are poaching employees from competitors. We are finding it difficult to increase prices to match our increase in costs. – Fed Survey Respondent As oil and gas prices are going up, inflationary pressures are impacting the industry’s operations concurrently. The cost of oilfield services is rising quickly. Lease operating expenses are increasing. Delays are a problem as well, as 70% of the respondents to the latest Dallas Fed survey said they experienced delays of some sort in the last quarter. This is partially a result of tight labor markets and it’s dampening enthusiasm somewhat. Also, as I have mentioned before, costs on development are going up as drilled but uncompleted (DUC) well inventories shrink. They have continued their downward march and are at the lowest levels in seven years (November 2014). This leads to another less heralded point as well. U.S. shale oil fields have been active for around a decade now. Many of the best drilling locations have been developed. Although there are a lot remaining, they haven’t been drilled yet for a reason. Productivity per rig metrics have fallen slightly this year and it may have more to do with geology rather than technology making production growth more expensive and squeezing margins. Investment Headwinds“Oil, natural gas and natural gas liquids prices are greatly improved and appear to be sustainable for the coming months. The greatest headwind is skilled labor supply and access to expanding credit on our reserve base loan. Initial conversations with regional energy banks show increasing interest in advancing incremental credit. The money center banks continue to seek to reduce their commitments to oil and gas borrowers.” – Fed Survey Respondent Although economics have shifted quickly for producers this year, though investment sentiment not so much. Capital providers are not only cautious, but fewer in number. The multi-year souring on the oil and gas sector from several investment segments has not changed recently, leaving upstream producers with fewer options. On the debt side, some regional banks have shown a willingness to lend, but larger banks have not. Some reasons for lending discomfort have included a wariness for shale’s ability to ramp up quickly and for margins to evaporate before loans can be paid back. It’s worth a remind that U.S. production has a higher cost floor than OPEC+. Larger banks appear not to be interested. Additionally, the shrinking pool of bankers has been mirrored by a shrinking pool of investors. Firstly, returns must be carefully evaluated as many upstream producers have hedged their portfolios and some have limited their upsides to execute their strategies. They are watching profit margins go elsewhere for the time being. Also, as ESG concepts have gained momentum, many investors have weaned their appetite off oil and gas production. There are simply fewer institutional and private equity investors evaluating and participating in the space. According to a recent Wall Street Journalarticle, there are less than one-third of the firms and capital available in the space compared to 2018. Simply put, it is harder for oil and gas producers to get expansion capital while they’re simultaneously paying much of it out. Talking heads and officials may be gaining political capital while talking about gouging, price controls and the like; but in a domestic industry populated with price takers and return oriented investors, prudence and temperance are driving decision making, not their ugly cousins – greed and avarice. Thank goodness for that. Originally appeared on Forbes.com.

Highlights From Recent 2021 Conferences | 2021 AICPA & CIMA Forensic and Valuation Services Conference and 2021 AAML Annual Meeting and AAML Foundation Luncheon

Last month I had the honor of co-chairing the AICPA & CIMA Forensic and Valuation Services Conference in Las Vegas, Nevada.

Top Considerations for Acquirers When Evaluating a Potential Bank Acquisition

With year-end approaching, we are starting our annual process of recapping 2021 and considering the outlook for 2022. In doing so, we turned our attention to the bank M&A data to see what trends were emerging. While the number of bank and thrift deals is on pace to roughly double from 2020 levels (117 deals in 2020 vs 199 deals through 11/22/21), the number of deals still remains well below pre-pandemic levels. Valuations at exit illustrate a similar trend with the median price/earnings nationally for announced deals at ~15.0x earnings and the average price/tangible multiple at ~1.54x for the YTD period through mid-November 2021. These valuation multiples implied by YTD 2021 deals are up relative to 2020, roughly in line with 2019 levels, but are still down relative to 2017 and 2018 levels.A bank acquisition could present an opportunity for growth to acquirers that are facing a challenging rate and market environment. Some recent data confirmed this as almost half of survey respondents in Bank Director’s 2022 Bank M&A Survey say their institution is likely to purchase another bank by the end of 2022 — a significant increase compared to the previous year, and more in line with the pre-pandemic environment.For those banks considering strategic options, like a sale, 2022 could also be a favorable year, should the improving trends experienced in 2021 continue. These trends include a continued increase in buyer’s interests in acquisitions, a continued expansion of the pool of buyers to include both traditional banks and non-traditional acquirers like credit unions and FinTechs, and the tax environment for sellers and their shareholders remaining favorable relative to historical levels.Against this backdrop of the potential for an active bank M&A environment in 2022, we consider the top three factors that, in our view, should be considered by bank acquirers to help make a successful bank acquisition.1. Developing a Reasonable Valuation Range for the Bank TargetDeveloping a reasonable valuation for a bank target is essential in any economic environment, but particularly in the current environment. We have noted previously that value drivers remain in flux as investors and acquirers assess how strong loan demand and the rate environment will be. In addition to those factors, evaluating earnings, earning power, multiples, and other key value drivers remain important. Bank Director’s 2022 Bank M&A Survey also noted the importance of valuation in bank acquisitions as pricing expectations of potential targets were cited as the top barrier to making a bank acquisition (with 73% of respondents citing this as a barrier).Determining an appropriate valuation for a bank requires assessing a variety of factors related to the bank (such as core earning power, growth/market potential, and risk factors). Then applying the appropriate valuation methodologies – such as a market approach that looks at comparably priced transactions and/or an income approach focused on future earnings potential and developed in a discounted cash flow or internal rate of return analysis. While deal values are often reported and compared based upon multiples of tangible book value, value to specific buyers is a function of projected cash flow estimates that they believe the bank target can produce in the future.Price and valuation can also vary from buyer to buyer as specific buyers may have differing viewpoints on the future earnings and the strategic benefits that the seller may provide. For example, 2021 has seen an emerging trend of non-traditional acquirers such as credit unions and FinTech companies entering the mix. They often have different strategic considerations/viewpoints on a potential bank transaction.2. Appropriately Consider the Strategic Fit of the Bank TargetAs someone who grew up as an avid junior and college tennis player, I have always admired the top pros and found lessons from sports to apply in my personal and business life. With fifteen grand slam titles and fifteen years as the top doubles team globally, the Bryan brothers – Bob and Mike – are often held out as the most successful doubles teams of all time and offer some lessons that we can learn from, in my view. Their team featured a unique combination of a left-handed and right-handed player, which provided variety to challenge their opponents and expand their offensive playbook. It also had many similar intangibles, such as how they approached practicing and playing since they were twins and taught by their father (Wayne) from a young age.Their success illustrates the importance of identifying both the key similarities and differences of a potential partnership to strengthen the chances for success once combined. Key questions to consider regarding strategic fit and identifying the right partner/opportunity for a bank acquisition include: Does the Target expand our geographic footprint into stronger or weaker markets? What types of customers will be acquired (retail/consumer, business, etc.) and at what cost (both initially and over time)? Is there a significant branch/market overlap that could lead to substantial cost savings? Is the seller’s business culture (particularly credit underwriting/client service approach) similar to ours? Will the acquisition diversify or enhance our loan/deposit mix? Will the acquisition provide scale to expand our business lines, balance sheet, and/or technology offerings? What potential cost savings and/or revenue enhancements does the potential acquisition provide?3. Evaluating Key Deal Metrics Implied by the Bank AcquisitionA transaction that looks favorable in terms of valuation and strategic fit may flounder if other key deal metrics are weak. Traditional deal metrics to assess bank targets include capital/book value dilution and the earnback period, earnings accretion/dilution, and an internal rate of return (IRR) analysis. Below we focus a bit more on some fundamental elements to consider when estimating the pro forma balance sheet impact and internal rate of return:Pro Forma Balance Sheet Impact and Earnback PeriodTo consider the pro forma impact of the bank target on the acquirer’s balance sheet, it is important to develop reasonable and accurate fair value estimates as these estimates will impact the pro forma balance sheet at closing as well as future earnings and capital/net worth after closing. In the initial accounting for a bank acquisition, acquired assets and liabilities are marked to their fair values. The most significant marks are typically for the loan portfolio, followed by intangible assets for depositor customer relationship (core deposit). Below are some key factors for acquirers to consider for those fair value estimates:Loan Valuation. The loan valuation process can be complex, with a variety of economic, company, or loan-specific factors impacting interest rate and credit loss assumptions. Our loan valuation process begins with due diligence discussions with the management team of the target to understand their underwriting strategy as well as specific areas of concern in the portfolio. We also typically factor in the acquirer’s loan review personnel to obtain their perspective. The actual valuation often relies upon a) monthly cash flow forecasts considering both the contractual loan terms, as well as the outlook for future interest rates; b) prepayment speeds; c) credit loss estimates based upon qualitative and quantitative assumptions; and d) appropriate discount rates. Problem credits above a certain threshold are typically evaluated on an individual basis.Core Deposit Intangible Valuation. Core deposit intangible asset values are driven by market factors (interest rates) and bank-specific factors such as customer retention, deposit base characteristics, and a bank’s expense and fee structure.Internal Rate of ReturnThe last deal metric that often gets a lot of focus from bank acquirers is the estimated internal rate of return (“IRR”) for the transaction. It is based upon the following key items: the price for the acquisition, the opportunity cost of the cash, and the forecast cash flows/valuation for the target, inclusive of any expense savings and growth/attrition over time in lines of business. This IRR estimate can then be compared to the acquirer’s historical and/or projected return on equity or net worth to assess whether the transaction offers the potential to enhance pro forma cash flow and provide a reasonable return to the acquirer.Mercer Capital Can HelpMercer Capital has significant experience providing valuation, due diligence, and advisory services to bank acquirers across each phase of a potential transaction. Our services for acquirers include providing initial valuation ranges for bank targets, performing due diligence on targets during the negotiation phase, providing fairness opinions and presentations related to the acquisition to the buyer’s management and/or board, and providing valuations for fair value estimates of loans and core deposit before or at closing.We also provide valuation and advisory services to community banks considering strategic options and can assist with developing a process to maximize valuation upon exit. Feel free to reach out to us to discuss your community bank or credit union’s unique situation and strategic objectives in confidence.

Family Business Dividend Survey Results

This summer, we partnered with Family Business Magazine to conduct our inaugural survey of dividend practices at family-owned businesses. This week, we feature an article that we wrote for the magazine summarizing the survey results. We hope you enjoy and gain some insights that can help you and your family evaluate your current policy and make plans for the future.Determining what portion of earnings should be distributed to family shareholders each year can be perilous.Few decisions faced by family business leaders are as perilous as determining what portion of earnings should be distributed to family shareholders each year. Pay too little, and shareholders having no other source of liquidity from their shares may grow restive. Pay too much, and attractive opportunities for growth may wither on the vine, imposing a hard to define, but very real, cost on future generations. As a result, maintaining the appropriate balance between current income for existing shareholders and reinvestment for future generations can feel like a tightrope walk for family business leaders.When embarking on such a high-stakes endeavor, prudent leaders want to learn as much as they can from others in similar situations. To help family business leaders learn from one another, Mercer Capital partnered with Family Business Magazine to administer a survey on dividend practices at family businesses. Nearly 300 enterprising families responded, and we provide a summary of what we learned in this article.Are There Any Families Like Mine?The respondents to the survey represent a diverse group of family businesses, in terms of age, industry, size and geography. The median age of the family businesses in our sample was about 70 years, with nearly half being founded prior to 1950. The largest industry concentrations were in manufacturing (30% of respondents) and real estate (12% of respondents). About half of respondents reported revenue of less than $100 million, and approximately 10% reported more than $1 billion of annual revenue.What’s the Plan?Unlike shareholders in public companies, family shareholders can’t easily access the value of their shares by selling on the open market. Dividends are the most tangible expression of what can often feel like merely “paper” wealth. It’s nice to be rich; it’s even better to have money. Given this dynamic, it is not surprising that family businesses are more likely than public companies to pay dividends. Whereas about half of public companies pay dividends to shareholders, over 80% of the family businesses responding to our survey indicated that they do. However, nearly half of respondents reported not having a formal dividend policy. In other words, a significant group of family businesses are paying dividends, but they’re not sure why.Those who do have a formal dividend policy reported a few different policy objectives. As shown in Exhibit 1, the most common dividend policy identifies a target payout ratio of earnings (net earnings for C corporations, or earnings after tax distributions for pass-through entities). While family businesses prioritize paying dividends, overall payout ratios tend to be modest, with the target payout ratio for 60% of respondents at less than 25% of earnings. This suggests to us that most family businesses are wary of killing the golden goose.Exhibit 1 Dividend Policy Objectives Nearly 30% of dividend policies prioritize the investment needs of the business and treat dividends as a residual amount after attractive investment opportunities have been funded. Finally, a smaller minority of respondents prioritize shareholder returns in the form of establishing a target dividend yield (generally on the order of 2% to 4% of value). What Signal Are You Sending?Dividends are powerful signals about management’s outlook for the family business. Annual reports and shareholder letters may or may not get read, but dividend checks always get cashed. Because of this “signaling effect,” public company managers are loath to cut dividends in the face of a short-term earnings crunch and are hesitant to raise dividends beyond a level that they are confident they can maintain. In contrast, nearly half of the family business survey respondents indicated that dividends fluctuate from year to year, and only 20% reported having a mechanism in place to smooth out dividends amid volatile earnings. Without strong, well-cultivated shareholder consensus and engagement around the dividend policy, dividend volatility can reduce the “value” of the dividend stream to shareholders. Uncertainty regarding the dividend stream makes it harder for shareholders to make reliable personal financial plans. Dividend uncertainty also presents challenges for family business managers who need to plan significant capital investments years in advance.Public companies can emphasize dividend stability amid volatile earnings using share repurchases. Buying back shares and paying dividends are both tools to return capital to shareholders. Public companies tend to allocate more capital to share repurchases than to dividend payments. There are likely several reasons for this, one of which is that when earnings are down and capital is scarce, slowing the pace of share repurchases is less of a negative signal to investors than cutting the dividend. In other words, share repurchases serve as a release valve for volatile earnings at public companies. However, only 21% of our survey respondents reported having a formal share repurchase program available to provide liquidity to family shareholders. Without this release valve in place, it should not be too surprising that families report a higher degree of dividend volatility. We suspect that more family businesses will institute share repurchase programs in the future.Pandemic BluesThe COVID pandemic presented a (hopefully) once-in-a-generation challenge for family businesses. Much like the broader economy, the pandemic did not affect all family businesses in the same way. We asked survey participants to describe what effect the pandemic had on the performance of their family businesses and their dividend decisions. Exhibit 2 summarizes the responses.Exhibit 2 Effect of Pandemic on Family Business DividendsJust over half of respondents indicated that the pandemic had no adverse effect on the financial performance of their family business. As a result, a significant majority of these respondents did not modify their dividend practices in response to the pandemic. Nonetheless, nearly 15% of those family businesses reporting no ill effects from the pandemic on financial performance reduced dividends, presumably to preserve family business capital in the face of grave economic uncertainty.Among family businesses that did see their financial performance suffer during the pandemic, there was a mix of dividend responses. Approximately 27% of such family businesses elected to maintain their dividend, signaling to family shareholders that they were confident in the long-term prospects of the family business. The remaining companies either cut dividends or suspended them entirely.Nearly 20% of all survey respondents reported suspending dividends altogether because of the pandemic. Given the significance of dividend payments to family shareholders, the decision to suspend dividends reveals the gravity of the threat the pandemic posed to some family businesses. Deciding when and how to reintroduce dividend payments will be a significant challenge for these families.What’s It Mean to You?Crack open a standard finance textbook, and dividend policy will look easy. Simply invest in all available positive investments with a positive net present value, maintaining an optimal mix of debt and equity financing, and distribute what is left over. Unfortunately, that theory assumes that shareholders are economic robots. However, most family shareholders are people. Unlike robots, people invest things (including family businesses) with meaning. We asked survey participants to describe what their family business means to them, and the responses are summarized on Exhibit 3.Exhibit 3 Family Business Meaning In our experience, the most successful (and peaceful) enterprising families are those in which there is consensus regarding what the family business means to the family. When there is alignment on meaning, it is easier to find alignment on dividend practices. This is borne out when we examine the median target payout ratios for businesses sorted by the different family business meanings noted in Exhibit 3. As shown in Exhibit 4, there is a clear correlation between what the family business means to the family and dividend practice. Exhibit 4 Family Business Meaning and Target Payout Ratio If the family business serves as a source of wealth accumulation and diversification for family members, it makes sense that payout ratios would be relatively high. In contrast, if the family business is perceived as an economic growth engine for future generations, large dividend payments will detract from that goal. Misalignment on meaning can trigger shareholder discontent: Individual shareholders who want the company to be a source of wealth accumulation will likely be frustrated if the rest of the family views the company as an economic growth engine and makes dividend decisions accordingly. The Last WordMany survey respondents provided additional comments that were illuminating. We will close with one that we think expresses the sentiments of many family shareholders: “I feel that maybe some businesses don’t discuss dividends openly. I feel that we are one of these. It is ‘undiscussable.’”Don’t let dividends be an “undiscussable” in your family. We hope the results of this survey can provide a starting point for healthy dividend discussions at your family business. SUMMARY RESULTS 2021 Family Business Dividend Practices SurveyDownload Summary

Posturing for a Successful Succession

Failing to Plan is Planning to Fail

A recent Schwab survey asked RIA principals to rank their firm’s top priorities in the coming year. We were disappointed but not surprised to discover that developing a succession plan was dead last. This is unfortunate because 62% of RIAs are still led by their founders, with only about a quarter of them sharing equity with other employees to support succession planning. Not much progress has been made, and there doesn’t seem to be much of a push to resolve this issue any time soon. Brent Brodeski, CEO of Savant Capital, describes this predicament more crassly:“The average RIA founder is over 60 years old, and many are like ostriches: They stick their heads in the sand, ignore the need for succession planning, ignore that their clients are aging, let organic growth slow to a crawl or even backslide, and have increasingly less fun and a waning interest in their business.”Fortunately, it doesn’t have to be this way. There are many viable exit options for RIA principals when it comes to succession planning:Sale to a strategic buyer. In all likelihood, the strategic buyer is another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing. This scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees or the company’s name.Sale to a consolidator or roll-up firm. These acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms. The deals are usually debt-financed and structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow. Consolidators and roll-up firms may not always pay as much as strategic buyers, but they often allow the seller more autonomy over future operations. While there are currently only a handful of consolidators, their share of sector deal-making has increased dramatically in recent years.Sale to a financial buyer. This scenario typically involves a private equity firm paying all-cash for a controlling interest position. PE firms will usually want the founder to stick around for a couple of years after the deal but expect them to exit the business before they flip it to a new owner. Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or permanent) capital infusion. Most permanent capital investors are family offices that make minority investments in RIAs in exchange for their pro-rata share of future dividends. They typically allow the sellers to retain their independence and usually don’t interfere much with future operations. While this option typically involves less up-front proceeds and higher risk retention than the ones above, it is often an ideal path for owners seeking short-term liquidity and continued involvement in this business.Internal transition to the next generation of firm leadership. Another way to maintain independence is by transitioning ownership internally to key staff members. This process often takes significant time and financing, as it’s unlikely that the next generation is able or willing to assume 100% ownership in a matter of months. Bank and/or seller financing is often required, and the entire transition can take 10-20 years depending on the size of the firm and interest transacted. This option typically requires the most preparation and patience but allows the founding shareholders to handpick their successors and future leadership.Combo deal. Many sellers choose a combination of these options to achieve their desired level of liquidity and control. Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer. Proper succession planning needs to be tailored, and all these options should be considered. If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning. You will have a leg up on your competition that’s probably not prioritizing this. You’ve likely spent your entire career helping clients plan for retirement, so it’s time to practice what you preach. Please stay tuned for future posts on this topic and give us a call if you are ready to start planning for your eventual business transition.

Major Acquisitions of Alternative Asset Managers Signal Continued Outperformance

As we wrote in our most recent investment manager sector highlight, Public Alt Asset Managers Have Nearly Doubled in Value Over the Last Year, alternative asset managers have outperformed all other investment manager sectors in the RIA post-pandemic rebound. According to Institutional Investor, eight of the world’s ten largest investment management firms by market capital are now alternative asset managers. Most notably, the private equity firm Blackstone surpassed the world’s largest investment management firm by AUM, Black Rock, as the most highly valued stand-alone investment management firm back in September of this year.The demand for investment management firms continues to reach new highs and has culminated in a number of prominent acquisitions over the past year. In the past month alone, three deal announcements of alternative asset managers by larger, traditional asset management firms and diversified financial institutions suggest the sector remains bullish.Franklin Templeton to acquire Lexington Partners acquisition – Nov. 1, 2021. At the time of the announcement, Lexington Partners managed $34.0 billion in AUM primarily in secondary private equity investments and co-investment funds. The deal marks Franklin Templeton’s second private equity acquisition in the past three years after acquiring Benefit Street Partners in 2019.T. Rowe Price to acquire Oak Hill Advisors – Oct. 28, 2021. The alternative credit provider, Oak Hill Advisors, currently manages about $52.0 billion in AUM. The $4.2 billion acquisition marks T. Rowe Price’s first in more than a decade.Macquarie Asset Management to acquire Central Park Group – Oct 21, 2021. Central Park Group is a private equity and real estate investment firm located in New York and has AUM of approximately $3.5 billion.Demand Drivers for Alternative Assets vs. Demand Drivers for Alternative ManagersThe deals listed above are indicative of strong demand for both alternative assets and the firms that manage them. While the niche investment expertise and narrow market presence of alternative asset management firms can sometimes complicate transactions, traditional investment managers are nevertheless finding value in the alternative asset management models which have proven to be highly profitable, resilient, and may be bolted on to existing asset management teams. Below, we look at several factors driving investor demand for alternative assets and for alternative asset management firms.Alternative Asset Demand & Performance Drivers:A low yield environment. When interest rates fall, investors are encouraged to take higher degrees of risk to maintain prior levels of return. Certain alternative assets such as private equity and venture capital are generally considered higher risk, higher reward investments. Interest rates have remained at historic lows since the Great Recession and dipped further during 2020.Heightened volatility. In times of heightened market volatility, investors flock to real assets and private equity which is less prone to price swings. Additionally, certain options-heavy investment firms are also positioned to benefit as the volatility on the underlying is directly related to the options value. The historic market volatility throughout the pandemic era has benefited hedge fund performance and left investors flocking to “safer” asset classes.Robust exit activity. While markets have been exceedingly volatile over the past year and a half, they have more than recovered from the lows at the onset of the pandemic. Asset inflation has run rampant, particularly in the private equity and venture capital space which is now well positioned to benefit from strong exit activity in the coming years.Inflation. According to data from Trading Economics, annualized inflation in October 2021 was 6.2%, the highest level in decades. Certain alternative asset classes are widely considered to be inflation hedges. Real assets such as commodities and private real estate traditionally outperform in times of high inflation because returns are tied to capital appreciation.Demand Drivers for Alternative Asset Manager Acquisitions:Positive Fund Flows. According to PWC’s midyear outlook for private equity, investor appetite for private equity has outpaced traditional investment manager fund flows over the past five years. Sector AUM increased nearly 20% in 2020 alone, and the trend seems to be gaining momentum. Currently, PE dry powder is at an all-time high at $150.1 billion, which is reflective of strong fundraising and investor demand.Fees. Alternative asset managers seem to be somewhat immune to fee compression which has been one of the strongest headwinds for asset management for over a decade. The widespread consensus among money managers is that alternative assets justify premium fees due to purported diversification benefits, higher return, and expertise needed to execute such strategies. The opaque nature of the investment strategies and asset classes employed by alternative asset managers may also help these firms avoid fee compression.Diversification. Implicit in most asset management models is operating leverage. Because revenues are directly tied to the performance of the market and expenses remain somewhat fixed to compensation and overhead, diversifying firm exposure by broadening product offering may smooth out the bottom line. For this reason, alternative asset management firms can make strong acquisition targets for traditional asset managers. While fund flows may taper off if systemic tailwinds subside, alternative asset managers will likely remain strong acquisition targets for traditional asset managers due to diversification benefits and superior fees. Additionally, demand for alternative asset managers from other financial institutions such as banks and insurance companies looking to gain exposure to the investment space will also likely remain strong.

EV Start-Up Rivian IPOs at Valuation of $86 Billion

What It Means for Ford, Other OEMs, and Auto Dealers

The stock market is near record highs despite the global economy still working on climbing out of a once-in-a-century pandemic. A couple of themes for high-flying equities are ESG and companies that have yet to turn a profit. Rivian Automotive takes this a step further, as its prospectus indicates it will lose $1.28 billion in the third quarter while revenue will range from $0 to $1 million. However, as of its opening price, Rivian is already worth more than Ford and GM. From a valuation perspective, all the value is clearly placed in the terminal value with minimal production to date.Amazon and Ford are backing the electric vehicle startup, and investors are clearly betting the company can grab a meaningful amount of the burgeoning EV market. Rivian has beat Tesla, GM, and Ford to market with a fully electric pickup truck, the R1T. While this is expected to launch in December, it remains to be seen how meaningfully the company can scale production—if it can’t, being first may not mean much.Rivian indicates its factory in Illinois has the capacity to produce approximately 65,000 pickup trucks/SUVs and 85,000 commercial delivery vans, the latter of which is why Amazon is interested. Amazon owns 20% of Rivian and has ordered 100,000 Rivian vehicles to be delivered by 2030. Ford was also interested in collaborating on production for its EV business. The investment increased to become a meaningful part of Ford’s market capitalization, regardless of synergistic opportunities. However, on Friday, it was announced that Ford and Rivian had canceled their plans to jointly develop an EV.There are numerous potential reasons for this split, and Rivian indicated the decision to split was mutual. When Ford invested in Rivian in 2019, it was likely viewed as a way to jump-start its EV initiatives. Since then, Rivian’s production has been de minimis while Ford sold about 22,000 Mustang Mach E's alone in 2021, which was named Car and Driver’s Electric Vehicle of the Year. While Ford will continue to benefit from its investment in Rivian, it doesn’t “need” Rivian to be successful in EVs.Below, we have included a recent blog from my colleague Atticus Frank on Mercer Capital’s Family Business Advisory Services team, highlighting the decision to invest in Rivian from Ford’s perspective.Ford Motor Company (NYSE:F) is one of America’s most iconic brands. Did you also know they are still significantly led and run by the Ford family? One of the great-grandsons of founder Henry Ford, William Clay Ford Jr., leads the board of directors at Ford. Another great-grandson, Edsel II, is also on the board. Collectively, the Ford family holds enough Class B super-voting shares to elect 40% of the board of directors.A newer car maker, Rivian Automotive (NasdaqGS: RIVN), saw its IPO price the company at nearly $70 billion. Admittedly, my first thoughts are best reflected by an investor of “The Big Short” fame Michael Burry: speculation gone wild. Rivian is an electric vehicle (or “EV”) startup that has generated virtually no revenue. At the time of this writing (November 12, 2021), Rivian’s market capitalization was north of $127 billion, making it the second most valuable U.S. car maker behind Tesla. Rivian has made 156 vehicles, implying a cool $1 billion per vehicle delivered valuation. Those are numbers that would make Elon Musk blush. For perspective, Ford delivered over 5 million cars in fiscal 2019, or an implied $15,000 per car.As fate would have it, Ford has an effective 14.4% ownership interest in the electric car startup, giving it an implied stake of over $18 billion. Not bad, given its sub-$1 billion of invested capital. If one were to do a “back-of-the-envelope” sum of the parts valuation of Ford, Rivian now represents over 20% of Ford’s market capitalization. We don’t highlight the current irrational exuberance to spur you into investing in an EV startup or give you a case of ‘FOMO’, but to encourage us to think again about family business diversification, something we have written on previously. When thinking about diversification, it is helpful for family business owners to think about three questions: What, Who, and Why? What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. Suppose one asset in the portfolio takes a big hit. In that case, some other segment of the portfolio will likely perform well at the same time, thereby blunting the negative impact on the overall portfolio. A big question when considering diversification is a correlation: if what you are investing in is closely tied to your business currently, diversification benefits are blunted. The following example illustrates the two sides of the equation when diversifying expected returns and correlation. We note there is not a right answer to the investment choice example above ex-ante: That choice depends on who is investing and for what purpose (discussed in detail below). If you aim to maximize returns and have confidence in your industry, you would pick option #1. If you are more conservative or are not highly confident in your near-term outlook, you may likely choose #3. We discuss the who and why later in this article. When one thinks about Ford’s investment in Rivian, it appears the legacy car company took the middle road (some correlation, but higher expected return). Rivian is very much a car company, but one focused on electric vehicles. Initially, Ford invested in Rivian so the two would work together to develop a fully electric Lincoln. Ford has catapulted into the electric car space in recent years to much fanfare, with its Mustang Mach-E and F-150 Lighting, making its current investment in a certain light appear redundant, albeit lucrative. However, Ford considers Rivian a “strategic investment,” according to a spokesman’s comments to CNBC. “We’ve said that Rivian is a strategic investment and we’re exploring potential collaborations,” T.R. Reid said. “We won’t speculate about what Ford will do, or not, in the future.” What Ford decides to do with its very richly priced potential conflict-of-interest investment (competitor, plus Ford supplies certain parts to the startup) is yet to be seen. Diversification to Whom?Whose perspective is most important in thinking about diversification? As we have discussed in previous posts, a family business shareholder likely has a view on diversification within the company based on their own personal portfolio mix. For example, if the vast majority of a shareholder’s personal wealth (and income) is derived from the family business, that individual would likely be more concerned with the riskiness of the business overall and prefer more diversification within the company to ensure stability.Also, consider a well-diversified shareholder outside the family business, and their family business ownership represents a smaller allocation of their personal portfolio. That person would likely prefer to make their own diversification decisions (with dividends paid by the company) or prefer the company to make focused (undiversified) investment decisions to maximize expected returns.In the case of Ford, one wonders how the Ford family feels maintaining a heavy weighting in the new venture. The Ford family has considerable wealth outside their Ford stock stakes, lowering the need to maintain conservatism within Ford. The family may view the large EV car company stake as a distraction and prefer to make their own, if they so choose, large EV investments outside the business. This logic could lead to a sale or paring down of the stake. This would also allow Ford to utilize part of the proceeds and invest deeper in their own company efforts.Conversely, one could argue the ‘combustion engine’ is going the way of the Model T, and diversification into an electric vehicle company might be a way to stabilize company performance. The family may view the investment in the separate EV company as a ‘safety valve’ if Ford’s own EV efforts do not pan out. While it may partially distract from the core Ford mission, it could lead to more stable shareholder returns. Again, ‘who’ is experiencing diversification affects how the company will likely face this question in the future.Why Diversify?Family businesses often provide a different ‘who’ regarding diversification and a different ‘why’ to their publicly traded, non-family controlled counterparts. What the family business means to you impacts how you think about diversification decisions for the family business. Depending on what the business means to the family, the potential for diversification benefits (correlation, discussed above) may take priority over absolute return. There are no right or wrong answers regarding risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know the ‘why’ for significant investment decisions. How do you or the Ford family think about your family business meaning? If dividends were key for Ford, with meaning in the ‘lifestyle’ or ‘wealth accumulation’ buckets, a divesture of sorts might be appropriate to generate liquidity for investing in other uncorrelated assets or maintain the family’s lifestyle. But as discussed, Ford’s recent performance and prior move into the EV space has been a big splash for the legacy car giant. Keeping Rivian may be a sign that the family views Ford as the combustion (or electric) engine for future generations of the family and is willing to keep diversification within the company lower and not attempt to overly diversify outside it. Your family must decide its meaning as a business before you begin to think about diversification to provide the framework and context for coming to a big decision. Next StepsFamily business owners can take these three questions and apply them to their businesses. Remembering what diversification is and the importance of correlation, who are the stakeholders seeing the largest impact of diversification, and defining what the business means to you all can help guide the diversification question. Some next steps he has highlighted in The 12 Questions That Keep Family Business Directors Awake at Night include:Calculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures And if in the end, your diversification plans send you into uncharted territory or lead you to maintain the status quo, Mr. Henry Ford Sr. has quotes for both.“If I had asked people what they wanted, they would have said faster horses.”“Any customer can have a car painted any color that he wants so long as it is black.”Takeaways From RivianAuto dealers are unlikely to be able to invest in the next Rivian, but that doesn’t mean there are no lessons to be learned here. The market is clearly indicating it believes EVs are the future, so dealers should be positioning themselves accordingly. With heightened margins in 2021, auto dealers need to decide the best way to reinvest their capital. That may mean using profits earned in the past years and investing in infrastructure to support EVs. Local markets will still be necessary and there won’t be a one size fits all solution, but Rivian making headlines should get auto dealers thinking about what it means for them.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.In addition to auto dealers, Mercer Capital also provides financial education services and other strategic financial consulting to family businesses. Click here to learn more about our Family Business Advisory Services.

Family Business Director’s Top Ten Questions Not to Ask at Thanksgiving Dinner

For most of us, Thanksgiving is a time to disregard normal dietary restraint in the company of extended family members that one rarely sees. For some enterprising families, however, Thanksgiving quickly devolves from a Rockwellian family gathering to a Costanza-style airing of grievances. So, in the holiday spirit, we offer this list of the top ten questions not to ask at Thanksgiving dinner. If you have trouble distinguishing between the board room and the dining room, this list is for you.1. Why can’t I work in the family business?Nearly all family businesses welcome the contributions of qualified family members; however, having the right last name is not a sufficient condition of employment for successful family businesses. As families grow into the third and subsequent generations, family employment policies can become especially contentious. Crafting a workable family employment policy that specifies required qualifications and external work experience is often one of the first and most important tasks undertaken by a family council.2. Why does cousin Joe get such a big salary?This can be a great question, and it is quite possible that Joe is either under – or over – paid relative to his contribution as an employee. As family businesses grow, the board should carefully evaluate how compensation practices for family members compare to those for non-family members. Working in the family business should be neither indentured servanthood nor a sinecure. It is a job, and successful families treat it as such. Having one or more independent (non-family) board members can be a great way to ensure that compensation practices in the family business are fair.3. Why does cousin Sam get anything from the business?This question gets to the heart of many family business disputes we have witnessed: the belief that family members who don’t spend their lives working in the family business aren’t entitled to any distributions. Successful families are able to separate the return on labor (wages and benefits) from the return on capital (distributions). Just as the family members providing labor are entitled to market-based compensation, family shareholders are entitled to distributions if and when paid, even if they don’t work in the business. That’s simply what ownership is. It works that way for public company shareholders, and there’s really no reason to treat your family shareholders any differently.4. Why isn’t the shareholder redemption price higher?A shareholder liquidity program can be a great way to promote peace in the family. Even when a shareholder liquidity program exists, however, shareholders often don’t understand that the family business has more than one value. Which value is appropriate for a redemption program depends on the family dynamics and goals for the program.5. Why doesn’t the business pay a bigger dividend?Being wealthy is not the same thing as feeling wealthy. Many family shareholders are wealthy but don’t necessarily feel that way because dividends either aren’t paid or are only a token amount. Having a well-reasoned and easily-articulated dividend policy is an essential step in promoting family harmony and sustainability. Occasionally, founders and second-generation leaders withhold distributions simply on principle, even if the business has limited reinvestment opportunities. This rarely ends well.6. Why doesn’t the business invest more for the future?This is the flipside to the previous question. Funds that are distributed are not available to reinvest in the family business. A single dollar of earnings cannot be both distributed and reinvested – a choice is required. Making that choice wisely requires knowing what time it is for your family business. As the family grows biologically, it is natural to wonder if the family business will, or can, keep up. You have to sow before you can harvest.7. Why doesn’t the business borrow more money?Growth requires capital, and since family businesses rarely have an appetite for admitting non-family shareholders, that means debt may be the only way to fund important growth investments. Prudent amounts of leverage to help finance growth investments can actually help secure, rather than imperil, the family business’s future. But before borrowing money, directors should ask a few key questions.8. Why does the business have so much debt?Some shareholders fret about using too little leverage, while others worry about the risk of having too much debt. Over the long-run, the capital structure of your family business should reflect the risk tolerances and preferences of your family shareholders. The idea that you can financially engineer your way to a lower cost of capital (and therefore, higher value) for your family business through fine-tuning capital structure is over-rated. Capital structure determines how much risk and reward shareholders can anticipate, but does relatively little to influence the actual value of your family business.9. Why don’t we register for an IPO?There are examples of families that have taken their businesses public while retaining control over the board of directors. It’s not always a lot of fun. Despite retaining control, being public means inviting the SEC and other regulators to take a keen interest in your business. Even if your family keeps its eye on the long-run, Wall Street can take you on a wild ride based on the short run. Having publicly-traded shares may be what’s best for your family business, but it’s a big step and a really hard one to take back.10. Why don’t we sell the business?When is the right time to convert the illiquid wealth that is the family business into ready cash? A buyer might approach your family business with an offer that you weren’t expecting, or your family might decide to put the business on the market and seek offers. In either case, you only get to sell the business once, so you need to make sure you have experienced, trustworthy advisors in your corner. Selling the family business will not remove all the stresses in your family; in fact, it may add some.Of course, all of these are really great questions to be asking – the Thanksgiving dinner table is just not the right venue. This Thanksgiving, try setting business to the side for at least one day. Our advice: instead of talking about the family business, stick to a safer topic like politics. Above all, be thankful for the opportunity to be a family that works together.Happy Thanksgiving!

CAUTION: Railroad Crossing Ahead

Minimizing Costs vs. Meeting Demands

Supply chain bottlenecks are causing companies to switch their cargo transportation from rail to truck. According to research conducted by JLL Inc, aggregate demand for goods is still 15% above its levels in the fourth quarter of 2019, just before the pandemic lockdowns began. Suppliers have drastically increased the volume of their output in response to this demand, which, along with other issues, has clogged supply chains. Challenges in retaining drivers and acquiring new trucks and trailers have exacerbated this problem. One of the results of the tangled supply chains has been the shift from rail to road transportation.

Differing Perspectives on the Used Vehicle Market

Feast or Famine?

With Thanksgiving around the corner next week, we hope that everyone will be able to visit with family, share a meal with loved ones, and rekindle old traditions from holidays past. All of us are not immune from the headlines that speak to disruptions in the global supply chain on a daily basis. Undoubtedly, each of us has been inconvenienced with those supply shortages with consumer products, food, and essential goods that impact our daily lives. The automobile market is no different.In a previous blog, we examined several key indicators for the entire automobile market incorporating the first six months of data. In this weeks’ blog, we offer commentary on the status of the used vehicle market and re-examine some of those metrics through third quarter data. Headlines persist describing inventory shortages, record transaction prices, record profitability and predictions for when conditions will return to normal. How do we make sense of all of it? What factors are contributing to the current conditions? Like the larger automotive industry as a whole, conditions can be described as the best of times and the worst of times, or feast or famine. Interpretation of the conditions can differ depending on the perspective of the consumer or the auto dealer. We examine some of the key used vehicle metrics and indicators and then discuss how we got here and where we are headed.PricesFeast for the Auto Dealers, Famine for the ConsumerAccording to Cox Automotive, the average transaction price for a used vehicle topped $27,000 for the month of September. This figure represents the largest average transaction price for used vehicles on record and indicates a 25% increase from the average price of used vehicles just one year ago in September 2020. Most car buyers understand the historical notion that the value of a car depreciates immediately after you drive it off of the dealership lot. In 2021, this notion simply isn’t true for the time being. There are plenty of examples in the marketplace of used vehicles that are 1-2 years old with minimal miles (25-30K) that are selling for prices higher than the original sticker price of the new vehicle!Gross Profit Per Unit Used VehicleFeast for the Auto Dealers, Famine for the ConsumerOf the department/profit centers for an auto dealership, historically, the new and used vehicle departments accounted for the largest contribution to revenue, but a substantially lower contribution to overall gross profit. According to the Average Dealership Profile from NADA, these departments typically comprised approximately 88-90% of revenues and approximately 52% of gross profits, with the remainder coming from fixed operations. Currently, these departments still comprise a similar percentage of total revenues but now comprise 60% of gross profits. This figure continues to climb as of September 2021 as reported by NADA. What is driving this increase? Rising transaction prices for used vehicles and, in turn, increased gross profit per unit (GPU). The graphic below details the current used vehicle GPU and the corresponding figures from the prior two year-ends.Average Days’ Supply Used VehiclesFamine for Auto Dealers and the ConsumerWe’ve written about average days’ supply previously in this blog, but it serves as a key indicator of the level of supply, or in this case, the shortage of used vehicles in the market. Average days’ supply is calculated as the number of used vehicles in inventory or in the market divided by the average daily number of used vehicles sold. Historically, this figure ranged between 55 and 66 for 2019 and 2020, as seen in the graphic below. The average days’ supply for used vehicles has not slumped nearly as bad as the same metric for new vehicles and has shown signs of steadying to slight improvement.Source: Cox AutomotiveThrough the early spring of 2021 and through September, this same metric cratered at 33 and has steadily maintained or slightly improved to 43.Source: Cox AutomotiveSourcing – Where do Used Vehicles Come From?To help explain the forces behind these metrics, let’s examine where used vehicles are sourced. Historically, used vehicles from an auto dealer were purchased from one of four areas: customer trade-ins, off-lease vehicles, fleet cars, and auctions.Trade-Ins – With plant shutdowns, microchip shortages, and supply chain issues, the supply of new vehicle inventory has been more adversely affected than its used vehicle counterpart. Average days’ supply for new vehicles dipped into the low 20s and dropped even lower for many local auto dealers. With fewer new vehicles to purchase, the number of customer trade-ins are also lower simply due to transaction volume and inventory availability.Off-Lease – Off-lease vehicles refer to a vehicle returned to a dealer at the end of its lease. Generally, off-lease vehicles have been gently used and tend to have lower mileage. Why are less leased cars being returned to the dealer? Most lease contracts have a clause where the consumer can purchase the vehicle at the end of the lease for a residual value. In most cases, the residual value is lower than the original value of the vehicle to reflect the depreciation of value.As discussed earlier, the value of used vehicles is at/near record highs. Many vehicles have a current value greater than the anticipated residual value stated in the original lease contract. Customers with leases face two choices: purchasing their vehicle for the residual value or returning the vehicle to the dealer at the end of the lease. Facing the inventory shortage conditions on both new and used vehicles and the prospect that the current value of their vehicle is greater than the residual value, most consumers are choosing to purchase the vehicle at the end of the lease. While others may purchase their leased vehicle and sell immediately to realize the arbitrage opportunity between the current value and residual value, most then face the prospect of locating and purchasing a more expensive vehicle. In either case, fewer off-lease vehicles are re-entering the used vehicle market.Fleet Cars – Fleet cars represent those vehicles sold to rental car companies, government agencies, or larger customer accounts. The trends affecting the current condition and the overall life cycle of these cars date back to the early days of the pandemic. In the Spring of 2020 with the advent of lockdowns and travel restrictions, rental car companies sold off much of their inventory which hit the used vehicle market at that time. Flash forward to the next 18 months that were characterized by plant shutdowns and lower sales by the OEMs in 2020, and then further inventory shortage issues caused by the lack of microchips and other factors in 2021.Historically, OEMs and the industry operated on an average days’ supply of new vehicles between 60-75. OEMs and auto dealers prioritized fleet sales with the extra inventory, as these contracts typically consisted of lower margins despite higher volumes. With the excess inventory being removed from the market, OEMs and auto dealers are now prioritizing direct consumers with the available inventory because they can achieve higher margins and offer fewer incentives. Fleet sales, and specifically rental car companies, have never been able to fully replenish their inventories. In turn, rental car companies no longer possess aging inventory that generally would get replaced and sold back into the used vehicle market. As a consequence, some rental companies are seeking to source their own used vehicles from auto auctions.The graphic below depicts total fleet sales from January through September for 2019, 2020, and 2021 as reported by Cox Automotive. While total fleet units are up slightly in 2021 from the same period in 2020, this figure is misleading when viewed in the context of more normal fleet sales in 2019. In fact, current year-to-date fleet sales are down nearly 41% over 2019 figures.Source: Cox AutomotiveAuto Auctions – Auto auctions are another source of used vehicles. The presence of auto auctions is also circular to the life cycle of the automobile. Auction cars come from various sources, including local car dealers, private sellers, police impounds, and bank repossessions. As detailed earlier in this post, the volume derived from the first two events has decreased simply due to the lack of overall transactions. Current economic conditions and forgiveness or grace periods have also led to fewer vehicles from the latter two events. If auto auctions are obtaining fewer cars, then auto dealers have fewer cars to potentially source from the auto auctions and the cycle and shortages continue.Predictions and ConclusionHow long can the good times (record profitability and margins) continue for the auto dealers and when will the bad times end for the consumer (high transaction prices and inventory shortages)? The simple answer is that they won’t continue like this forever, but no one knows when they will end. Many industry experts predict that the prevailing inventory and microchip shortages on the new vehicle side could last well into the first half or for the entire year in 2022 and beyond and will impact the used vehicle market for much of that time.For the used vehicle market, analysts at Black Book are predicting retail sales for the remainder of 2021 will equal or eclipse the levels for the same time period in 2019. Some analysts believe profit margins and transaction prices for used vehicles are already showing signs of moderating, despite some of those metrics still peaking. As a backdrop, 2019 is often considered by many as the best year ever for retail sales of used vehicles.For an understanding of how your dealership is performing along with an indication of what your dealership is worth amidst all of the noise, contact a professional at Mercer Capital to perform a valuation or analysis. Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by economic, industry, and financial performance factors.

Built Ford “Family” Tough

Ford, Rivian, and Lessons on Family Business Diversifications

Ford Motor Company (NYSE:F) is one of America’s most iconic brands. Did you also know they are still significantly led and run by the Ford family? One of the great-grandsons of founder Henry Ford, William Clay Ford Jr., leads the board of directors at Ford. Another great-grandson, Edsel II, is also on the board. Collectively, the Ford family holds enough Class B super-voting shares to elect 40% of the board of directors.A newer car maker, Rivian Automotive (NasdaqGS: RIVN), saw its IPO price the company at nearly $70 billion. Admittedly, my first thoughts are best reflected by an investor of “The Big Short” fame Michael Burry: speculation gone wild. Rivian is an electric vehicle (or “EV”) start-up that has generated virtually no revenue. At the time of this writing (November 12, 2021), Rivian’s market capitalization was north of $127 billion, making it the second most valuable U.S. car maker behind Tesla. Rivian has made 156 vehicles, implying a cool $1 billion per vehicle delivered valuation. Those are numbers that would make Elon Musk blush. For perspective, Ford delivered over 5 million cars in fiscal 2019, or an implied $15,000 per car.As fate would have it, Ford has an effective 14.4% ownership interest in the electric car start-up, giving it an implied stake of over $18 billion. Not bad given its sub-$1 billion of invested capital. If one were to do a "back-of-the-envelope" sum of the parts valuation of Ford, Rivian now represents over 20% of Ford’s market capitalization. We don’t highlight the current irrational exuberance to spur you into investing in an EV start-up or give you a case of ‘FOMO', but to encourage us to think again about family business diversification, something we have written on previously. When thinking about diversification, it is helpful for family business owners to think about three questions: What, Who, and Why? What Is Diversification?Diversification is simply investing in multiple assets as a means of reducing risk. Suppose one asset in the portfolio takes a big hit. In that case, some other segment of the portfolio will likely perform well at the same time, thereby blunting the negative impact on the overall portfolio. A big question when considering diversification is correlation: if what you are investing in is closely tied to your business currently, diversification benefits are blunted. The following example illustrates the two sides of the equation when diversifying expected returns and correlation. We note there is not a right answer to the investment choice example above ex-ante: That choice depends on who is investing and for what purpose (discussed in detail below). If you aim to maximize returns and have confidence in your industry, you would pick option #1. If you are more conservative or are not highly confident in your near-term outlook, you may likely choose #3. We discuss the who and why later in this article. When one thinks about Ford’s investment in Rivian, it appears the legacy car company took the middle road (some correlation, but higher expected return). Rivian is very much a car company, but one focused on electric vehicles. Initially, Ford invested in Rivian so the two would work together to develop a fully electric Lincoln. Ford has catapulted into the electric car space in recent years to much fanfare, with its Mustang Mach-E and F-150 Lighting, making its current investment in a certain light appear redundant, albeit lucrative. However, Ford considers Rivian a “strategic investment,” according to a spokesman’s comments to CNBC. “We’ve said that Rivian is a strategic investment and we’re exploring potential collaborations,” T.R. Reid said. “We won’t speculate about what Ford will do, or not, in the future.” What Ford decides to do with its very richly priced potential conflict-of-interest investment (competitor, plus Ford supplies certain parts to the start-up) is yet to be seen. Diversification to Whom?Whose perspective is most important in thinking about diversification? As we have discussed in previous posts, a family business shareholder likely has a view on diversification within the company based on their own personal portfolio mix. For example, if the vast majority of a shareholder’s personal wealth (and income) is derived from the family business, that individual would likely be more concerned with the riskiness of the business overall and prefer more diversification within the company to ensure stability.Also, consider a well-diversified shareholder outside the family business, and their family business ownership represents a smaller allocation of their personal portfolio. That person would likely prefer to make their own diversification decisions (with dividends paid by the company) or prefer the company to make focused (undiversified) investment decisions to maximize expected returns.In the case of Ford, one wonders how the Ford family feels maintaining a heavy weighting in the new venture. The Ford family has considerable wealth outside their Ford stock stakes, lowering the need to maintain conservatism within Ford. The family may view the large EV car company stake as a distraction and prefer to make their own, if they so choose, large EV investments outside the business. This logic could lead to a sale or paring down of the stake. This would also allow Ford to utilize part of the proceeds and invest deeper in their own company efforts.Conversely, one could argue the ‘combustion engine’ is going the way of the Model T, and diversification into an electric vehicle company might be a way to stabilize company performance. The family may view the investment in the separate EV company as a ‘safety valve’ if Ford’s own EV efforts do not pan out. While it may partially distract from the core Ford mission, it could lead to more stable shareholder returns. Again, ‘who’ is experiencing diversification affects how the company will likely face this question in the future.Why Diversify?Family businesses often provide a different 'who' regarding diversification and a different 'why' to their publicly traded, non-family controlled counterparts. What the family business means to you impacts how you think about diversification decisions for the family business. Depending on what the business means to the family, the potential for diversification benefits (correlation, discussed above) may take priority over absolute return. There are no right or wrong answers regarding risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know the 'why' for significant investment decisions. How do you or the Ford family think about your family business meaning? If dividends were key for Ford, with meaning in the ‘lifestyle’ or ‘wealth accumulation’ buckets, a divesture of sorts might be appropriate to generate liquidity for investing in other uncorrelated assets or maintain the family’s lifestyle. But as discussed, Ford’s recent performance and prior move into the EV space has been a big splash for the legacy car giant. Keeping Rivian may be a sign that the family views Ford as the combustion (or electric) engine for future generations of the family and is willing to keep diversification within the company lower and not attempt to overly diversify outside it. Your family must decide its meaning as a business before you begin to think about diversification to provide the framework and context for coming to a big decision. Next StepsFamily business owners can take these three questions and apply them to their businesses. Remembering what diversification is and the importance of correlation, who are the stakeholders seeing the largest impact of diversification, and defining what the business means to you all can help guide the diversification question. Some next steps he has highlighted in The 12 Questions That Keep Family Business Directors Awake at Night include:Calculate what portion of the family’s overall wealth is represented by the family businessIdentify the three biggest long-term strategic threats to the sustainability of the existing family business operationsEstablish a family LLC or partnership to hold a portfolio of diversifying assets (real estate, marketable securities, etc.)Create opportunities to provide seed funding to family members with compelling ideas for new business ventures And if in the end, your diversification plans send you into uncharted territory or lead you to maintain the status quo, Mr. Henry Ford Sr. has quotes for both. “If I had asked people what they wanted, they would have said faster horses.” “Any customer can have a car painted any color that he wants so long as it is black.”

How Does Your RIA’s Client Base Affect Your Firm’s Value, and What Can You Do To Improve It?

We’re often asked by clients what the range of multiples for RIAs is in the current market. At any given time, the range can be quite wide between the least attractive firms and the most attractive firms. The factors that affect where a firm falls within that range include the firm’s margin, scale, growth rate of new client assets, effective realized fees, personnel, geographic market, firm culture, and client demographics (among others).In this post, we focus on the client demographics factor, explain how buyers view client demographics and explore steps some firms take to reach a broader client base.Client relationships are one of the most significant assets that RIAs possess, and maintaining and profitably servicing these client relationships is key to an RIA’s financial success. In a transaction context, the strength of an RIA’s client relationships and the demographics of the client base can have a significant bearing on the multiple buyers will be willing to pay for the firm. An RIA’s outlook for future asset growth can be significantly impacted based on factors such as expected client retention, which stage current clients are at in terms of wealth accumulation (are they withdrawing assets or contributing assets), and the prospect for future liquidity events within the client base.Client relationships are one of the most significant assets that RIAs possess.Many of these factors can be proxied by the age profile of the client base. For most RIAs, the age of the client base tends to skew older (particularly on an asset-weighted basis) simply due to the fact that older clients generally have more assets. Decades of compounding returns can create some very large accounts for older clients, and the RIA can profitably service these accounts. However, with an older client base, the asset base usually declines as these individuals withdraw, rather than contributing additional funds. And, of course, the remaining life expectancy for older clients is less. As such, the age profile of the client base is a key area of inquiry for many buyers.Because an older average client base tends to suggest headwinds for future asset growth, an older client base is generally seen as a negative (all else equal) from a valuation perspective. In general, the younger the client base, the better the outlook for future asset growth and the higher multiple the firm commands. RIAs can expand their reach to a younger client demographic by focusing on retaining assets to the next generation and positioning themselves to appeal to a younger client demographic.Retaining Assets To Next GenerationIn general, RIAs are not particularly successful at retaining assets to the next generation. According to Cerulli, more than 70% of heirs are likely to fire or change financial advisors after inheriting their parents’ wealth. However, firms that prioritize engaging and developing relationships with next-generation family members today can significantly improve asset retention once the assets are transferred from the current client to the next generation. The earlier this is done, the better the chance at retaining assets into the next generation.Focusing on asset retention today is particularly important, given that more than $70 trillion is expected to transfer from older generations to heirs or charities by 2042. RIAs that can capture or retain these assets as they transfer to younger generations will have a competitive advantage against those that cannot.Attracting Younger ClientsA recent Wall Street Journal article highlighted the struggle many advisory firms face in attracting younger clients. See Rich Millennials to Financial Advisers: Thanks for the Golf Invite, but You Can’t Invest My Money. As the article suggests, many younger clients are electing to manage their own assets rather than hire a traditional financial advisor. While DIY investment management is popular among younger clients, many see this preference as temporary. Once these clients reach an asset or life stage threshold where their financial lives become more complicated, it’s anticipated that the need for traditional, personalized advice will increase.While attracting younger clients can be difficult, there are several strategies RIAs can use to position themselves to capture this emerging client segment. For one, RIAs should recognize that investment expertise is table stakes for attracting younger clients. These clients are often looking for financial coaching and holistic financial advice that goes beyond simple asset allocation. By offering these “soft” services in addition to traditional investment management, RIAs are better positioned to win younger clients.RIAs can also attract younger clients by hiring younger advisers. Anecdotally, advisers tend to attract clients within plus or minus ten years of their own age. Thus, having a broader age range of advisors can unlock younger client segments (and also contribute to the stability and continuity of the firm).RIAs can also attract younger clients by hiring younger advisers.RIAs can also revaluate which marketing strategies they are using to appeal to younger client demographics. As the WSJ headline suggests, golf invites have fallen by the wayside for most younger clients. While referrals and word of mouth are the traditional sources for new clients, having a strong online presence and digital marketing strategy is critical for attracting a younger client demographic.In order to effectively service accounts for a younger client demographic, RIAs may also want to reevaluate how they determine fees for these accounts. While the traditional percentage of AUM model works well for many clients, RIAs may find this model difficult to apply to a younger client demographic. For individuals still in the prime of their working career, it’s not uncommon to see a significant amount of their net worth tied up in privately held companies. The value of these assets is not generally included in AUM, and thus does not generate fee revenue. Other clients may have significant incomes and financial planning needs, but have not yet accumulated an asset base significant enough for an RIA to profitably service the account using a traditional percentage of AUM model. Many firms that have been successful at attracting a younger client demographic can offer alternative pricing arrangements to account for situations such as these.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

Charting the Course of the <i>Build Back Better</i> Bill

Charting the Course of the Build Back Better Bill

By this Thanksgiving, Congress hopes to pass two of the largest bills in American history, the $1 trillion infrastructure bill (which was signed into law by President Biden on November 15th) along with a $1.75 trillion Build Back Better bill. While the infrastructure bill made it through Congress with minimal tax hikes, the passing of the larger reconciliation bill may still create sweeping changes to American tax policy, specific to high-net-worth individuals.Over the past several months, numerous tax code changes have been proposed to fund the two bills, and concessions have whittled away some of the more drastic proposals that made headlines back in the Spring of 2021. In this article, we look to address what policies are still on the table, which are most likely to pass, and what the implications for their passing might be.The Unfolding of Biden’s Economic AgendaOn March 31, 2021, the Biden administration proposed The American Jobs Plan which outlined $1.7 trillion in infrastructure investment targeting a number of projects such as public drinking water, renewed electric grid, high-speed broadband, housing, educational facilities, veteran hospitals, and job training programs among various other projects. The Made in America Tax Plan was proposed simultaneously with the American Jobs Plan as a source of funding. The plan enumerated on several proposed increases to individual and corporate tax rates as well as various other reforms. Some of which have found their way into current legislative efforts. On April 28, 2021, President Biden proposed an additional spending plan, The American Families Plan, targeting “social infrastructural” works such as universal pre-school, universal two-year community college and postsecondary education (since dropped), childcare, paid leave (also has been dropped), nutrition, unemployment insurance, as well as various tax cuts to low-income workers. The Plan also outlined extensive tax reform directly targeting high income earners: setting capital gains and dividend taxes equal to taxes on wages and increasing tax rates on the top tax bracket from 37% to 39.6%. The sticker price of the American Families Plan was set at $1.8 trillion, with $1 trillion in direct government investment and the remainder in tax breaks. On May 28, 2021, the Biden Administration further elaborated on his economic agenda in the unveiling of the 2022 fiscal budget plan to Congress alongside the Treasury Department “Green Book.” On August 10, 2021, the Senate approved the $1.2 trillion infrastructure bill with bi-partisan support after months of debate. The bill includes many of the hard infrastructure objectives outlined in Biden’s American Jobs Plan. On the same day, a 100-member Congressional Progressive Caucus declared that it would refuse to vote for the bill before the larger reconciliation bill was passed in the Senate, despite overwhelming popularity of the infrastructure bill in Congress and in polling. In prioritizing Biden’s “soft infrastructure proposals” as specified in the reconciliation bill, Progressives effectively tied the fate of both the infrastructure and reconciliation bill in ongoing negotiations. On August 24, 2021, the House Democrats approved a $3.5 trillion budget resolution which set in motion the reconciliation process by which Democrats could potentially sign the budget into law, requiring only a majority approval while circumventing an inevitable filibuster from Republicans in the Senate. The same measures were taken by the Republican Party with the passing of the American Tax Cuts and Jobs Act in 2017. Support from all 50 Democratic Senators and all but a handful of House Democrats would be needed to pass the legislation as objections from Republicans are widely expected. The budget resolution has since been negotiated down to a $1.9 trillion dollar package. On September 12, 2021, the House and Ways Committee released a revised draft of the tax changes proposed as part of the budget reconciliation bill. Specific tax increases largely targeted trusts and estates and carried significant implications for gift and estate tax planning. On September 27, 2021, under pressure from both moderates and progressives, Speaker of the House, Nancy Pelosi originally scheduled the House vote for the infrastructure bill for September 27th. But without the passing of the budget resolution bill, and therefore the support of Progressives, Nancy Pelosi postponed the House vote to extend negotiations. In doing so, ongoing government funding was jeopardized without a fiscal 2022 budget and government debt neared the self-imposed debt ceiling. On September 30, 2021, the last day of the federal calendar, Congress narrowly avoided a government shut down by passing a temporary package funding the government through December 3, 2021 while the House suspended the debt ceiling through December 2022. The increase in the debt ceiling is widely expected to be rejected by Senate Republicans. On October 21, 2021, the New York Times reported, Arizona Senator Krysten Sinema, would refuse to vote to support any increases in corporate or individual tax rates. The opposition came as a surprise to many and left the Democratic party scrambling to secure funding for the Build Back Better Bill from other avenues. On October 28, 2021, President Biden unveiled a $1.75 trillion framework for the Build Back Better social spending bill, a draft of the legislation quickly followed. The announcement was released moments before Mr. Biden departed for Rome followed by Glasgow for the 2021 United Nations Climate Change Conference. On November 8, 2021, the $1 trillion infrastructure bill passed in the House with bipartisan support after months of debate among members of the Democratic party looking to pass the Build Back Better bill before sending the infrastructure bill to a vote. On November 15, 2021, the $ 1 trillion infrastructure bill was signed into law by President Biden.Proposals, Negotiations, Amendments, and More ProposalsBiden’s historically ambitious proposals made earlier in the year have since been trimmed by months of negotiations with more conservative members of the Democratic party. Most notably Joe Manchin of West Virginia and Krysten Sinema of Arizona have criticized the size of the bill, the tax hikes required for funding the bill, and the speed and process by which the party hopes to pass such landmark legislation. In efforts to gain the support of these two senators, and thereby achieve the unanimous support needed for the reconciliation, Democratic leaders have floated numerous tax proposals in recent months to fund the bill.While many of the tax change proposals outlined in the House and Ways Committee draft for the reconciliation bill were not included in the most recent framework published by the Biden Administration on October 29, 2021, many believe the policies outlined in mid-September may still be in play as negotiations continue amongst the conservative and progressive members of Congress. It is widely believed that the intent behind some of the initial funding proposals outlined by the Biden administration and later incorporated in the House and Ways Committee draft were beyond economics and were intended to combat “wealth inequality” and disparities in effective corporate tax rates.As reported in an article from CNBC, none of the three major holdouts, Joe Manchin, Krysten Sinema, or Bernie Sanders, have committed to supporting the framework as it stands. As many of the initial social spending policies have been cut, including most recently the federal paid family and medical leave proposal, uncertainty remains surrounding the scope of the bill and the funding it will require.Tax changes proposed in the House and Ways Committee draft were numerous, albeit less drastic than those considered earlier in the year. A comprehensive summary of the funding provisions can be found here. Key tax reforms specific to closely held businesses include the following:A reduction in the estate and gift tax exemption effectively reducing the exemption from $11.7 million to $6.0 million per individual.A change in the tax status of grantor trusts. Grantor trusts would be included in the grantor’s taxable estate, and transactions between grantor and a grantor trust would be subject to income tax.Discounts for lack of control and marketability would be disallowed for gifts of entities holding non-business assets such as asset holding entities.An increase in the individual income tax for the top tax bracket from 37% to 39.6%, essentially reversing tax reductions established in the 2017 Tax Cuts and Jobs Act, also passed via the reconciliation processAn increase in the maximum long term capital gains rate to 25% from the current rate of 20%. The effective date was set at September 13, 2021.Elimination of exemptions to the net investment income tax for active participants in the business, which applies a 3.8% tax to a taxpayer’s net investment income when adjusted gross income exceeds a certain threshold. Currently, income earned from active participants in the business is exempt.Limitations on the qualified business income deduction (QBID). The deduction would be subject to a cap once qualified business income exceeds $2.5 million for married couples filing jointly, $2.0 million for single filers, $1.3 million for married taxpayers filing separately, and $50.0 thousand for trusts and estates.Reimplementation of the graduated corporate income tax rate structure. In 2017, the Tax Cuts and Jobs Act established a flat rate of 21%. The proposal would restore the graduated rate structure: < $400 thousand : 18% $400 thousand $5 million : 21% (the current rate)$5 million : 26.5%What Made it into the Biden Framework for the Build Back Better Bill?Because of recent opposition from conservative members of Congress, many of the proposed tax reforms recommended in the House and Ways Committee draft back in September were not included in Biden’s Build Back Better framework issued October 28. Funding proposals for the Build Back Better bill issued in Biden’s most recent draft included the following:A 15% minimum tax on corporations based on 15% of adjusted financial statement (book) income rather than recognized income. The tax increase was proposed as an alternative to propositions made earlier in the year to increase the corporate tax rate to 28%.A 1% surcharge on corporate stock buybacks.A separate 15% global minimum tax on corporate profits earned abroad along with a penalty rate for foreign corporations based in non-compliant countries. The proposal comes after the U.S. led negotiations earlier in the year among G20 leaders in adopting a minimum 15% corporate tax rate along with other restrictive reforms.New surtax on multi-millionaires and billionaires.Close Medicare self-employment tax loophole.Continue limitation on excess business losses. The new surtax on multi-millionaires and billionaires is intended to replace numerous other proposals to tax high income individuals such as: a rate increase to the top tax bracket, taxing unrealized gains annually, a wealth tax, taxing unrealized capital gains at death, and ending the practice of stepped-up in basis. The surtax is set to add an additional 5% tax on income exceeding $10 million and an additional 3% tax on income exceeding $25 million. While perhaps not too different than levying additional income taxes, the surtax was agreed upon after Krysten Sinema refused to support increases to income tax rates on high earners. While the most recent draft still targets high income individuals and corporations, most of the significant tax changes have been avoided for now. Avenues for gift and estate planning and taxes related to closely held businesses were largely spared in the recent proposal. For now, it appears that there will be no changes made to the step-up in basis, reduction in estate and gift taxes, the application of marketability and control discounts, income tax rates on the top tax bracket, capital gains tax rates, or changes in the qualified business income deductions.Forward Looking ExpectationsMuch like the Infrastructure bill, which gained bipartisan support via not drastically changing the tax code, the Build Back Better bill may make it to the final yard line without incorporating the vast majority of major tax changes proposed earlier in the year or during the negotiations in recent months. The outline and proposals set forth represent the closest framework for consensus among the Democratic party, and tax proposals put forth have been forged by nearly a year of debate among party members. However, in no way is the recent draft set forth by President Biden final.Much uncertainty still remains regarding the draft’s support from the party’s more progressive and conservative members. If the recent months have taught us anything, with a bill this large, funding measures are liable to shift upon further negotiations. Regardless, many expect the bill to be put to a vote within weeks.Mercer Capital will continue to monitor any changes to the tax code and report on how they may affect our clients. In the meantime, to discuss a valuation need in confidence, please don’t hesitate to contact us.

Themes from Q3 Earnings Calls

Part 1: E&P Operators

In Part I of our Themes from Q2 Earnings, an overarching narrative was an oil and gas industry reaching a relatively steady operational state, with efficiencies offsetting cost inflation and helping lead to growth in free cash flow despite the tumultuous past 18 to 24 months. These factors allowed most E&P operators to deleverage, and in some cases, also resume or increase their return of capital (either via dividends or share buybacks) to shareholders. In the latest earnings calls, these themes continue as the primary focus as we head towards year-end 2021. Some of the talking points in the Q3 earnings calls continue on the same trajectory as in Q2, such as maintaining capital discipline with flat or low growth in production volumes. However, there was more variance in the latest round of calls regarding E&P operators' possible approaches to fortify their value proposition to shareholders.Natural Gas ExportsAs noted in our recent blog post regarding natural gas prices and production levels, demand for U.S. LNG exports from European and Asian (primarily China) markets have resulted in elevated prices for natural gas despite the relatively high level of gas production coming from U.S. basins. This particular topic came up in several of the Q3 calls."We've talked in the past about the nearly 550,000 barrel a day increase in petchem demand in China from 2021 to 2023 and over 110,000 barrels a day of European and North American PDH growth during that same time period. What many did not anticipate was the global pressure for hydrocarbons this fall and winter that resulted in elevated LNG prices in Europe and Asia. This is driving additional demand for LPG in these markets through its use in industrial heating and power applications in lieu of today's high cost of natural gas. On a BTU equivalent basis, LPG is nearly half the price of LNG delivered in the Far East markets. The impact from this incremental demand for LPG is a widening export arb." – David Cannelongo, Vice President of Liquids Marketing & Transportation, Antero Resources"We're going to continue to look at new opportunities from an LNG standpoint and are very well-positioned. Again, it gets back to our transport, our export capacities, and just having that ability to transact, we can definitely be very nimble as we think about new opportunities." – Lance Terveen, Senior Vice President – Marketing, EOG ResourcesMany Paths to the Value PropositionPerhaps the most significant divergence in the Q3 E&P operator calls compared to the Q2 calls stemmed from how the management teams viewed their value proposition to shareholders. Global energy prices were shaken in early 2020 with the onset of the COVID-19 pandemic, with prices retreating further when the discussions regarding renewal of the OPEC+ production/price cooperation pact, a 3-year plan that was set to expire at the end of Q1 2021, fell apart as Moscow refused to support Riyadh's demand for additional production cuts. As energy prices recovered amid a background of heightened uncertainty in the global economic and financial markets, E&P operators tightened their belts and took this opportunity to enact highly disciplined capital programs in order to extract greater free cash flow from flat production levels.For some companies, the value proposition to shareholders remains focused on either increasing the intrinsic value per share via share repurchases or returns to shareholders through dividend programs."As we continue to trade at a material discount to our intrinsic per share value as we see it, we steadily increased our attention on share count reduction. And Q3 was a good example of this. Approximately 60% of free cash flow was returned to shareholders in the form of buybacks. We continue to see a significant opportunity to retire additional shares in what we believe to be currently attractive prices. And as a result, on October 25, earlier this week, the Board has increased our share repurchase authorization by $1 billion, now having a sizable share repurchase authorization at our disposal." – Nicholas Deluliis, President & CEO, CNX Resources"I don't want to get ahead of my Board, but I would say at Murphy, we're more tuned to dividend and getting our dividend back. We're a dividend payer for 60 years. And that would be best for us. And, of course, a variable dividend, I suppose, can come into that mix. And I would say at this share count, that would be the basis today." – David Looney, CFO, Murphy Oil For other E&P operators, the name of the game moving forward is flexibility to deliver returns to shareholders through share repurchases and dividend programs."In mid-September, our Board approved a $2 billion share repurchase program. After that announcement, we repurchased over 268,000 shares at an average share price of $82 for a total cost of $22 million in the third quarter. If we do not repurchase enough shares in the quarter to equal at least 50% of free cash flow for that particular quarter, then we will make our investors whole by distributing the rest of that free cash flow via a variable dividend. This strategy gives us the ability to be flexible and opportunistic when distributing capital above and beyond our base dividend, but importantly, at least 50% of free cash flow will be returned." – Travis Stice, CEO, Diamondback Energy Perhaps most interestingly, a handful of companies cited additional sources of future shareholder value, setting their sights on opportunities to be had out in the field, be it through acquisition activity or plans to enhance their exploration program.[Regarding the November 3rd announcement of Continental Resources's agreement to purchase Delaware basin assets from Pioneer Natural Resources] "We focus every day on maximizing both shareholder and corporate returns. The Permian Basin acquisition will be an integral contributor to these shareholder return plans. Possibly most importantly, this Permian transaction is projected to add up to 2% to our return on capital employed annually over the next five years. The acquisition of these assets strongly supports the tenants of Continental's shareholder return on investment and return of investment, dividends and share repurchases." – William Berry, CEO, Continental Resources"After weathering two downturns during which we did not cut nor suspend the dividend, the new annual rate of $3 per share reflects the significant improvement in EOG's capital efficiency since the transition to premium drilling. Going forward, we are confident in our ability to continue adding to our double-premium inventory without any need for expensive M&A by improving our existing assets and adding new plays from our deep pipeline of organic exploration prospects, developing high-return, low-cost reserves that meet our stringent double premium hurdle rate, expands our future free cash flow potential and supports EOG's commitment to sustainably growing our regular dividend." – Ezra Yacob, CEO, EOG ResourcesConclusionMercer Capital has its finger on the pulse of the E&P operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

Can You Hear Me Now? Lessons from a $20 Billion Family Business Fight

"If you cannot get rid of the family skeleton, you may as well make it dance." - George Bernard Shaw Thankfully, the Family Business Director blog does not cover much tabloid news. However, recent turmoil engulfing the Rogers Communications (NYSE: RCI) family, who are controlling shareholders of the $20 billion Canadian wireless communications and media conglomerate, piqued our interest. Numerous outlets have covered the drama, pulling back the curtain on a bitter family battle for control of the company. What can the public family strife affecting the Rogers family teach us (other than hug our moms a little more)? Well, quite a bit. Below we summarize the family drama and provide three strategies to keep in mind to stave off harsh family infighting that can, ultimately, bleed over into your company's ability to operate effectively.Rogers Family Dispute TimelineThe table below highlights key developments in the Rogers family saga in recent months (adapted from Reuters). The summary is far from exhaustive.Click here to enlarge the image So what went wrong, and what can you do to avoid these mistakes? We cover that next. Prioritize Communication and Don't Forget the RelationshipThe issue at hand is, at first blush, a leadership dispute: one group supporting the current CEO (Ms. Loretta Rogers, widow to the company's founder, along with her two daughters) and another opposed to current leadership (Mr. Edward Rogers, son to the founder and former chairman). However, as we have written about previously, family business relationships are complex. What may be banal or standard in a traditional business setting can be far from it when the parties are parents and children. So always have the family dynamic in mind.Additionally, the chain of events was kicked off with a pocket-dial, revealing the son's secret plot (with help from the CFO, no less) to oust the existing CEO. We suspect things could have been less contentious if what amounts to an attempted "corporate coup" did not take place prior to more formal leadership discussions. Were Edward Roger's concerns with the CEO known to the rest of the board? Was Loretta Roger's position understood? Was communication prioritized? Evidence points to multiple resounding "nos."Defuse the Time-Bombs in Your Governance DocumentsFollowing the revelation of Edward Roger's dissatisfaction with the existing CEO, multiple board meetings were held to discuss whether to retain the company's CEO. The independent board weighed the removal of the CEO, with an imminent acquisition of Shaw Communications (NYSE: SJR), as unwise. The board voted to withdraw the CEO's resignation and force the resignation of the CFO. Given what could be perceived as severe insubordination from the CFO (secret ousting of a superior to his benefit), this seems appropriate. The board additionally removed Edward Roger's chairman title, escalating the dispute between the two family camps.However, following board action, Edward Rogers triggered his "ace in the hole." As chairman of the Rogers Control Trust, Edward Rogers had an effective 97.5% voting interest in the company. Edward Rogers used this power in this role to negate independent board action, place a new board in power, and reinstate himself as chairman. Edward Rogers had thrown a knockout punch. As of this writing, a Canadian judge approved the action.What happened? We have written numerous times on the potential time-bombs lurking in your family business buy-sell agreements. Well, there was a "nuclear option" in Rogers Communications governance and voting structure, and Edward Rogers held the launch codes. When a single shareholder, even if it is family, can overrule the independent board and other family shareholders unilaterally, your structure is broken. A "board-in-name-only" does not represent best governance practice. One wonders how a similar board structure was not present in the Rogers Control Trust (where power resided). We recommend creating guardrails to ward off a scenario like the Rogers family is currently undergoing.Have a (Neutral) IntermediaryYou don't have to read too closely between the lines to see that the family and certain board members may have been less than independent. Thinly-veiled (and completely unveiled) barbs on social media have moved the debate into the open. The conflict between the Edward Rogers camp and the Loretta Rogers group had been brewing for a while. You don't like to see subtweets between siblings. Like our call for communication, having someone in the middle who you and your family trust can be all the difference between passionate, constructive discussions and public feuds. The board appears to have been meant for this role, in theory. However, with members aligning themselves with rivaling family factions, neutrality and independence were lost. You and your family board should aim to go the extra mile to limit any conflict of interest or perverse incentives for board members. Additionally, if significant issues arise, bring in an outside mediator or consultant to help guide the conversation back to business and out of the family drama quagmire. We Are FamilyThe family battle culminated in a "victory" for the eldest son, Edward Rogers, over his mother and two sisters. Justice Shelley Fitzpatrick on November 5th ruled in favor of Edward Rogers. "These family squabbles are an interesting backdrop to this dispute that would be more in keeping with a Shakespearean drama," she noted, but "at best, they are a distraction."Not to dig up the past, but we previously wrote on the Larson brothers and the contentious shareholder redemption of shares in a fossil-hunting enterprise. The result? The brothers refuse to talk to each other. Many families wisely prioritize being able to share a holiday meal when making business decisions. You and your family board are sure to learn lessons on what not to do and what steps you can take to avoid publicly damaging family brawls by studying the Rogers story. Prioritize communication and remember your familial relationships, craft conflict-reducing governance documents, and introduce truly independent intermediaries in contentious situations are three ways you can avoid the worst of the Rogers family drama.Mercer Capital has experience in thousands of valuation and financial consulting engagements for family business clients. Give one of our professionals a call if we can help guide your family through some of your family's own valuation issues.

In the Market for a Good Used RIA?

8 Tips for Being a Buyer in a Seller’s Market

Last week I got an email from the finance company that holds the lease on my car announcing that the “countdown had begun.” My lease ends in May, and the manufacturer was encouraging me to start thinking about my next vehicle – even offering to waive the $575 lease disposition fee if I terminated the lease early. Strange, I thought. Given the scarcity of new vehicles in the market, why is the manufacturer’s finance company offering me incentives to join the line of people who want but can’t get a new car?Eager to uncover the motivation for this surprising act of Teutonic generosity, I reviewed my lease agreement to see if I could solve the mystery. Knowing I had the option the buy the car at the lease’s stated residual value, I also checked some used car listings for comps with the age and mileage my roadster will have in May. This exercise suggested my car will be worth about 40% to 50% more than what I could buy it for at the end of the lease. So, my call option is in the money, and the finance company is keen to let me surrender that option to them.Alas, my good fortune isn’t all that good. If I choose to buy-and-hold my car at the end of the lease, I can’t monetize the option. If, instead, I buy-and-trade my car for something else, I may get market value, but I’ll have to find something to buy. These days that will cost me both in terms of time and money. At this point, the only thing I know for sure is that I won’t be returning my car to the finance company. Sorry fellas.In the Market for a Good Used RIA?A couple of times a week, we get calls from someone we’ve never met saying they’d like to talk with us about their RIA acquisition strategy. About half are RIAs or trustcos looking for expansion, and the other half are private equity or family offices. Very few are calling because they have a particular target in mind; fewer still have begun the process of negotiating with a potentially interested seller.If your acquisition strategy these days is starting from scratch, you’re in a tough spot. There’s nothing on the lot, and what is available looks expensive. That doesn’t mean you should give up, though. Here are some practical tips to pursue an acquisition strategy in this market environment, as well as the markets to follow.Build relationships. Sellers faced with a dozen potential suitors often exhibit a common behavior: they don’t know what they like – they like what they know. Sellers are drawn to preexisting relationships, even when the offer from those parties doesn’t quite measure up to other offers. This makes a lot of sense given that selling an RIA often means going into business with the buyer for several years. Acquisitions are a process, not an event, so get to know the people you might want to be in business with – early and often. It’ll help you win the auction – or avoid it altogether.Deliver what you promise. The most frustrating part of the transaction process is when counterparties (or their advisors) don’t meet deadlines. If indications of interest are due on Friday, don’t call on Friday to ask for more time. You might get it, but you’ll also earn a reputation for not meeting expectations, which will make sellers leery of dealing with you. Sellers are usually represented, and buyers often aren’t. If you need professional assistance in pursuing an acquisition, get them on board so that you’ll maximize your opportunity.Consider alternative structures. Not every seller needs or even wants a check. Some want a partner. Some want your stock. Some want a joint venture. Ask questions about the underlying needs of the seller to find out how you can creatively accommodate their needs and meet yours as well. Winning a deal isn’t always about being the high bid – it’s about being the best bid.Accept pricing for what it is. For lots of very rational reasons, pricing in the RIA space is high. It might not be quite as high as reported, because everyone in the deal community is motivated to dress up the multiples as much as possible (we’ve written before about reported versus pro forma numbers, pricing with and without earn-outs, the impact of rollover equity, etc.). But, like prices for new and used cars, RIAs are worth top-dollar. Neither situation is going to resolve itself anytime soon. Microchip availability may drive the supply/demand imbalance in automobiles for years. Low interest rates and a flood of PE capital may do the same for RIAs.Turn your acquisition strategy on its head. If you accept the fact that this is a seller’s market, why do you want to be a buyer? Think about selling - or merging - into a larger firm. As part of a larger buyer, you’ll have more support (talent and capital) for building through acquisitions, and you’ll have the benefit of firsthand experience as a seller.Don’t get caught up in FOMO. There is a frenzy to buy RIAs, but that doesn’t mean you have to be part of it. Discipline still matters. Some buyers are so desperate to acquire an RIA that they’re willing to look at “opportunities” that don’t make any sense. Remember that opportunity is a two-way street. The bull market of the past twelve years has redeemed a lot of bad acquisitions in the RIA space. These days, everybody on the buyside feels smart.Don’t wait for the market to become rational. If you’re sitting this “period” out because you’re waiting for valuations to come down, find another reason. Prices may drop – but it may be a long time from now. If paying full freight for acquisitions doesn’t suit you, I won’t judge you. But don’t base your expectations for the future on the hope that things will change. They may not change.You might do better on your own. For most firms, organic growth is the best growth. Competing for acquisitions is hard, and integrating them is even harder. Conventional wisdom these days is that organic growth opportunities in the RIA space are narrowing and growth is slowing. But conventional wisdom yields conventional results. If you can devise a way to generate organic growth, you’ll gain control over your future – and a standout presence as a target one day. Shortages and tight markets are more the exception than the rule right now. I’ve heard an emerging theory in fixed income that rates will stay “lower-for-longer.” If so, yield starved investors of all stripes will be drawn to the growth and income characteristics of RIAs – which will keep multiples “higher-for-longer.” Whether or not this turns out to be the case, the shortage of acquisition opportunities in investment management firms will likely outlast the shortage of microchips that’s plaguing car manufacturing, such that even scratch-and-dent RIAs will remain pricey. As a buyer, you can’t entirely sidestep this problem, but you can pursue some basic tactics that will help – both now and in the future.

October 2021 SAAR

October 2021 SAAR was just shy of 13.0 million, as new light vehicle sales saw their first month-to-month gain since April. The October SAAR is up 6.3% from last month but remains 20.8% lower than last October. Auto dealers began the month with record low inventory levels of 972,000 units, and low inventories continue to keep car buying activity constrained. Dealers are pre-selling a significant amount of the new inventory they receive as they attempt to satisfy demand. According to Thomas King, President of Data and Analytics, nearly 54% of vehicles will be sold within 10 days of arriving at a dealership.As of now, there is no expectation that inventory on the lot will increase anytime soon. There is some optimism around the industry that inventory levels will slowly increase throughout 2022, but it is likely that these inventories will remain below pre-COVID levels for the foreseeable future. Based on our discussions with dealers and reading of the tea leaves, we think it’s reasonable OEMs will see heightened profits under the status quo and seek to structurally tweak how much inventory is kept on dealer’s lots going forward. In October, prices have continued to rise and OEM incentive spending has continued to fall. This has been the case for several months now, and dealers have been realizing record profitability on vehicles sold for some time. If it seems like there are new profitability records being set every month, it is because there have been. Average incentive spending per unit has hit another record low of $1,628 in October. Total retailer profit per unit is on pace to reach another record high of $5,129 as well, the metric’s first time above the $5,000 mark. For perspective, this is an increase of $2,937 (more than double) from a year ago, and total aggregate retailer profits, a measure of the industry’s profitability as a whole, is up 213% from October 2019, reaching $4.8 billion. This October was the most profitable October on record for auto dealers, and it is likely that November will yield some of the same, if not better, results. Inventory shortages and record profitability are not the only persistent conditions in which auto dealers are operating. Fleet sales continue to be outpaced by retail sales, accounting for only 142,000 units over the last month. Trucks and SUVs are on pace to account for a record high 80.9% of new vehicle retail sales in October as well. As far as new vehicle prices are concerned, transaction prices on the average new car reached another record high of $42,921. While supply and demand imbalance plays a role in these increasing prices, we note the mix of vehicles is also important. Trucks tend to be more expensive than cars, so the mix continuing to shift towards higher profit trucks leads to higher transaction prices. The moral of the story is that October proved to be more of the same for auto dealers across the country, and most dealers are still thriving in a low inventory–high price environment. Microchip Background and UpdateMany OEMs, dealers, and research analysts following the industry have been looking ahead to try and predict when the ongoing inventory shortage might begin to improve. As we have mentioned earlier in this blog and on previous blog posts, the current estimate seems to be around the middle of 2022 at least, depending on your definition of improvement. One important determinant that many are looking at is the state of the semiconductor industry.Semiconductors, referred to by many as microchips or chips, are the brains behind electronic devices. As more electronic devices are being produced each year around the globe, the semiconductor industry has struggled to keep pace with demand for some time now. The rise of 5G technology can be blamed for increased demand, as well as increased demand from industries that have traditionally been semiconductor-free (auto makers can be included here, although chips have been common in new vehicles for years now). Another driver of increased demand is the rising number of semiconductors needed per manufactured unit across the many affected industries. For example, just one car can have anywhere from 500 to 1,500 different semiconductors. As we discussed previously, the pandemic exacerbated issues with people stuck at home reaching for electronics as a means of entertainment.The increased demand mentioned above, paired with supply chain disruptions have set up the perfect storm for a semiconductor crisis. The crisis is hitting OEMs particularly hard, as many manufacturers are announcing major slowdowns and stoppages during the fourth quarter of 2021. We have not touched on the geopolitical ramifications of the semiconductor shortage, although the sourcing of these chips going forward will be an important factor to keep an eye on.Toyota Motor recently announced that it was on pace to produce 40% fewer cars and trucks in October as a result of the chip shortage. This marks the second month in a row that Toyota slashed production estimates. GM, Ford, and Stellantis, who have all dealt with intermittent shutdowns over the last 6 months, account for 855,000 units of reduced vehicle production. Particular models from these OEMs that have been severely affected are Ford F-Series trucks, the Jeep Cherokee, the Chevy Equinox, and Chevy Malibu. Given that this crisis is becoming the single most important factor in getting vehicles on dealer lots, many executives are being asked when they think the supply chain for semiconductors will reach pre-pandemic levels.A Volkswagen executive recently released a statement, saying that “Without a doubt, this shortage is going to go well into 2022, at least the second half of '22."Likewise, Ford CFO John Lawler said that Ford is “doing everything we can to get our hands on as many chips as we can. We do see the shortage running through 2022. It could extend into 2023, although we do anticipate that the scope and severity of that to reduce.”Executives of the other major OEMs are echoing these concerns as all OEMs face similar challenges in securing chips for their vehicle production. That being said, the industry is prepping for an extended waiting game and cannot do much to produce more units in the meantime than what is allowed by current semiconductor inventories. While auto dealers are bearing the brunt of consumer frustration over the higher prices and lower availability, at least profits are up.ForecastLooking ahead to next month and the remainder of the year, we expect that the sales pace of the industry will continue to be constrained by the procurement, production, and distribution problems outlined above. From a dealer’s standpoint, inventories will most likely continue to be sold within days of arriving on the lot. However, the number of incoming units is not expected to materially change in November. Essentially, dealers can expect more of the same.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

WHITEPAPER | Selling Your Business

Practical Steps Business Owners Can Take to Ready Their Businesses for the Best Transaction OutcomeSelling your business is a daunting exercise that requires careful preparation and real-time vigilance.In this whitepaper, we define some practical steps business owners can take to ready their businesses for the best transaction outcome.These steps include identifying the right kind of buyer and transaction design, setting expectations for the timeline to consummate a transaction, hiring an advisor, understanding the various advisory fee structures that best suit each transaction scenario, as well as a few considerations every owner should contemplate before bringing their business to market.

NADA Is Busy Working on Capitol Hill on Behalf of Auto Dealers

In last week’s blog, we wrote about attending some of the Tennessee Automotive Association meetings and explored the buy/sell considerations discussed there. That topic is certainly timely for auto dealers, as record profits are the norm rather than the exception during the ongoing inventory shortages and supply chain disruptions. However, transaction considerations were not the only updates that attendees received. This week’s blog touches on federal legislation that NADA prioritizes and how that legislation could impact your dealership's operations.Tax Hikes That Impact DealershipsOne of NADA’s top priorities has always been to keep taxes low for dealerships, and that mission has not changed. In their outlined legislative priorities, NADA states that it is concerned that significant tax hikes will weaken the nation’s auto industry. Specifically, NADA is opposed to the tax structure currently laid out in the pending House Reconciliation Bill. Here is a breakdown of the potential tax changes included in the bill that could affect your dealership:Most auto dealerships are tax pass-through entities, and the current blended tax rate on pass-through earnings is about 29.6%. This tax rate accounts for the 20% Qualified Business Income (QBI) deduction, individual income taxes, and a Net Investment Income (NII) tax.According to NADA, if the House Reconciliation Bill were passed as proposed, the blended tax rate on pass-through earnings could be as high as 43.4%. The QBI deduction would reduce, corporate and individual income taxes would increase, and the NII tax would expand to essentially all pass-through income.From a valuation standpoint, higher tax rates reduce after-tax cash flows to auto dealers, which all else equal would lead to lower values for auto dealerships.No one wants to pay more than their fair share of taxes, and NADA is lobbying to improve the rates at which dealerships are exposed to them. Like all business owners, auto dealers would see lower after-tax proceeds that could be reinvested in their business. While NADA is lobbying on behalf of auto dealers, this is an issue that hits businesses across all industries, and it appears to be a legislative priority for the White House.From our perspective, we find it likely that taxes will increase from current levels, though just how much of an increase might occur and the timing of the increase remains to be seen. Dealers should be aware of the tax law changes and prepare accordingly. From a valuation standpoint, higher tax rates reduce after-tax cash flows to auto dealers, which all else equal would lower auto dealerships' values.Electric Vehicle Incentives Need to Work for DealersOn September 15th, the House of Representatives, Ways and Means Committee, approved a new electric vehicle incentive program as another part of the pending House Reconciliation Bill. This program supports tax credits to consumers for purchasing an electric vehicle and would increase the tax credit from $7,500 to $12,500. The bill would also make the tax credit “transferrable”, meaning that the dealership could claim the incentive and the consumer could treat that incentive as “cash on the hood”.NADA is concerned that dealerships are being asked to front-load the credit on these transactions and wants to make sure that the IRS pays the full value of these credits to dealerships in a timely manner. Dealers will remember this cash drag as an issue during the Cash for Clunkers program. Additionally, NADA wants to ensure that every franchised brand receives the benefits of these incentives, meaning that no one gets left out. From a valuation standpoint, we know certain brands change hands at higher blue sky multiples than others. If only certain brands were able to participate in a program that benefits dealerships, those brands could see better multiples in the short term.Further incentivizing consumers to purchase vehicles is almost always a positive thing for dealers. If the IRS is accurate and timely with its payment of EV credits, the program could be a success, but if credit payments become unreliable or too sluggish, dealers may choose not to participate in the program and lose sales to competitors.Treasury Should Grant Lifo Tax Relief for DealershipsLast November, NADA petitioned the Treasury Department to exercise its authority by allowing dealerships that use LIFO (Last-In, First-Out) inventory accounting to replace their new vehicle inventories over a three-year period. This request responds to LIFO recapture taxes that are expected to heavily impact dealers in the current environment of rising prices but declining inventories.While prices are generally expected to increase over time, inventory levels are also expected to remain somewhat constant or slightly increase over time as well.Many, though not all, auto dealers report their inventory on a LIFO basis. This typically leads to lower reported taxable income because inventories sold are based on the last price. In a typical inflationary environment, this means the cost of goods sold is higher under LIFO than FIFO.While prices are generally expected to increase over time, inventory levels are also expected to remain somewhat constant or slightly increase over time as well. However, during the recent supply shortages, inventory balances have dropped considerably, affecting dealers’ reported LIFO reserve more drastically than many dealers would expect.An example is provided below of how a dealer may have been impacted in 2020. However, because the supply chain issues have further devolved since this case was presented in December 2020, the income reported by dealers in 2021 is expected to be considerably higher due to accounting and not cash flow. Dealers should not hold their breath when it comes to the possibility of avoiding LIFO recapture taxes. The request was submitted by NADA a year ago and Treasury Department has not formally responded to the petition yet. While unique supply chain issues may be negative in the near-term, eventually inventory balances will rebuild, which would lower future tax bills. In essence, dealers on LIFO would be forced to pay taxes on front-loaded phony profits, which would eventually smooth out. Dealers that are subject to LIFO recapture could use the forgiveness as a chance to invest in replenishing inventory, EV infrastructure, and employee training. While this is clearly a negative for dealers, it is our understanding, legislators (generally speaking) would prefer to do away with LIFO entirely, so we do not anticipate much accommodation. It is more likely that subjected dealers should begin preparing for a larger-than-usual tax bill, though some options may exist. From a valuation standpoint, LIFO recapture is unlikely to impact valuations materially. Many valuation professionals already adjust to FIFO, so this would already be normalized whether it is positive or negative to cash flow in any particular period. As with many pieces of legislation or contemplated legislation, LIFO may impact the motivations of buyers and sellers, though it will have less impact on the determination of ongoing cash flows. ConclusionNADA is busy working on Capitol Hill on behalf of auto dealers, but the organization’s influence can only go so far. This makes it even more important that dealers know the legislative issues that could affect their dealership ahead of time and regularly communicate with their local politicians. Being proactive instead of reactive can make a big difference when running an auto dealership, making it worth the dealer’s time to stay plugged in.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Leftover Candy and Lazy Capital

Despite our best efforts, having four kids in the house means that we are a net candy importer over the Halloween weekend. Staring at the piles of candy in our house this morning brought to mind several recent conversations we’ve had with clients and prospects. The topic of those conversations was “lazy” capital.What Do We Mean by Lazy Capital?We were introduced to this term a few years ago, and it rather aptly describes a common situation in family businesses: capital on the balance sheet that is not generating a fair return for family shareholders.Where Does Lazy Capital Come From?Unlike leftover Halloween candy, lazy capital tends to accumulate slowly. I’ve not seen too many family businesses that have intentionally built bloated balance sheets. Perhaps ironically, the threat of lazy capital accumulating on the balance sheet is greatest for successful companies. How do successful companies wind up with excess capital?The following five broad headings capture most of the reasons.1. Reluctance to Invest in New Business LinesLike all companies, a family business has a natural lifecycle. At some point, the original business of the family will mature, with slow (or no) sales growth and more limited reinvestment needs. At this point, the family business directors should be deliberate about either (a) adopting a “harvest” mindset or (b) identifying new fields to “plant.” Families that are unwilling to take on the risk of “planting” a new crop of investments are much more likely to see lazy capital accumulate.2. Reluctance to Pay DistributionsSome family businesses appear to avoid paying significant distributions out of earnings on principle: owning shares in the family business should not provide one with disposable income. This “principle” is generally animated by a belief that the family shareholders cannot be trusted with financial resources. Granted, there is no shortage of individual family shareholders whose stories amply validate this fear. However well-intentioned, we suspect that a reluctance to pay distributions often has serious unintended negative consequences for the family, one of which is the accumulation of lazy capital on the family business balance sheet.3. Reluctance to Divest Unproductive AssetsFamily businesses occasionally have sentimental attachment to lines of business, facilities, and other assets that have outlived their usefulness to the family business. If Division X is consistently generating a 2% return on invested capital with no real prospects for improvement, it should not be considered untouchable, even if it was the apple of Grandpa’s eye thirty years ago. Family business managers and directors are asset allocators, and a refusal to evaluate business assets and segments with a cold eye will lead to a bloated balance sheet stuffed with operating assets that either do not earn an adequate return or no longer fit the strategy of the family business.4. Reluctance to Do Things DifferentlyWithout intentional attention and monitoring, the business practices that worked well a decade ago may not be driving optimal use of capital today. Working capital can be an overlooked hiding place for lazy capital. Active management of accounts receivable, inventory, and payables is critical to ensuring that the family is earning an appropriate return on its capital.5. Reluctance to Acknowledge Available Borrowing CapacityMany family businesses are debt averse. Capital structure is a function of, among other things, family risk tolerance. Yet, there is a difference between a family business preferring to operate without debt and one maintaining a cash balance sufficient to meet every potential contingency facing the business. The prudent move for debt-averse families is to maintain and update credit facilities that will allow the business to handle sudden cash needs that may arise without carrying unwieldy cash balances which weigh down investor returns. Even families that prefer not to use debt should acknowledge their ability to issue debt in the future if needed. That borrowing capacity should not be ignored in risk management discussions. Ignoring the available borrowing capacity of the family business leads to an exaggerated sense of how much liquidity the company needs to maintain on the balance sheet.What Are Some Consequences of Lazy Capital?Unlike leftover Halloween candy, an accumulation of lazy capital is unlikely to lead to tooth decay or increased risk of diabetes. However, there are some negative consequences of which family business directors should be aware.Diminished ReturnsThis one is just math – if a significant portion of your family business capital is allocated to low-returning assets, the overall return earned by the family will be pulled down. In today’s low-rate environment, the return on cash is functionally zero. As a result, allocating 10% of invested capital to cash means taking a 10% haircut to what would otherwise be ROIC. We’ve written about ROIC in a prior post because for most family businesses it is the best comprehensive measure of performance. Whatever form it takes, lazy capital puts pressure on ROIC.Lazy ManagementWe are all more aware of how viruses spread these days, and laziness is infectious. The presence of lazy capital on the family business balance sheet can take away a healthy “edge” in how the business is managed. It is not in anyone’s best interest to fabricate some artificial sense of crisis. However, we suspect most businesses operate best with what one of our high school coaches was fond of referring to as a “sense of urgency.” An accumulation of lazy capital can blunt the productive sense of urgency and breed unintended negative consequences throughout the business.Disgruntled ShareholdersLazy capital flourishes in an environment of limited, or poor, shareholder communication. And poor communication inevitably leads to mistrust and conflict. Positive shareholder engagement is much easier to maintain when family shareholders are confident that their capital is being put to good use.How to Get Rid of Lazy Capital?It’s easy enough to foist leftover Halloween candy on unsuspecting co-workers. Disposing of lazy capital is less straightforward, but the two primary strategies are to (1) return the lazy capital to shareholders so they can put it to work themselves, or (2) find more productive uses for the lazy capital within the family business.Finding the right strategy for dealing with lazy capital in your family business is a complex process that needs to consider the attributes of the business, your industry, and your family. Give one of our professionals a call today to review your situation in confidence and see how we can help.

Sharing Growth & Spotlight

Natural Gas & Renewables Join the D-CEO Awards Stage in Dallas

Mercer Capital’s energy team sponsored and attended the D-CEO 2021 Energy Awards in Dallas last week, October 26, 2021. It was a great event and a good opportunity to connect with clients, peers, and industry leaders in the energy space. Awards ranged from honoring top executives, including Scott Sheffield of Pioneer Energy, to private equity firm innovators like Pearl Energy Investments.Oil, Natural Gas, and RenewablesThe focus of the night was the interdisciplinary threads between oil, natural gas, and renewables. “Sustainability and profitability are not mutually exclusive,” said Vikram Agrawal of EarthxCapital who participated on a panel alongside Joe Foran, CEO of Matador Resources. According to the panelists, renewables and natural gas are to be watched as the energy mix needs evolve in the U.S. and around the world. As an example, natural gas fuels about 40% of our power in the U.S. according to Agrawal.If the move goes towards more electrification, as illustrated by the news this week that Hertz has ordered 100,000 Tesla electric vehicles, there will be a need for 20% - 40% more power in the next 20 years. As we’ve discussed before, the current trajectory of renewables appears unable to meet these demand growth needs. Therefore, cleaner-burning natural gas will be a key contributor. One panelist mentioned the exception was hydrogen as a potential contributor. Interestingly, this was echoed in comments on the latest Dallas Fed Energy Survey: “The more I become educated on EVs [electric vehicles] and the charging and battery disposal problems, the more I think they will have little effect on the market in the future. My investigation turns more toward the hydrogen cell as the long-term solution.”No matter what the source, recent price growth suggests that more investments will be needed. The panel also stated that oil and gas investment will drop 26% from pre-pandemic levels to $356 billion in 2021. Various sources, including Exxon, suggest that this figure needs to increase to around $600 billion by 2040.Optimism for investment opportunities was not limited to upstream, but also infrastructure, with nearly $18 trillion in investment opportunities for energy transmission alone.Interesting Tidbits & StatisticsWithin the theme of investment opportunities, renewables, and natural gas, several interesting factoids from the evening emerged (in no particular order):1.Electric Vehicles and Charging StationsHow many electric vehicles are there for every charging station in the U.S.? The current ratio is 17Many think this ratio needs to be closer to 10 (there are about 42,000 charging stations in the U.S. right now – many at hotels and other overnight destinations)The Biden Administration suggests we need 500,000. Agrawal thinks the real number is 1,000,000 to 1,500,0002.Electric Cars Are Not a New ThingDid you know that 120 years ago, nearly one-third of our cars were electric? Granted there were only 4,000 cars at the time. Did you also know that Thomas Edison invented the first electric-powered car?3.Investment in the Space Is Picking UpSo far this year 35 SPACs acquired businesses worth $100 billion4. What Do “Net Zero” or “Carbon Offsets” Really Mean? According to a Wall Street Journal article, only 5% of “carbon offsets” actually remove carbon.ConclusionThanks to our clients, friends, and partners that we saw at the event. It was fabulous and nostalgic to be getting out again! And thanks to D-CEO for putting on a great event. Until next time!

Public Alt Asset Managers Have Nearly Doubled in Value Over the Last Year

Hedge Funds and Private Equity Firms Capitalize on Market Volatility and Growing Investor Appetite for Alt Asset Products

Industry Overview and HistoryOver the last year, alternative asset managers have bested the market and most other categories of investment management firms by a considerable margin. Favorable market conditions, heightened volatility, strong investment returns, and growing interest from institutional investors are the primary drivers behind the sector’s recent rally. Our alt manager index actually doubled from October of 2020 to August of this year before giving back some of these gains during the market downturn last month. Before this uptick, many alternative asset managers had struggled over the last several years. Asset outflows, the rising popularity of passive products, fee pressure, and underperformance relative to broader market returns had caused many hedge funds and PE firms to lag other investment management sectors. Industry valuations appear to have bottomed out with the market collapse during the first quarter of last year and have since rebounded. Growing investor appetite for risky assets with purported diversification benefits has fueled a fairly substantial turnaround for the sector over the last eighteen months or so. Current pricing is close to the 52-week high, and forward multiples are noticeably lower than LTM multiples, suggesting peaked valuations and expected earnings increases over the next twelve months. While hedge funds have underperformed since the Financial Crisis (the S&P 500 index has dwarfed the performance of hedge funds as measured by the HFRI Fund Weighted Composite Index since 2009), recent volatility has improved their performance on a relative basis. Hedge fund capital typically lags its underlying fund performance, so the market seems to be anticipating that higher inflows in the coming months as investors reallocate their portfolios in light of recent performance. Alternative assets often serve to either increase diversification or enhance portfolio returns. In a near zero interest rate environment, institutional investors have sought return-generating assets. Over the last couple of years, pension funds have started diversifying their portfolios to include alternative investments in order to chase higher risk, higher return assets. It is more difficult for the average investor to gain exposure to alternative assets due to significant minimum investment requirements. While some efforts have been made to expand distribution to the retail market, institutional investors are still the primary target market for alternative managers. Over the last couple of years, pension funds have started diversifying their portfolios to include alternative investments in order to chase higher risk, higher return assets.Over the last several years, alternative asset managers have been largely successful at securing a spot in institutional investors’ portfolios. In terms of diversification, investors have started positioning themselves for longer term volatility due to the pandemic and a slowing IPO market. While investor interest in uncorrelated asset classes such as alternatives fell during the longest bull market run in history (2009-20), recent volatility has pushed investors back to the asset class.Franklin Resources’s (ticker: BEN) recently announced purchase of private equity firm Lexington Partners for $1.75 billion is illustrative of growing interest from more traditional asset managers in the alt space.Practice ManagementToday, the main priority for most alternative asset managers is raising assets. Assets follow performance and fee reduction, especially in the alternatives space, are the most consequential ways to attract fund flow. After a decade of lackluster performance, alternative managers have had no choice but to look to price reduction to bring in new assets. Amidst fee pressure, alterative managers are deviating from the typical “2 and 20” model.While traditional asset managers have been able to reduce fees by achieving some measure of scale, alternative managers must be careful to not sacrifice specialization. Alternative managers have seen some success utilizing technology in the front office or outsourcing certain functions in order to reduce overhead and spare time for management to focus on asset raising.SummaryDespite improving performance over the last year or so, the alt asset sector continues to face many headwinds, including fee pressure and expanding index opportunities. While the idea of passively managed alternative asset products seems like an oxymoron, a number of funds exist with the goal of imitating private equity returns. Innovative products are being introduced to the investing public every day. And while there is currently no passive substitute to alternatives, we do believe that the industry will continue to be influenced by many of the same pressures that traditional asset managers are facing today, despite the recent uptick in alt manager valuations.

Navigating Tax Returns Tips and Key Focus Areas Part II

Navigating Tax Returns: Tips and Key Focus Areas for Family Law Attorneys and Divorcing Individuals/Business Owners – Part II

Part II of III- Schedule A (Form 1040) Itemized Deductions

Value Drivers in Flux

Last July I gave a presentation to the third-year students attending the Consumer Bankers Association’s Executive Banking School. The presentation, which can be found here, touched on three big valuation themes for bank investors: estimate revisions, earning power and long-term growth.Although Wall Street is overly focused on the quarterly earnings process, investors care because of what quarterly results imply about earnings (or cash flow) estimates for the next year and more generally about a company’s earning power. Earning beats that are based upon fundamentals of faster revenue growth and/or positive operating leverage usually will result in rising estimates and an increase in the share price. The opposite is true, too.For U.S. banks that have largely finished reporting third quarter results, questions about all three—especially earning power—are in flux more than usual. Industry profitability has always been cyclical, but what is normal depends. Since the early 1980s, there have been fewer recessions that have resulted in long periods of low credit costs. Monetary policy has been radical since 2008. What’s normal was also distorted in 2020 and 2021 by PPP income that padded earnings but will evaporate in 2023.Most banks beat consensus EPS estimates, largely due to negligible credit costs if not negative loan loss provisions as COVID-19 related reserve builds that occurred in 2020 proved to be too much; however, there was no new news with the earnings release as it relates to credit.Investors concluded with the release of third and fourth quarter 2020 results that credit losses would not be outsized. Overlaid was confirmation from the corporate bond market as spreads on high yield bonds, CLOs and other structured products began to narrow in the second quarter of 2020 as banks were still building reserves.As of October 28, 2020, the NASDAQ Bank Index has risen 78% over the past year and 39% year-to-date.Much of that gain occurred during November (October 2020 was a strong month, too) through May as investors initially priced-in reserve releases to come; and then NIMs that might not fall as far as feared as the yield on the 10-year UST doubled to 1.75% by late March. Bank stocks underperformed the market during the summer as the 10-year UST yield fell. Since late September banks rallied again as investors began to price rate hikes by the Fed beginning in 2022 rather than 2023.No one knows for sure; the future is always uncertain. For banks, two key variables have an outsized influence on earnings other than credit costs: loan demand and rates. In other industries the variables are called volume and price. If both rise, most banks will see a pronounced increase in earnings as revenues rise and presumably operating leverage improves. Street estimates for 2022 and 2023 will rise, and investors’ view of earning power will too.We do not know what the future will be either.Loan demand and excess liquidity have been counter cyclical forces in the banking industry since banks came into being.The question is not if but how strong loan demand will be when the cycle turns. Interest rates used to be cyclical, too, until governments became so indebted that “normal” rates apparently cannot be tolerated.Nonetheless, at Mercer Capital we have decades of experience of evaluating earnings, earning power, multiples and other value drivers. Please give us a call if we can assist your institution.

The Tricks and Treats of the Buy/Sell Process from a Selling Dealer’s Perspective

Fall District Meeting Roundup

Fall is upon us. The weather is getting cooler, the leaves are changing colors, football is in full swing, the World Series is beginning, and Halloween is right around the corner. For auto dealers this year, Fall may also be a sign of change.As we’ve written in this space, 2021 has been largely profitable for dealers, despite unique challenges. A combination of good fortunes, high blue sky multiples, consolidation in the industry, the onset of electric vehicles, proposed tax law changes, and other factors can have many dealers contemplating their future.October and November are also when many state auto associations hold their District Meetings to discuss timely topics with their dealer members. We recently attended a series of District Meetings in Tennessee and the topic at hand seemed to revolve around potential transactions.In the spirit of Halloween, we review some of the buy/sell considerations (from the perspective of the selling auto dealer) that were discussed at the district meetings. For those statements that are true, we will classify them as TREATS and provide additional commentary. For those statements that are false, we will classify them as TRICKS and provide additional commentary.TREAT - Timing Is EverythingDeciding whether to sell your dealership or continue to hold on to it should be a conscious decision. Don’t wait until you have to sell. Dealers should consider the following areas in their decision-making process:Family – What are the ages and current health status of the operating dealer and his/her spouse? Does the dealer have any children that are either active in the business or are capable of eventually running the business?Market – What are the prevailing market conditions? Is this a good time to sell or a bad time to sell? As we have discussed numerous times during 2021, the M&A market has been very active for auto dealers. Despite operating challenges with COVID and inventory supplies with the chip shortage, auto dealers have posted record or near-record profits. Favorable operational results combined with increased blue sky multiples have yielded a frenzy in the valuations of some dealerships.OEM/Brand – What conditions is the dealer currently facing with their own OEM? Has the brand been favorable in recent history, or does the dealership represent an OEM that has faced production issues or the inability to release attractive vehicle models? Is the OEM demanding additional image requirements? How is the OEM responding to the electrification of vehicles and how will they involve the traditional dealership moving forward?Monetary – What are the unique financial needs of the operating dealer and his/her family? Is the perceived value of the dealership equal to or greater than the offers in the marketplace? Are there sizable capital projects on the horizon needed to compete with other dealership groups or with OEM demands?TRICK - An Auto Dealer Contemplating a Sale Should Hire a Business BrokerTransactions can be very complicated and complex. A selling dealer should hire capable professionals to assist in the process. These professionals should include a transaction attorney and a CPA at a minimum. These roles shouldn’t automatically be filled by your existing professionals if those professionals aren’t seasoned in transactions of auto dealerships.Should the selling dealer hire a business broker?It depends.Not all business brokers can be helpful to the process. Be careful and selective about whether to hire a business broker, and if so, which business broker to hire. If the buyer or target is already identified, the business broker may not be necessary. Be cautious of business brokers that want to establish a long-term exclusive relationship. The selling dealer wants to maintain privacy and confidentiality about their potential decision to market their dealership. Some business brokers might market the dealership to everyone around town which can cause uncertainty and strain to existing employees and might cause harm to the value of the dealership if the seller loses the leverage of their decision.Business brokers can be helpful as can industry-specific valuation specialists like Mercer Capital. One obstacle to any potential transaction is the value or price of the dealership. Dealers may have an indication of what their store might be worth, but often a valuation is crucial to manage expectations or assist in the negotiation of price with the potential buyer.TREAT - A Selling Dealer Must Prepare for a Potential Sale Prior to the Transaction ClosingDealers that are contemplating a sale should begin to take steps to prepare for the eventual transaction. Some of those steps consist of the following:Capital Projects Pending – Are there capital projects that need to be completed or are required by the OEM? Has the dealer recently completed an image requirement or are additional requirements pending? The status of the facilities and capital projects can greatly affect the price paid for the dealership in a transaction.Key Personnel – Identify the key employees that you want to retain during the process and/or those the buyer might want to retain. The future success of a dealership can be impacted by key employees and department heads. Selling dealers might consider granting special bonuses to these key individuals to keep them focused during this process. A potential buyer would not want to see a hiccup in financial performance or turnover in key personnel during the process.Customer Obligations – Selling dealers should examine their long-term customer obligations. Are there any “warranties for life” such as free lifetime oil changes or obligations to provide loaner vehicles to prior owners or immediate/distant family members? A potential buyer would want to know their exposure in these areas and may not wish to continue these arrangements.Existing Contracts/Contract Renewals – Selling dealers should review their existing contracts. How long will they continue or are any set to expire? Key contracts would include the Dealer Management System (DMS) among others. Selling dealers must balance opposing factors with contracts: not wanting to experience an interruption during the transaction process versus renewing a long-term contract that a perspective buyer would not view as attractive or valuable.Environmental Survey – Does the dealership have any exposure to environmental issues? A selling dealer should complete an environmental survey at the beginning or during this process. Environmental concerns for dealerships usually involve in-ground lifts, underground storage tanks, and oil/water separators.TRICK - A Selling Dealer Should Inform Their OEM That They Are Contemplating a Potential TransactionSimilar to the decision regarding whether to hire a business broker or not, the decision to inform the OEM should be diligently thought out.Should a dealer inform their OEM that they are contemplating a transaction?Again, it depends.A selling dealer wants to maintain privacy and confidentiality within their community and their workforce. An OEM or area manager might inform other dealerships of the news of your potential sale, or the information could make its way back to your key employees. Selling dealers will want to continue consistency in operations and performance and maintain their leverage in their possible sale to ensure the highest success and value for a transaction. Conversely, the OEM will need to be informed at some point because they will ultimately have to approve the dealer principal after a transition.TREAT - A Buyer’s Due Diligence Is Essential to the Transaction ProcessDue diligence refers to the part of the process where the potential buyer collects and analyzes certain information from the seller, including financial statements and other reports, in an effort to make a decision about conducting the transaction and to ensure that a party is not held legally liable or any loss or damages. Key elements of the due diligence process include the following:Financial Statements – Buyers will typically want to review at least three prior years to gain an understanding of the dealership’s historical performance and an expectation of anticipated future performance. Sellers will want to make sure they have complete and accurate financial statements to aid in the transaction process.Existing Litigation – Prospective buyers will want to know of any pending litigation with any customers or employees.Environmental Assessment – As previously discussed, a buyer will want to know if there are any pending environmental liabilities. If a selling dealer had a survey performed recently it can keep the process moving and not cause any interruption waiting for a survey to be completed.Facilities Inspection – Buyers will want to inspect the physical premises of the dealerships. Buyers will also inquire and inspect the status of current conditions in light of OEM imaging requirements.TRICK - The Character of the Buyer Is Not Important to the TransactionOne might think that if a prospective buyer can be located at an agreeable price, then the process is over. However, the seller should be concerned with the character of the buyer. What is the buyer’s reputation with other stores that he/she operates? Has the buyer ever been involved in lawsuits with their OEM, their employees, or with other sellers in previous transactions? Has the buyer ever been turned down by an OEM for approval as a dealer principal in a previous transaction or transition?In most cases, a dealer may only sell a dealership once in their lifetime. Chances are they have established a legacy within their local community and with their employees. Despite exiting after a transaction, dealers do not want to see their reputation and legacy diminished.ConclusionMercer Capital can assist auto dealers that are contemplating a sale by joining the team of professionals involved in a transaction. Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by economic, industry and financial performance factors. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

RIA M&A Q3 Transaction Update

RIA M&A Activity Continues to Reach Record Highs

Despite the dip in the second quarter of 2021, RIA M&A activity continues to reach record highs putting the sector on track for its ninth consecutive year of record annual deal volume. The same three demand drivers discussed last quarter persisted throughout the third quarter of 2021: (1) secular trends, (2) supportive capital markets, and (3) looming potential changes in the tax code. While fee pressure in the asset management space and a lack of succession planning by many wealth managers continues to drive consolidation, looming proposals to increase the capital gains tax rate has accelerated some M&A activity in the short-term as sellers seek to realize gains at current rates. Increased funding availability in the space has further propelled deal activity as acquisitions by consolidators and direct private equity investments increased significantly as a percentage of total deals during the recent quarter. Private Equity Drives RIA M&AWe’ve written extensively on the prominence of acquisitions by private equity backed consolidators in the RIA industry. Over a decade of rapid growth and persistent profitability has established a class of RIAs with institutional scale as well as an influx of new entrants. According to a recent study by McKinsey, in 2020 there were 15 retail-oriented RIAs eclipsing $20 billion in AUM while approximately 700 new RIAs were started annually over the past five years. This dynamic of a handful of large, financially mature firms surrounded by a highly fragmented market has attracted immense buying activity from private equity sponsors looking to leverage the number of established firms with expertise and scale available to acquire lower valuation, high growth RIA firms in the earlier stages of development.... a handful of large, financially mature firms surrounded by a highly fragmented market has attracted immense buying activity from private equity sponsorsThree-quarters of Barron’s 2020 top 20 RIAs are owned by private equity firms or other financial institutions. Notable examples such as Focus Financial (backed by Stone Point Capital prior to IPO), HighTower Advisors (Thomas H. Lee Partners), Wealth Enhancement Group (TA Associates), and Mercer Advisors (Oak Hill Capital Partners) accounted for an outsized share of total deal volume during the third quarter of 2021, and the percentage of total acquisitions made by consolidators increased from 50% to over 70% of all transactions in the past quarter. Direct investments in the third quarter also reached an all-time high for a total of 12 transactions. Such interest from private equity backed buyers continues to support high valuation multiples.2021 RIA-to-RIA transactions as a percentage of total deal volume is expected to be at a ten-year low largely due to the increase in acquisitions made by consolidators and private equity direct investments. Increased competition for deals favors consolidators who have dedicated deal teams, capital backing, and experience to win larger transactions, and even multiple large transactions simultaneously. The trend is evidenced by increased AUM size per deal, which is on track to reach a record high for the fourth consecutive year. While this is partially a result of increased AUM due to strong market performance, Echelon Partners notes that the persistent increase is also likely due to the deep pocketed supply of capital by sophisticated buyers which has caused demand for acquisitions to outpace the supply of firms looking to sell.While systemic factors continue to be a primary driver of RIA deal activity, the surge in acquisitions made by financial buyers has led some to question the sustainability of recent M&A highs. Notably, while deal volume increased to record levels in September 2021, investor sentiment for RIA consolidators was mixed during the same period as investors have expressed concern about rising competition for deals and high leverage which may limit the ability of these firms to continue to source attractive deals in the future. Private equity buyers, and consolidators acting as private equity portfolio companies, are motivated by investment opportunity. As financial buyers flock to opportunities, they drive up valuations and simultaneously diminish IRR. Recent private equity and consolidator interest in the UK market exemplifies the saturated valuations in the U.S. market as buyers have begun to seek out cheaper entry points abroad.The RIA industry remains highly fragmented and growing.While deal volume has continued to reach new highs for nearly a decade now, there continues to be ample supply of potential acquisition targets (although not all of these firms are actively looking to sell today). The RIA industry remains highly fragmented and growing with over 13,000 registered firms and more money managers and advisors who are capable of setting up independent shops. Systemic trends and strong buyer demand will likely continue to bring sellers to market, and for now, there are no signs that momentum in deal activity is stalling anytime soon.What Does This Mean for Your RIA Firm?If you are planning to grow through strategic acquisitions, the price may be higher, and the deal terms will likely favor the seller, leaving you more exposed to underperformance. That said, a long-term investment horizon is the greatest hedge against valuation risks. As discussed in our recent post, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions.If you are considering an internal transition, there are many financing options to consider for buy outs. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but bank financing can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling, valuations stand at or near historic highs with ample demand from buyers. That said, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. A strategic buyer will likely be interested in acquiring a controlling position in your firm with some form of contingent consideration to incentivize the selling owners to transition the business smoothly after closing. Alternatively, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Sellers looking to leverage the scale and expertise of a strategic partner after the transaction may have many buyers to choose from.

Why Do Buy-Sell Agreements Rarely Work as Intended?

The most common valuation-related family business disputes we see in our practice relate to measuring value for buy-sell agreements. Far too often, buy-sell agreements include valuation provisions that appear designed to promote strife, incur needless expense, and increase the likelihood of intra-family litigation.The ubiquity of valuation provisions in buy-sell agreements that do not work is striking. While there are many variations on the theme, the exhibit below illustrates the broad outline of the valuation processes common to many buy-sell agreements.The buy-sell agreement presumably exists to avoid litigation, but the valuation processes in most agreements seem to increase, rather than decrease, the likelihood of litigation. It is almost as if failure is a built-in design feature of many plans.Top Five Causes of Valuation Process FailureAmbiguous (or absent) level of value. As we discussed at length in section 3 of the What Family Business Advisors Need to Know About Valuation whitepaper, family businesses have more than one value. There is no “right” level of value for a buy-sell agreement, so the agreement must specify very clearly which level of value is desired. Failing to specify the level of value, and just assuming that the eventual appraiser will know what the parties intended is a recipe for disaster. The difference between the pro rata value of the family business to a strategic control buyer and the value of a single illiquid minority share in the family business can be large. Yet too many buy-sell agreements simply say that the appraisers will determine the “value” or “fair market value” of the shares. That is not good enough.Information asymmetries. Most buy-sell agreements have no mechanisms for ensuring that the appraiser for the selling shareholder has access to the same information regarding historical financial performance, operating metrics, plans, and forecasted financial performance as the appraiser retained by the family business. The resulting asymmetries give both sides a ready-made excuse to cry foul when the valuation results do not meet their expectations. We recommend a thoroughly documented process of simultaneous information sharing, joint management interviews, and cross-review of valuation drafts to eliminate the likelihood of information asymmetries derailing the transaction.Lack of valuation standards / appraiser qualifications. It is not hard to find an investment banker, business broker, or other industry insider who probably has a well-informed idea of what the family business might be worth (particularly in the context of a sale to a strategic buyer). However, when executing the valuation provisions of a buy-sell agreement, it is crucial to specify the qualifications for the appraisers. While an opinion of value from a business broker might be suitable for some purposes, the scrutiny that is attached to a buy-sell transaction can best be withstood by an appraiser who is accountable to a recognized set of professional standards that set forth analytical procedures to be followed and reporting guidelines for communicating the results of their analysis. There are multiple reputable credentialing bodies for business appraisers that promulgate quality standards for their members. The buy-sell agreement should specify which professional credentials are required to serve as an appraiser for either the selling shareholder or the company.Unrealistic timetable / budget. Families often share a well-founded fear that the valuation process will prove interminable without specified deadlines. Deadlines are important but must be realistic. If there is ever a time for a “measure twice, cut once” mentality, it is in buy-sell transactions. Due diligence and analysis takes time, and the schedule set forth in the buy-sell agreement needs to take into account the inevitable “dead time” during which appraisers are being interviewed and retained, information is being collected, and diligence meetings are being scheduled. The same goes for budget: if you think a quality appraisal is expensive, see how costly it is to get a cheap one. Provisions that identify which parties will bear the cost of the appraisal can help incentivize the parties to reach a reasonable resolution, but can also be so punitive that they discourage shareholders from pursuing what is rightfully theirs. Each family should carefully evaluate what system will work best for their circumstances.Advocative valuation conclusions. Sadly, even when the level of value is clearly defined, information asymmetries are eliminated, valuation standards are specified, and the timetable and budget is reasonable, the two appraisers may still reach strikingly different valuation conclusions. Whether this is a result of genuine difference of (informed) opinion or bald advocacy is hard to say, but it is rare for the appraiser for the selling shareholder to conclude a lower value than that of the appraiser for the company. Valuation is a range concept, so it should ultimately not be too surprising when appraisers don’t agree. Yet that inevitable disagreement adds time and cost to many buy-sell valuation processes.Is There a Better Way?Given the challenges and pitfalls described above, is there any hope that a valuation process for a buy-sell agreement can reliably lead to reasonable resolutions? We think so. We have identified three steps that we recommend for clients to help make their buy-sell agreements work better.Make sure that the buy-sell agreement provides unambiguous guidance to all parties as to the level of value and qualifications of the appraiser.Retain an appraiser to value the company now, before a triggering event occurs. This is essential for two reasons. First, it transforms the “words on the page” into an actual document that shareholders can review and question. No matter how carefully one defines what an appraisal is supposed to do, the shareholders are likely to have different ideas about what the output will actually look like. This appraisal report should be widely circulated among the shareholders, so they have an opportunity to familiarize themselves with how the company is appraised. Second, performing the valuation before a triggering event occurs increases the likelihood that the family shareholders can build consensus around what a reasonable valuation looks like. People tend to take a more sane view of things when they don’t know if they will be the buyer or the seller.Update the valuation periodically. Simply put, static valuation formulas don’t work in a changing world. Periodic updates to the valuation help the valuation process become more efficient, and help all shareholders keep reasonable expectations about the outcome in the event of an actual triggering event. Discontent and strife are more likely to be the product of unmet expectations rather than the absolute valuation outcome. Periodic valuations help to set expectations and reduce the likelihood of friction. Following these three steps are essential to increasing the likelihood that the valuation process in a buy-sell agreement will actually work and will help keep the family out of the courtroom, where both sides to the dispute often walk away losers. Following these three steps are essential to increasing the likelihood that the valuation process in a buy-sell agreement will actually work and will help keep the family out of the courtroom, where both sides to the dispute often walk away losers. This week's post is an excerpt from the whitepaper, What Family Business Advisors Need to Know About Valuation. If you would like to read the full version click here.

Natural Gas Production Levels Are High, But So Are Prices

There’s been much coverage of the run-up in oil prices since November 2020, from $37/barrel (WTI) to current prices in excess of $80/barrel. That of course ignores the April to October 2020 $28/barrel recovery from the Covid/OPEC+/Russia-induced oil price death plunge during the February to April 2020 period. Now it seems that it’s natural gas’s turn at the price run-up game.While Henry Hub (a benchmark for natural gas prices) also showed a post-Covid recovery from its March to June 2020 lows (near $1.60/MMbtu) to prices generally in the $2.60 to $3.00 range from October 2020 to May 2021, it has since been on a run that has taken it to recent highs over $5.70. So, what gives? In this week’s blog post, we address the market forces that have led to higher natural gas prices despite near record U.S. natural gas production levels.Production Is High, So Why Are Prices Rising?Per U.S. Energy Information Administration (EIA) data, 3Q2021 U.S. natural gas production neared its prior peak level, and EIA analysts expect that production will reach new record highs during 3Q2022. With such high production, basic economic theory would suggest that natural gas prices should be facing downward pressure. However, there’s the demand side of the equation to consider as well. Since the 2020 Covid-induced demand decline, the increase in natural gas demand has exceeded production recovery. Therefore, a supply versus demand imbalance has pushed prices up at an unusual rate. Why Not Just Increase Production to Satisfy Demand? A natural question to be asked is, why wouldn’t the gas producers simply increase production to meet the heightened level of demand? That’s where an interesting set of factors come into play, with one such factor being future gas price expectations.Why wouldn’t gas producers simply increase production to meet demand? Future gas price expectations.Tsvetana Paraskova, writing for OilPrice.com, notes that producers in Appalachia, America’s largest gas-producing basin, are expecting stronger pricing signals in the future curve for gas prices a year or two from now. As such, to some extent, those producers are looking at to (i) invest now to boost production for which they’ll receive current prices, or (ii) delay that investment to boost production until later when they’re expecting to sell the same volumes at higher prices. Depending on their level of confidence in those higher future prices, they may be significantly incentivized to hold off on those volume boosting investments. Furthermore, Peter McNally, with the consulting firm, Third Bridge, reminds us that the more recent trend among oil and gas investors in preferring more near-term return on investment (current distributions to investors), rather than more drilling (with larger distributions down the road), has pressured the producers to ease back on their drilling programs that would otherwise help maintain production levels.Where Is Demand Coming From?A natural question to be asked is, where is all the demand side pressure coming from? The answer, in large part, is exports. While the U.S. has exported natural gas via pipeline for many years, the capacity for LNG exports has ballooned in recent years and reached record levels in 2020 and 2021. Two regions are driving demand for U.S. LNG exports. The first is Europe. After the much colder than usual winter, natural gas inventories remain well below typical seasonal levels. As a result of the lower inventories, Europeans are paying four to five times as much for natural gas relative to what is being paid in the U.S. That creates quite the incentive for U.S. produced natural gas to be exported, rather than staying within the country. The second is China. Reuters reports that China has become concerned in regard to its country-wide fuel security and is facing a winter fuel supply gap. That, in the midst of Asian gas prices that have increased more than 400% in 2021, has led to advanced talks between top Chinese energy companies and U.S. LNG exporters for the purpose of locking-in future U.S. LNG export volumes. What Does This Mean for the U.S.?As a result of the indicated supply and demand forces at play, Reuters reports that power crunches are already hitting large economies such as China and India. While the impact in the U.S. (so far) has been relatively modest, expectations are for U.S. consumers to spend much more to heat their homes this winter. In the U.S., nearly half of homes use natural gas for heating purposes, as natural gas has traditionally been the most economical source for heating residences. The U.S. Department of Energy estimates that those homeowners will pay 30% more for natural gas this winter compared to last winter.What Are the Ripple Effects of Higher Natural Gas Prices?While home heating is a more straight-forward result of the higher natural gas prices, there are numerous ripple effects that are far less obvious. Natural gas is a key input to a number of industries where higher natural gas costs will naturally be passed through to consumers. Bozorgmehr Sharafedin, Susanna Twidale and Roslan Khasawneh, with Reuters, note several such industries including steel producers, fertilizer manufacturers, and glass makers having been forced to reduce production due to the higher natural gas prices.Industrial Energy Consumers of America, a trade group representing chemical, food and materials manufacturers has even urged the U.S. Department of Energy to limit U.S. LNG exports in order to ease their member firms’ energy-related expenses. Food producers in particular are reporting shortages of CO2 (a byproduct of fertilizer production) that is used in packaging processes, meat processing, and even for putting the “fizz” in carbonated drinks and beer. As a result, prices for those types of products are already on the rise.ConclusionAs indicated, the market forces at work in the supply and demand for U.S.-produced natural gas are many, and come from both domestic and foreign sources. The current supply/demand gap has pushed natural gas prices to recent record levels, with the impacts being both obvious in winter heating costs, and not so obvious in higher food and beverage prices. Keep reading this blog as we continue to track natural gas pricing and other energy-related industry topics.Mercer Capital has significant experience valuing assets and companies in the energy industry. Our energy industry valuations have been reviewed and relied on by buyers, sellers and Big 4 Auditors. These energy related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed energy industry valuations domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Middle Market Transaction Update First Half 2021

U.S. M&A activity continued to rebound in the first half of 2021 from depressed levels of activity seen in 2020 due to the COVID-19 pandemic.

How Stable Is Your Family Business Stool?

My family and I have been out at the Broadmoor in Colorado Springs for a work conference. Since we were going to a nice resort and conference center, we decided to parlay the weekend into a family business meeting.Many readers here likely undertake family meetings, whether they involve dozens of family members or just a small handful of key family stakeholders.Our agenda included company division updates, a review of the family balance sheet and estate planning, individual and family goals, and new investment opportunities. We framed many of these questions within a broader framework of defining what the family business means to us, a framework we have laid out in full in a previous post.The meaning of the family business impacts the three key legs of the family business stool: dividend policy, capital investment, and financing decisions. For our family meeting, we summarized the different meanings in the graphic below. We then extended how we define our business to the stool legs; both as it is currently and future targets.Our Business StoolMy family’s business portfolio consists of three core businesses: media, technology, and movie theatres. The holdings come in part through inheritance, in part as a diversification strategy, but mainly resulted from the passions of the primary owners: newspapers, new technologies, and the movies. How do these businesses impact the legs of our family stool: dividend policy, capital investment, and financing decisions?Dividends: Currently our technology business distributes a considerable amount of its earnings to shareholders, requiring minimal working capital and other cash needs. Our media and theatre businesses have higher up-front cash costs and have experienced margin pressure in recent years due in large part to the COVID-19 pandemic, limiting any dividends. The dividends that have been paid by the core businesses have generally been used to diversify shareholder wealth outside the core businesses into other investment areas: equities and alternative investments. Investment: While we have limited additional capital spending into the technology business, the media and theatre businesses have required additional capital to both meet operational needs and growth objectives. Similar to dividends, reinvestment capital has generally been used to diversify the family business holdings into other areas outside the core businesses.Financing: Family businesses are notorious for taking on little debt, where investor psychology and how well you sleep at night may trump return considerations. In our family, that means we are averse to taking on debt to fund investments.Do We Need To Fix the Stool?After first identifying our stool (and how stable the legs were) we asked some questions regarding what we wanted the family business to pursue in our three key decisions areas: dividends, investment, and financing.Dividends: Our technology business is successful and pays solid dividends. Should we consider reinvesting into the business (a growth sector) and pursue a more aggressive growth strategy? How would limiting these dividends impact the family business from an income perspective? Are there decisions in our media and theatre operations that we should consider to improve current income returns? What does the family need regarding current income?Investment: This discussion focused on the question of diversification, something we have touched on in detail in previous posts. What should the family be investing in? Do we need an investment committee moving forward? Different family members have different personal goals, wealth levels, and beliefs: how do we reconcile these differences?Financing: While the family business has historically avoided debt, we discussed what would lead the family to accept some debt financing. Other questions were more philosophical than return focused: why would we take on debt? How does debt play into our overall risk profile? What do different family members think about taking on debt?Final TakeawaysWhile we did not answer all the questions we had regarding our family business stool, the framework of defining business meaning and how they impact the legs of the stool did lead us to ask some important questions. These questions helped us to think about the fundamental “why” of being in business together as a family. The conversation helped us to more clearly identify our goals and desires as a family, and to better position our businesses in ways to lead the business to a sustainable long-term future.Mercer Capital works with family businesses in addressing all three legs of the family business stool. We help directors identify what the business means to the family, benchmarking key metrics to relevant peers, and improving shareholder communications. Give one of our senior professionals a call today to discuss how we can help secure a more sustainable future for your family business.BonusAs a final thought, for posterity and the “family business lore” my in-laws were insistent we bring my one and two-year-old to the board meeting. Their only comment: “More dividends!”

Asset / Wealth Management Stocks See Mixed Performance During Third Quarter

After a Strong Summer, Public Asset Managers See Stock Prices Dip as Market Pulls Back in September

RIA stocks saw mixed performance during the third quarter amidst volatile performance in the broader market. In September, the S&P 500 had its worst month since March 2020, and many publicly traded asset and wealth management stocks followed suit.Performance varied by sector, with alternative asset managers faring particularly well over the last quarter. Our index of alternative asset managers was up 10% during the quarter, reflecting bullish investor sentiment for these companies based in part on long-term secular tailwinds resulting from rising asset allocations to alternative assets.The index of traditional asset and wealth managers declined 4% during the quarter, with performance reflecting the pullback in the broader market. RIA aggregators experienced a volatile quarter, but ended flat relative to the prior quarter end. The performance of RIA aggregators may be reflective of mixed investor sentiment towards the aggregator model. While the opportunity for consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising competition for deals and high leverage at many aggregators which may limit the ability of these firms to continue to source attractive deals. Performance for many of these public companies continued to be impacted by headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded asset managers, while larger scaled asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance over the last year has generally been better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts. As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and first half of 2021, multiples pulled back moderately during the most recent quarter, reflecting the market’s anticipation of lower or flat revenue and earnings as the market pulled back and AUM declined. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately-held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity continues to be significant, and multiples for privately held RIAs remain at or near all time highs due to buyer competition and shortage of firms on the market.Improving OutlookThe outlook for RIAs depends on several factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are somewhat tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has remained strong despite volatility over the prior quarter. AUM remains at or near all-time highs for many firms, and it’s likely that industry-wide revenue and earnings are as well. Given this backdrop, many RIAs are well positioned for strong financial performance in the fourth quarter.

Interpreting Inflation and Interest Rates for Auto Dealers

Can Retail Vehicle Prices Continue to Soar?

Inflation and interest rates are on more people's minds lately due to supply chain disruptions across all industries. People understand how inflation and interest rates affect their daily lives when noticing the rising cost of goods/services and the cost to borrow money to buy a house, but many don't realize that inflation and interest rates are interconnected. Inflation and interest rates are frequently linked when discussing macroeconomics and they tend to have an inverse relationship. When interest rates go up, in theory, inflation goes down. However, there are many more factors other than inflation and interest rates impacting the economy in the real world.In this post, we discuss how we got to our current reality, what auto dealers might expect regarding inflation and interest rates, and how it all might impact the dealership.How Did We Get Here?Back in April, Federal Reserve Chair Jerome Powell indicated the Fed wasn’t close to raising interest rates, labeling inflation as “transitory.” At the time, he cited strengthening economic indicators, including employment and household spending and continued vaccinations which were expected to ease uncertainty and continue the economic recovery.According to Powell, “An episode of one-time price increases as the economy reopens is not likely to lead to persistent year-over-year inflation into the future.” Further, the Fed indicated that clogged supply chains would not affect Fed policy as they were seen as temporary and expected to resolve themselves.While this transitory stance appeared reasonable at the time, confidence in this stance has waned and the Fed has begun signaling it would end its accommodative policies. Below we’ve included the first chart and table in the September edition of the Consumer Price Index (“CPI”) published by the Bureau of Labor Statistics last Wednesday (October 13, 2021).Source: Bureau of Labor Statistics- Consumer Price Index-September 2021Source: Bureau of Labor Statistics- Consumer Price Index-September 2021In our view, the graph of 12-month change supports the transitory view, at least in the beginning. Comparing prices in April 2021 to April 2020 is not very meaningful given the significant impediments to the economy at the time. However, as seen in the tables above, inflation has persisted on a monthly basis over the past six months. While 0.3% and 0.4% growth in the past two months is an improvement over March through July, it shows that the problem continues to linger.Are inflationary pressures still expected to be brief and transitory?On Tuesday, the day before September inflation numbers were published, Atlanta Federal Reserve President Raphael Bostic indicated inflationary pressures “will not be brief” and that he and his staff would no longer refer to inflation as transitory. Notably, Bostic is a voting member of the 2021 Federal Open Market Committee, and his public statement is the first to our knowledge challenging the transitory narrative. However, it shows how the Fed has evolved its stance over the past six months.In March, the Fed signaled it wouldn’t raise the Federal Funds rate until at least 2024. In June, the Fed stood by its transitory stance but began to indicate rate hikes would come sooner as the dot plot of expectations from FOMC members indicated two rate hikes in 2023. By September, half of Fed policymakers are expected to start raising rates in 2022, as seen below. While the timing of rate hikes is uncertain, it appears that accommodative policy will be eased in the not so distant future. What does that mean for auto dealers? Impact of Inflation on Auto DealershipsNotably for auto dealers, used vehicle prices surged by over 10% month-over-month in both April and June, which accounted for about a third of the total increase in the CPI for those periods. According to Cox Automotive Chief Economist Jonathan Smoke back in July, used vehicles were “the poster child illustration for transitory price hikes." While used vehicle prices, according to the CPI, have come back down to Earth in recent months, including decreases of 1.5% and 0.7% in the past two months, new vehicles have seen monthly growth of at least 1.2% since May due to supply shortages.New and used vehicle retail prices continue to climb to all-time highs. Even despite lower volumes, dealers are seeing higher revenues. Through August 2021, the average dealership was getting $3,668 in retail gross profit per new vehicle retailed. Through April of this year, that figure was $2,906 indicating a widening of profits for dealers on a per unit basis. This has played a role in the outsized profits achieved by auto dealers in 2021, who are likely wondering how long this can last.In our view, prices will continue to rise in the short-term due to supply constraints. However, consumers are becoming increasingly aware of these higher costs, and new vehicle buyers are likely delaying purchases if they are able to wait. While businesses across all industries are able to point at supply shortages and COVID as reasons for higher prices right now, at some point buyers will leave the market to wait for prices to normalize.While retail vehicle prices will eventually begin to level off, dealers are likely to remain in a strong position because dealerships have numerous complimentary profit centers. But how long will it last?While retail vehicle prices will eventually begin to level off, dealers are likely to remain in a strong position. As we’ve discussed before, auto dealerships have numerous complimentary profit centers. If a customer can’t find the new vehicle they want, a deft salesman can get them into a used vehicle. When consumers delay purchases of a vehicle, they put more mileage on their current vehicle, driving business to the higher margin service and parts operations. With fewer vehicles put on the road in 2021 due to shortages, we see a runway for more vehicle sales, even if the profit per unit declines. In the medium term, parts and service may be the area to watch. Fewer vehicle sales means parts and service will eventually dip in the future, though this likely won’t be felt for a few years. It will also be interesting to see where consumers get their vehicles serviced after purchasing from online used vehicle retailers that don’t have these operations. Along with the factors already mentioned, the future path of inflation for vehicles will likely also be impacted and interconnect to the path taken by interest rates.Impact of Interest Rates on Auto DealershipsAccording to an interesting Lexington Law study on how Americans are buying cars, auto loans are used on 85% of new car purchases and 53% of used car purchases nationwide. When interest rates fall to the prevailing low levels, consumers are able to afford more expensive cars. However, the mathematical movement of lower interest rates doesn’t necessarily mean consumers will correspondingly purchase a more expensive car. Similarly, when interest rates rise, that doesn’t mean vehicle prices have to decline. Still, dealers should be aware that this is the case, at least in theory.Interest rates matter. Auto loans are used on 85% of new car purchases and 53% of used car purchases nationwide.In practice, F&I departments can smooth out rising interest rates or rising vehicle prices by extending the length of loans. According to Lexington Law study, the amount of the monthly payment was the top priority for the average car buyer. It is natural for people to consider their monthly out-of-pocket costs and what they can afford, even if it leads to a longer loan term or higher interest rates. We should also note that APR and total interest paid are similar considerations, which when combined, amount to almost half of the decision.Source: Lexington Law | Study: How Are Americans Buying Cars?Rising interest rates will increase costs to consumers and if they’re on a fixed budget, this places downward pressure on vehicle prices. In December 2015, the Fed raised rates for the first time since the Global Financial Criss. Dealers will have to lean on their past experience on how to navigate vehicle sales in an environment of rising interest rates. Interest rates don’t only affect top line revenues for dealerships, however. The prevailing low interest environment and inventory shortage has significantly reduced one key operating expense for auto dealerships: floor-plan interest expense. Lower interest rates mean the price of keeping inventory on the lot for test drives is lower. With lower levels of inventory, interest expense is being reduced by volume as well as price. With inventories expected to normalize and interest rates expected to creep up, auto dealers will see floor plan expenses rising. It may not get back to pre-COVID levels if OEMs structurally change the level of inventories kept on dealers’ lots, but that’s another topic for another blog post.ConclusionMercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by the greater macroeconomic environment. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Chesapeake Finds Vine Ripe for the Picking

In August, Chesapeake Energy Corporation announced that it would acquire Vine Energy Inc. in a stock-and-cash transaction valued at approximately $2.2 billion. We previously discussed Vine’s IPO, which was the first upstream (non-minerals, non-SPAC) initial public offering since Berry Petroleum’s debut in mid-2017. Vine’s decision to be acquired in a ~0% premium transaction less than five months after its IPO speaks to the difficulty for E&P companies to manage public market dynamics even in a much-improved commodity price environment. In this post, we dig into the transaction rationale, look at relative value measures, and analyze how this transaction seems to indicate a shift in Chesapeake’s strategy.Transaction RationaleChesapeake’s acquisition generally follows the recent upstream M&A playbook: mostly stock, low-to no-premium, and a focus on cost synergies.Cash consideration of $1.20 per share represents 8% of the $15.00 total consideration per share. It is somewhat curious that there’s a cash component to the purchase, especially for a company that recentlyemerged from bankruptcy in a transaction that doubles the company’s leverage. However, even with the cash outlay and assumption of Vine’s debt, Chesapeake management indicates that the pro forma entity will have a relatively modest net debt to 2022E EBITDAX ratio of 0.6x.Based on market data, immediately prior to announcement, the transaction consideration represents a <1% premium to Vine’s stock price. While that may not seem like a great deal for shareholders, the 92% stock consideration means that legacy Vine shareholders should benefit from any synergies achieved by the transaction. On the announcement date, market reaction was generally positive, with both Vine and Chesapeake outperforming the broader upstream universe (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF, ticker XOP). As for those synergies, management expects to save $20 million per year on general & administrative and lease operating expenses, with another $30 million per year in capital efficiencies, resulting in an annual savings of $50 million per year. Valuation ConsiderationsRelative value measures for the transaction are shown in the following table: As with any transaction with a stock component, the transaction consideration is dynamic and fluctuates with the acquirer’s stock price. The initial transaction consideration of $15 per share was only $1 higher than Vine’s IPO price. But with the run-up in natural gas prices and continued exposure via stock consideration, Vine has recently traded at all-time highs and is now within its initial IPO offer range. Chesapeake Shifts Back to Natural Gas RootsChesapeake has historically focused on natural gas production. However, in the wake of persistently low natural gas prices from roughly 2010-2020, the company sought to diversify its production mix and become more oil focused. In pursuit of this goal, the company was particularly active on the M&A and A&D front, with actions including the sale of itsUtica assets in Ohio and acquisition of Eagle Ford producer WildHorse Development Corporation. Ultimately, the company overextended itself and entered bankruptcy in mid-2020. After emerging from bankruptcy earlier this year, management indicated that investment activity would be focused on natural gas assets. The timing seems apt with the recent increase in natural gas prices. The acquisition of Vine will stem Chesapeake’s recent trend of production declines and materially increase its natural gas mix. ConclusionVine’s brief stint as a public company looks to be coming to an end. With natural gas stealing the spotlight from crude oil, Chesapeake is seeking to return to its former glory as America’s natural gas champion. The combination with Vine will make Chesapeake a dominate force in the Haynesville and support the company’s pivot away from oil.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Looming Estate Plan Disruptions

Are You Prepared?

"Have you not reserved even some type of blessing for me? Has my brother really taken everything?!" cried Esau. Isaac answered, "Behold, I made him a master over you, and I gave him all his brothers as servants, and I have sustained him with corn and wine; so for you then, what shall I do, my son?” – Genesis 27 : 36-37Jacob may have caused the first recorded major disruption to a family’s long-term estate planning goals. While there is no familial deception or lentil soup traded for birthrights, numerous changes lurk in the current reconciliation bill snaking its way through Congress and it could have major ramifications to the plans you worked up just a few years ago.We applaud family businesses and their advisors setting up estate plans with more guardrails than deathbed blessings, but would we be remiss if we failed to ask: Have you pulled out those documents recently? Below we briefly touch on planning vehicles and structures as well as valuation tools currently being debated in the reconciliation bill and why they are important to many family business owners and advisors.Estate & Gift Tax ExemptionThe current law provides an estate and gift tax exemption of $11.7 million per individual or $23.4 million for a married couple. This provision is currently set to sunset December 31, 2025. Previous guidance has stated any gifts made prior to any changes to the exemption will not be clawed back.The current proposal rolls back the exemption amount to $6.02 million per individual adjusted for inflation or $12.04 million for a married couple, slashing the benefit effectively in half. The effective date of change under the current proposed bill is January 1, 2022.Individuals who anticipate their estate may exceed the lower threshold of $12.04 million should consider executing estate planning strategies to transfer that wealth before the end of the year, including gifting to descendants or a trust (more discussed below). In less eloquent terms: Use It or Lose It!Trust ChangesThe “Bull Moose” would likely beam with pride regarding the current reconciliation bill’s “Trust busting” features. In general, many of the law’s provisions are meant to curtail, if not outright eliminate, tools utilized by estate tax advisors and attorneys. Many of the changes are expected to become effective either 1) at signage of the bill or 2) January 1, 2022.The National Law Review provided a good summary regarding Grantor Trusts. In general, the current reconciliation bill largely eliminates many of the estate planning benefits of grantor trusts (trusts deemed to be owned by the creator of the trust or another person (each referred to as a “grantor”) for federal income tax purposes). The following rules would apply to trusts created on or after the date of enactment and to existing trusts to the extent transfers are made to such trusts on or after the date of enactment.Estate Tax Inclusion - Assets owned by a grantor trust would be included in the grantor's estate and subject to estate tax upon the grantor's death.Distributions as Gifts - Distributions from a grantor trust during the grantor's lifetime would generally be treated as taxable gifts.Taxation Upon Termination of Grantor Trust Status - If the trust's grantor trust status is terminated (i.e., the trust becomes a separate taxpayer from the deemed owner), the grantor would be deemed to have made a taxable gift of the trust assets.Gain Recognized Upon Transfers to Grantor Trust - Transfers between a grantor trust and its grantor would be subject to income tax regardless of when the grantor trust was created. A key piece you and your planning team need to consider is, as it reads: The Legislation would apply to all post-enactment transfers between a grantor and grantor trust, including grantor trusts created prior to the date of enactment. Therefore, a sale or swap of assets after the Legislation’s effective date between a pre-enactment grantor trust and its grantor would be an income tax realization event. Likewise, a GRAT annuity payment made in kind with appreciated assets to the grantor, after the Legislation’s effective date, would be an income tax realization event. With respect to these grantor trust provisions, the House Bill includes a footnote which states, “A technical correction may be necessary to reflect this intent.” Grantor trusts are a big deal, but many other trust structures could fall under some of the same new, restrictive rules, including the following:Grantor Retained Annuity Trusts (GRATs)Qualified Personal Residence Trusts (QPRTs)Grantor Charitable Lead Annuity Trusts (CLATs)Spousal Lifetime Access Trusts (SLATs)Irrevocable Life Insurance Trusts (ILITs) Gassman, Crotty, & Denicolo, P.A. had a great webinar recently to cover several possible changes to these vehicles. You can check it out here.Valuation Discounts for Passive AssetsIn a business valuation setting, valuation discounts for lack of control, lack of marketability, and lack of voting rights are allowed, but often require substantiation, quantification, and defense by a business appraiser communicated in a formal appraisal report.As discussed in Mercer Capital’s Auto Dealer blog, the current version of the reconciliation bill proposes to eliminate valuation discounts for an entity’s “non-business”, or passive, assets including certain cash balances, marketable securities, equity in another entity, or real estate. Actively utilized working capital or real estate for business operations would not be considered “passive.” The effective date of enactment would be January 1, 2022.We would argue discounts for lack of marketability and control represent quantifiable economic realities facing minority owners in nonmarketable passive entities. Regardless, the law’s impact would be large. Often, combined discounts for lack of control and marketability can range from 25-45%.An option business owners should consider is triggering a valuation of minority ownership positions with a valuation date prior to the effective law date. A 25%-45% increase in reportable gifts would only be compounded by the law’s lowering gift tax exemption (discussed previously).ConclusionWe provide valuation services to families seeking to optimize their estate plans and we work with estate tax attorneys all across the country. Give one of our professionals a call to discuss how we can help you in the current environment.

“Permanent” Capital Providers Offer a Different Type of RIA Investor

Beginning With No End in Mind

Several pre-pandemic years ago, my family and I enjoyed a long vacation in England, touring the usual castles, cathedrals, and museums. At some point in the trip, my kids noticed that many of the buildings we toured and historical objects we saw were in some way tied to, owned by, or were on loan from, the royal family. Whether it was Windsor Castle, the Crown Jewels in the Tower of London, or the Bentley limousines garaged at Buckingham Palace, much of what you see as a tourist in England is recorded on Her Majesty’s balance sheet.I took the opportunity to point out to my kids that a reliable way to accumulate wealth was to invest in assets you would never want to sell, and then don’t sell them. The best assets tend to remain the best, and the avoidance of transaction costs removes a drag on returns that everyone – in my experience – underestimates.The increased prominence of “permanent” capital providers in the RIA space takes me back to the multi-generational buy-and-hold strategy of the royals, not just because of the avoidance of transaction costs but also because of the premium entry prices being paid. In 1852, Prince Albert and Queen Victoria paid £32,000 for a vacation home now known as Balmoral Castle. What was that price relative to market? I don’t know, but 170 years later, it doesn’t matter.GPs at private equity conferences once liked to boast about their success in booking “gains on purchase” – a clever way of saying they could buy at a discount to market. No one talks that way in the RIA community these days. If anything, I’m struck by how sponsor-backed acquirers are willing to state, publicly, their willingness to outbid each other. I won’t call anyone out with specific examples, but they aren’t hard to find.RIAs are probably the best coupon available in a low-to-no yield environment.It’s as if a land-grab is underway, with competing interests looking to consolidate as much market share in the investment management community as they can, as fast as possible. The trouble is that RIAs are a sort of land that is actually still being manufactured. Despite the rampant consolidation in the space, the number of RIAs is steadily on the increase. Nevertheless, there is legitimate cause for enthusiasm.As we’ve written many times in this blog, investing in the RIA space represents a singular opportunity. RIAs are probably the best coupon available in a low-to-no yield environment. They are a growth and income play like none other. They are practically the apotheosis of diversification in a way that Harry Markowitz could have only dreamed of when he started publishing his research nearly 60 years ago.Unfortunately, many reasonable ambitions, stretched far enough, eventually become wellsprings of regret.Returns and valuations are inversely related, after all. An unfettered willingness to pay more is just a race to the bottom on ROI. Financial engineering doesn’t repeal the laws of financial gravity. Taking more and greater risks leads to a greater variability of outcomes. Paying more compresses returns. To my way of thinking, this isn’t prudent – but I’m not paid to manage capital.Professional investors must work in the market they have, not the market they want. It’s all well and good to talk about “patient” capital, but LPs aren’t going to pay 200 basis points for someone to hold their cash, regardless of how advisable that might be. Given that mandate, the question of whether to make investments at these levels pivots to how best to do it. What opportunities are available in the present – and potentially lingering – environment of high entrance multiples?Financial engineering doesn’t repeal the laws of financial gravity.I’ll posit that the rise of “permanent capital” providers is both in response to and appropriate for current market conditions in the RIA space. This is in sharp contrast to the prevailing “fund” behavior in the private equity community, in which LPs commit capital for a specified length of time – ten years or so – and fund managers have to make investment decisions with an expectation of being in and out of an investment in less time than that – say five to seven – to generate the kind of ROI it takes to raise the next fund.Anyone who’s spent a few moments (or a career) with DCF models knows that there are a limited number of levers to pull to rationalize a high entry price with a five-year holding period. You can assume supernormal growth (unlikely in a mature space like investment management), high exit pricing (multiple arbitrage - aka the greater fool theory), squeezing margins (underinvestment), or low discount rates (race to the bottom on ROI).The other possible lever is, of course, leverage. Debt can enhance equity returns so long as it doesn’t wipe them out entirely. Unfortunately, it’s only in hindsight that we know what leverage ratio is (or was) optimal.Making a permanent capital investment doesn’t eliminate the depressive effects of current valuations on returns, but it mitigates them. Without the pressure to generate an exit within the foreseeable future, RIA investors can focus on the opportunities for sustainable and growing distributions. The longer distributions persist and the more they grow, the less of an impact the entry price has on total return.Further, without the financial friction of trading out of an investment in a few years and the costs and risks of reinvestment, the opportunity for superior returns – especially relative to those available at similar risk elsewhere in the current market – is greater.The question of how long “permanent capital” lasts is a good one. The investors backing many of these enterprises tend to be insurance companies with very long time horizons. The thousand-year outlook of William the Conqueror probably isn’t relevant to investing in RIAs, but the mindset of an indefinitely lengthy holding period leads permanent capital sponsors to different decision making, which may prove useful in times like this. It’s hard to think long term when the M&A headlines keep coming, but the business cycle has a lot of staying power. In this market, investors need staying power as well.

The Evolution of E&P ESG Scores

Trends from 2016-2020

As quarterly earnings calls have come and gone over the past several years, the frequency with which environmental, social, and governance topics are explicitly discussed have been ever-increasing. On the whole, ESG topics are sector and industry agnostic. While not all ESG topics come into play equally for every sector and industry, there are always some elements, issues or characteristics of any given company or industry that could be put into at least one, if not all, of those three buckets.Within the E&P space–and the oil and gas sector overall–operators have increasingly included ESG talking points in their management commentary, signaling proactive initiative rather than reactive response. One could argue this approach helps to lead the discussion by addressing what they can do, are doing, and will do, as opposed to having to answer to why they are not taking actions to mitigate some issues that were determined or assumed to be a priority by an outside party.Regardless of the impetus for ESG topics entering the zeitgeist, the result is an increase in self-reporting by E&P operators as to what they’re doing to improve, or at least address, noted ESG concerns.Naturally, however, the noble action of self-reporting does not mean the stated or signaled information is accurate or fully reflects all known or knowable information. Of course, it should not be assumed that such information is inherently or purposefully misleading either. Sometimes you take it with a grain of salt; sometimes you empty the shaker or season to taste.Given the potential for obfuscation, though, it helps to have a more objective party discern what information is verifiable and accurate, as far as that may be determinable. One such platform, S&P’s Global Market Intelligence, provides such ESG evaluation services, including the provision of ESG scores to gauge where companies stand with respect to their self-reporting.In this post, we take a brief look at several ESG criteria among E&P operators to see what trends may be present among the operators with the highest and lowest ESG scores, as provided by Global Market Intelligence.Total ESG ScoresIt is far beyond the scope of this article to explain the machinations and processes that underlie the production of the ESG scores determined by Global Market Intelligence. For simplicity, we consider the ESG scores in an ordinal and relative way. For example, if Company A and Company B have ESG scores of 10 and 20, respectively, it is not to say that the self-reporting by Company B is twice as good as Company A’s reporting, but simply that Company B reports more information which can be verified.The other side of the coin is that, in theory, a company could be a model example of ESG stewardship, but still have an ESG score of 0 if it doesn’t self-report or may not provide information that is readily verifiable. This would not be a likely scenario, but again, “in theory…”.Note that, in addition to a company’s “Total” ESG score, there are scores for the respective E, S and G groups, with more granular scores for specific criteria within each of those three buckets. We will refer to the Total ESG scores, as well as scores for three criteria that represent the environmental, social, and governance groups, respectively.We utilized the Global Market Intelligence platform to screen for U.S. E&P operators with market capitalizations over $10 million (as of October 6), with 124 resulting companies. We then pared this list down to 12 operators that consistently had annual Total ESG scores from 2016 to 2020 (the latest data available), presented as follows:Click here to expand the image aboveGenerally, the list is presented in ascending order, with the lower-scoring operators towards the top and higher-scoring operators towards the bottom.As may be gleaned from the chart above, the three lowest scoring E&P operators, on average, were Diamondback Energy, Continental Resources, and Coterra Energy.1The three highest scoring operators, on average, were Hess Corporation, ConocoPhillips, and Ovintiv (formerly Encana Corporation).We note that the ESG scores among the lowest-scoring companies all declined from 2016 to 2020, with Continental Resources’ and Coterra Energy’s scores among those with the greatest decline among the entire group of companies presented. The ESG scores for ConocoPhillips and Hess Corporation were approximately at the 3rd quartile with respect to their “growth”, while Ovintiv’s ESG scores showed a moderate decline from 2016 to 2020. Although we do not discuss Pioneer Natural Resources in depth here, we do note that it exhibited the greatest growth in its ESG score from 2016 to 2020.E, S, and GAs mentioned earlier, each of the environmental, social, and governance groups have respective subsets of criteria which are surveyed, analyzed, scored, and weighted by Global Market Intelligence. For example: criteria within the environmental group includes items such as “biodiversity,” “climate strategy,” and “water related risks”; the social group includes criteria such as “social impacts on communities,” “human capital development,” and “human rights”; and the governance group includes criteria such as “brand management,” “marketing practices,” and “supply chain management.”One environmental criterion we looked at was climate strategy, 2 with the company ESG scores as follows:Click here to expand the image aboveOnly 3 companies had ESG scores for this criterion that indicated improvement from 2016 to 2020. However, the growth between these two periods masks the development of these scores in the interceding periods. Notably, the score for Diamondback Energy dipped in 2018 and 2019, but returned to the levels seen in 2016 and 2017. Furthermore, several companies, including EOG Resources, Pioneer Natural Resources, Marathon Oil, and Ovintiv all showed significant improvement in the score from 2019 to 2020.Last, but not least, we reach the criterion selected representing the governance topics: policy influence.3Click here to expand the image aboveAs you will notice, all companies had “NA” in place of scores in 2016, indicating this criterion was not included on the Global Market Intelligence survey that year. We note that these scores objectively focus on the extent of the verifiable public disclosure related to the companies’ contributions to political campaigns, lobby groups, and trade associations which may influence the policies affecting industry operations and regulations; these scores do not indicate levels of financial contribution or subjective perspectives regarding levels of influence in promoting or interfering with any particular policy.On the HorizonMoving forward, it will be interesting to compare the objective ESG scores with the quantity and quality of the information divulged and discussed in E&P operators’ earnings calls. Presumably, the ESG scores should rise in tandem with the greater levels of discussion and disclosures in the calls. We may find out soon enough with the upcoming earnings call season, as Diamondback Energy, Continental Resources, EOG Resources, Pioneer Natural Resources, Marathon Oil, and EQT Corporation regularly make appearances in our quarterly blog post, Earnings Calls - E&P Operators.ConclusionMercer Capital has its finger on the pulse of the E&P operator space. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.1 We note that the results of our company screen included E&P operators which may have had an “na” in place of a Total ESG score in one of the years from 2016 to 2020, in which case these companies were excluded from the companies listed above. There are several reasons this may occur (most likely, a lack of self-reporting for whatever reason in that particular year), but we selected the presented companies to focus on E&P operators which have made a concerted effort to self-report with consistency in the recent past.2 From Global Market Intelligence: “Most industries are likely to be impacted by climate change, albeit to a varying degree; consequently, they face a need to design strategies commensurate to the scale of the challenge for their industry. While most focus on the risks associated with a changing climate, some seek to identify and seize the business opportunities linked to this global challenge. The questions in this criterion have been developed in alignment with the CDP methodology as part of a collaboration between us and CDP https://www.cdproject.net.” We note that CDP is a not-for-profit charity that runs a global disclosure system for investors, companies, cities, states and regions to manage their environmental impacts.3 From Global Market Intelligence: “Although companies legitimately represent themselves in legislative, political and public discourse, excessive contributions to political campaigns, lobbying expenditures and contributions to trade associations and other tax-exempt groups may damage companies’ reputations and creates risks of corruption. In this criterion, we evaluate the amount of money companies are allocating to organizations whose primary role is to create or influence public policy, legislation and regulations. We also ask for the largest contributions to such groups, and we assess the public disclosure on these two aspects.”

September 2021 SAAR

September 2021 SAAR was 12.2 million, dropping for the fifth consecutive month amidst an ongoing inventory shortage. The September SAAR was the lowest since May 2020’s 12.1 million units but has not fallen near the COVID-19 pandemic low of 8.6 million units in April of 2020.Tight inventories limited both fleet and retail sales in September, which has been the same case over the last four months. Fleet sales continue to fall as a percent of total sales, making up just 12% over the last month, as higher profit retail sales continue to be prioritized.As mentioned in last month’s SAAR blog, auto dealers started the month with industry-wide record low inventory levels of 1.06 million units. Inventory levels have not improved much since then, but the industry inventory to sales ratio has modestly ticked up from 0.68 to 0.72. This could be explained by sales rates finally slowing down and keeping pace with production rates. High levels of demand and low supply have been coexisting for months, and there are only so many new vehicles to go around as consumers are increasingly pre-ordering vehicles before they even arrive on dealers’ lots. While high prices are keeping away certain customers that have decided to wait, wider margins are keeping dealers profitable. However, at current production rates there are only so many vehicles being produced by OEMs that can make it to the lot, and high trade-in values and wide margins can only do so much to bridge the gap for dealers that may not have a new car to sell to a potential trade-in customer down the line. In response to the current climate, average transaction prices have continued to rise. The average transaction price of a new vehicle is expected to top $42,800, another all-time high and the fourth straight month that prices have exceeded $40,000. Dealers have taken advantage of high prices to sustain profitability by achieving high margins on each vehicle sold for months now, and the factors involved continue to benefit dealers. For example, average incentive spending per unit is expected to reach another record low of $1,755 per vehicle, down from $1,823 a month ago, driving GPUs up even further. Another factor that influences dealer profitability, inventory turnover, decreased again as well. The average time that a new vehicle sat in the lot during September was 23 days, down from 25 days in August and 54 days in September 2020 reducing floor plan interest expense. What Do Tech Investments By OEMs Mean For My Dealership?In a previous blog outlining the different options that dealers have when allocating capital amidst excess liquidity, a few options were highlighted. Dealers can either 1) reinvest in the business, 2) return capital to debt and equity stakeholders or 3) seek acquisitions to drive growth. These fundamental decisions apply to OEMs as well, and over the last several months many OEMs have decided to reinvest in the core operations of the business by shifting their focus to electric vehicles.Listed below are narratives of some of the investments OEMs have made and how they might affect the value of your privately held dealership.Nissan has developed a new technique for assembling vehicles more efficiently and with less waste. This technique, called SUMO, enables Nissan to produce vehicles 10% cheaper than before, despite them manufacturing increasingly complex vehicles like hybrids and EVs.General Motors is developing a supply chain for rare-earth metals for the production of EVs, a move expected to pave the way for a more reliable stream of General Motors EVs in the future.Ford has also reinvested in EV operations, and has recently partnered with Electrify America, ChargePoint and others to bolster its charging network.Ford has also announced a state-of-the-art production facility that is set to be built in west Tennessee, creating 5,800 positions to produce electric F-150 trucks. The plant is also said to be a zero-waste-to-landfill facility. The point is that almost every major vehicle manufacturer is investing in the future of its EV production process, a move that some analysts think will lead to higher, Tesla-like, valuations. However, it is unclear whether OEMs will start to invest in support for dealership maintenance infrastructure. Many have already chosen to pass along the costs of investments needed for the sale and service of EV vehicles onto the dealer, creating several issues surrounding the economics of an upgrade for rural and smaller dealerships. Time will tell whether OEMs will choose to prioritize the amount of EVs on lots by further subsiding transition fees.ForecastLooking ahead to October, expectations for the full year 2021 SAAR have once again been lowered. Experts estimate that the global industry has already lost around 9 million units of production related to supply chain issues, and that number should continue to mount with no end in sight for OEMS until and likely into 2022. The demand for new and used vehicles is expected to remain feverish, but sales will have to contend with ongoing production constraints. Sales can no longer outpace production as inventory has been drawn down.At this point, we are pretty confident sales in Q4 won’t be high enough to reach our initial 2021 target. Despite a challenging year from an operational standpoint, we doubt many dealers will be complaining with the results and the profits achieved this year.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

September Acquisitions by Sonic, Asbury, and Group 1 and What They Mean for Privately Held Auto Dealerships

Smallest Public Players Getting Larger

In three consecutive weeks, 117 auto dealerships were bought across 3 transactions, each scooping up more dealerships than the last. The three smaller pure-play public auto dealership companies (Group 1 Automotive, Sonic Automotive and Asbury Auto Group) all made sizable acquisitions in a red hot M&A market coming after Lithia purchased a large private auto group back in April. Surely, executives of these companies have been reading our blog about achieving growth by reinvesting in core operations through M&A.Group 1 (188 dealerships) is acquiring 30 stores (13.8% of pro forma dealership count) from Prime Automotive Group, which is the smallest acquisition by the largest player in this post, though it still shows a significant trend for the industry. Sonic’s acquisition of 33-store RFJ Auto Partners is sizable compared to its 84 franchised dealerships as of mid-year (28.2% of pro forma) and renders our writeup of Sonic from two weeks ago stale.Asbury is acquiring 54 new-vehicle dealerships from Larry H. Miller compared to 91 dealership locations at mid-year (37.2% of pro forma) which is a considerable transaction particularly on the back of its Park Place Acquisition of 12 luxury stores just over a year ago.These transactions highlight a couple of key themes in the marketplace for auto dealerships. First, elevated performance and valuations mean that now may be a good time to sell. Secondly, scale will be increasingly important in the online retailing age, and even the public players are looking to catch up while some of the largest private players are willing to exit.Group 1 Acquisition of PrimeAs reported by Automotive News on September 13, Group 1 agreed to pay $880 million for 30 dealerships, three collision centers and related real estate from Prime Automotive Group, the 18th largest dealer by 2020 new retail volumes. The timeline for execution of the deal was set for 75 days, though this could be delayed by framework agreements, which govern the relationships between automakers and their largest franchised dealers, limiting the number of stores one owner can have of the same brand or in a certain region.The deal could also be delayed by investors in Prime’s majority owner GPB Capital Holdings, an alternative-asset management firm that has been marred by scandal and lawsuits. These legal issues led those in the industry to expect a sale in 2021 as Prime had received termination notices from a couple of its brands at three of its dealerships.Prime Automotive Group is based in Westwood Massachusetts with operations in the Mid-Atlantic and New England markets. Its brand portfolio includes Acura, Airstream, Audi, BMW, Buick, Chrysler, Dodge, Ford, GMC, Honda, Jeep, Land Rover, Mazda, Mercedes-Benz, MINI, Porsche, RAM, Subaru, Toyota, Volkswagen, and Volvo. Once the acquisition is completed, Group 1's consolidated brand mix is expected to be approximately 43% luxury, 36% non-luxury import, and 21% non-luxury domestic.Group 1 executives highlighted cost synergies, diversification of its U.S. footprint, and extending the reach of its online digital retailing process “AcceleRide” as key reasons for the acquisition. While the Company has some international diversification (44 of 188 pre-transaction dealership locations are international in the U.K. or Brazil), this transaction should provide geographic diversification as Group 1’s domestic dealerships are heavily concentrated in Texas. The northeast is also a natural extension for Group 1, which already has 16 locations in the region.Sonic Acquisition of RFJ Auto PartnersAs reported by Automotive News on September 22, Sonic paid $700 million to add an estimated $3.2 billion in annualized revenues with its acquisition of RFJ Auto Partners. The deal is expected to close in December 2021 and management expects “day one” synergies based on its prior relationship with RFJ CEO Rick Ford, a former Sonic executive.Sonic management also noted the deal furthers their strategy to increase its geographic reach and expand its brand portfolio, diversifying within the auto retailing space which is important as the smallest of the pure-play franchised retailers. Like Group 1, Sonic also touted the benefits the transaction would have with launching its digital omnichannel platform later this year.RFJ Auto Partners, Inc. was established in 2014 and is based in Plano, Texas. It is one of the largest privately owned auto retail platforms in the United States, with nearly 1,700 employees and a dealership footprint of 33 rooftops located in 7 states throughout the Pacific Northwest, Midwest and Southwest. The RFJ Auto brand portfolio includes Chrysler, Jeep, Dodge, RAM, Chevrolet, GMC, Buick, Lexus, Toyota, Ford, Nissan, Hyundai, Honda, Mazda, Alfa Romeo, and Maserati.The transaction will add six incremental states (Idaho, Indiana, Missouri, Montana, New Mexico, and Washington) to Sonic’s geographic coverage and five additional brands to its portfolio, including the highest volume CDJR dealer in the world in Dave Smith Motors.The deal was touted as an acquisition of a top-15 dealer group. Reviewing the annual Auto News publication, RFJ came in as the 42nd largest dealership by new vehicles retailed. However, it is the 14th largest by revenues, meaning its portfolio has a heavier tilt towards luxury than those ranked above it. Also notable is that RFJ acquired 13 of its 38 dealerships in March 2020. While RFJ may or may not have benefitted from a price concession due to the uncertainty of the COVID-19 pandemic, the deal occurred well before the recent run-up in valuations.RFJ is currently owned by The Jordan Company, a middle-market PE firm headquartered in New York who classified the investment as an automotive dealership platform. While deal terms were not disclosed, it is likely the seller opted to monetize while valuations are relatively high. Private equity is typically viewed to not be a permanent source of capital with a typical investment horizon of 5-7 years. RFJ was founded in 2014, meaning its sale in 2021 was at the longer end of that range. The sale was likely aided by the market conditions for auto dealerships coming out of the pandemic.While other public players, namely Lithia, have sought to expand through numerous smaller acquisitions, Sonic opted to take a larger bite at the apple acquiring a dealership group that will contribute about 28% of Sonic’s post-acquisition stores. In valuation, a size premium is usually added to the cost of capital for smaller operations, meaning a premium is likely paid for larger dealership groups. However, this eases the efforts of integrating into Sonic’s established platform and also reduces excessive costs associated with doing due diligence across numerous deals.Asbury Acquisition of Larry H. Miller DealershipsNot to be outdone, Asbury announced its acquisition of Larry H. Miller Dealerships a week later paying $3.2 billion for annualized revenues of $5.7 billion. Larry H. Miller Dealerships ranked 8th in both revenues and new vehicles retailed in 2020, the second largest private dealership behind Hendrick Automotive Group. This is a significant statement made by Asbury, likely to make it the fourth largest new auto retailer behind only Lithia, AutoNation, and Penske.This “transformative” acquisition follows another transformative transaction all the way back in 2020 when it acquired Park Place, a deal that was downsized from its original announcement due to complications brought on by the uncertainty related to the COVID-19 pandemic. The deal is expected to close prior to the end of the year. Like Group 1, manufacturer approval is not anticipated to be a material concern though Asbury CEO David Hult did note one unidentified brand might pose an issue.Hult noted the acquisition will help the Company “rapidly expand [its] presence into these desirable, high-growth Western markets with strong accretion from day-one.” He continued to note how the geographic footprint will be complemented by “Clicklane,” its omnichannel platform.This transaction will diversify Asbury's geographic mix, with entry into six Western states: Arizona, Utah, New Mexico, Idaho, California, and Washington, and adds to its growing Colorado footprint. Larry H. Miller Dealerships portfolio mix is largely domestic brands, contrasting the Park Place Acquisition that was primarily luxury offerings.Going from 91 to 145 dealerships is a significant step up in size for Asbury. According to Automotive News, this acquisition may make Asbury too large for a takeover attempt by Lithia, who has been the most aggressive acquiror in the automotive retail space. While Asbury would have been complementary geographically to Lithia, the Miller locations would now create more overlap, complicating a deal.Trends for Private Auto DealershipsThese significant acquisitions show a clear appetite from the larger players to grow their operations. Current operating trends also provide some helpful perspective. Inventory shortages and potential for structural changes to inventory levels are likely to make sourcing vehicles increasingly important for auto dealerships.Dealers operating in multiple geographic areas are likely to benefit from sourcing vehicles from numerous places that can be reconditioned and sold where demand is highest. Vehicles can also be moved around to areas where demand is highest in order to maximize GPUs. From a valuation perspective, brand and geographic diversity also reduce risk for dealers looking to go all-in on automotive retail. While diversification is beneficial from a risk perspective, it’s also likely required from a practical standpoint due to framework agreements.Used-only retailers may have better name recognition among consumers than some of these public players because many acquired dealerships continue to operate under the name of the prevailing business. However, increasing scale and building out online platforms will help, and these dealers have the built-in advantage of also having the ability to sell new vehicles, which the Carvanas of the world cannot.For private dealers, it appears there is and will be a market for bolt-on acquisitions, though public players may be more likely to act on larger groups first if these transactions are any indications. Still, Group 1 acquired two dealerships in Texas on Monday, so it seems they are willing to listen to all sizes of deals. According to Erin Kerrigan of Kerrigan Advisors, these three transactions are “indicative of an accelerating pace of industry consolidation with the top 50 dealership groups that are private now looking, in many cases, to exit.” While the Asbury-Larry H. Miller deal may appear to be capping this trend with four mega-deals, Kerrigan indicates it may be “a harbinger for the future”.ConclusionLarger private dealerships exiting the business is something to keep an eye on. Transactions occur on a case-by-case basis, as illustrated by the turmoil surrounding Prime. However, a trend is clear with four of the largest privately held auto groups selling in 2021. Dealers will want to continue their dialogues with their OEMs for the future of automotive retailing and how they can best compete as the industry consolidates.As we’ve noted before, these transactions indicate that there are fewer owners now than in the past, but the number of dealerships hasn’t moved significantly, meaning even smaller players will continue to have a foothold and serve their local communities.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Should Your Family Consider a Family Office?

Who Should Manage Your Family Wealth?If you are in the fortunate position to be the owner of a profitable family business you might consider hiring an expert to help manage your wealth. If so, you should be familiar with two primary business models available to assist in wealth management: traditional wealth management firms and family offices.While there is overlap in the services provided and the clientele served, there are some key differences in deciding which financial solution is best for an ultra-high net worth individual or family.Traditional Wealth ManagersTraditional wealth management offices are the most accessible avenue for financial guidance and most cost-effective solution for managing family wealth. Clients of traditional wealth managers include everyone from the mass affluent (typically considered a net worth of above $250 thousand to $1 million) to ultra-high net worth individuals (exceeding $30 million). In general, wealth management advisors manage a client’s wealth holistically, typically for a set fee based on total assets under management, a flat fee, or an hourly fee.Wealth management advisors manage a client’s wealth holistically, typically for a set fee based on total assets under management, a flat fee, or an hourly fee.The investment process often begins with financial planning, communicating a client’s financial situation, goals, and risk tolerance. Once an investment plan is in place, investors can expect annual or quarterly meetings to review and rebalance the portfolio according to the client’s current financial situation. Asset classes and investment products utilized may differ among wealth managers but for the most are usually selected based on the objective of the client.Wealth managers can either manage your assets on a discretionary or non-discretionary basis depending on what level of involvement you prefer. For those who are looking to entirely outsource their investment panning, a discretionary plan will allow an authorized broker or advisor to buy and sell securities without the client’s consent for each trade. As wealth accumulates, many families pursuing a traditional wealth management route seek management on a discretionary basis.In the wealth management community, there are two primary business types to work with: wirehouse teams and independent Registered Investment Advisors (or “RIAs”). Wirehouses include well-known brands such as Morgan Stanley, Bank of America’s Merrill Lynch, UBS, Wells Fargo among numerous others. Wirehouses are typically much larger than RIAs with branch offices and correspondents internationally sharing financial information, research, and prices. Clients can often choose to be charged on a fee basis in which advisors are paid a percentage of assets managed or by commission on transactions.In the wealth management community, there are two primary business types to work with: wirehouse teams and independent Registered Investment Advisors (or “RIAs”).RIAs are generally much smaller and more well-known RIA brands include Cambridge Associates, Mercer Global Advisors, and Fisher Asset Management among others. However, because RIAs generally consist of a single office with a handful of advisors operating on a local or regional scale, it is likely that the most readily available and appropriate RIA for you is locally owned, operated, and known (much like a local or regional bank).Hallmarks of RIAs include the fee structure of assets managed for compensation, the use of custodians, and the “Fiduciary” standard. While assets and transactions are overseen by an advisor, assets are “held away” with a custodian such as Fidelity, Schwab, Pershing, or TD Ameritrade, among others, to ensure the safety of assets and minimize holding costs. The fiduciary standard legally binds advisors to act in the best interest of the client in all circumstances. By contrast, other advisor models are held to a lower, “suitability” standard. In recent history legislation has increasingly narrowed the divide between these two standards.Other wealth management models include regional firms such as Raymond James and Ameriprise Financial, as well as boutique firms such as Credit Suisee, Deutsche Bank, and Barclays. Regional firms operate similarly to wirehouses despite having a limited geographic presence. Boutique firms are generally located in major metropolitan areas and cater to clients with a minimum of $2 million in liquid assets held. Depending on the firm, boutique managers may offer more flexible and unique investment strategies or may offer expertise in a single, niche asset class or strategy.Family OfficesThe concept of a family office dates back as far as 27 BC, however, the modern family office, as we know it today, took shape in 1882 when the Rockefeller family (with approximately $1.4 billion, equating to around $255 billion today) founded their family office to organize the family’s business operations and manage their investment needs.Like a traditional wealth manager, a family office provides investment management services. However, a family office offers a wider variety of services providing a total outsourced solution tailored to individual family needs. A family office can assist in investment management, tax planning, charitable giving, family education, legacy planning, and in some cases, even lifestyle assistance through travel arrangements, personal security, and other household services. Because most family offices are built around an individual family’s needs, it is difficult to identify a “typical” family office.A family office offers a wider variety of services providing a total outsourced solution tailored to individual family needs.Single family offices cater a comprehensive array of services to a family, but the costs can be prohibitive due to their extensive and unique nature. Typically, a family’s assets must exceed $100 million to warrant the operation of a family office. Multi-family offices were developed as a more cost effective option, pulling a group of families’ assets (usually in excess of $25 million per family) with similar needs to share overhead. Unlike a single family office, multi-family offices must be registered with the SEC and are typically structured like RIAs or trust companies.One key differentiator is that a multi-family office is a profit driven institution whereas a single family office’s primary goal is to preserve and generate wealth for the family. Because profits are shared between families (via returns on investment) and the ownership base, multi-family offices theoretically generate lower returns on assets than single-family offices despite being more efficient due to the cost sharing across families.Which Is Right For You?At the end of the day, it comes down to your needs and, to a certain extent, preference. Family offices offer a more tailored client experience than a traditional wealth management firm and can provide a great deal more flexibility and convenience due to their ability to manage nearly all aspects of client financial life. However, traditional wealth managers can help prevent disputes arising from mixing business with family and don’t come with the prohibitive costs or necessary asset base associated with opening a family office.Most advisors recommend a balance sheet figure of approximately $100 million dollars in net worth before considering a family office and often $250 million before considering in house investment management and research. However, just because you can afford one, doesn’t mean you need one. The decision to start a family office is nuanced and relates to the complexity of a family’s portfolio, liquidity needs, lifestyle, and estate planning among numerous other factors best discussed with a personal wealth advisor.For instance, even an entrepreneur with several hundred million dollars in net worth may not need the support of a family office if his/her wealth is mostly held in one company stock. Similarly, families with net worth’s mostly tied to trading securities will not need a family office, regardless of net worth, as such a portfolio would be more efficiently served by a wealth manager. Conversely, for an investor with a highly diversified portfolio with a high degree of illiquidity and legal and accounting complexity, a family office may be justified.A complicated lifestyle and expenditure can also qualify a family or individual for a family office. If a family’s time spent budgeting, coordinating private travel, and making purchases is burdening their ability to run a successful enterprise, a family office may free up time and resources better served in the careers and businesses that created such wealth to begin with. Or perhaps, a family office can free up a family to pursue philanthropic endeavors. Families with complicated estate plans consisting of multiple family entities, foundations, and trusts may also require full time staff to execute.Family offices are not merely reserved for the passive investor. Family offices often facilitate direct investments into private equity and allow for a more “hands on” approach of investment alongside qualified professionals into alternative asset classes. The prominence of direct investments by family offices has been growing in recent years as private business owners looking for liquidity are often attracted to the longer holding periods of a family office while family offices are increasingly looking invest in specific industries or make an impact.Ultimately, the family office will be funded by a family’s sustainable discretionary income, not necessarily assets held, and the benefits of financing a family office should outweigh additional costs of simply working with a team of advisors and CPAs. For reference, a survey from Citibank estimates a small family office with two professionals and four support personnel can cost anywhere from $1.5 million to $1.8 million per year.

What Is a Reserve Report?

In this blog post we discuss the most important information contained in a reserve report, the assumptions used to create it, and what factors should be changed to arrive at Fair Value[1] or Fair Market Value[2].Why Is a Reserve Report Important?A reserve report is a fascinating disclosure of information. This is, in part, because the disclosures reveal the strategies and financial confidence an E&P company believes about itself in the near future. Strategies include capital budgeting decisions, future investment decisions, and cash flow expectations.For investors, these disclosures assist in comparing projects across different reserve plays and perhaps where the economics are better for returns on investment than others.However, not all the information in a reserve report is forward-looking, nor is it representative of Fair Value or Fair Market Value. For a public company, disclosures are made under a certain set of reporting parameters to promote comparability across different reserve reports. Disclosures do not take into account certain important future expectations that many investors would consider to estimate Fair Value or Fair Market Value.What Is a Reserve Report?Simply put, a reserve report is a reporting of remaining quantities of minerals which can be recoverable over a period of time. Rules of 2009define these remaining quantities of mineral as reserves. The calculation of reserves can be very subjective, therefore the SEC has provided, among these rules, the following definitions, rules and guidance for estimating oil and gas reserves:Reserves are “the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible;The estimate is “as of a given date”; andThe reserve “is formed by application of development projects to known accumulations”. In other words, production must exist in or around the current project.“In addition, there must exist, or there must be a reasonable expectation that there will exist, the legal right to produce or a revenue interest in the production of oil and gas”There also must be “installed means of delivering oil and gas or related substances to market, and all permits and financing required to implement the project.”Therefore, a reserve report details the information and assumptions used to calculate a company’s cash flow from specific projects which extract minerals from the ground and deliver to the market in a legal manner. In short, for an E&P company, a reserve report is a project-specific forecast. If the project is large enough, it can, for all intents and purposes, become a company forecast.What Is the Purpose of a Reserve Report?Many companies create forecasts. Forecasts create an internal vision, a plan for the near future and a goal for employees to strive to obtain. Internal reserve reports are no different from forecasts in most respects, except they are focused on specific projects.Externally, reserve reports are primarily done to satisfy disclosure requirements related to financial transactions. These would include capital financing, due diligence requirements, public disclosure requirements, etc.Publicly traded companies generally hire an independent petroleum engineering firm to update their reserve reports each year and are generally included as part of an annual report. Like an audit report for GAAP financial statements, independent petroleum engineers provide certification reserve reports.Investors can learn much about the outlook for the future production and development plans based upon the details contained in reserve reports. Remember, these reserve reports are project-specific forecasts. Forecasts are used to plan and encourage a company goal.How Are Reserve Reports Prepared?Reserve reports can be prepared many different ways. However, for the reports to be deemed certified, they must be prepared in a certain manner. Similar to generally accepted accounting principles (GAAP) for financial statements, the SEC has prepared reporting guidance for reserve reports with the intended purpose of providing “investors with a more meaningful and comprehensive understanding of oil and gas reserves, which should help investors evaluate the relative value of oil and gas companies.” Therefore, the purpose of SEC reporting guidelines is to assist with project comparability between oil and gas companies.What Is in a Reserve Report?Reserve reports contain the predictable and reasonably estimable revenue, expense, and capital investment factors that impact cash flow for a given project. This includes the following:Current well production: Wells producing reserves.Future well production: Wells that will be drilled and have a high degree of certainty that they will be producing within five years.Working interest assumption: The ownership percentage the Company has within each well and project.Royalty interest assumptions: The royalty interest paid to the land owner to produce on their property.Five-year production plan: All the wells the Company plans to drill and have the financial capacity to drill in the next five years.Production decline rates: The rate of decline in producing minerals as time passes. Minerals are a depleting asset when producing them and over time the production rate declines without reinvestment to stimulate more production. This is also known as a decline curve.Mineral price deck: The price at which the minerals are assumed to be sold in the market place. SEC rules state companies should use the average of the first day of the month price for the previous 12 months. Essentially, reserve reports use historical prices to project future revenue.Production taxes: Some states charge taxes for the production of minerals. The rates vary based on the state and county, as well as the type of mineral produced.Operating expenses for the wells: This includes all expenses anticipated to operate the project. This does not include corporate overhead expenses. Generally, this is asset-specific operating expenses.Capital expenditures: Cash that will be needed to fund new wells, stimulate or repair existing wells, infrastructure builds to move minerals to market and cost of plugging and abandoning wells that are not economical.Pre-tax cash flow: After calculating the projected revenues and subtracting the projected expenses and capital expenditures, the result is a pre-tax cash flow, by year, for the project.Present value factor: The annual pre-tax cash flows are then adjusted to present dollars through a present value calculation. The discount rate used in the calculation is 10%. This discount rate is an SEC rule, commonly known as PV 10. The overall assumption in preparing a reserve report is that the company has the financial ability to execute the plan presented in the reserve report. They have the approval of company executives, they have secured the talent and capabilities to operate the project, and have the financial capacity to complete it. Without the existence of these expectations, a reserve report could not be certified by an independent reserve engineer.ConclusionMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries.Contact a Mercer Capital professional today to discuss your valuation needs in confidence.Endnotes[1] “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.” – FASB Glossary[2] “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” – U.S. Treasury regulations 26 C.F.R. sec. 20.2031-1(b)

Meet the Team – Karolina Calhoun, CPA/ABV/CFF

In each “Meet the Team” segment, we highlight a different professional on our Family Law team.

E&P Fourth Quarter 2021

Appalachian Basin

Appalachian Basin // The fourth quarter of 2021 marked a recent milestone in a long upward march for energy prices.

Transportation & Logistics Newsletter

Fourth Quarter 2021

Tax/Estate Planning Cheat Sheet for Auto Dealers

Winds of Change?

Benjamin Franklin famously said that the only things certain in this life are death and taxes. While both may be certain, taxes are always subject to change.Last fall, we wrote a blog post about the estate planning environment for auto dealers and other industries. In that post, we highlighted the prevailing conditions that existed in the marketplace that would enable auto dealers to capitalize on executing any estate planning opportunities. Those conditions included opportunities for depressed valuations caused by uncertain operational results (at the time), low interest rates, and changing political forces caused by the Presidential election.Fast forward to Fall 2021 and while some of these conditions have changed, rumors of potential tax changes have finally re-surfaced nearly three-fourths of the way through the first year of the Biden Administration.Earlier this month, President Biden and Congress introduced the Build Back Better Act (“BBB Act”). After its introduction, the House Ways and Means Committee commented and circulated a draft of many of the proposed policies. A brief synopsis of the entire BBB Act from BKD CPAs and Advisors is provided here.In this post, we focus on four particular proposals that impact estate planning and business valuations for auto dealers (and other industries): 1) Estate Tax / Lifetime Exclusion; 2) Corporate Income Tax Rates; 3) Capital Gains Rates; and 4) Valuation Discounts for Passive Assets.Estate Tax/Lifetime Exclusion AmountThe Estate Tax / Lifetime Exclusion Amount is also referred to as the Generation Skipping Transfer Tax Exemption. This concept consists of the amount of an estate that is subject to be transferred free from taxes either during the lifetime of an individual/couple or at death.Current Status: $11.7 million per individual or $23.4 million for a married couple as stated in the Tax Cuts and Jobs Act (“TCJA”) for gifts made between January 1, 2018 and December 31, 2025. Based on these figures, all estates under these amounts can be transferred during the lifetime or at death without incurring any estate taxes.Current Proposal: Revert back to $5 million per individual adjusted for inflation to arrive at a figure of approximately $6.02 million per person or $12.04 million for a married couple.Effective Date of Change: January 1, 2022Valuation Impact: If enacted, the current proposal would now lower the lifetime annual exemption to $12.04 million for married couples, nearly cutting the exclusion in half. Estates with a value over $12.04 million would now be subject to tax on the amount exceeding $12.04 million.Who Should Consider: Individuals who anticipate their estate may exceed the lower threshold of $12.04 million should consider executing estate planning strategies to transfer that wealth before the BBB Act is passed. Current estates with values exceeding $23.4 million or those estates that have not utilized the full prior lifetime annual exclusion amount, should also consider executing estate planning strategies before that heightened amount is reduced. The reduced exclusion amount also increases the number of affected people. Someone owning a business worth $15 million could now benefit from tax planning strategies that previously may have been less concerned when they fell below the threshold established by the TCJA.Corporate Income Tax RatesCorporate income tax rates are the amount of taxes paid on profits earned by a corporation.Current Status: Flat rate of 21%, reduced by the TCJALatest Proposal: Graduated rates with a top rate of 26.5%Effective Date: January 1, 2022Valuation Impact: Business valuations of auto dealerships are generally impacted by three broad overall assumptions: expected annual cash flows, growth of said cash flows, and risks to achieve those cash flows. A proposed increase in the corporate income taxes would reduce the annual cash flows of an auto dealership simply by the fact that income tax rates are higher. We saw the reverse of this trend when income tax rates were lowered by the TCJA. While many auto dealerships are organized in entities that consist of S Corporations, Limited Liability Companies, and Partnerships, the corporate income tax assumption still impacts the business valuation. We won’t belabor the mechanics of a business valuation in this post, but effectively the hypothetical earnings of a business are tax affected to a C Corporation equivalent basis since the assumptions for the discount and capitalization rates (the risks associated with achieving expected cash flows) are derived from public C Corporations.Who Should Consider: As briefly discussed above, income tax rates comprise one of the assumptions in a business valuation. On its surface, the proposed increase in corporate income taxes will certainly reduce expected the after-tax earnings of an auto dealership, all other things being equal. However, other prevailing industry conditions, such as heightened profitability due to operational efficiencies, might mitigate the overall impact caused by increased tax rates. The opposite was true in 2017.Capital Gains Tax RateThe capital gains rate is the tax rate paid on the disposition of an asset. Rates can differ based on the holding period of the asset prior to disposition and are often bifurcated into short-term (one year or less) or long-term (longer than one year) rates.Current Status: Rates of 15% to 20% + 3.8% surtax on net investment incomeLatest Proposal: Top rate of 25% + 3.8% surtax on net investment income for tax year 2022Effective Date: Transactions occurring after September 13, 2021, would be subject to new rates. Transactions occurring prior to September 13, 2021 would be subject to current rates.Valuation Impact: Most business valuations do not calculate or consider the net amount received after a sale or disposition of the company or asset because the premise of these valuations is a going concern. However, we know business owners are definitely interested in the proceeds that ultimately hit their bank account.Who Should Consider: Auto dealers that are contemplating whether to sell their dealership or continue to hold and operate should consider this potential rate increase. Dealers are currently experiencing record profits but also face challenges with the inventory shortages caused by suspended manufacturing from the pandemic and the microchip shortage. While it can be hard to let go when profits are rolling in, there are long term concerns surrounding the increasing capital costs of developing and maintaining digital platforms to compete with the public auto groups and larger private groups. Many dealers are choosing to sell, as evidenced by the current white hot auto dealer M&A market. If the BBB Act passes, auto dealers that sell in 2022 can expect fewer after-tax dollars from a sale or disposition due to higher capital gains tax rates, all other things being equal.Valuation Discounts for Passive AssetsBusiness valuations of auto dealerships, real estate holding companies, and related businesses typically consist of determining the value of the entire business, as well as the value of a particular interest in the business. Often the subject interest comprises less than 100% of the total business and exhibits elements of lack of control and marketability. As such, discounts for lack of control, lack of marketability, and lack of voting rights are often applicable and determined to reduce the fair market value of the overall pro rata value of the subject interest.Current Status: Valuation discounts for lack of control, lack of marketability, and lack of voting rights are allowed, but often require substantiation, quantification, and defense by a business appraiser communicated in a formal appraisal report.Latest Proposal: The current version of the BBB Act proposes to eliminate valuation discounts for an entity’s “non-business,” or passive, assets. The BBB Act defines “non-business” or passive assets as cash, marketable securities, equity in another entity, real estate, etc. Further, passive assets are those assets that are held for the production or collection of income and are not used in the active conduct of a trade or business. Passive assets which are held as part of the reasonably required working capital of a trade or business are also excluded. Real property is excluded from this rule if real property assets are used in the active conduct of real property trade or business in which the transferor actively and materially participates. Examples include real property used for rental, operation, and management, among others.Effective Date: January 1, 2022Valuation Impact: In a world where combined discounts for lack of control and marketability can range from 25-45%, this is a material impact. Passage of this piece of the legislation in its current form may not have a dramatic impact on the business valuation of dealership operations, which would still be subject to discounts. However, many auto dealerships carry excess cash or working capital in order to smoothly run operations or provide cushions in down periods. If the BBB Act were to interpret that all cash or working capital exceeds the “guide” figure on the dealer financial statement, this could inflate both the total value of the business as well as the portion attributable to passive assets, which would not be subject to discounts. Many auto dealers currently hold heightened levels of cash and marketable securities as a result of increased profitability and retainage of any PPP funds and loan forgiveness. Many of our auto dealer clients also own the operating real estate for the dealership in a separate asset holding company. These proposed rules could also jeopardize the applicable discounts for lack of control and marketability in those entities for any marketable securities or “non-business” or passive assets.Who Should Consider: If these discounts are eliminated for “non-business” or passive assets, auto dealers owning both types of entities, operating dealerships and real estate holding companies, should consider implementing and executing estate planning strategies. If all the discounts (not likely) or the discounts on “non-business” or passive assets are eliminated, the resulting business valuation of a subject interest in either of these types of entities will be dramatically higher. In turn, the overall values of the estates of auto dealers or the net value of transfers could be greatly increased for transfer tax purposes.ConclusionsJust as death and taxes are the only certain things in life, another relevant adage is that change is inevitable. As the BBB Act and proposals from the House Ways and Means Committee start to evolve, there are numerous tax and estate planning implications.While the final version of the Act will look almost certainly different than the current proposals for each provision, changes to existing rates and policies are anticipated. Fall 2021 is shaping up to be a busy estate planning season.Seek qualified professionals to assist you with your estate planning, from the attorneys determining and drafting the plan to the valuation professional providing the valuation. Not all valuations and valuation professionals are created equal. The role of all of the professionals in your estate planning process should be to protect the integrity of the proposed transaction. Often when these transactions are challenged, they are challenged based on the formation factors or the quality/conclusion of the valuation.Contact a professional at Mercer Capital to assist you and your attorney with your valuation needs involving your estate planning.

Fairness Opinions - Evaluating a Buyer’s Shares from the Seller’s Perspective

Depository M&A activity in the U.S. has accelerated in 2021 from a very subdued pace in 2020 when uncertainty about the impact of COVID-19 and the policy responses to it weighed on bank stocks. At the time, investors were grappling with questions related to how high credit losses would be and how far would net interest margins decline. Since then, credit concerns have faded with only a nominal increase in losses for many banks. The margin outlook remains problematic because it appears unlikely the Fed will abandon its zero-interest rate policy (“ZIRP”) anytime soon.As of September 23, 2021, 157 bank and thrift acquisitions have been announced, which equates to 3.0% of the number of charters as of January 1. Assuming bank stocks are steady or trend higher, we expect 200 to 225 acquisitions this year, equivalent to about 4% of the industry and in-line with 3% to 5% of the industry that is acquired in a typical year. During 2020, only 117 acquisitions representing 2.2% of the industry were announced, less than half of the 272 deals (5.0%) announced in pre-covid 2019.To be clear, M&A activity follows the public market, as shown in Figure 1. When public market valuations improve, M&A activity and multiples have a propensity to increase as the valuation of the buyers’ shares trend higher. When bank stocks are depressed for whatever reason, acquisition activity usually falls, and multiples decline.Click here to expand the image aboveThe rebound in M&A activity this year did not occur in a vacuum. Year-to-date through September 23, 2021, the S&P Small Cap and Large Cap Bank Indices have risen 25% and 31% compared to 18% for the S&P 500. Over the past year, the bank indices are up 87% and 79% compared to 37% for the S&P 500.Excluding small transactions, the issuance of common shares by bank acquirers usually is the dominant form of consideration sellers receive. While buyers have some flexibility regarding the number of shares issued and the mix of stock and cash, buyers are limited in the amount of dilution in tangible book value they are willing to accept and require visibility in EPS accretion over the next several years to recapture the dilution.Because the number of shares will be relatively fixed, the value of a transaction and the multiples the seller hopes to realize is a function of the buyer’s valuation. High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares are issued to achieve a targeted dollar value.However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.Our experience is that some, if not most, members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to “value.”A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares - What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends - The analysis should consider the buyer’s historical growth and projected growth in revenues, pretax pre-provision operating income and net income as well as various profitability ratios before and after consideration of credit costs. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated. This is particularly important because many banks’ earnings in 2020 and 2021 have been supported by mortgage banking and PPP fees.Pro Forma Impact - The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital ratios in addition to dilution or accretion in earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.Tangible BVPS Earn-Back - As noted, the projected earn-back period in tangible book value per share is an important consideration for the buyer. In the aftermath of the GFC, an acceptable earn back period was on the order of three to five years; today, two to three years may be the required earn-back period absent other compelling factors. Earn-back periods that are viewed as too long by market participants is one reason buyers’ shares can be heavily sold when a deal is announced that otherwise may be compelling.Dividends - In a yield starved world, dividend paying stocks have greater attraction than in past years. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?Capital and the Parent Capital Stack - Sellers should have a full understanding of the buyer’s pro-forma regulatory capital ratios both at the bank-level and on a consolidated basis (for large bank holding companies). Separately, parent company capital stacks often are overlooked because of the emphasis placed on capital ratios and the combined bank-parent financial statements. Sellers should have a complete understanding of a parent company’s capital structure and the amount of bank earnings that must be paid to the parent company for debt service and shareholder dividends.Loan Portfolio Concentrations - Sellers should understand concentrations in the buyer’s loan portfolio, outsized hold positions, and a review the source of historical and expected losses.Ability to Raise Cash to Close -What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates - If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation - Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance - Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position - Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities - Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. The professionals at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business. Give us a call to discuss your needs in confidence.

Three Considerations Before You Sell Your Business

After spending years, if not decades, building your business through hard work, determination, and a little luck, what happens when you are ready to monetize your efforts by selling part or all of your business? Exiting the business you built from the ground up is often a bittersweet experience. Many business owners focus their efforts on growing their business and push planning for their eventual exit aside until it can’t be ignored any longer. However, long before your eventual exit, you should begin planning for the day you will leave the business you built.We suggest you consider these three things.1. Have a Reasonable Expectation of ValueMany business owners have difficulty taking an objective view of the value of their company. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many business owners have spent most of their adult lives operating and growing their companies. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction.The development of pricing expectations for an external sale should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers can (and do) use various methods to develop a reasonable purchase price. An acquirer will utilize historical performance data, along with expectations for the future, to develop a level of cash flow or earnings that is considered sustainable going forward. In most cases, this analysis will focus on earnings before interest, taxes, depreciation and amortization (EBITDA) or some other pre-interest cash flow. A multiple is applied to this sustainable cash flow to provide an indication of value for the company. Multiples are developed based on an assessment of the underlying risk and growth factors of the subject company.Valuations and financial analysis for transactions encompass a refined and scenario-specific framework. The valuation process should enhance a buyer’s understanding of the cash flows and corresponding returns that result from purchasing or investing in a firm. For sellers or prospective sellers, valuations and exit scenarios can be modeled to assist in the decision to sell now or later and to assess the adequacy of deal consideration. Setting expectations and/or defining deal limitations are critical to good transaction discipline.2. Consider the Tax Implications When analyzing the net proceeds from a transaction, you must consider the potential tax implications. From simple concepts such as ordinary income vs. capital gains and asset sales vs. stock sales, to more nuanced concepts such as depreciation recapture and purchase price allocation, there are almost unlimited issues that can come up related to the taxation of transaction proceeds. The structure of your own corporate entity (C Corporation vs. tax-pass through entity) may have a material impact on the level of taxes owed from a potential transaction.We recommend consulting with your outside accountant (or hiring a tax attorney) early in the process of investigating a transaction. Only a tax specialist can provide the detailed advice that is needed regarding the tax implications of different transaction structures. There could be strategies that can be implemented well in advance of a transaction to better position your business or business interest for an eventual transaction.3. Have a Real Reason to Sell Your BusinessStrategy is often discussed as something belonging exclusively to buyers in a transaction. Not true.Sellers need a strategy as well: what’s in it for you? Sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! Your Company, and the cash flow that creates value, transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe you are selling because you want or need to retire. Maybe you are selling because you want to consolidate with a larger organization, or need to bring in a financial partner to diversify your own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future compensation for a check. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.The process of selling a business is typically one of the most important, and potentially complex, events in an individual’s life. Important decisions such as this are best made after a thorough consideration of the entire situation. Early planning can often be the difference between an efficient, controlled sales process and a rushed, chaotic process.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have assisted hundreds of companies with planning and executing potential transactions since Mercer Capital was founded in 1982. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients.Our dedicated and responsive team is available to advise you through a transaction process, from initial planning and investigation through eventual execution. To discuss your situation in confidence, give us a call.

Bakken Recovery Falters

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. This quarter we take a closer look at the Bakken.Production and Activity LevelsEstimated Bakken production (on a barrels of oil equivalent, or “boe” basis) decreased approximately 4% year-over-year through September. Production in the Permian and Appalachia increased 10% and 3% year-over-year, respectively, while the Eagle Ford’s production declined 2%. While production in the Bakken rebounded sharply once wells were brought back online aftercurtailments in mid-2020, it has generally trended lower during 2021. Production in the Eagle Ford and Permian was meaningfully impacted in February 2021, driven by Winter Storm Uri that disrupted power supplies throughout Texas. As of September 17th, there were 23 rigs in the Bakken up 156% from September 11, 2020. Eagle Ford, Permian, and Appalachia rig counts were up 300%, 109%, and 34%, respectively, over the same period. One may wonder why Bakken production has been on the decline given substantial rig count growth, while Permian production has continued to increase despite a more moderate increase in rigs. The answer has to do with legacy production declines and new well production per rig. Based on data from the U.S. Energy Information Administration, the Bakken needs roughly 19 rigs running to offset existing production declines. That number for the Permian is approximately 200 rigs. The Bakken’s rig count only recently broke above that maintenance level of drilling, whereas the Permian has had over 200 active drilling rigs since February 2021. Current activity in the Bakken should stem the recent production declines, but growth will likely be modest without additional rigs. Oil Stabilizes while Natural Gas SoarsAfter a significant run-up in the first two quarters of the year, oil prices were largely range-bound during the third quarter of 2021, with front-month futures prices for West Texas Intermediate (WTI) generally oscillating between $65/bbl and $75/bbl. Rising COVID-19 cases in the U.S. caused the Delta variant to put a damper on travel activity and associated fuel consumption. However, producers seem to be maintaining their capital discipline even in light of higher prices, which is limiting production growth. Henry Hub natural gas front-month futures prices began the quarter at approximately $3.63/mmbtu but broke above $5.00/mmbtu in September. The current run-up in natural gas prices has some concerned about what the winter may hold, when prices generally increase due to heating demand. In Europe, declining coal capacity and less-than-expected wind generation from North Sea wind turbines have contributed to surging natural gas prices, and the situation is beginning to impact industrial production. However, the current commodity price environment may be short-lived. Commodity futures prices are in backwardation (meaning that current prices are higher than future prices), implying some near-term tightness that is expected to subside. This sentiment is echoed by the U.S. Energy Information Administration, which stated in their September 2021 Short-term Energy Outlookthat “growth in production from OPEC+, U.S. tight oil, and other non-OPEC countries will outpace slowing growth in global oil consumption” and would likely lead to lower oil prices. Financial PerformanceThe Bakken public comp group saw strong stock price performance over the past year (through September 20th), with all constituents outperforming the broader E&P sector (as proxied by XOP). Continental and Whiting prices increased 175% and 151% year-over-year, compared to the XOP’s increase of 78%. Oasis, which emerged from bankruptcy in November 2020, is up 191% from its initial closing price post-bankruptcy. However, this impressive stock price performance is probably more reflective of the dire straits of these companies last year. Both Whiting and Oasis declared bankruptcy in 2020 and appear to have benefited from a cleaned-up capital structure.Keystone XL Finally CancelledThe Keystone XL pipeline, originally proposed in 2008, was finally cancelled by its developer, Canadian midstream company TC Energy. President Biden revoked a key permit needed for the project on his first day in office.The proposed pipeline caused significant controversy during its planning stages as it provided takeaway capacity for production from Alberta oil sands (which is more energy intensive, and thus less sustainable, than other forms of hydrocarbon extraction) and its path through Nebraska’s environmentally sensitive Sandhills region and Ogallala Aquifer. Keystone XL also would have provided additional pipeline capacity out of the Bakken, which could become very needed if the also-controversial Dakota Access Pipeline gets shutdown.ConclusionWhile the Bakken saw strong production increases in the wake of mid-2020’s commodity price rout, that recovery appears to have faltered in 2021. Production has generally been on the decline this year, though the recent increase in rigs operating in the basin should stem this decrease and provide for modest production growth going forward. However, companies’ current emphasis on returning cash to shareholders may lead to less investment than has been seen in previous periods with similar commodity price environments.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Tax Changes Remain Murky: A(nother) Tax Update

Estragon: Let's go! Vladimir: We can't. Estragon: Why not? Vladimir: We're waiting for Godot. Estragon: (despairingly) Ah!Waiting for Godot, Act I- Samuel BeckettYes, “Ah!”. Tax watchers seem to have been unsuspectingly cast in Samuel Beckett’s famous existential and absurdist play, leaving many waiting and waiting. We have waited alongside many tax professionals and family business advisors, writing about the prospect of tax changes here, here, and here among other places throughout the year.However, in what could only be described as excitement similar to Christmas morning, many rushed to tear open the U.S. House Ways and Means markup of the $3.5 trillion reconciliation bill. There were definitely surprises both big and small, and below we summarize some of the major pieces that you and your family board need to keep an especially close eye on as Godot finally approaches.Summary ChangesBKDprovides a good summary of the House’s Tax bill changes for both corporations and individuals. While the write-up goes into more details, the changes we are watching most closely include:Increases the top rate C Corp tax rate to 26.5% from 21% for corporations with incomes of $5 million while reducing the rate to 18% for corporations with incomes less than $400,000 (corporations with income from $400,000 to $5 million would remain at 21%).Increases the top capital gains rate to 31.8% (25% statutory rate + 3.8% NIIT + 3% percent surtax). This proposal is lower than the 43.4% top capital gains rate proposed by the president for those with adjusted gross incomes exceeding $1 million ($500,000 married filing separately). The proposed effective date for a 25% capital gain rate is September 13, 2021.Cuts the estate and gift tax lifetime exemption from the current inflation adjusted $10 million per person ($11.7 million in 2021) to an inflation adjusted $5 million. The proposed change would apply to estates of decedents dying and gifts made after December 31, 2021. Numerous other changes, including limitations on Roth IRA rollovers, creating a 3% surtax on individuals at certain income thresholds, and a host of other changes exist in the reconciliation bill and are being hashed out in Congress currently.Estate and Gift TaxesThe National Law Reviewdiscussed specifics of the reduction in the gift and estate tax exemption available to family businesses. In addition to the reduction of the exemption by 50% beginning January 1, 2022, current legislation is also targeting other estate planning tools. WealthManagement.com highlights a bevy of changes to current trust treatments as well as valuation discounts on gifts of specific entities.Some Dodged BulletsRandall Forsyth at Barron’s summarized some areas where the current iterations of the tax plan diverged from the original White House proposals. The top capital gains rate is expected to be well below the top individual rate as discussed previously. Additionally, the proposed elimination of the step-up in cost basis for estates, an area of concern for many multi-generation family businesses, did not make the House’s language. The $10,000 ceiling on state and local tax deductions was unchanged, which ruffled the feathers of Congressmen from high-tax states.Something Is Rotten in the State of DenmarkSimilar to Shakespeare’s Hamlet, something is in fact “rotten” in the Democrat’s respective Senate and House caucuses. Some obvious defections are highlighted below:Senator Joe Manchin (D-WV), the nation’s most watched Senator, penned an op-ed highlighting his concerns with the current $3.5 trillion reconciliation bill. Senator Manchin has called for a more modest proposal and highlighted hesitation to numerous new taxes.Senator Krysten Sinema (D-AZ), as well as moderate House Democrats, are sharing their own reservations as well as a desire to vote on the bi-partisan infrastructure bill first.The Hill highlighted opening issues on the more progressive side as well, with Senator Bernie Sanders (I-VT) and Rep. Pramila Jayapal (D-WA) arguing the bill must stand at $3.5 trillion, which they view as a compromise from their initial $6 trillion goal. We mention these political developments only to highlight one thing: the final bill is going to look different.ConclusionDissimilar to Godot, the budget bill will, in fact, arrive in the next few weeks. Family business directors can prepare themselves and their businesses by checking in with their estate attorneys and financial advisors regarding their estate plans.We provide valuation services to families seeking to optimize their estate plans. Give one of our professionals a call to discuss how we can help you in the current environment.

Valuations for Gift & Estate Tax Planning

Managing Complicated Multi-Tiered Entity Valuation EngagementsWhen equity markets fell in early 2020 due to the onset of the COVID-19 global pandemic, many business owners and tax planners contemplated whether it was an opportune time to engage in significant ownership transfers.Although equity markets have recovered to all-time highs, a confluence of three factors may make 2021 an ideal time for estate planning transactions for owners of private companies:Depressed Valuations. Valuations for many privately held businesses remain somewhat depressed due to significant supply chain challenges and hiring difficulties.Low Interest Rates.Applicable federal rates (AFRs) are at historically low levels, allowing business owners to make leveraged estate planning strategies more efficient.Political Risk.The Biden administration’s proposal to lower the gift and estate tax exemption andincrease the capital gains tax rate may prompt some individuals and businesses to take advantage of currently favorable tax conditions before any adverse changes are made.Mercer Capital has been performing valuations for complicated tax engagements since its inception in 1982.For many high net worth individuals and family offices, complex ownership structures have evolved over time, typically involving multi-tiered entity organizations and businesses with complicated ownership structures and governance.In this article, we describe the processes that lead to credible and timely valuation reports.These processes contribute to smoother engagements and better outcomes for clients.Defining the EngagementDefining the valuation project is an important step in every engagement process, but when multiple or tiered entities are involved, it becomes critical.It is insufficient to define a complicated engagement by referring only to the top tier entity in a multi-tiered organizational structure.The engagement scope should clearly identify all the direct and indirect ownership interests that will need to be valued.This allows the appraiser to plan the underlying due diligence and analytical framework to design the deliverable work product.For example, will the appraiser need to perform a separate appraisal at each level of a tiered structure?Or, can certain entities or underlying assets be valued using a consolidated analytical framework?Planning well on the front end of an engagement leads to more straightforward analyses that are easier to defend.Collecting the Necessary InformationDuring the initial discussion of the engagement, the appraiser will usually request certain descriptive and financial information (such as governing documents, recent audits, compilations, and/or tax returns) to determine the scope of analysis needed to render a credible appraisal for the master, top-tier entity and the underlying entities and assets.Upon being retained, one of the first things an appraiser will do is to prepare a more comprehensive information request list designed to solicit all the documentation necessary to render a valuation opinion.Full and complete disclosure of all requested information, as well as other information believed pertinent to the appraisal, will aid the appraiser in preventing double-counting or otherwise missing assets all together.Information Needed for Complex Multi-Tiered Entity ValuationRequested information for complex multi-tiered entity valuations typically falls into three broad categories:Legal documentation. The legal structure and inter-relationships in complex assignments are essential to deriving reliable valuation conclusions.In addition to the operating agreements, it is important to have current shareholder/member lists.A graphical organization chart is often a very helpful supplement to the legal documents and helps ensure that everyone really is “on the same page” regarding the objectives of the valuation assignment.Financial statements. A careful review of the historical financial statements for each entity in the overall structure provides essential context for the cash flow projections, growth outlook, and risk assessment that are the basic building blocks for any valuation assignment. Depending on ownership characteristics and business attributes, it may be appropriate to combine financial statements for multiple entities to promote efficiency in project execution.Supplementary information.For operating businesses, supplementary information may include financial projections, detailed revenue and margin data (by customer, product, region or some other basis), personnel information, and/or information pertaining to the competitive environment.For asset-holding entities, supplementary data may include current appraisals of real estate or other illiquid underlying assets, brokerage statements, and the like.The ultimate efficiency of the project often hinges on timely receipt of all requested information. Disorganized information or data that requires a lot of handling or interpretation on the part of the appraiser adds to project cost, and more importantly, can make it harder to defend valuation conclusions that are later subject to scrutiny.In short, providing high quality information in response to the appraiser’s request list promotes a more predicable outcome with the IRS and with other stakeholders.The Importance of Reviewing the Draft AppraisalUpon completing research, due diligence interviews with appropriate parties, and the valuation analysis, the appraiser should provide a draft appraisal report for review.The steps discussed thus far – careful planning and timely information collection – are not substitutes for careful review of the draft appraisal report.The complexity of many multi-tiered structures increases the need for relevant parties to review the draft appraisal for completeness and factual accuracy.Engagements involving complicated entity and operational structures are not easily shoehorned into typical appraisal reporting formats and presentation. Unique entity and asset attributes may require complex valuation techniques and heighten the need for clear and concise reporting of appraisal results. Regardless of the complexity of the underlying structure and valuation techniques, the appraisal report should still be easy to read and understand.Click here to expand the checklist above

Four "To Dos" Before You Sell Your Investment Management Firm

Considerations for Every RIA Owner

Selling the business you built from the ground up is a bittersweet experience. Many business owners focus their efforts on growing their business and push planning for their eventual exit aside until it can’t be ignored any longer. While this delay may only prove mildly detrimental to deal proceeds in other industries, in the investment management space, there are very few buyers who will be interested in YOUR business without YOU (at least for a little while).Long before your eventual exit, you should begin planning for the day you will leave the business you built. There are many considerations for investment managers contemplating a sale, but we suggest you start with these four:1. Have a Reasonable Expectation of ValueTaking an objective view of the value of your company is difficult. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many investment managers have spent most of their adult lives nurturing client relationships, growing their client base, and developing talent at their firm. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction.The development of pricing expectations for an external sale should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers use various methods of developing a reasonable purchase price. Most commonly, an acquirer will utilize historical performance data, along with expectations for future cash flow to generate a reasonable estimate of run-rate EBITDA, and an appropriate multiple that considers the underlying risk and growth factors of the subject company.With the recent run-up in RIA multiples observed, and the even faster run-up in headline multiples, setting reasonable pricing expectations given your firm’s specific risks and opportunities is an increasingly important step in preparing for a transaction.Valuations and financial analysis for transactions encompass a refined and scenario-specific framework. The valuation process can enhance a seller’s understanding of how a buyer will perceive the cash flows and corresponding returns that result from purchasing or investing in a firm. Additionally, valuations and exit scenarios can be modeled to assist in the decision to sell now or later and to assess the adequacy of deal consideration. Setting expectations and/or defining deal limitations are critical to good transaction discipline.2. Have a Real Reason To Sell Your BusinessStrategy is often discussed as something that belongs exclusively to buyers in a transaction, but this isn’t always the case.Without a strategy, sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! Your company, and the cash flow that creates value, transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe you are selling because you want or need to retire. Maybe you are selling because you want to consolidate with a larger organization to reduce the day-to-day headache of running a business, or need to bring in a financial partner to diversify your own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future cash flow for a check today. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.3. Get Your Books in Order Today To Maximize Proceeds TomorrowAs Zach Milam, mentioned last week, in his post on bridging valuation gaps between RIA buyers and sellers, the best time to address a potential buyer’s concerns about your firm is before you start the process.In advance of transactions, sellers should consider an outsider’s perspective on their firm and take action to address the perceived risk factors that lower value. For example, distinguishing owner compensation and regular distributions of excess capital prior to a sale will decrease the buyer’s concern about liquidity and marketability of the investment and increase the perceived value of equity ownership.Similarly, focusing on staff development in client-facing roles, increasing the number of client contacts with the firm, and creating an internal pipeline of talent to manage the business will all serve to reduce key person risk from the perspective of a buyer, thereby increasing the value that the buyer ascribes to the firm.4. Consider the Tax ImplicationsWhen considering the potential proceeds from a transaction, you should contemplate the tax implications. A large number of RIAs are S-corporations and C-corporations, which is no longer the preferred structure as they constrain a company’s ability to easily grow and transfer equity. We recommend consulting with a tax attorney prior to a transaction on the tax implication of different transaction structures. Before selling your business, you should also be aware of the pros and cons of a stock versus an asset sale as well as an all cash transaction versus a combination of cash and stock consideration.How Can We Help?At Mercer Capital, we routinely perform valuations and financial analysis for buy-sell agreements and internal transactions as well as offer fairness opinions for proposed transactions. We can help you better understand the potential risks to your business model and the opportunities for growth, as well as help you establish reasonable pricing expectations so that when you are ready to sell, the process is more seamless.

Public Auto Dealer Profiles: Sonic Automotive

As we discussed in the first installment of this blog series, there are six primary publicly traded companies that own approximately 923 new vehicle franchised dealerships as of Q2 2021, or 5.6% of the total number of dealerships in the U.S. (16,623 at year-end 2020 per NADA). This demonstrates how fragmented the industry continues to be, despite recent consolidation.The total number of dealerships has remained largely the same, though the number of dealers is dwindling as big shifts towards e-commerce accelerated by the pandemic require heavier investment for smaller operations to compete.This issue of consolidation is not limited to just mom and pop stores.According to the Wall Street Journal, Suburban Collection of Michigan sold to Lithia this year in part due to the need for outside capital. David Fischer Jr. and his father sought a strategic partner to update their business to the new digital retailing environment despite having 56 franchises across 34 stores. In 2020, Suburban Collection was the 21st ranked auto group in terms of size, retailing just under 30 thousand new vehicle units.Given current blue sky values, the size of the deal and Lithia’s aggressive acquisition strategy, we realize premium pricing may have ultimately won the day in the Fischers’ decision to divest. Still, for an auto group of that size to be seeking a minority partner, prior to eventually being acquired, is noteworthy. We’ve also heard concerns from our clients that the potential for rising taxes and tweaks to the supply chain (with OEMs considering a model that reduces the autonomy of dealers) could lead to further consolidation.Our goal with these posts is to serve as a reference point for private dealers who may be less familiar with the public players, particularly if they don’t operate in the same market. Larger dealers may benefit in benchmarking to public auto dealers. Smaller or single point franchises may find better peers in the average information reported in NADA’s dealership financial profiles or more regional 20 Group reports. Public auto dealers also give dealers insight to how the market prices their earnings, the environment for M&A, and trends in the industry.Sonic Automotive Locations and BrandsBased in Charlotte, North Carolina, Sonic has 84 franchised dealerships, the lowest of any publicly traded company that operates principally as a new vehicle dealer. As seen below, the company earned over 50% of its revenue in Texas and California, with another 30% of 2020 revenue coming from Colorado, Tennessee, Florida, and Alabama. By year-end 2021, the company projects 25% population coverage. While the company is smaller and relatively concentrated in terms of its footprint compared to its public peers, Sonic is targeting 90% population coverage by 2025 (see projection below in recent investor materials). This growth will largely come from its EchoPark segment comprised of physical locations selling pre-owned “nearly new” vehicles with many having remaining OEM warranty. According to the Automotive News Top 150, Sonic sold the seventh most new retail units in 2020, at just over 93 thousand, trailing the other public dealers and Hendrick Automotive Group, the largest private auto group, also based in Charlotte. As seen in the table below, 55% of Sonic’s 2020 revenues came from Luxury brands, particularly BMW and Mercedes. This is more than double the company’s combined sales from domestic (10%) and EchoPark (15%), which are assumed to target a lower price point. Assuming continued growth in EchoPark, Sonic appears to be targeting consumers at various income levels which should provide balance in any market environment. Historical Financial PerformanceAs we’ve discussed frequently, there are numerous hurdles to clear when comparing a privately held dealership to a publicly traded retailer. Scale and access to capital make the business models different, even if store and unit-level economics remain similar. Sonic’s 10K’s and Q’s look different than the dealer financial statements produced by our dealer clients. For example, “Other income” items such as doc fees and dealer incentives can significantly impact profitability for privately held dealers. For dealers that sacrifice upfront gross margins to get volume based incentive fees, operating income can be negative for dealers before accounting for these profits.Due to differences in reporting, Sonic captures other income along with F&I as a revenue item with no corresponding cost of sales line item. The minimal amount of reported other income/expense not included as revenue if added to gross profit, would not change its reported gross margin of 14.85% by one basis point.Interestingly, its gross margin through the first half of 2021 was down immaterially from 14.89% in 2020. This comes despite industry-wide improvement in gross margins and a pickup in margin for new vehicles, whole vehicles, and parts, service and collision operations. That means Sonic has been negatively impacted by its declining margins on used vehicles (2.8% compared to 3.6%) and/or the contribution of gross profit (relatively less high margin fixed operations and/or more used vehicles).While EchoPark likely explains this, it is interesting to contrast to the average dealership as reported by NADA which saw gross margin improve from 11.8% to 13.4% in the first half of 2021. While this appears lower than the figures reported by Sonic, we note the difference between operating profit and pre-tax profits (largely aforementioned back-end profits) was 2.3% of revenues, which added to gross margin, would be 15.7%.Implied Blue Sky MultipleIn prior blogs, we’ve discussed how blue sky multiples reported by Haig Partners and Kerrigan Advisors represent one way to consider the market for private dealerships. Below, we attempt to quantify the implied blue sky multiple investors place on Sonic Automotive. If we assume that the difference between stock price and tangible book value per share is made up exclusively by franchise rights, then Sonic’s Blue Sky value per share is approximately $35.19.Given recent outperformance, Haig Partners prescribes a 3-year average be taken in determining ongoing pre-tax income (2018, 2019, and LTM June 30, 2021). Using this methodology and applying the 25% tax rate implied by Sonic’s financials, its ongoing pre-tax earnings per share would be $4.97 or just over 7.0x Blue Sky. While this is lower than all of its public counterparts besides Group 1 Automotive, it is relatively high compared to import or domestic dealerships likely due to its size and growth potential as well as its tilt towards luxury brands. ConclusionAt first glance, Sonic may appear to be a close comparable for private auto groups. Unlike other public auto dealers, it does not have other business lines (Penske) or international operations (Group 1). It’s not rapidly acquiring other dealerships (Lithia) and its franchised dealership count is about a third of AutoNation. However, like Asbury, it is tilted towards luxury with very little domestic sales, and still has significantly more dealerships than most groups.Sonic also has meaningful used-only operations in EchoPark, which is where the company is allocating much of its capital. Geographic diversification and access to capital markets can also materially impact comparisons, particularly for smaller dealerships. Still, management commentary on the macro environment in the auto dealer space is valuable and appropriate benchmarking comparisons are still possible if you know what you’re looking for.At Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. Surveying the operating performance, strategic investment initiatives, market pricing of the public new vehicle retailers, gives us insight to the market that may exist for a private dealership. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

Bakken M&A

Transaction Volume and Deal Size Rebound in 2021

Over the last year, deal activity in the Bakken has been steadily increasing after a challenging 2020. Eight of the nine deals referenced below occurred in the last eight months as the price environment has turned more favorable. As the industry seems optimistic that the worst of COVID-19 is behind us, deal activity may continue to increase into next year, but there is always hesitation, especially with the Delta variant on the rise.Recent Transactions in the BakkenA table detailing E&P transaction activity in the Bakken over the last twelve months is shown below. Relative to 2019-2020, deal count was unchanged, but median deal size increased by roughly $480 million, which was lead by the $5.6 billion Devon-WPX transaction.Click here to expand the chart aboveOasis Adds Strategic Acreage in Core AreaOn May 3, 2021, Oasis Petroleum announced that it entered a definitive agreement to acquire select Williston Basin assets from Diamondback Energy in a cash transaction valued at approximately $745 million. The effective date of the acquisition will be April 1, 2021, and the deal has yet to officially close. The purchase consideration is expected to be financed by cash, revolver borrowings, and a bridge loan. Transaction highlights include:Production (2021 Q1) – 27 Mboe/dAcreage – 95,000 net acres in Dunn, McLean, McKenzie counties, ND200 drilling locationsProved Reserves - 80.2 mmboe A pro forma table of the transaction is shown below: Diamondback has built a reputation of being focused on the Permian Basin, but in late 2020, the company acquired QEP Resources which gave them exposure to Williston acreage. It took them roughly six months to sell their Bakken acreage package to Oasis, returning them to their pure-play Permian status. Equinor Lets Go of Its Bakken PositionOn February 10, 2021, Equinor announced that it was selling its Bakken asset portfolio to Grayson Mill Energy for $900 million. Grayson Mill Energy is a Houston-based exploration and production company backed by Encap Investments, a private equity firm that has raised over $38 billion of capital. An exit from the Bakken, which Equinor entered in 2011 by acquiring Brigham Exploration Company for $4.7 billion, follows the sale of its operated assets in the Eagle Ford for $325 million to Repsol in November 2019. The deal closed on April 27, 2021 and included the following:242,000 net acres, and associated midstream assets48,000 Boep/d as of Q4 2020 In parallel with the transaction, Equinor Marketing and Trading entered into a term purchase agreement for crude offtake with Grayson Mill Energy. Al Cook, Equinor’s executive vice president of Development & Production, referenced that the company is focused on improving the profitability of its international portfolio.ConclusionM&A transaction activity in the Bakken was steady through year-to-date 2021 and consisted of notable strategic acquisitions and exits in the basin. Deal activity in the Bakken will be important to monitor as companies shift their focus to other basins and are forced to prioritize other initiatives.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Selling Your RIA? Four Ways to Bridge the Valuation Gap

Valuation gaps are frequently encountered in RIA transactions. Buyers and sellers naturally have different perspectives that lead to different opinions on value: Where a seller sees a strong management team, a buyer sees key person risk. "Long-term client relationships" in the eyes of a seller translates to “aging client base” in the eyes of a buyer. When a seller touts a strong growth trajectory, the buyer wonders if that will continue.These different perspectives on the same firm, unsurprisingly, lead to different opinions on value, and the gap can be substantial. Bridging that gap is key to getting a deal done. Below, we address four ways that buyers and sellers can bridge a valuation gap.1. EarnoutEarnouts are a common way to bridge a valuation gap. Through an earnout structure, the buyer pays one price at closing and makes additional payments over time contingent on the achievement of certain performance thresholds. If, for example, a seller thinks that a firm is worth $100 and the buyer thinks the firm is worth $70, the deal might be structured such that $70 is paid at closing and an additional $30 is paid over time if certain growth targets are met.Through an earnout structure, if the seller’s optimistic vision for the future of the firm materializes, the price ultimately paid reflects that. Likewise, if the downside scenario envisioned by the buyer materializes, the hurdles for the earnout payment will likely not be met, and the price will reflect that reality. Rather than hoping they get what they pay for, the buyer pays for what they get. Similarly, sellers are compensated for what the firm actually delivers.2. Staged TransactionIf an RIA is being sold internally to next-generation management, then selling the firm in multiple stages is one way to help bridge valuation gaps. This is partly because it’s easier to come to an agreement on valuation when the stakes are smaller. But there’s also many potentially value-enhancing benefits to internal sales which take time to realize. Through internal transactions, founders get to hand pick their own successors and incentivize them to grow the firm through equity ownership. The buyers (next generation management) have a pathway to advance their career and increase the economic benefit they receive from their efforts.However, if an internal transaction is done all at once, the owner does not have time to benefit from the growth incentives management hoped the transaction would provide. By structuring the transaction over time, subsequent transactions will take place at higher valuations that reflect the growth that results from the alignment of next gen management’s incentives with existing ownership. As a result, sellers in internal transactions may be willing to come down on price for early transactions to incentivize employees to grow the business, while buyers may be willing to come up in price for the opportunity to become an equity partner in the business and participate in the upside.Selling an interest over time also lessens the capital requirement for the buyer, which is often a barrier in internal transactions where the buyer may not have the financial resources to purchase a large block of the company at one time.3. Deal FinancingBeyond the price, how the purchase price is paid can make a significant difference in the perceived economics of the deal. While external buyers will generally pay cash or stock at closing (with possible future earnout payments as discussed above), internal transactions are often seller-financed.We’ve seen a number of internal transactions where an otherwise attractive valuation was offset by payment terms that were extremely favorable to the buyer such as seller notes with low interest rates and long repayment terms. Similar to earnouts, such favorable payment terms allow the seller to feel like they are getting full value for the business while making the higher purchase price more palatable for the buyer.4. Mitigate Risk Factors Before You SellSellers can mitigate potential valuation gaps in advance of a transaction by addressing aspects of the firm that could be concerning to potential buyers. Consider an outsider’s perspective on your firm, and take action to address the perceived risk factors that lower value. For example, if transitioning the firm internally, distinguishing owner compensation and regular distributions of excess capital prior to a sale will decrease the buyer’s concern about liquidity and marketability of the investment and increase the perceived value of equity ownership.Similarly, focusing on staff development in client-facing roles, increasing the number of client contacts with the firm, and creating an internal pipeline of talent to manage the business will all serve to reduce key person risk from the perspective of a buyer, thereby increasing the value that the buyer ascribes to the firm.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

How Are Business Valuations Prepared?

For family businesses that have never had an external valuation, there is likely to be some confusion as to what the process involves. In this post, we give a brief walk-through of the valuation process, from engagement through to issuance of the final report.EngagementThe first step in the valuation process is preparing and executing an engagement letter. The engagement letter should clearly define several key components of the valuation, including:The subject interest to be valued (i.e., XX shares of XYZ Corporation, Inc.) - There needs to be absolute clarity on what will be valued. It is not uncommon for enterprising families to develop a rather elaborate structure of holding companies and operating businesses, and the engagement letter should clearly state what is being valued.The "as of" date for the appraisal - Any valuation conclusion pertains to a specific subject interest as of a specific date. Markets change, and the value of a family business is not static across time. For most engagements, the valuation report is issued after the "as of" date. In other words, there is nearly always some lag between the effective date for the conclusion and when that conclusion is rendered.The level of value for the conclusion - As we discuss at greater length in the following section of this whitepaper, family businesses have more than one value at any particular date, so the engagement letter should specify which level(s) of value are relevant for the valuation.The standard of value and purpose of the engagement - The engagement letter should indicate how the valuation is expected to be used and what the corresponding standard of value is.Fees - Most valuation engagements can be performed for a fixed fee. Occasionally, the scope of an engagement is sufficiently open-ended that the parties agree to calculate fees on an hourly basis. In either case, the engagement letter should spell out how fees will be calculated and when billings will occur. Prospective clients naturally want to know how much a valuation will cost. Unfortunately, the answer to that question is that it depends on the complexity of the assignment. Most valuation professionals will ask to review a family business’s financial statements to help in preparing a fee quote. This allows the valuation professional to gauge the complexity of the analysis that will be required. Valuation fees are ultimately a product of the estimated time required to complete the engagement and a targeted effective billing rate. Effective billing rate is a function of project complexity and the ability of the firm to leverage staff resources effectively to complete the valuation engagement efficiently. When comparing fee quotes, family businesses should keep this in mind. When presented with widely diverging fee quotes, one should ask if there are underlying differences in scope expectations or perceived complexity that need to be clarified.Data CollectionValuation is a data-intensive process. Concurrent with the engagement letter, most valuation firms will provide a preliminary information request. While potentially voluminous, the requested items are often ready to hand for family businesses, and include historical financial statements, financial projections, data on the assembled workforce, customer relationships, market segments, and product lines. In addition, clients often have access to industry-wide performance measures that are not readily available to those outside the industry. In short, the valuation professional will seek to collect the same sorts of data on the subject company that a potential investor would.DiligenceUpon receipt of the requested information, the valuation firm will perform diligence procedures, including relevant economic and industry research and analysis of the subject company’s historical and projected financial performance. The diligence phase of the engagement culminates in an interview with senior management of the family business. The purpose of the management interview is to help the valuation professionals identify and articulate the underlying narrative of the company: what makes this family business tick, and why is it valuable?AnalysisThe heart of the process is the application of valuation methods under the asset-based, income, and market approaches. Each approach seeks to answer the valuation question from a unique perspective.What are the current market values of the business’s assets and liabilities? This is the key question underlying the asset-based approach. It may involve assessing whether there are assets or liabilities that do not appear on the company’s balance sheet and evaluating whether there are assets having current market value different from that recorded on the balance sheet (such as real estate that has been owned for decades).What are the expected future cash flows of the family business, and how risky are those cash flows? This is the income approach to valuation, and it involves a careful analysis of the historical earnings of the family business, as adjusted for unusual or nonrecurring items, and the outlook for the economy, relevant industry, and the family business itself.What can be inferred about the value of the family business from transactions in reasonably similar businesses? This is the essence of the market approach, and it involves searching for and analyzing comparable public companies and/or transactions involving comparable private companies. In applying these methods, the valuation professional seeks to develop reasonable inputs and consider prevailing market conditions at the “as of” date for the valuation.Draft Report ReviewConcurrent with performing the analysis, the valuation firm will prepare a draft valuation report which describes the company, relevant industry and economic trends, valuation methods applied, and inputs used. The client should have an opportunity to read this document in draft form. This draft review is a critical step in the valuation process, helping to ensure there have not been any misunderstandings or miscommunications that would undermine the credibility of the conclusions in the valuation report.Clients should read the draft report carefully to assess whether the valuation firm developed a balanced and informed view of the industry and the company. Clients should be able to recognize their company in the valuation report. If they don’t, the draft review process should allow them to discuss those concerns with the valuation analyst.Issuance of Final ReportOnce the draft review process is concluded, the valuation firm will issue a final report. The final report should include the attributes of the engagement from the engagement letter and a clear description of who is entitled to use the report and for what purpose.BillingBilling practices vary and should be detailed in the engagement letter. Many valuation firms request a retainer at the beginning of the engagement and invoice for the remainder of the professional fee at the end of the engagement, either upon completion of the draft report or issuance of the final report.TimelineIn the normal course, family business leaders should anticipate that the valuation process described in this section should take six to eight weeks to complete. Most valuation firms are able to adjust as needed to accommodate reasonable deadline requests so long as they are communicated to the valuation firm during the engagement process. Prompt responses to information requests and follow-up questions help to keep the valuation process on track. Regular communication between the client and the valuation firm is the most important factor in meeting deadlines for project completion.ConclusionMercer Capital has worked with hundreds of family businesses over the last 40 years. If you think your family business needs a valuation but don’t know where to start, give one of our professionals a call, we’d be happy to help discuss your needs today.This week's post is an excerpt from section 2 of What Family Business Advisors Need to Know About Valuation whitepaper. If you would like to read the full version click here.

Cash-Out Transactions and SEC Amended Rule 15c2-11

It may seem an odd time for some publicly traded companies to consider cash-out merger transactions because broad equity market indices are at or near record levels. Nonetheless, the changing market structure means some boards may want to consider it.Among a small subset of public companies that may are those that are traded on OTC Markets Group’s Pink Open Market (“Pink”), the lowest of three tiers behind OTCQB Venture Market and OTCQX Best Market. Pink is the successor to the “pink sheets” which was published by a quotation firm that was purchased by investors who rechristened the firm OTC Markets Group.Today, OTC Markets Group is an important operator in U.S. capital markets because it facilitates capital flows for 11,000 US and global securities that range from micro-cap and small-cap issuers across all major industries to ADRs of foreign large cap conglomerates. Many issuers are SEC registrants, too.The issue that may cause some boards of companies traded on Pink to contemplate a cash-out merger or other transaction to reduce the number of shareholders is an amendment by the SEC to Rule 15c2-11, which governs the publication of OTC quotes and was last amended in 1991. Since then, markets and the public participation in markets have increased significantly as trading costs have declined and information has become more widely disseminated. The amendment applies only to Pink listed companies because those traded on OTCQB and OTCQX already meet the new requirements.Because of a quirk in how the rule was written in conjunction with a “piggyback exception” for dealers, financial information for some Pink issuers is not publicly available. The amended rule, which goes into effect September 28, 2021, prohibits dealers from publishing quotes for companies that do not provide current information including balance sheets, income statements and retained earnings statements. OTC Markets Group requires companies to comply with the rule through posting information to the issuer’s publicly available landing page that it maintains.While the disclosure requirement presumably is not burdensome, not all companies want to disclose such information, especially to competitors. Companies that choose not to comply with amended Rule 15c2-11 will no longer be eligible for quotation. Because shareholders of these companies historically have had the option to obtain liquidity, boards may want to evaluate an offer to repurchase shares or a cash-out merger transaction that reduces the number of shareholders.1Also, some micro-cap and small-cap companies whether traded on an OTC market or a national exchange may not obtain as many advantages compared to a decade or so ago.Given the rise of passive investing in which upwards of 50% of US equities are now held in a passively managed fund, companies that are not included in a major index such as the S&P 500, Russell 1000, NASDAQ or Russell 2000 are at a disadvantage given the amount of capital that now flows into passive funds. In some instances, it may make sense for these companies to go private, too.Cash-out transactions can be particularly attractive for companies that have a high number of shareholders in which a small number of shareholders have substantial ownership. Cash-out merger transactions require significant planning with help from appropriate financial and legal advisors. The link here provides an overview of valuation and fairness issues to consider in going private and cash-out transactions for companies whether privately or publicly held.Mercer Capital is a national valuation and financial advisory firm that works with companies, financial institutions, private equity and credit sponsors, high net worth individuals, benefit plan trustees, and government agencies to value illiquid securities and to provide financial advisory services related to M&A, divestitures, capital raises, buy-backs and other significant corporate transactions.1 Cash-out merger transactions are also referred to as freeze-out mergers or squeeze-out mergers in shareholders owning fewer than a set number of shares receive cash for their shares while those holding more than the threshold amount will be continuing shareholders.

Fairness Considerations in Going Private and Other Squeeze-Out Transactions

Going Private 2023 presentation by Mercer Capitals’, Jeff K. Davis, CFA, that provides an overview of issues surrounding a decision to take an SEC-registrant private.Pros and Cons of Going PrivateStructuring a TransactionValuation AnalysisFairness Considerations

Not Every RIA Buyer Is a Control Freak

Despite Conventional Wisdom, Some Investors Prefer Minority Positions

Ideally, our work with investment management firms at Mercer Capital distills both conventional valuation principles and real-world industry experience. These two influences typically align; valuation theory develops to represent the thinking of actual transacting parties, and – in turn – transaction behavior validates theory.Sometimes, though, we witness rational actors engaging in transactions that challenge certain norms of professional thinking. At such times, we ask ourselves whether valuation theory, as we know it, is doctrine or dogma.The pricing of minority transactions in the RIA space leaves some people scratching their head. Traditional valuation theory holds that investors pay less for minority interests than controlling interests. Reality suggests otherwise. Some established institutional buyers of minority interests in RIAs invest at similar, or even higher, multiples to what other consolidators will pay for controlling interests. Some institutional buyers even prefer taking minority stakes in investment management firms – not a circumstance we see much from the private equity community. Even insider transactions don’t always follow valuation maxims, as valuations for succession are colored by considerations far beyond the sterile realm of hypothetical buyers and sellers. It seems to some that the RIA community has turned valuation theory on its head, but the truth is more nuanced.Valuation Vacuum WonkeryConventional wisdom holds that minority interests in closely held companies are worth less than their pro rata stake in the enterprise. A 15% interest in a business that would sell for $10 million is widely believed by valuation practitioners to be worth something less than the $1.5 million that its pro rata stake in the enterprise would otherwise command. The difference between value inherent in controlling interests and minority interests can be illustrated by way of a diagram known as a levels of value chart. The value of an enterprise can be described as the present value of distributable cash flow – and this parameter is useful for thinking about the different perspectives of control and minority investors. A control level investor effectively has direct access to enterprise level cash flows, with unilateral influence over operations, the ability to buy, sell or merge the enterprise, pay distributions, and set compensation policy. Absent special considerations, a control investor can achieve the greatest benefit, and therefore pay (or expect to be paid) the highest price for an enterprise. Most reported transactions in the RIA channel are made on this basis, and M&A multiples reported publicly, or whispered privately, reflect change of control valuations. Minority investors lack two important prerogatives of control: influence and liquidity.Minority investors lack two important prerogatives of control: influence and liquidity. Discounts for lack of control – also known as minority interest discounts – reflect the inability of minority interest holders to direct the enterprise for their own benefit. The marketable, minority interest level of value is analogous to an interest in a publicly traded company, wherein investors can access the present value of distributable cash flow by way of an open market transaction but have no particular sway over a company’s strategy or operations.Discounts for lack of marketability (a.k.a. marketability discounts) capture the lack of access to enterprise cash flows via distributions or a ready and organized market to sell the interest. The nonmarketable, minority interest level of value is what most valuation practitioners think of when they think of minority interests in closely held enterprises: a value which is materially distinct from a pro rata controlling interest.Internal Transactions Challenge Valuation TheoryReal world economics of minority transactions in RIAs can look very different than our professional discipline would suggest, reflecting issues unique both to the industry and to the universe of typical investors in the industry.Much of the reason that RIA transactions don’t always conform to traditional valuation pedagogy is the nature of the investment management model itself. The theory behind the levels of value is intended to represent the perspective of hypothetical disinterested investors. In a world of financial buyers who can choose freely between alternative instruments, this idea holds.But most RIA investors are insiders, practitioners who work at the investment management firms. The lines between returns to labor and returns to capital are often blurred (although we strongly advise structuring your model otherwise). Insiders have different motivations to show loyalty to their employer, and in turn firms often bestow ownership on staff on favorable terms because of the labor-intensive, relationship-based nature of investment management.Insider ownership is often managed by buy-sell agreements, which at the same time restrict owners from certain actions but also provide them with access to liquidity (under specified circumstances) and a claim on returns. Buy-sell agreements often establish particular parameters for valuation as a way to side-step valuation theory to benefit the ownership and the business model of the particular RIA. Valuation theory operates in a ceteris paribus (all else equal) universe, whereas buy-sell agreements do not operate in this vacuum.Valuation theory operates in an all else equal universe, whereas buy-sell agreements do not.Finally, the issue of discounts for lack of marketability – that minority investors suffer from lack of ready access to enterprise level cash flows – is a byproduct of focus on old economy, heavy industry businesses structured as C-corporations in which dividend policy can be parsimonious. Most RIAs are structured as tax pass-through enterprises (LLCs or S-corporations) and don’t rely on heavy amounts of capital reinvestment. High payout ratios (often nearing 100%) mean minority investors do, in fact, typically enjoy regular returns from enterprise cash flows. Consequently, discounts for lack of marketability are usually smaller for investment management firms than for minority investments in many other industries.Institutional Investors Make Minority Investments With Majority ConditionsOne would expect institutional investors, as financially driven actors who are free to invest across a broad spectrum of opportunities, to behave in a manner more consistent with the hypothetical investors described by valuation theory. The institutional community has, however, developed practices to protect itself from many of the vagaries of minority investing. Achieving rights and returns similar to control investors has led to transaction pricing on par with control transactions, a phenomenon which isn’t inconsistent with conventional wisdom.Institutional investors in the RIA space have corrected for many of the disadvantages associated with being a minority investor by way of contractual minority interest protections.Institutional investors in the RIA space have corrected for many of the disadvantages associated with being a minority investor by way of contractual minority interest protections. No two firms handle this the same way, but board representation, performance reporting, rights to change senior management, compensation agreements, bonus plans, restrictions on non-cash benefits, assurance of timing and performance for distributions, and even revenue sharing arrangements can go a long way to putting a minority investor on terms comparable to a majority owner. Without the risks that accompany lack of control and lack of marketability, minority participants can focus on the value of the enterprise.As an added benefit, if management still holds most of a firm’s equity, then outside investors have more assurance that insiders will pay attention to their jobs. This avoids the issue of RIA leadership “calling in rich” following a lucrative recapitalization and mitigates the monitoring costs that accompany most private equity investing. Sitting alongside management on an economic basis, but knowing management is sufficiently motivated, many institutional investors have effectively created the best of both worlds in minority investing: comparable returns without comparable responsibility.Valuation Theory Is the Real WorldUltimately, valuation models are descriptive, not prescriptive. The economic principles underlying valuation models are the real secret sauce.The behavior of insiders and professional investors is often seen in conflict with the notion that minority interests carry a lower value than pro rata control. In fact, these minority investors are not typical, coupling their money with conditions of ownership that mitigate or eliminate the distinctions between value on an enterprise basis and value on a fractional basis. In our view, the behavior of professional minority investors substantiates the presence of valuation discounts for investors who lack similar protections and privileges.About the car: In the late 1950s, while Detroit focused on building huge, heavy, powerful, front engine sedans and wagons, Italian automaker Fiat designed a petite coupe with a canvas roof and a two-cylinder rear-mounted engine. The Fiat 500 was as contradictory to conventional wisdom at the time as it was easy to park and cheap to own. Detroit boomed, but the Cinquecento sold almost four million units over 18 years. Different markets have different needs.

When Does Valuation Matter to Family Businesses?

Why should family business leaders care about the value of their business? If the family is not contemplating a sale of the business, why does valuation matter?Clearly, valuation matters a lot when it is time to sell. But valuation matters at other times as well. In this post, we describe four common valuation applications in family business.Ownership Succession and Tax ComplianceEnterprising families prioritizing sustainability of the family business over decades need a strategy for ownership succession from generation to generation. Ownership transfers within a family unit can occur either during the present owner’s lifetime or upon death. In either case, compliance with tax laws require that the shareholders determine the fair market value of the shares being transferred.Family shareholders occasionally confuse fair market value with what they believe the shares to be worth to them. Fair market value is the statutory standard of value that emphasizes the actions of "hypothetical willing" buyers and sellers of shares in the family business. Revenue Ruling 59-60, which provides guidance for valuation of closely held companies, presents a working definition of fair market value:2.2 Section 20.2031-1(b) of the Estate Tax Regulations … define fair market value, in effect, as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.In other words, fair market value is not defined by what a particular family shareholder feels like the shares are worth to them or “what they would be willing to pay,” but is rather defined by a more rigorous process that considers the behavior of rational, willing, and well-informed parties to a hypothetical transaction involving the subject block of shares.Shareholder RedemptionsNot all family shareholders need the same things from the family business. A share redemption program can help provide interim liquidity for shareholders and provide a release valve in the event relationships among the shareholders deteriorate to the point that it becomes advantageous for some shareholders to be bought out completely.In contrast to tax compliance valuations that must conform to fair market value, there is more flexibility in pricing shareholder redemptions. In other words, enterprising families can seek to execute shareholder redemptions at a price considered to be “fair” or that otherwise advances the goals of the share redemption program.Regardless of the underlying goals or valuation philosophy selected, it is important for the transaction price to be the product of a disciplined valuation process. Doing so helps to ensure that the share redemptions do not detract from broader family goals or undermine other estate planning objectives of family shareholders.Performance Measurement, Evaluation, and CompensationWhether family members or outside “professionals,” the managers of the family business are stewards of family resources. Family shareholders should be entitled to periodic reporting on the effectiveness of that stewardship. While there are a variety of “internal” measures of corporate performance that are helpful in this regard (return on invested capital, etc.), periodic “external” measures that reflect the change in the value of the family business over time are also essential.Most observers acknowledge the benefit of aligning the economic interests of managers and family shareholders. The most common strategy for doing so involves using some form of equity-based compensation, and the most common equity-based compensation programs require periodic valuations for administration. Many family businesses have installed employee stock ownership plans, or ESOPs, to provide a broad-based ownership platform for employees, and ESOP administration requires an annual independent valuation of the ESOP shares.Corporate Finance DecisionsFinally, valuation is an essential component of the most important long-term corporate finance decisions made by family business directors and managers.The graph below depicts the inter-relationships between the capital structure, dividend policy, and capital budgeting decisions facing family businesses.The capital structure and capital budgeting decisions are linked by the cost of capital. There is a mutually reinforcing relationship between the value of the family business and the cost of capital, as each one influences, and is in turn influenced by, the other. The cost of capital depends on both the financing mix of the company and the riskiness of capital projects undertaken. The cost of capital also serves as the hurdle rate when evaluating potential capital projects.The availability of attractive capital projects is also reflected in the value of the family business and is the point of intersection between capital budgeting and dividend policy. If attractive capital projects are abundant, family business leaders will be more inclined to retain than distribute earnings.Finally, the cost and availability of marginal financing is also affected by the value of the family business. The resulting cost of capital influences both the value of the family business and the decision to distribute or retain earnings or to borrow or repay debt.In short, the value of the family business is inextricably bound up with these critical corporate finance decisions and is an important consideration in making those decisions.This week's post is an excerpt from section 1 of What Family Business Advisors Need to Know About Valuation whitepaper. If you would like to read the full version click here.

Oilfield Water Management

Clean Future Act Regulatory Concerns

In the midst of the COVID pandemic, the rise of the Delta-variant, and general summer distractions, not a lot of attention has been given to the 117th Congress’ H.R. 1512 – aka the “Climate Leadership and Environmental Action for our Nation’s Future Act” or the “CLEAN Future Act.” The Act was first presented as a draft for discussion purposes in January 2020. After more than a year of hearings and stakeholder input, it was introduced as H.R. 1512 in March 2021. The Act’s stated purpose is:“To build a clean and prosperous future by addressing the climate crisis, protecting the health and welfare of all Americans, and putting the Nation on the path to a net-zero greenhouse gas economy by 2050, and for other purposes.”As broad as that stated purpose is, it’s not surprising just how far-reaching the implications of the nearly one-thousand-page-long Act are for many sectors of the U.S. economy. While Congress is a long way away from any bipartisan climate legislation being enacted, the Act provides some insight regarding the plans of the House Democrat Leadership for a clean energy future. It also potentially serves as a “red flag” to many industry participants that will be materially impacted by those plans.Of particular interest to the Oilfield Water Management sector, is Section 625 of the Act. In that section, the Environmental Protection Agency would be ordered to determine whether certain oil and gas production byproducts, including produced water, meet the criteria to be identified as hazardous waste. The legislation in fact, mandates that the EPA must make its determination within a year after the Act becomes law.Per the EPA’s April 2019 study publication, Management of Exploration, Development and Production Wastes: Factors Informing a Decision on the Need for Regulatory Action, produced water is defined as “the water (brine) brought up from the hydrocarbon bearing strata during the extraction of oil and gas. It can include formation water, injection water, and any chemicals added downhole or during the oil/water separation process.” Since 1988, EPA has held that oilfield-produced water should be regulated as non-hazardous waste. As such, produced water has been subject to the Resource Conservation and Recovery Act’s (RCRA) much less restrictive Section D provisions regarding non-hazardous waste, instead of RCRA Section C’s much more restrictive provisions regarding hazardous waste.Per a June 2021 report by Rice University’s Baker Institute for Public Policy, if the EPA’s Act-directed review of the 1988 produced water’s non-hazardous classification is revised to a hazardous classification, an enormous disruption in oilfield water management would result. The report specifies that severe disposal capacity constraints would be brought into play.At the current time, oilfield produced water disposal is available at an estimated 180,000 Class II disposal wells located throughout the U.S. If the Act were to lead the EPA to reclassify produced water as hazardous waste, all produced water would have to be disposed of in Class I wells, of which there are far fewer. The EPA’s data on Class I wells indicates that approximately 800 such wells are in existence; however, the wells are located in only 10 states due to geological requirements. The majority of those Class I wells are located in Texas and Louisiana. The EPA also indicates that only 17% of the Class I wells are available for hazardous waste disposal. Adding to the limited Class I well availability matter, the University of Wisconsin Eau Claire reports that those hazardous waste disposal wells are located at a mere 51 facilities. Source: EPA The cost of transporting Eagle Ford and Permian Basin produced water (in excess of 10 million barrels per day), for example, hundreds for miles to Class I facilities on the Texas and Louisiana Gulf Coast would be prohibitive to many producers. As a result, a substantial reduction in U.S. oil and gas production would be a natural and expected consequence, with the economic and industry ripple effect of such reduced production being enormous. Gabriel Collins, the Baker Botts Fellow in Energy and Environmental Regulatory Affairs at the Baker Institute, notes that any such re-classification would very likely lead to multi-system disruptions severe enough to make achieving the Act’s climate, energy, environmental, and social objectives impossible.While the Act is awaiting action by the U.S. House of Representatives, it’s well worth Oilfield Water Management industry participants keeping a close eye on it. Although Congress’ attention has been focused on COVID relief and is now focused on infrastructure matters, the CLEAN Future Act will eventually come to the forefront, with potentially far-reaching impacts if unchanged from its current form.ConclusionMercer Capital closely monitors the Oilfield Water Management and other areas of the Oilfield Services industry. We’re always happy to answer your OFS-related, or more general valuation-related questions. Please contact a Mercer Capital professional to discuss your needs in confidence.

Understand the Income Approach in a Business Valuation

What Is the Income Approach and How Is It Utilized?

Growing Pains

Is the RIA Industry in Growth Mode or Shake-Out?

While the wealth management industry is not new, the amount of change, churn, and growth that has occurred in the industry over the past ten years make it easy to forget how far the RIA industry has come since the heyday of broker-dealers.Following a financial crisis brought on by scandal and exacerbated by leverage, the fiduciary model has become the solution to restore trust in the industry among both clients and regulators. Since this transition, AUM has grown dramatically, as has the number of RIA firms. After a ten-year bull run, which was only momentarily stalled by the country’s shortest economic recession, strong performance from passively managed funds has enabled fee compression throughout the industry.Contextualizing the challenges facing the wealth management industry leaves one to wonder if many of these trends are no more than growing pains in the sector’s life cycle. And if so, what might such analysis suggest about the prospects for the fiduciary model?The lifecycle of an industry is often characterized by the following phases: start-up, growth, shakeout, maturity, and decline.Start-Up. During an industry’s infancy, customer demand is at first limited due to unfamiliarity with the new product and its performance. From the aftermath of WWII until the advent of ERISA in the 1970s, the broker dealer model flourished. During the 1970s, bad market conditions kept the lid on RIA growth, but by the 1980s registered reps were leaving wire-house firms and young trust officers were leaving banks to set up registered investment advisors, usually offering a very wide variety of services priced under what was then the new fee-based concept, instead of commissions.Growth. Just as customer demand is limited at first, so is competition which can lead to impressive growth and profits until more players enter the space. However, the inevitability of competitors chasing profits, is an elementary principal of economics. Over the past couple of decades, the count of RIAs, the number of professionals who work for RIAs, and the dollar volume of assets managed by RIAs, has exploded. But, competition has led to the need for differentiation, and that need has led to specialization.Shakeout. Periods of high profits, low market concentration, and pressure for consolidation is often described as the shakeout period because many firms aren’t positioned to survive. As market participants vie for a limited supply of market share, all the while cutting costs to remain competitive, consolidation is inevitable. In theory, ‘economic profit’ in an industry is only temporary. If the recent history of the wealth management industry can be grafted to a typical industry life cycle framework, the wealth management industry may be in a shakeout period. Consider the following trends that have dominated the independent advisor narrative in recent years:The wealth management industry may be in a shakeout period.Product Innovation: Product innovation is the catalyst for every industry lifecycle. That initial great idea, product, or service is adopted by many market players as the industry grows. These adopters often bring their own ideas to the table, or spawn other industries in response. In short, innovation, and the industry life cycle for that matter, is an iterative process bound by serendipity—or disaster as was the case for the fiduciary model after the Financial Crisis. While fiduciary money management has been around for quite some time, its rapid adoption resembles something like a genesis. The growth in the RIA space over the years has been charged by innovation, be it money managers finding new business models that allow their teams more independence or clients demanding new services or increasing levels of specialization. As seen in the 2021 Charles Schwab RIA Benchmarking Study, firms of all sizes are continuing to increase their offerings (across all service types: tax planning, charitable planning, estate planning, family education, bank deposits, and lifestyle management) as firms look to distinguish their value proposition.CLICK HERE TO ENLARGE THE IMAGE ABOVENumber of firms: A shakeout period is often defined by both low market concentration and rapid consolidation as firms use acquisitions to maintain economic profit rather than seek growth organically. As we recently noted, the number of RIA firms continues to grow to record numbers despite intense deal activity that would otherwise be considered a hallmark of consolidation. Meanwhile, wire-houses have consistently lost market share over the past ten years as the myth of corporate brand continues to be undermined by AUM flow. This conflict between the increasing number of firms and the pressure for consolidation is in large part being driven by the same profit dynamics that categorize the beginnings of a shakeout period. Growth & Profitability: While assets managed by independent advisors nearly tripled during the ten years between 2009 and 2019 profitability has begun to lag as clients have become increasingly fee sensitive. Much of the fee compression in the RIA space is being driven by competition with passively managed funds, which until recently have had the longest bull run in history to go unchallenged. But, as evidenced by the record number of independent advisors, competition among firms is just as easily responsible. Regardless, profitability explains the high deal volume in a wealth management space that benefits from economies of scale. Because revenues are tied to AUM and certain overhead costs are more or less fixed, operating leverage can have a positive impact on margins even with modest fee pressure. But it’s not just fees that are feeling pinched. RIAs are increasingly competing for talented money managers who have become more aware than ever of the value of their book of business.Economic utility might just be a better metric than economic profitability for understanding the incentives behind consolidation in the wealth management space.For this reason, economic utility might just be a better metric than economic profitability for understanding the incentives behind consolidation in the wealth management space. In an industry as labor intensive as wealth management, advisors are just as much clients as they are the product, and advisors are leaving wire-houses in favor of independence, often for reasons not always tied to pure economics.Ultimately, as the industry tries to accommodate both the price preference of clients and the lifestyle preferences of its most valuable assets, market concentration will remain low and deal values high. As such, and despite ballooning valuations, acquisitions remain at all-time highs while so too does the number of RIA firms. A shakeout period explains the conflict between the need for scale and the pressure to retain talent as economic utility is being carved out.CLICK HERE TO ENLARGE THE IMAGE ABOVEOr, is the RIA Industry still in Growth Mode?For now, we see no end in sight for the RIA acquisition frenzy. And, despite the large number of RIA transactions, most firms are not looking to sell. In a yield starved environment, RIAs continually are perceived as the ultimate growth and income investment. AUM growth, and ultimately earnings growth, show no signs of slowing. An upward trending market is a further catalyst. So, while there may be a growing quantity of RIA firms, the appetite for acquisitions appears to be greater with many owners holding on.What does this mean for your independent wealth management firm? While the industry lifecycle may be a helpful tool for understanding current industry headwinds, the timeline of industry phases is impossible to predict. Innovations can arise that can propel an industry back into a growth phase or just as likely syphon profitability towards rival industries. Additionally, firms can always achieve high growth through product innovation or superior capital budgeting no matter what industry they operate in. At most, the industry lifecycle helps make sense of the challenges facing the industry today and perhaps where to look for solutions, be that through additional services, reduced fees, or acquisitions.That said, the wealth management industry is competitive and will continue to be so. Fee compression will continue to be a headwind, and as a result staying cost competitive is as important as ever. Higher fees should be justifiable by premium services, value adds or ancillary services. But perhaps equally as important, retaining talent will continue to be crucial as advisors have more market power than perhaps ever before. And while the days of charging 1% of AUM might be waning, the combination of high cash flow and high growth continue to be attractive as evidence by elevated deal volume and multiples.

M&A, Reinvesting in Core Operations, or Paying Dividends

How Public and Private Dealerships Should Think About Allocating Capital Amidst Excess Liquidity

Over the past year or so, many auto dealers “outperformed” particularly as inventory shortages have raised margins on new and used vehicles in 2021. Additionally, cost cutting initiatives have dealerships running more efficiently, leading to record profitability. The question now comes for public and private auto dealerships alike: what do I do with this excess liquidity?In last week’s blog, we looked at second quarter earnings calls from public franchised auto dealers. Several themes were present in these calls, one of which was the movement toward share repurchases in several firms’ capital allocation approach over the quarter. Many CEOs implied that high multiples and frenzied activity in the M&A market was a determinant in the decision to repurchase shares.In this post, we consider what options are available to both public and private dealers. We look at what decisions the publics are making, and what that could mean for private dealers.Capital Allocation OptionsAuto dealers, and many other businesses more broadly, have numerous options when it comes to allocating capital, including:Reinvest in the business Expand organically (including adding rooftops to current locations or adding new locations)Acquire other dealerships/companies to increase revenue and earningsReturn capital to providers of capital Debt repaymentsDividendsShare repurchasesReinvesting in the BusinessDuring the depths of the pandemic, M&A activity plummeted as significant uncertainty created a chasm between what buyers were willing to pay and what sellers were willing to sell for. As the operating environment stabilized and ultimately improved, deal activity picked up considerably. For the public auto dealers and larger private auto groups, acquisitions have been a clear way to reinvest in automotive retail. However, if recent earnings calls are any indication, this activity may begin too slow as sellers seek peak multiples on peak earnings, something we’ve discussed as unlikely to be palatable for acquirers for obvious reasons.Outside of M&A, options for growth or reinvesting in the business may be limited particularly for private auto dealerships with only a few stores/rooftops. Auto dealers, like other retail businesses have four primary avenues for growth:Penetration (same product, same markets: increase frequency of trips or size of transactions to get an increased share of discretionary spending). Auto dealers can focus advertising spend to seek to capture more market share, particularly on fixed operations side where there are more regular interactions with consumers.Expansion (same product, new customers: adding new store locations in different markets to get new customers with current product offerings). Auto dealers can look to open points in adjacent markets. This can also include investing in the Company’s digital sales strategy, if we consider the digital ether as another “market” itself even if the dealership location doesn’t change.Innovation (new product, same customers: to offer in their existing footprint or additional sales channels). This can be somewhat limited for auto dealers as OEMs exert control over what vehicles are produced. However, dealer principals can improve their product offering by adding new rooftops, whether connected to their existing footprint, or nearby. There are also opportunities to introduce or refine the suite of F&I products offered to consumers.Diversification (new product, new customers: companies can seek to vertically integrate their supply chain or enter adjacent/new lines of business in order to diversify both their product offerings and customer base). Auto dealers aren’t able to vertically integrate as they are dependent on their OEM. However, entering adjacent industries that may have synergies is still possible, whether that be a heavy truck dealership, powersports dealership, or business interest entirely. OEMs have significant power when it comes to awarding new points, which can limit Expansion. OEMs are also in charge of product innovation (what new models will be available), and OEMs and competitive market forces can leave relatively little wiggle room on vehicle pricing (part of penetration). Even capital expenditure decisions can be influenced by imaging requirements. Dealer principals seeking growth are likely to look at adding rooftops or new locations, increasing market share, or adding new business lines. However, efficient allocators of capital seek to hit certain return thresholds. Absent attractive prospects, it may be wise to instead return capital to its providers.Returning Capital to Debt Providers and ShareholdersIndustries have been impacted by the pandemic in various ways. While some saw material declines in activity, others have performed greater than they did in 2019, which has been the case for many auto dealerships. Companies that received PPP loans are likely to have even more liquidity, which has caused business owners to contemplate what to do with the funds once they’ve been forgiven. Many have chosen to pay down debt, reducing ongoing interest costs and helping the owners of more heavily indebted companies to sleep better at night.However, since inventory is financed by floor-plan debt and many auto dealers opt to hold the real estate in a separate entity, many do not carry material third party debt related to the core operations of the auto dealership. That leaves two options: paying dividends/distributions or share repurchases.Private companies are much more likely to be paying distributions as there is either not an active market for their shares, or those holding minority positions in the company are not interested in selling. There’s been much talk about restrictions on share buybacks in industries that received considerable stimulus (like airlines). Since executives of the auto dealers have begun buying back shares instead of splurging on what they view as expensive M&A, we give some thoughts on stock buybacks below.Stock BuybacksFor public companies, management teams may elect to buy back shares for a number of reasons. First, they likely will not buy back shares if they think the market is overvaluing their stock. As a corollary, buying back shares can serve to raise the stock price as it provides a signal to the market that they believe the stock is undervalued. Signaling is important in the presence of asymmetric information, which exists when corporate insiders have access to better information about the company’s prospects than outside investors.While the company may not receive any direct benefit from an increase in the stock price (no cash received), this can lower the cost of capital for the company. If the company takes on debt to repurchase shares, this shifts the weighted average cost of capital more towards debt than equity, which can lower the cost of capital if it helps achieve a more optimal capital structure. So long as the debt does not become burdensome to the point it leads to higher interest rates or increases the equity discount rate, this can be advantageous.Fundamentally, share buybacks are another form of distributing capital to remaining shareholders. While some investors pick companies for dividends, many investors, particularly in recent years, are investing for long-term capital appreciation. Share buybacks is a tax-advantaged way to return capital to shareholders that does not trigger dividend taxes. Instead, a company that elects to buy back shares instead of paying dividends would be expected to see higher levels of share price appreciation, and capital gains taxes are deferred until the investor decides to sell their shares.ConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These trends give insight to the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

How Long Will It Take to Sell My Family Business?

That Depends on the Type of Transaction …

In this week’s Family Business Director, Tim Lee, ASA, Managing Director of Corporate Valuation and John T. (Tripp) Crews, III, Senior Financial Analyst, discuss expectations around the timeline for your business transition or sale and summarize key points to keep in mind when driving towards an internal or external sale. Ownership transitions, whether internal among family and other shareholders or external with third parties, require effective planning and a team of qualified advisors to achieve the desired outcome. In this article, we examine some “typical” timelines involved in various types of transactions and expectations you can share with your family board members.Internal TransitionsIn this section, we discuss the importance of a buy-sell agreement in a sale to the next generation. Then we take a brief look at employee stock ownership plans as another potential avenue to an internal transition.Sale to Next GenerationInternal transitions are often undertaken in accordance with provisions outlined in the Company’s existing or newly minted buy-sell agreement. A buy-sell agreement is an agreement by and between the family members and other shareholders of a closely owned business that defines the terms for the purchase when an owner requires liquidity. Buy-sell agreements typically specify how pricing is determined, including the timing, the standard of value used, the level of value, and the appraiser performing the valuation.A buy-sell agreement is an agreement by and between the family members and other shareholders of a closely owned business that defines the terms for the purchase when an owner requires liquidity.As a matter of practicality, the timing for transfers using an existing buy-sell agreement is often dependent on the readiness of financing and the service level of the assisting legal and valuation advisory professionals. Experience suggests this can take as little as four to eight weeks, but often involves processes that can require three to six months to carry out.In circumstances where a newly crafted buy-sell agreement is being developed, you should expect a lengthier process of at least several months so that the attending financial, valuation, and legal frameworks are satisfactorily achieved.Mercer Capital has published numerous books on the topic of buy-sell agreements, which readers of this article should avail themselves of, or better yet, contact a Mercer Capital valuation professional to make sure you get directed to the most useful content to assist in your circumstance.Family-owned companies with an existing buy-sell agreement and those that obtain regular appraisal work, stand the best chance of achieving a timely process. Those Companies that are embarking on their first real valuation process, and that have stakeholders who require a thorough education on valuation and other topics, should allow for a deliberate and paced process.In the event of an unexpected need for ownership transfer (death and divorce to name a few), it is sound advice to retain a primary facilitator to administer to the potentially complex sets of needs that often accompany the unexpected.Employee Stock Ownership PlansThe establishment of an Employee Stock Ownership Plans (ESOP) is a necessarily involved process that requires a variety of analyses, one of which is an appraisal of the Company’s shares that will be held by the plan.For a family business with well-established internal processes and systems, the initial ESOP transaction typically requires four to six months. In a typical ESOP transaction, the Company will engage a number of advisors who work together to assist the family and its shareholders in the transaction process. The typical “deal team” includes a firm that specializes in ESOP implementation, as well legal counsel, an accounting firm, a banker, and an independent trustee (and that trustee’s team of advisors as well).Most modern-day ESOPs involve complex financing arrangementsMost modern-day ESOPs involve complex financing arrangements including senior bankers and differing types and combinations of subordinated lenders (mezzanine lenders and seller notes). There are numerous designs to achieve an ESOP installation. In general, the Company establishes and then funds the ESOP’s purchase financing via annual contributions.ESOPs are qualified retirement plans that are subject to the Employee Retirement Income Security Act and regulated by the Department of Labor. Accordingly, ESOP design and installation are in the least, a time consuming process (plan for six months) and in some cases an arduous one that requires fortitude and an appreciation by all parties for the consequences of not getting it right up front. The intricacies and processes for a successful ESOP transaction are many.A more detailed assessment of ESOPs is provided here on Mercer Capital’s website.The following graphics depict the prototypical ESOP structure and the flow of funds.External SalesMany families cannot fathom why success in business may not equally apply to getting a deal done. In most external transactions, there is a significant imbalance of deal experience: today’s buyers have often completed many transactions, while sellers may have never sold a business. Accordingly, family businesses need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Without exception, we recommend retaining a transaction team composed of at least three deal-savvy players: a transaction attorney, a tax accountant, and a sell-side financial advisor. If you do not already have some of these capable advisors, assembling a strong team can require time to accomplish. Since many transactions with external buyers originate as unsolicited approaches from the growing myriad of private equity and family office investors, it is advisable to maintain a posture of readiness.Up-to-date financial reporting, good general housekeeping with respect to accounts, inventory, real property maintenance, information technology, and the like are all part of a time-efficient transaction process. These aspects of readiness are the things that family business directors and managers can control in order to improve timing efficiency. As is often said in the transaction environment - time wounds all deals.In most external transactions, there is a significant imbalance of deal experience ... accordingly, family businesses need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Sellers doing their part on the readiness front are given license to expect an efficient process from their sell-side advisors and from buyers. We do caution that selling in today’s mid-market environment ($10-$500 million deal size) often involves facilitating potentially exhaustive buyer due diligence in the form of financial, legal, tax, regulatory and other matters not to mention potentially open-ended Quality of Earnings processes used by today’s sophisticated investors and strategic consolidators. A seasoned sell-side advisor can help economize on and facilitate these processes if not in the least comfort sellers as to the inherent complexity of the transaction process.The sell-side advisor assists the family (or the seller’s board as the case may be) in setting reasonable value expectations, preparing the confidential information memorandum, identifying a target list of potential motivated buyers, soliciting and assessing initial indications of interest and formal bids, evaluating offers, facilitating due diligence, and negotiating key economic terms of the various contractual agreements.The typical external transaction process takes four to seven months and is done in three often overlapping and recycling phases. While every deal process involves different twists and turns on the path to consummation, the typical external transaction process takes five to seven months and is completed in the three phases depicted in the following graphics.CLICK HERE TO ENLARGE THE IMAGE ABOVECLICK HERE TO ENLARGE THE IMAGE ABOVEConclusionAs seasoned advisors participating on both front-end and post-transaction processes, we understand that every deal is unique. We have experienced the rush of rapid deal execution and the trying of patience in deals that required multiple rounds of market exposure. A proper initial Phase I process is often required to fully vet the practical timing required for an external transaction process.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help manage your transaction.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of August 24, 2021

Q2 2021 Earnings Calls

Public Auto Dealers Weigh Record Profits, Days’ Supply, and Capital Allocation

Second quarter earnings calls across the group of public auto dealers began with similar themes: record profits and earnings, record Gross Profits Per Unit (GPU) on new and used vehicles, and tightening inventory conditions. Additionally, the public franchised dealers continue to post large scale improvements in SG&A expense as a percentage of gross profit.Executives revisited the reductions in personnel expense and their sustainability as GPUs are expected to decline at some point in the future. In a previousblog post, we discussed the prevailing industry conditions in inventory as reflected in the average days’ supply of new and used vehicles. The table below displays SG&A expense as a percentage of gross profit and the average days’ supply for the public auto companies for the second quarter:Click here to expand the image aboveThe trends reported by the public franchised dealers mirror those of the industry as a whole: continued tightening on the new vehicle side, but improvements on used vehicles. Executives offered their predictions for how the OEMs and the industry might evolve to supplying new vehicles once plant production and the microchip crisis normalize. Executives also discussed the ability to leverage their dealership platforms to source used vehicles from several sources including trade-ins, lease returns and campaigns such as “We’ll Buy Your Car” by AutoNation. As a result, the public franchised dealers are less reliant on auctions for used vehicle sourcing and are seeing some improvement in their used vehicle counts.Last week’s blogexamined the investment thesis and results of used-only public retailers such as CarMax, Carvana, Shift and Vroom. With record profits and a red hot M&A market, public executives discussed the opportunities for capital allocation and how they are evaluating and prioritizing the best fit for their companies. Three of the public companies in particular, AutoNation, Sonic and Penske, have chosen to invest in their used vehicle supercenter locations branded as AutoNation USA, EchoPark, and CarShop, respectively.Sonic provided some insight into the overall strategy of its used-only retail locations in its second quarter investor presentation. While front-end GPUs are expected to be lower (and sometimes negative) at the EchoPark locations, executives expect superior returns to be driven by the increased F&I GPU and overall volume of transactions at these platforms, compared to their franchised dealerships. These investments and strategies combined with other omnichannel investments by all of the public companies are in an attempt to capture the overall trend of an online retail experience.A deeper dive into some of the themes listed above is provided below, including remarks from management, related to expectations moving forward.Theme 1: The public companies continue to post improvements in SG&A as a percentage of Gross Profits driven by both sides of the equation: decreased expenses and record gross profits. While gross margins are universally expected to decline at some point, the jury is out on sustainability of cost reductions?“Our strong performance continues to be driven by strict cost discipline, leverage of our digital capabilities and robust vehicle margins. […] overhead decreased by 760 basis points, compensation decreased by 380 basis points, and advertising decreased by 30 basis points on a year-over-year basis […] I think for this year we will be in around the 60% range […] over 90% [of the increase in SG&A] is coming through variable cost. We are doing a very good job of keeping the fixed costs fixed, with strong discipline and leveraging the digital tools that we have” – Joe Lower, CFO, AutoNation“Same store SG&A to gross profit was 56.4% in the quarter, an improvement of 1,440 basis points over 2019. While we expect SG&A to gross profit to normalize [as] new vehicle supply and gross margins bounce back to historical levels […] we continue to benefit from the permanent headcount reductions of almost 20% or almost 300 basis points of SG&A and other efficiency measures implemented last year.” - Christopher Holzshu, COO of Lithia Motors“Obviously if growth comes down, that impacts SG&A…we’ve taken 11.5% of our workforce out […] we’re finding out we’ve got better productivity. Our mechanics are all over 120%. We see sales now per unit for a sales associate going from 9% to maybe 12% or 13%.” – Roger Penske, CEO Penske Automotive Group“If you look at our productivity on our sales associates […] we used to sell 12 units per month […] now we’re running 18,19. […] the other one [cost saving] is centralization of advertising […] we’re spending a lot less on advertising, and it’s even more effective.” - Heath Byrd Chief Financial Officer, Sonic AutomotiveTheme 2: Public executives boast of continued improvements in their omnichannel/digital platforms displaying that customer behaviors justify the infrastructure costs from these platforms. Advancements are illustrated in unique number of visitors, online transactions, and increased use of DocuSign and other electronic forms of signature software. Digital channels also allow the public companies to expand their footprint.“Our customers continue to vote yes on Acceleride […] we continued our upward trajectory in the second quarter by selling a record 5,600 vehicles through Acceleride, more than double the prior year. […] when incorporating all steps of the sales process, nearly 30% of our customers are using Acceleride. […] there’s opportunity to leverage Acceleride to expand our used vehicle business through our existing footprint […] in this quarter, we acquired almost 4,000 units through Acceleride […] and that was in a lot of markets that we’re not in today.” - Darryl Kenningham, President of US and Brazilian Operations, Group 1 Automotive“Driveway generated over 350,000 monthly unique visitors in June. Driveway eclipsed the 500-unit milestone with 550 transactions in June […] 98% of our Driveway customers during our second quarter were incremental and have never done business with Lithia or Driveway before […] we can now market and deliver our 57,000 vehicle inventory to the entire country under a single brand name and negotiation free experience […] 97.5% of customers in Driveway are entirely new to Lithia and Driveway […] we are delivering cars at a lot further radius […] last quarter we were at 740 miles or so […] we’re at 930 miles [because of] scarcity in vehicles." - Bryan DeBoer, CEO and President, Lithia MotorsTheme 3: A frenzied M&A market and heightened valuations have forced public executives to be more disciplined in their capital allocation approaches. Some of the publics (AutoNation, Group 1 and Penske) have prioritized share repurchases, others (AutoNation, Sonic) have prioritized reinvestment into their existing used vehicle platforms, while all must constantly evaluate acquisition opportunities against their individual growth, geographic and rate of return requirements.“A lot of different sellers that would like to work multiples off of Covid earnings. […] in the last six months [we] have walked away from $3 billion or $4 billion in business because we didn’t feel like it was priced appropriately.” – David Hult, President and CEO, Asbury Automotive Group“We’re investing in our existing stores […] keeping them top-notch […] but when we see that AutoNation is an attractive price, we have not hesitated to buy aggressively […] we view purchasing our own company relative to the pricing we see as other choices as the best use of that capital after having taken care of investing in our existing stores and building out [AutoNation] USA. […] I bought 9% of AutoNation rather than doing a lot of acquisitions that I thought were overpriced.” – Mike Jackson, CEO, AutoNation“During the second quarter, we repurchased 125,000 shares […] while the first priority for capital allocation remains M&A, we continue to be open to returning cash to our shareholders in the form of both share repurchases and an increase in our quarterly dividend. […] But the acquisition market is probably as frothy as it’s ever been […] it’s best if our acquisitions are accretive […] so we’re going to keep that as our top priority for capital allocation […] I would say it’s clear that share buybacks have been our second priority when we’re not able to find acquisitions to meet our financial hurdle.” – Daniel McHenry, Senior VP and CFO, and Earl Hesterberg, President and CEO, Group 1 Automotive“Despite a slightly more competitive environment, we continue to successfully target after tax returns of 15% plus, investments of 15% to 30% of revenues, and three to seven times EBITDA […] potential acquisitions that we believe are priced to meet our return thresholds […] we are expecting acquisition cadence for the remainder of 2021 to be strong.” - Bryan DeBoer, CEO and President, Lithia MotorsTheme 4: While average days’ supply on used vehicles is beginning to improve, the supply of new vehicles still remains near record lows due to production challenges from plant shutdowns, microchip shortages and increased consumer demand. Public and private franchised dealers have navigated these conditions to record profits. Will the current levels of production and inventory supply prove transitory, or will the OEMs adapt to the current conditions that one executive compared to the aphorism “rising tides raise all boats”.“I’m hopeful that when things normalize, we don’t quite settle back at the 70-80 day supply, we’ve run a good 20 days below that. […] OEMs are building the inventory the consumer wants.” - David Hult, President and CEO, and Dan Clara, SVP of Operations, Asbury Automotive Group, Inc.“The manufacturers […] are using the chips that they do have to produce vehicles that consumers want [to] buy. […] I really don’t know if we will ever see a crossover point back to the old push system […] maybe the best path is somewhere in between. […] it’s not 14 days […] but maybe its 30-40 days […] somewhere like we run pre-owned […] I was expressing more of a hope of where the industry would see as a new goal and not going back to the 70,75,80, 90 days’ worth of inventory. […] I have never been a strong proponent or advocate of the build-to-order model […] People are getting 95%, 98% of what they really want in a relatively short period of time of 30 days to 45 days.” - Mike Jackson, CEO, AutoNation“With our geography, we’re very big truck retailers […] You traditionally carry a pretty high day supply of those domestic brands because of the proliferation of models on full-size pickup trucks […] so if we could run a leaner distribution system, it would really reduce our inventory carrying costs and our land requirements.” – Earl Hesterberg, President and CEO, Group 1 Automotive“I think there’s a big wave between 60-70 days supply and a zero-day supply […] even at a 23-day supply, customers are able to get immediate gratification […] this idea that you’re going to have 100 cars to choose from that are all quite similar, that Americans seem to like […] I think consumers will ultimately determine that by not buying cars on the lot that are run of the mill and rather get that additional individuality that maybe they’re looking for.” - Bryan DeBoer, CEO, Lithia Motors“The big question there is can we keep the discipline at the OEM level from the standpoint of days’ supply in the 30 to 40 days […] and see what it does for them from a profitability standpoint. And obviously it’s been key for us at the dealer level.[….][OEMs] understand that their costs are down on supporting inventories […] if they start building units to fill these plants that aren’t the ones that customers want we’re then going to see an inventory pickup of vehicles that are not ones that people want to buy and then it’s going to start bouncing back in the same direction we were before.” - Roger Penske, CEO, Penske AutomotiveTheme 5: With the proliferation of Electronic Vehicles (EVs), private franchised dealers are left wondering what their involvement will be from the retail and service side. Most of the public executives envision the continued use of the dealer franchise system for EVs as opposed to a direct to consumer model.“The best model of supply [EVs] to the consumer is through the dealer franchise system. These cars are very complex, people need to be able to communicate locally [….] the highest dollar spent [in the service department] on electric vehicles […] its first generation technology, there’s a lot of software glitches […] we’re already working them into our collision center […] over time […] they still need brakes, batteries….[…] we’ve made a lot of investments already and we’ll continue to make more investments both in physical training and equipment.” - David Hult, President and CEO, Asbury Automotive Group“The complexity of the automobile is going exponentially. And that when there are issues […] the number of entities that actually can care for it and fix it are fewer and fewer. And that we look at only the electric vehicles, the investments we are having to make in specialty equipment and technical training. Expertise is unbelievable in the connected [EV] car.” - Mike Jackson, CEO, AutoNation“We’re supporting our OEMs with EV. EV is going to be driven by political [forces] […] from a dealership standpoint, until we get a significant market of EVs, I don’t see a big issue from the standpoint of parts and service growth. It’s going to take a different technician…because of the technology. […] the warranty [work] will have to be done by us and we’ll also obviously have to deal with the complexity.” – Roger Penske, CEO, Penske AutomotiveConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to the market that may exist for a private dealership which informs our valuation and litigation support engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

WHITEPAPER | What Family Business Owners and Advisors Need to Know About Valuation

Family business advisors help companies and leaders navigate a wide range of business and family challenges, ranging from corporate governance to succession planning to family relationship dynamics and all points in between. Over the past several years, many of the family business advisors we have met have expressed a desire to better understand the intersection between business valuation and the family business advisory services they provide. We have written this whitepaper to help fill in that gap. The whitepaper is organized in four sections, each of which seek to answer a specific question about valuation.

Don’t Read This Book

Don’t read this book if you run a family business that is flush with cash, growing like a weed, regularly enjoys drama free family dinners, has their succession plan for your grandchildren in order, and do not foresee any disruption to your business over the next few generations.Assuming the above does not describe you perfectly, the Harvard Business Review | Family Business Handbook by Josh Baron and Rob Lachenauer is a comprehensive and useful tool for anyone involved with or working in their family business. Messrs. Baron and Lachenauer are cofounders and partners at BanyanGlobal, a global family business advisor group, and have decades of experience in family business consulting. BanyanGlobal is a thought leader in the family business advisory space, and when this group talks, we like to listen.When we think about the important stakeholder groups in our lives, often the top of the list includes our places of work and our families. There are bookstores full of family cohesion books and best business practice guides: this handbook provides a comprehensive guide on the intersection and intertwining of these two stakeholders.If you have read other Harvard Business Review books or "10 Must Reads," you will be familiar with the format. Each chapter introduces a key concept, provides a roadmap and tools to address the concept, and summarizes the key takeaways for you to apply – all in 15-20 pages. Enjoy it with a cup of coffee, or if you are like me with two kids under three, in the recess of night when everyone is sound asleep.The book is divided into three parts:Cracking the Code of Your Family Business: Understand the influence of individuals, relationships, and ownership on your family business across generations.The Five Rights of Family Owners: Determine your business type, governance strategies, transition planning, and communication strategies to develop the core of your business.Challenges You Will Face: How to handle and address family disruptions, conflict among family members, family employment policies, how to live with your wealth, and the pros and cons of a family office. The authors remind us that, "Family and business are two of the most powerful forces in the world." At its foundation, the Family Business Handbook provides an in-depth education for family businesses, not just businesses run by families. The challenges and opportunities that face family businesses are unique and advice often runs opposed to standard business advice. Add leverage to maximize ROE? Not if you are concerned with family control and are opposed to your family values. Triple revenue growth? Not if you care about work-life balance and have a different family mandate that’s not dependent on growth. We’d recommend following the authors prompts and roughly analyzing your own company throughout the chapters. Who can own my company? Do we have a family employment policy? Is an outside CEO necessary? How do we bridge family branch gaps despite divergence? What’s our shareholder communication strategy? How do we arrive at a healthy level of conflict within the family that drives us forward? Why are we in business together? I took more from some chapters than others, but a continual theme is the counter-intuitive opposition of "financial theory" against “family practicality and values." One example highlighted this well for me. We excerpt the section below:Because family companies face so little scrutiny from the outside world, it might be all too easy to take "just this once" baby steps down a path that can eventually destroy the values they hold dear. Radio Flyer’s Pasin recalls one such moment with his father, years ago, when he questioned his father’s decision not to use cheaper materials for one of the company’s trademark red wagons. "I remember my Dad making the decision whether to use a cheaper steel and a cheaper tire on one of our wagons years ago," Pasin recalls. "And I said to my Dad ‘Does it really matter? Will consumers know?’ And my Dad said I’m not sure. But when in doubt, I like to overbuild stuff because I can sleep at night. There will be a lot of things you will lose sleep over running this business, but this won’t be one of them.’ I think about that every day. It’s one of the most important lessons my Dad ever taught me."My father-in-law, David, runs the family business my wife works in currently. He often reminisces about his father who founded the business and ran the company for 40 years. David, who ran the company with his dad as CEO, would ask why they don’t make a change to improve earnings and cut costs: "No one will really miss it and we will improve earnings." My wife’s grandfather would simply retort, "Yes, but I will know."Family businesses have multiple objectives that both include, and extend beyond, dollars and cents. The Family Business Handbook is a timely reminder that none of these objectives can be pursued in isolation at the expense of the others. We endorse this book whole-heartedly for any family business and recommend it as a resource to keep on your shelf or to share at your next family business meeting with your shareholders.

Why Is No One Selling in a Seller’s Market?

Even in One of Hottest M&A Markets in Recent History, Most RIA Principals Still Do Not Plan to Sell Their Business in the Next Three Years.

According to a recent Franklin Templeton Survey, only 14% of RIA principals expect to transact their ownership-interest in their investment management firm over the next year while 36% expect to sell between one and three years from now.Source: Franklin Templeton InvestmentsThese statistics are perplexing for an aging industry where less than half of advisors over the age of 65 have a formal succession plan and acquisition multiples continue to climb higher.Source:Franklin Templeton InvestmentsThere are some explanations to this disconnect. From an economic perspective, many RIA principals are hesitant to forego their high dividend coupon in a yield-starved environment. Additionally, when an RIA principal exits the business, they forfeit their salary and bonus payments, so the sale price would have to justify this substantial loss of annual income. Many principals also prefer to keep their firm employee owned, but it’s often difficult to sell the business to younger staff members who may be unwilling or unable to purchase the firm at its current market value. Additionally, the sale of smaller advisory practices (under $100 million in AUM) may not be practical since the primary principal often manages most of the client relationships, which may not transfer after he or she exits the business.These realities don’t excuse the industry’s ownership from failing to plan for an eventual sale or exit from the business. Most investment management firms have value beyond their founding principals. Not only can planning for that eventuality maximize your sale proceeds, but it can also ensure your key employees and clients will stick around long after your departure.How To Ensure a Successful SuccessionA logical starting point for accomplishing a successful transaction is tying management succession to ownership succession. Many of our clients’ principals sell a portion of their ownership to junior partners every year (or two) at fair market value (FMV). This process ensures that selling shareholders (who hope to sell at a maximum value) are incentivized to continue operating the business at peak levels while allowing rising partners to accrue ownership over time. Many buy-sell agreements also call for departing partners to sell their shares at a discount to FMV if they are terminated or leave within a pre-specified period to ensure they remain committed after the initial buy-in.Simply put, a successful succession requires the alignment of buyer and seller interests. Gradually transitioning ownership to the next generation of management at a reasonable price is one way to align your interests with the next generation of management.A successful succession plan also requires decoupling your day-to-day responsibilities from ownership. This can’t (and shouldn’t) happen overnight. After you’ve identified a capable successor(s), make sure he or she assumes more of your management responsibilities and not just your share count. Your work hours should decrease over this transition period.When advising clients on management and ownership succession, we often tell principals that are approaching retirement to ask themselves where they want to be in five or ten years (depending on their age and other factors) and work towards that goal. We rarely hear that they want to maintain their current work levels for the rest of their career. Have a goal in mind and steadily work towards it as others assume your responsibilities and ownership. It should pay off in retirement.

Understanding Transaction Advisory Fees

Real Expertise Is an Investment, and the Benefits in Return Should Well Exceed the Costs In the previous article, we highlighted the various benefits of hiring a financial advisor when investigating the potential sale of a business. In a transaction with an outside party, the buyer will almost always be far more experienced in “deal-making” relative to the seller, who often will be undertaking the process for the first (and likely only) time. With such an imbalance, it is important for sellers to level the playing field by securing competent legal, tax and financial expertise. A qualified sell-side advisor will help ensure an efficient process while also pushing to optimize the terms and proceeds of the transaction for the sellers. As with anything in this world, favorable transaction processes and outcomes require an investment. Fee structures for transaction advisory services can vary widely based on the type and/or size of the business, the specific transaction situation, and the varying roles and responsibilities of the advisor in the transaction process. Even with this variance, most fee structures fall within a common general framework and include two primary components: 1) Project Fees and 2) Success Fees. Project Fees Project fees are paid to advisors throughout an engagement for the various activities performed on the project. Such activities include the initial valuation assessment, development of the Confidential Information Memorandum, development of the potential buyer list, and other activities. These fees generally include an upfront “retainer” fee paid at the beginning of the engagement. Retainer fees serve to ensure that a seller is serious about considering the sale of their business. For lower middle market transactions, the upfront retainer fee is typically in the $10,000 to $20,000 range. Often times, a fixed monthly project fee will be charged throughout the term of the engagement. These fees are meant to cover some, but not all, of an advisor’s costs associated with the project. For lower middle market transactions, monthly fees are typically $5,000 to $10,000. In certain situations, the engagement will include hourly fees paid throughout the engagement for the hourly time billed by the advisor. Such hourly fees are billed in place of a fixed monthly project fee. Hourly fees are typically appropriate when the project is more advisory-oriented versus being focused on turn-key transaction execution. Hourly fees serve to emphasize the objective needs of the client by counter-balancing the incentive for an advisor to “push a deal through” that may not be in the best long-term interests of the client. An hourly fee structure typically front loads the fees paid throughout the transaction process and is paired with a reduced success fee structure at closing which brings total fees back in line with market norms. Mercer Capital has had favorable outcomes with numerous clients when fee structures are well-tailored to the facts and circumstances of the seller and the seller’s options in the marketplace. Success Fee A success fee is paid to a transaction advisor upon the successful closing of a transaction. Typically, success fees are paid as part of the disbursement of funds on the day of closing. As with project fees, success fees can be structured in a number of different ways. A simple approach is to apply a flat percentage to the aggregate purchase price to calculate the success fee. The use of a flat percentage fee seems to have increased in recent years, and makes a fair bit of sense as it allows the client to clearly understand what the fees will look like on the back-end of a transaction. Traditionally, the most used success fee structure employs a waterfall of rates and deal valuation referred to as the Lehman Formula. This formula calculates the success fee based on declining fee percentages applied to set increments (“tranches”) of the total transaction purchase price. For lower middle market transactions, the simplest Lehman approach is a 5-4-3-2-1 structure: 5% on the first million dollars, 4% on the next million, and so on down to 1% on any amount above $4 million. The Lehman Formula, which can be applied using different percentages and varying tranche amounts, pays lower percentages in fee as the purchase price gets higher. Smaller deals may include a modified rate structure (for example 6-5-4-3-2) or may alter the tranche increments from $1 million to $2 million. The Lehman Formula, in its varying forms, has been utilized to calculate transaction advisory fees for decades. While the formula may add some unnecessary complexities to the calculation (versus say a flat percentage), it has proven over time to provide reasonable fee levels from the perspective of both sell-side advisors and their clients. A success fee can also be structured on a tiered basis, with a higher percentage being paid on transaction consideration above a certain benchmark. If base-level pricing expectations on a transaction are $15 million, the success fee might be set at 2.5% of the consideration up to $15 million and 5% of the transaction consideration above this level. If the business were sold for $18 million, the fee would be 2.5% of $15 million plus 5% of $3 million. The blended fee in this case would total $525,000, a little under 3% of the total consideration. Escalating success fees are often favored by clients because they provide an incentive for advisors to push for maximized deal pricing rather than settling for an easier deal at a lower price. Typical Total Fees Transaction advisory fees, on a percentage basis, tend to be higher for smaller transactions and decline as the dollars of transaction consideration increases. Various surveys of transaction advisors are available online that suggest typical fee ranges. Consensus figures from these sources are outlined below. Based on our experience, these “typical” ranges (or at least the upper end of each range) appear to be somewhat inflated relative to what most business owners should expect in an actual transaction advisory engagement. Mercer Capital’s View on Fees At Mercer Capital, we tailor fees in every transaction engagement to fit both the transaction situation at hand and our client’s objectives and alternatives. In situations where a client has an identified buyer, we understand that our role will likely be focused on valuation and negotiation. Many sellers are unaware that price is only one aspect of the deal, and terms are another. Altering the terms of a definitive agreement can move the needle by 5%-10% and can potentially accelerate end-game liquidity by 6 to 12 months. Accordingly, we design each fee structure to recognize what we are bringing to the process, typically utilizing some combination of hourly billings and a tiered success fee structure on the portions of the deal where our services are making a difference in the total outcome. If we are assisting a client through a full auction process, it may be appropriate to utilize a more traditional Lehman Formula or a flat percentage calculation. A primary focus of our initial conversations with a potential client is to understand the situation in detail so that we can develop a fee structure that ensures that the client receives a favorable return from their investment in our services. Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. Mercer Capital leverages its historical valuation and investment banking experience to help clients navigate critical transactions, providing timely, accurate, and reliable results. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients. We recommend to clients to accept the right deal or no deal at all. Our dedicated and responsive team is available to manage your transaction process. To discuss your situation in confidence, give us a call.

Themes from Q2 Earnings Calls

Part 2: Mineral Aggregators

Last week, we reviewed the second quarter earnings calls for a select group of E&P companies and briefly discussed the macroeconomic factors affecting the oil and gas industry. In this post, we focus on the key takeaways from mineral aggregator second quarter 2021 earnings calls.Operators Maintaining Drill Bit DisciplineAggregators keep a close eye on E&P companies as they often reap the benefits of the drill bit, but also fall victim to capital discipline initiatives. In the second quarter, many aggregators made note of operators’ disciplined approach as prices and rig counts continued to rise.“Our portfolio has benefited as bigger and better capitalized operators have taken over operatorship of our minerals to enable more consistent and disciplined development. Our focus on the highest rate of return undeveloped locations throughout our history ensures that our mineral position migrates to the top of any operator's drilling inventory.” – Ben Brigham, Executive Chairman & Director, Brigham Minerals“Despite the increase in rig count through the second quarter, we do anticipate that trend to flatten through the remainder of the year, as operators maintain their capital discipline.” – Jeff Wood, President & CFO, Black Stone Minerals“Operators in the U.S. continue to practice discipline with their drilling activity even in the face of significantly higher commodity prices.” – Bob Ravnaas, Chairman & CEO, Kimbell Royalty PartnersCapitalizing on Favorable Price EnvironmentIndustry participants remain optimistic as prices have increased significantly over the last year. Some aggregators were heavily hedged, and others, like Brigham Minerals, are reaping the benefits of their unhedged position.“In fact, this is the best macro setup I've seen in my career, and I've lived through numerous cycles. Benefiting from our diversified portfolio of high-quality mineral assets, our shareholders are positioned to benefit from what I believe is very likely a long ramp of elevated pricing for oil, NGL and natural gas prices. This is particularly true given that unlike some of our peers, we are unhedged.” – Bud Brigham, Founder & Executive Chairman, Brigham Minerals“Oil prices are now well above pre-COVID levels, but the U.S. land rig count is 39% below year end 2019 levels. Furthermore, natural gas prices are trading at multiyear highs, driven primarily by increased power demand in the U.S. and surging exports of LNG to Europe and Asia. Given that a significant portion of our daily production is natural gas, we expect this improved pricing to benefit our cash available for distribution in Q3 2021 and into the winter months based on the current strip pricing.” – Bob Ravnaas, Chairman & CEO, Kimbell Royalty Partners“The increase in royalty volumes was mainly due to the Midland and Delaware properties but we also saw nice increases outside of our major shale plays as well, but seen a remarkable rebound in commodity prices since the middle of last year and are currently well above pre-pandemic price levels.” – Tom Carter, Chairman & CEO, Black Stone MineralsDistributions Ramping UpAggregators have built a reputation of acting as a yield vehicle with the ability to reinvest, unlike traditional royalty trusts. Their popularity increased as they maintained healthy distributions over the years, however the challenging environment in 2020 put most payouts in jeopardy. With the uptick in prices and a more optimistic outlook, aggregators seem confident to return to historical payout levels.“The $0.31 per common unit distribution this quarter reflects a 75% payout of cash available for distribution. We will use the retained amount, 25%, to pay down a portion of the outstanding borrowings under Kimbell’s credit facility.” – Davis Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“This allowed us to maintain a 100% distribution in the second quarter of 2020 and importantly enter 2021 unhedged with our investors fully exposed to the run-up in commodity prices as the economic reopening took hold toward the end of last year and more fully during the first quarter of this year associated with the vaccine rollout.” – Robert Roosa, CEO & Director, Brigham Minerals“We generated $72.1 million of distributable cash flow for the second quarter or $0.35 per unit. That gave us a lot of flexibility to increase our distribution while still holding some cash and reserve for further debt repayment.” – Jeff Wood, President & CFO, Black Stone Minerals Conclusion Aggregators seemed optimistic across the board in the second quarter of 2021. Prices have rebounded, and distribution policies are returning to normal, which in their minds creates good shareholder sentiment. However, the continued capital discipline of E&P operators may affect aggregators in the short to intermediate term.Conclusion Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership. Contact a Mercer Capital professional to discuss your needs in confidence.

ATRI’s Report on Critical Issues in 2021

In October 2021, the American Transportation Research Institute released its 2021 survey of Critical Issues in the Trucking Industry. The ATRI survey was open from September 8, 2021 through October 15, 2021 and includes responses from over 2,500 stakeholders in the trucking industry in North America. Respondents include motor carrier personnel (52.4% of respondents), commercial drivers (24.1%), and other industry stakeholders (23.5%, including suppliers, trainers, and law enforcement).

Used Vehicle Margins in 2021

How Large Used-Only Auto Retailers Are Measuring Up

As our dealer clients know, automotive retailing competition has intensified with large, well-capitalized online-only retailers getting plenty of attention. Due to imbalances between supply and demand, gross margins on both new and used vehicles have increased in 2021.In this post, we survey gross margins for the publicly traded dealerships, in light of the current operating environment and reconsider the investment thesis put forth by the new entrants.Investment Thesis of Online Used-Only RetailersInvestors in used-only retailers likely have numerous reasons for believing in these companies. We’ll highlight some of the reasons below, then delve deeper into a few of them.Lack of franchise agreements in used vehicle space enable significant growth/market reachCOVID-19 anticipated to accelerate auto retailing towards e-commerce seen in other retail sectorsCustomer dissatisfaction with traditional retail experienceGross margins tend to be higher on used vehicles than new vehiclesAsset-light business modelLack of Franchise AgreementsFor the publicly traded traditional auto retailers, franchise agreements can inhibit growth. Executives have discussed on earnings calls the obstacles that can occur when they accumulate numerous stores in the same brand. For used-only retailers, there are no similar restrictions as the sale of used vehicles are not subject to franchise agreements. While this may be a positive for growth and geographic diversification, this limits the market available to these companies.Vroom’s 2020 investor deck highlighted used auto as one of the largest markets at $840B trailed by grocery ($683B) and new auto ($636B). Using these figures (which are pre-pandemic), used-only players are limited to ~57% of the market.While growing to become the premier used vehicle operator would have obvious benefits, if any of these players can meaningfully consolidate the highly fragmented market, there is a downside to only interacting with consumers when they want a used vehicle. This is also why executives of franchised auto dealers have started harping on the number of "touch-points" they have with consumers which includes new and used sales as well as service appointments. source: Vroom, Inc.COVID-19 and the Shift to EcommerceA core strength of pre-pandemic automotive retail was the lack of penetration from ecommerce. As seen above, ecommerce penetration prior to the pandemic was less than 1% as determined by Vroom. The space has been Amazon-proof to a degree, though auto dealers and consumers were thrust into a digital world last March and April. Over a year later, it seems clear that the number of transactions and the percentage of transactions completed online will increase.Online retailers tout that they are the future, and the pandemic has only accelerated trends in consumer preference towards online. Only time will tell how truly transformed the environment is. Does the lack of ecommerce penetration represent a massive opportunity for new entrants in the market, or does it just paint a picture of how difficult it will be for these companies to attract profitable market share?Gross Margins and Profitability at LargeAnother long-term key consideration will be profitability. As with Amazon and Facebook, tech companies can command huge valuations prior to turning profitable. Many Silicon Valley startups claim to be the next unicorn that will achieve scale, ramp down expenses relative to revenue growth, and watch red ink turn to black.Because Carvana, Shift, and Vroom are still relatively young companies, their lack of profitability has not yet detracted from their value. However, gross margins can still be compared because companies spending significant amounts on advertising will have a hard time turning the corner if the unit level economics aren’t there.Let’s revisit what was mentioned at the outset. Used vehicle margins have been stronger than new vehicle margins. That remains to be true. Gross profit margin for the average dealership through the first half of 2021 was 13.4%, up from 11.8% through 1H20. For the new vehicle department, gross as a percentage of selling price increased to 8.3% YTD 2021, up significantly from 5.5% in the prior year period. The same is true for used vehicles: 14.0% YTD 2021 versus 11.4% in 2020. New and used margins are up in 2021, and used margins continue to outpace new.Parts and service departments have higher margins than vehicle sales departments, and these departments account for a significant portion of gross profit for auto dealers. According to NADA, through the first half of 2021, gross profit contribution from parts and service was considerably lower than historical levels (37.4% of total gross profit), but it still outpaced that of both new and used vehicle departments despite making up a much lower percentage of revenue. Below, we have calculated gross margins in 2021 for the public auto dealers.Click here to expand the image aboveUsed vehicle gross margins exceed new vehicle gross margins for Asbury, AutoNation, Group 1, and Lithia. Notably, however, that is not the case for Penske, LMP, or Sonic. Sonic’s 2.8% used vehicle gross margin stands out as an outlier, but we do see here that used vehicle gross margins are not exclusively higher than new. This could be due to the difficulty of sourcing vehicles in this environment.LMP and Penske also have the highest new vehicle margins, which could be at the detriment of used vehicles margins if they extract higher ASPs on new vehicles by offering higher trade in values.For total gross margin, however, the impact of fixed operations is clear. Blended total gross margin for traditional franchised auto dealers is approximately 15-18%. For used-only retailers, used and total gross margins are much lower as seen below.Click here to expand the image abovePerhaps these retailers are underpricing their vehicles to gain market share, and it is true that lost incremental vehicle sales from these retailers has a compounding effect. In addition to a lost vehicle sale, consumers are also less likely to go to a dealership for parts and service if they didn’t originally purchase the vehicle from that dealership. While this could have a long-term negative impact on total gross profit for dealerships, it remains to be seen if there will be mass adoption to buying vehicles from these platforms. Unless there is a material change in franchise laws, these companies won’t be able to sell new vehicles.ConclusionUsed-only online retailers may be the future. Customer dissatisfaction with "the old way" may push more people to try something new. The Carvana's of the world may improve their gross margins with data-driven technologies lowering costs and tactfully raising prices without losing their new customers.The asset-light model may help attract enough investors to lower the cost of capital for larger players enabling a virtuous cycle of greater scale and efficiencies. These players may eventually also look to get into the service and parts business to improve gross margins, though this would be hard to square with an asset-light approach.For now, though, franchised auto dealers will continue to operate with the strong foothold afforded to new vehicle dealers that can cater to customers throughout the life cycle of their vehicles.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Treasures in the Attic

The Value of Future Fiduciary Appointments

Independent trust companies are frequently named in wills to serve as the trustee of an estate or living trust. These appointments may create a revenue opportunity for an independent trust company next year or fifty years from now. A trust company is sometimes notified of their assignment but isn’t always. Future fiduciary appointments certainly have some value; but how much and how do you measure it?Valuation MethodologyFuture fiduciary appointments are one element that factors into a trust company’s overall valuation. As such, the value of these relationships isn’t generally considered separately from the rest of the business, and the guidance on how these appointments contribute to the overall value of the business is limited. There are, however, many situations where analogous assets may be valued on a stand-alone basis for accounting or other purposes. These similar concepts from other disciplines or industries can provide direction and perspective on the value of future fiduciary appointments.Future fiduciary appointments are one element that factors into a trust company’s overall valuation.Contract ValuationsWhen a business combination such as a merger or acquisition occurs, accounting standards generally require that an exercise known as a purchase price allocation (PPA) be performed. The purpose of a PPA is to allocate the consideration paid for a business to the acquired tangible and intangible assets, which can include acquired technology, customer relationships, contracts (customer and supplier), noncompete agreements, tradenames, etc. Future fiduciary appointments for trust companies bear some similarity to a customer contract; although, a trust company does not have to agree to a fiduciary appointment, the executor of an estate is contractually obligated to hire the trust company unless it does not accept.There are many different commonly accepted approaches to contract valuation, but the most relevant as it relates to future fiduciary appointments is the income approach. In a purchase price allocation, the value of a contract can be determined using the income approach by projecting out the future cash flows that result from the contract and applying an appropriate discount rate. But in purchase price allocations, the existence of the contracts and terms of the contracts are known, whereas independent trust companies are not always notified of their appointment in a will, and even if notified, the size of the estate and potential revenue is often unknown.Oil & Gas Reserve ValuationsAt first glance, it’s hard to imagine two industries more different than independent trust administration and oil and gas. But the future fiduciary appointments held by trust companies do have a notable similarity to oil and gas reserves. Oil and gas reserves represent a real asset to the landowner, but the size and profitability of these reserves is often unknown. Likewise, future fiduciary appointments are a real asset for trust companies, but the size and profitability of these relationships is generally not known in advance. Oil and gas reserves are categorized as Proven Developed Producing (PDP), Proven Undeveloped (PUDs), Possible (P2), or Probable (P3). PDP reserves currently generate revenue and can be valued using a discounted cash flow analysis. But PUD reserves, which are proven to exist but not currently developed or revenue generating, and probably and possible reserves, which are less likely to be recovered, are not as easily valued.Can future fiduciary appointments be viewed similarly to the PUDs, P2, and P3 reserves?So, can future fiduciary appointments be viewed similarly to the PUDs, P2, and P3 reserves? Are known appointments comparable to PUDS and unknown appointments comparable to P2 and P3 reserves?Valuation practitioners sometimes rely on option pricing to capture the value of PUDs, probable, and possible reserves. As the price of oil increases, PUDs, probable, and possible reserves become more economical to develop. The PUD and unproved valuation model are typically seen as an adaptation of the Black Scholes option model. Applying this same principle to value fiduciary appointments would require significant assumptions about the possible number of appointments, the size of the estates, and the average number of deaths per year. Additionally, a future fiduciary appointment is not necessarily option-like, as there is no set exercise price. And for most independent trust companies who are likely to generate significant cash flows in the near term, the impact of these future cash flows may be too small to matter (once present value math has been applied).The Right Way To Value Fiduciary Appointments May Be More SubjectiveFiduciary appointments do have value, but separating this value from the enterprise as a whole may not be the best way to think about it. Rather than valuing these separately, we typically adjust our projection and discount rate assumptions and our guideline company analysis.Discounted Cash Flow Method. As we discussed above, discretely projecting cash flows from future fiduciary appointments is not always possible. But an analyst can factor in the potential upside of these assignments when selecting the appropriate discount rate and terminal growth rate. Should the discount rate be lower since there are additional future revenue opportunities that weren’t built into the projections? Or maybe the terminal growth rate should be higher, as these appointments will allow the company to sustain higher levels of ongoing cash flow growth.Guideline Public Company Method. Although there are no publicly traded pure-play trust companies, publicly traded investment managers do have a similar structure to independent trust companies. Both earn fees on assets under management / administration and have operating leverage such that when AUM / AUA increase, fixed costs do not increase at the same rate. Therefore, we often use the pricing of publicly traded investment managers to gauge investor sentiment and establish a reasonable range for pricing expectations for businesses that manage or administer assets on behalf of clients.We may apply an adjustment to the implied valuation multiples of the public companies to account for the differences between an independent trust company and the selected group of publicly trade investment managers. While many independent trust companies are smaller in size, have less access to capital markets, and have lower margins (trust administration is labor intensive), some of this risk may be offset by the growth opportunity presented by future fiduciary appointments. How much of that risk is offset is a matter of the facts and circumstances of the particular independent trust company.Who Should Value Your Independent Trust Company?Choosing someone to perform a valuation of your independent trust company can be daunting in and of itself. There are plenty of valuation experts who have the appropriate training and professional designations, understand the valuation standards and concepts, and see the market in a hypothetical buyer-seller framework. And there are a number of industry experts who are long-time observers and analysts focused on the industry, who understand industry trends, and have experience providing advisory services to independent trust companies.At Mercer Capital, we think it is most beneficial to be both industry specialists and valuation specialists.

Sanderson Farms Case Study

Cargill is one of the largest family businesses in the world. Earlier this year, we analyzed the Family Capital list of the world’s 750 largest family businesses; Cargill checked in at number 15 on that list, with annual revenue reported to be in excess of $110 billion. Cargill made headlines earlier last week for its acquisition (together with another family business, Continental Grain) of Sanderson Farms, a publicly traded poultry business (ticker: SAFM).It is not every day that family businesses acquire publicly traded companies, so the transaction is worth exploring a bit further. For family business directors contemplating M&A activity of their own, or thinking about whether now is the right time for the family to sell, the Sanderson Farms acquisition rather perfectly illustrates why family businesses have more than one value.The Value of Sanderson Farms on a Standalone BasisSince its shares are traded in the public markets, we know what Sanderson Farms was worth on a standalone basis. Prior to rumors of a potential transaction influencing trading, SAFM shares closed at $155.74 per share on June 18, 2021 (corresponding to 7.9x trailing EBITDA).Business values always reflects consensus expectations regarding future cash flows, risk profile, and growth prospects. We will spare you the math, but the public market expectations for each of these factors is summarized in Table 1. As is the case with many agribusiness companies, earnings for Sanderson Farms are cyclical, depending in large measure on various commodity markets. Table 2 relates the estimate of "ongoing" EBITDA noted above, to recent earnings (the green dotted line). So, what does the public market price of $155.74 "mean"? If investors paid that price, and the company continued to operate on a standalone basis while growing at 2.9%, those investors would earn an annualized return of 6.5% on their investment, which is consistent – on a risk-adjusted basis – with alternative investments available to them. The Value of Sanderson Farms to Cargill/ContinentalIn contrast to public market investors, the Cargill/Continental consortium agreed to pay $203 per share for Sanderson Farms, or 10.4x trailing EBITDA. This represents a 30% premium to the public market price. Why where these buyers willing to pay more to for the company? As described in last week’s post, Cargill and Continental are strategic buyers. In other words, they anticipate integrating Sanderson Farms into their existing poultry operations. By doing so, their expectations for the three factors determining value are different, in some respect, than the expectations of public market investors for the company on a standalone basis.Table 3 summarizes several different scenarios that correspond to the $203 per share transaction price. Why might Cargill and Continental have different expectations than public market investors? Cash Flow. As strategic acquirers, the Cargill/Continental consortium might reasonably expect to be able to extract higher earnings from Sanderson Farms by combining with existing operations. Common cost savings in mergers come from consolidating facilities and eliminating redundant overhead costs. As shown in Table 3, the purchase price implies approximately $50 million of annual cost savings. In recent years, total selling, general and administrative expenses for Sanderson Farms have been on the order of $200 million annually. Could the buyers anticipate eliminating 25% of the existing corporate overhead? Perhaps, but one shouldn’t rule out other expense saving opportunities within cost of goods sold as the combined entity will likely enjoy greater negotiating leverage with suppliers than Sanderson Farms did on a standalone basis.Growth Prospects. Moving one column to the right in Table 3, we see that the higher acquisition price could also be explained by more aggressive growth expectations. It is likely that the newly combined entity will also enjoy enhanced negotiating leverage with customers as well as suppliers. Perhaps the greater market share of the combined entity will unlock opportunities for faster growth than would be available to Sanderson Farms on a standalone basis.Risk. Return follows risk. If the acquiring consortium enjoys a lower cost of capital than SAFM does, it may be willing to accept a lower prospective return on the acquisition. By way of perspective, published data on the returns for shares of companies stratified by size suggests that the returns for mid-cap firms like Sanderson Farms is on the order of 125bps higher than the return for large cap companies the size of Cargill. The acquiring consortium is more likely to anticipate incremental value from each of the three potential sources, as illustrated in the rightmost column of Table 3. It is important to note that transaction prices do not necessarily represent the maximum price that a strategic buyer could pay for the acquired company. In other words, it is possible that Sanderson Farms is really worth $220 per share to Cargill/Continental, but the seller was only able to extract $203 per share due to the relative negotiating leverage of the two parties. The value of the seller on a standalone basis (in this case, $156 per share) sets the floor for the transaction, while the (unobservable) value of SAFM to the acquiring consortium represents the ceiling. The ultimate transaction price of $203 is the point within that range at which the negotiating leverage of the two parties was balanced.Takeaways for Family Business DirectorsMost of our family business clients are not likely to acquire a public company. Even so, family business directors should bring the same discipline to bear when evaluating a potential transaction.When considering an acquisition opportunity, it is important to carefully analyze not just what the target company could be worth to you, but also what it is worth to the existing owners. Developing a bid for the target within that range should consider both the actions of other potential bidders for the target and how unique the target is.When contemplating a sale, the same considerations are appropriate. What is the family business worth to your family? What can you reasonably expect the family business to be worth to potential buyers? What strategies can you put in place today to help tip the negotiating leverage in your favor so you can extract more of the incremental value to the buyer? These are tough deliberations and the consequences of your final decision may affect your family for decades to come. Don’t make these decisions without a seasoned financial advisor in your corner. Give one of our professionals a call today to discuss your situation in confidence.

The SEC Adopts New Rule 2a-5 for Valuation of Fund Portfolio Investments

In December 2020, the Securities and Exchange Commission (“SEC”) adopted a new rule 2a-5 to update the regulatory framework around valuations of investments held by a registered investment company or business development company (“fund”). Boards of directors of funds are obligated to determine fair value of investments without readily available market quotations in good faith under the Investment Company Act of 1940 (“Act”).

Portfolio Valuation: Private Equity and Credit

Third Quarter 2021

The third quarter is off to a great start for private equity and credit. Public market and acquisition markets are strong; debt capital is plentiful and available at record low yields. SPAC IPOs have slowed (~$120 billion YTD) but SPACs have lots of capital to deploy and have become another liquidity option for VC-backed companies that by-pass a traditional IPO.

Consolidation in the RIA Industry

RIAs Are Being Acquired at a Record Pace, But Does That Really Mean the Industry Is Consolidating?

Consolidation is a theme that has a lot of traction in the RIA industry: that a growing multitude of buyers are scrambling to outbid each other for a limited and shrinking number of firms.Circumstances, such as, aging founders or a lack of internal succession planning are bringing firms to market, where firms are quickly bought up and rolled into any one of a number of acquisition models that have emerged (and continue to emerge) in the industry. Aggregators are bolting RIAs onto their platforms, branded acquirers are assembling RIAs with national scale through a series of acquisitions, and larger RIAs are growing through strategic acquisitions of smaller firms. Competition amongst these buyers for the limited number of firms coming on the market has driven acquisition activity and multiples to all-time highs.With the rapid pace of deal activity in the RIA industry, you might expect to see the number of firms decline, as that is typically the norm for consolidating industries. The banking industry, for example, has been consolidating for three decades and, as a consequence, the number of banks in the U.S. has steadily declined from about 18,000 in 1990 to about 6,000 today. But that’s not been the case in the RIA industry, at least yet.Despite consolidation pressures and record levels of acquisition activity, the reality is that the number of RIAs continues to increase, with formations outpacing consolidation. In 2019, there were approximately 13,000 individual SEC registered investment advisory firms, up from about 10,900 in 2014.Several factors have contributed to the increase in the number of RIA firms. For one, the RIA industry has experienced secular tailwinds from the shift from the broker dealer / commission model to the fee-based, fiduciary model. As the chart demonstrates, the number of FINRA registered broker dealers has gradually declined in recent years—the mirror image of the growth seen in the RIA industry. In many cases, broker dealers have shifted to fee-based models, and firms with dual registrations have gradually shifted to the RIA side of the business.This overarching shift from the broker dealer model to the RIA model is multi-faceted. For one, it’s clear that clients (in general) prefer the advisory relationship offered by RIAs over that offered by their broker dealer counterparts. And a model that’s in demand by clients is also in demand by advisors. Additionally, we’ve found that building significant enterprise value (value attributable to the business, not the individual) is generally easier for firm owners to achieve under the RIA revenue model than the broker dealer model. This prospect of building a business with enduring value that can be sold to an external buyer at the end of the founder’s career or transitioned to next generation management is a key motivation behind many advisors’ decisions to start their own RIA. It also doesn’t hurt that, compared to the broker-dealer model, the amount of capital required to start an RIA is relatively minimal.When looking at the increase in the number of RIA firms, though, there are a couple of nuances to keep in mind. Some acquisition models in the industry result in the acquired firm maintaining its SEC registration, so consolidation doesn’t necessarily mean a decline in the number of registered firms. Another caveat is that the data captures only SEC-registered investment advisors and not state registered investment advisors (generally, advisory firms with over $100 million in AUM are required to register with the SEC, whereas firms below that threshold are regulated by the state in which they do business). These wrinkles aside, the data is unambiguous that there are more SEC registered advisory firms today than ever before—and that’s hardly indicative of an industry in the throes of consolidation.Another way to track consolidation is to look at how assets under management are distributed across firms of different sizes, rather than at the number of firms. The industry hasn’t seen significant consolidation by this metric either. Consider the chart below, which shows the distribution of industry assets across different sized firms in 2011 and 2021. After a decade of significant M&A activity and strong market growth, the distribution of assets across different size firms looks about the same as it did ten years ago. Then, as now, firms under $100B AUM controlled approximately one-third of industry assets, while firms over $100B control approximately two-thirds of industry assets. What we haven’t seen is an erosion of market share for smaller firms; in fact, they’ve maintained market share in a growing market.What does all this mean for the industry? As it stands today, rising supply of RIAs has done little to dampen the pricing for RIAs; instead, it’s seemingly added fuel to the M&A fire. Notwithstanding an increase in the number of firms, attractive firms whose founders are open to selling today remain scarce, and the ratio of buyers to sellers remains high. As a consequence, multiples for RIAs are at or near all-time highs today. Whatever downward pressure there’s been from the supply side of the equation, strong buyer demand has more than offset it.While the consolidation pressure in the industry is real, we are still in early stages. Many successful advisory practices prefer to go at it alone and transition internally, unless circumstances such as age of the principals or lack of next-generation management arise to force an external transaction. Consolidation pressures may ultimately lead to an increase in the number of firms that are on the market and a shift in the supply/demand equilibrium, but as it stands today, sellers are scarce, and building a new firm from scratch is difficult. Time will tell if the RIA industry sees the same level of consolidation as we’ve seen in the banking industry, but at least in the near term, the number of RIA firms appears poised to continue growing as the supply of new firms more than offsets a significant level of M&A activity.

2021 Transportation Industry Update | COVID in Review

COVID-19 has had a lasting impression on many industries throughout the world, but the U.S. trucking and transportation industry was among the first industries to feel the impact of the pandemic.Lockdowns in China (initiated in December 2019) began affecting the U.S. trucking industry in very early 2020 as Chinese imports account for nearly 40% of all shipments entering the U.S. By the beginning of March, the U.S. had already begun to see massive declines in incoming freight with an escalation of shipping cancellations. The ports of Seattle and Long Beach experienced 50-60 container shipment cancellations reflecting declines of 9% relative to the prior year.When discussing the decline of imports in the port of Seattle, Sheri Call of the Washington Trucking Association said, “That’s the kind of decline we’d normally see over the course of an entire year.” Disruption of international trade led to transportation companies reducing capacity as early as the beginning of March. Outbound rail and trucking shipments from LA dropped 25% and 20% respectively, in March 2020.Due to social distancing requirements throughout the United States, many roadside eateries and rest areas were closed in the first several months of the pandemic, which reduced truck drivers’ access to food and other necessities for long days on the road. Trucking companies were forced to alter their transportation network, frequently carrying empty loads as a result of uneven and declining demand. According to Reuters, “trucks hauling food and consumer products north to the United State are returning empty to Mexico where mass job losses have hit demand, leaving cash-strapped truckers to log hundreds of costly, empty miles.” Empty loads increased nearly 40% worldwide in the immediate aftermath of the lockdown.An indication of the health of U.S. trucking industry can be seen through the ratio of full north bound trips to full southbound trips at the Mexico-US border. The ratio is typically one full southbound trip to every three full northbound trips, but the ratio began to lean closer to a one to seven ratio during the pandemic with the remainder being empty or partially full. Additionally, new freight contracts have fallen 60% to 90% since the rise of COVID-19 in 2020.Increased online shopping from consumers has led to a spike in demand for last-mile delivery services. Amazon reported $75.5 billion in 2020 first-quarter sales which was a 26% increase from the first quarter of 2019. Many last-mile delivery companies like FedEx and Amazon continued to hire workers with Amazon seeing an increase in company employment of nearly 175,000 workers from March to April of 2020. Last-mile delivery carriers also eliminated signature requirements so that they can now achieve a “contactless” delivery process.The level of domestic industrial production is correlated to the demand for services within the transportation industry. The Industrial Production Index is an economic measure of all real output from manufacturing, mining, electric, and gas utilities.Lockdowns that began in March of 2020, as a result of the pandemic, led to a sharp decline in the Industrial Production Index. The index began a rapid recovery during the summer months of 2020. At the end of the first quarter of 2020, the Industrial Production Index saw a quarter-over-quarter decrease of 16.7% while also being down 17.7% on a year-over-year basis. The index rebounded in the second quarter of 2020 with a quarter-over-quarter increase of 12.7%. The index continually increased over the last three quarters of 2020, but it had not reached pre-pandemic levels as of April 2021. The outlook for the trucking industry at the beginning of 2020 was promising with economists predicting that freight rates would grow 2% over the course of the year. Strong economic growth in the first two months of 2020 was halted by the outbreak of the unforeseen pandemic. The impact was dramatic – though not entirely negative for all carriers. Carriers of essential goods like groceries, cleaning supplies, and medical supplies experienced skyrocketing demand for their services while industrial, manufacturing, and other non-essential carriers are still undergoing lasting effects from the pandemic. One non-essential industry that experienced a downward turn at the onset of the pandemic was the vehicle shipping services industry. A strong economy with high disposable income and consumer confidence ramped up consumer spending for the American automobile industry in the periods leading up to the pandemic. The industry’s growth prospects were halted during 2020 due to a high unemployment rate and a drop-off in disposable income. The success of the vehicle shipping services industry is closely intertwined with new car sales and consumer confidence. The graph below shows the relationship between revenue of the vehicle shipping services industry and new car sales and consumer confidence. Overall, decreased consumer confidence in 2020 led to many Americans electing to defer vehicle upgrades, which created a major economic downturn for the vehicle shipping services industry.With many businesses closed, overall Cass Freight trucking shipments plummeted, seeing a decrease of 15.1% and 22.7% from April 2019 to April 2020. Truck tonnage also dropped 9.3% on a from March 2020 to April 2020 while declining 8.90% from April 2019 through April 2020.The fall of the number of shipments along with overall truck tonnage caused transportation companies to lower contract and spot rates. Flatbed and reefer rates hit a five-year low in April of 2020, though they rapidly recovered and had surpassed pre-pandemic rates by the fourth quarter of 2020. Truck tonnage has not recovered at the same rate as spot and contract pricing and had not reached pre-pandemic levels by March 2021. These trends are reflected in the Cass Freight and Shipment Indices. While the Shipments index has increased relative to its April 2020 level and has surpassed pre-pandemic levels, the Expenditures index increased over 27% from March 2020 through April 2020.Even though contract rates did not have as sharp of a decline in March of 2020 as spot rates, both experienced a drop-off at the onset of the pandemic. Spot rates dropped below numbers that had been seen in recent years. After the sharp decline of spot rates in March, rates for all categories began to steadily increase. Rates hit a seasonal decline at the end of December due to decreased consumer spending after the holiday season. Rates resumed their climb during the first months of 2021. Overall, the rising price of contract and spot rates spins a positive image for overall outlook of the trucking industry, while also encouraging new competition to enter the market.At the beginning of 2020, there were strong predictions for revenue in both the long distance and local trucking industries. Once the COVID-19 pandemic hit, revenues for both parts of the trucking industry dropped along with future revenue predictions. After a few months of lockdowns, the trucking industry began a rapid rebound as a result of businesses reopening and increased online retail. Future revenue predictions from March and April of 2021 from both the long distance and local sectors exceed predictions made in October 2020.Industrial production and consumer spending, spurred on by the substantial stimulus programs enacted by federal government, have recovered more rapidly than initially expected. This rapid recovery has seemingly reduced the expected long-term impacts of COVID-19 on the long-distance and local trucking industries.The effects of rising trucking rates and revenues coupled with optimistic outlooks for both categories can be seen in the number of long-distance and local trucking establishments. Lured in by appealing spot and contract rates, March 2021 predictions for the number of establishments in the trucking industry look to be on the rise. Naturally, there was a drop-off in the number of establishments in 2020, but the industry seems to have recovered with numerous new entries into the market in 2021. The long-distance trucking industry is projected to have more than one hundred thousand more establishments than originally forecasted in January of 2020.

The Potential Buyers of Your Family Business

An Overview of the Different Types of Buyers for Closely Held, Family Businesses

In this week’s Family Business Director, Tim Lee, ASA, Managing Director of Corporate Valuation and John T. (Tripp) Crews, III, Senior Financial Analyst, discuss internal and external exit options for you and your family business and summarize the possible buyers for your family enterprise. We regularly encounter family business owners contemplating the dilemma of ownership transition. After years (maybe even decades) of cultivating the business through hard work, determination, and perhaps a bit of luck, many families believe now is a sensible time to exit. Tax changes are looming, pandemic and post-pandemic winners see solutions to a myriad of operational challenges, and valuations remain favorable in most industries. However, a seller’s timing, the readiness of the business, and the readiness of the marketplace may not be aligned without careful preparation and real-time market awareness from your family business board of directors. Families often fail to realize that their preparation, their tolerance for post-deal involvement, their health and ability to remain active, and their needs for liquidity will influence the breadth and priorities of their options and will influence who the potential buyers might be and how they might target the business. Proactivity (or backfilling for the lack thereof) will also influence the design and costs of the process for effective representation. Under ideal circumstances, your family will begin planning for ownership transition well before the need for an actual ownership transfer arises. One of the first steps in planning for an eventual exit is to understand who the potential buyers might be and the different characteristics of these buyers. In this article, we discuss some exit options and summarize some of the specifics of certain types of buyers and what that could mean for transaction structure and economic outcomes.Internal Ownership TransitionPotential buyers in an internal transition generally include the next generation of the owner’s family or key employees of the company (or a mix thereof). When done carefully, an internal transition can be desirable in order to protect both the existing employees and the culture of the business. These transactions generally occur two ways: through a direct sale from the exiting owner to the next generation or through the establishment of an Employee Stock Ownership Plan (ESOP). While these transactions may not yield the pricing or turnkey liquidity that selling to an outside buyer might, they can provide comfort to the current generation of family owners regarding their legacy and the continuing prospects of the business as an independent going concern.Sale or Transfer to Next GenerationFor many family businesses, transitioning ownership and leadership to the next generation of family members is the primary exit consideration. For other families, a sale to the non-family management team makes more sense. In either event, the value of the shares being transferred is critical.Whether transferring ownership to the next generation of family members or to the non-family management team, the value of the shares being transferred is criticalFor sale transactions, the question of how the transaction will be financed is equally important. Internal transactions are often achieved by share redemptions in installments and/or through a leveraged buyout process. Often, the seller will provide financing using one of many potential structures. Seller financing carries the risk of the buyer’s inability to pay, which often requires the seller to reinsert themselves into active leadership. Many may view seller financing as desirable in order to control the terms and costs of the arrangements and to benefit from the interest and other terms of the financing.As noted, a seller’s liquidity requirements and the underlying fundamental borrowing capacity of the business play a big part in determining how much third party capital can be employed. Many sellers want their buyers, family or otherwise, to have real skin in the game by way of at least partial external financing.If the next generation of family members and/or employees are not well situated to achieve a buyout as a concentrated ownership group, then the feasibility of a more formal collective buyer group may be a good alternative. The following is a brief overview of Employee Stock Ownership Plans, which can serve as an alternative to a concentrated internal transition.Establishing an Employee Stock Ownership Plan“ESOPs” are a proven vehicle of ownership transfer. They can provide for either an incremental or a turnkey ownership transfer. They also facilitate the opportunity for legacy owners to continue contributing to the stability and success of the business while allowing employees to reap the rewards and benefits of capital ownership. Assessing the feasibility of an ESOP requires the advisory support of experienced financial and legal professionals who help ensure best practices are implemented and compliance awareness governs the transaction. To that end, family businesses contemplating an ESOP need to be keenly aware of the importance of following a well designed process that satisfies the requirements of the Department of Labor and adheres to governing rules and regulations.As a qualified retirement plan subject to regulations set forth by ERISA, ESOPs are regulated using strict guidelines for process, fairness, and administration. Accordingly, the entire life cycle of a contemplated ESOP needs to be studied in a process generally referred to as an ESOP Feasibility Study. Valuation, financing, plan design, plan administration, future repurchase obligations, and many other concerns must be assessed before venturing down the ESOP path.Establishing an ESOP includes creating an ESOP trust, which, using one of many possible transaction structures, becomes the ultimate owner of some or all the stock of the sponsoring ESOP company. ESOPs are unique in being the only qualified retirement plans allowed to use debt to purchase the shares of the employer corporation. Once an ESOP is in place, the qualifying employee participants are allocated interests in the trust annually according to the Plan’s design. As employees cycle through their employment tenure, they trigger milestone events that allow for the effective sale of their accumulated ownership positions, providing a nest egg for retirement. During their tenure of employment, the employee’s account is mostly concentrated in company stock, the valuation of which determines the amount they receive when nearing and eventually reaching retirement age. The stock accumulated during active employment is converted to cash and the Plan shares are either redeemed or recycled to perpetuate the ESOP.There are certain tax-related and transaction design features in an ESOP transaction that can benefit family business sellers in numerous different waysThere are certain tax-related and transaction design features in an ESOP transaction that can benefit family business sellers in numerous different ways. Sellers in ESOP installations must understand the necessary complexities and nuances of a well-run ESOP transaction. Sellers lacking the patience and gumption for an ESOP process or those who require turnkey liquidity in their ownership exit should consider an alternative liquidity strategy.External SaleIn general, the ability to sell your family business to an external party yields the highest proceeds. If you have succeeded in creating a sustainable business model with favorable prospects for growth, your business assets may generate interest from both strategic and financial buyers, the pros and cons of which are listed in the following sections.Strategic BuyersA strategic buyer is usually a complementary or competitive industry player within your markets or looking to enter your markets. These buyers can be generally characterized as either vertical or horizontal in nature. Such buyers are interested in the natural economies of scale that result from expanded market area and/or from specific synergies that create the opportunity for market and financial accretion (think 1 + 1 = 3).There is a good chance that a potential strategic buyer for your family business is someone or some group you already know. Such buyers don’t require the full ground-up familiarization process because they are already in tune with the risk and growth profiles of the business model. Accordingly, owners interested in a turnkey, walk-away sale of their business are often compelled toward a strategic buyer since strategic buyers can quickly integrate the family’s business into their own.The moving parts of transaction consideration paid by strategic buyers can cover a broad spectrum. We see simple nearly 100% cash deals as well as deals that include various forms of contingent consideration and employment/non-compete agreements.There is a good chance that a potential strategic buyer for your family business is someone or some group you already knowMany family owners in strategic deals are not inclined to work for their buyers other than in a purely consultative role that helps deliver the full tangible and intangible value the buyer is paying for. In many cases strategic buyers want a clean and relatively abrupt break from prior ownership in order to hasten the integration processes and cultural shift that come with a change in control. Further, strategic deals may include highly tailored earn-outs that are designed with hurdles based on industry-specific metrics. In general, earn-outs are often designed to close gaps in the bid/ask spread that occur in the negotiation process. These features allow sellers more consideration if post-transaction performance meets or beats the defined hurdles and vis-a-versa. Family business owners must be aware of the sophisticated means by which larger strategic buyers can creatively engineer the outcomes of contingent consideration.In certain industries, strategic buyers may structure consideration as part cash and part or all stock. Sellers in the financials sector are often selling equity ownership as opposed to the asset sales that dominate most non-financial sectors. In such deals, sellers who take equity in the merged entity must be cognizant of their own valuation and that of the buyer. The science of the exchange rate and the post-closing true ups that may apply are areas in which family business owners should seek proper professional advisory guidance outside their family boards and advisors.Financial BuyersFinancial buyers are primarily interested in the returns achieved from their investment activities. These returns are achieved by the conventions of 1) traditional opportunistic investment and 2) by means of sophisticated front end and back end financial engineering with respect to the original financing and the subsequent re-financings that often occur.Most traditional buy-out financial investors are looking to satisfy the specific investment criterion on behalf of their underlying fund investors, who have signed on for a targeted duration of investment that by nature requires the financial investor to achieve a secondary exit of the business within three to seven years after acquisition (the house flipping analogy is a clear but oversimplified one). Financial investors may have significant expertise acquiring companies in certain industries or may act as generalists willing to acquire different types of businesses across different industries.In general, there are three types of financial buyers:Private Equity Groups or other Alternative Financial Investors,Permanent Capital Providers, andSingle/Multi-Family Offices Despite their financial expertise, financial buyers usually do not typically have the capacity or knowledge to assume the management of the day-to-day operations of all of their investments. As such, the family’s management team at the time of a sale will likely remain involved with the Company for the foreseeable future. A sale to a financial investor can be a viable solution for ownership groups in which one owner wants to cash out and completely exit the business while other owners remain involved (rollover) with the business.A sale to a financial investor can be a viable solution in situations where one owner wants to cash out and completely exit the business while other owners remain involved with the businessWith respect to work force and employee stability, financial investors will ultimately seek maximum efficiency, but they often begin the process of making sure they secure the services of both frontline and managerial employees. In many cases, the desired growth of such investors can bolster the employment security of good employees while screening out those that resist change and impede progress.The value of the assembled workforce is becoming a more meaningful asset to prospective buyers in the marketplace, whether they be strategic and financial in nature. Further, larger acquirers often can present employees with a more comprehensive benefit package and enhanced upward mobility in job responsibility and compensation. All this said, financial investors will ultimately seek to optimize their returns with relentless efficiency.Lastly, as the financial buyer universe has matured over the past 20+ years, we have witnessed directly that many strategic consolidators are platform businesses with private equity sponsorship, which blurs or even eliminates the notion of a strictly strategic or financial buyer in many industries.ConclusionAn outside buyer might approach your family business with an offer that you were not expecting, you and your family might decide to put the business on the market and seek offers, or your family might opt to sell to the next generation of the family in an internal sale. Whatever the case may be, most owners only get to sell their business once, so you need to be sure you have experienced, trustworthy advisors in your corner.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries.Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor to inform sellers about their options and to encourage market-based decision making that aligns with the personal priorities of each client.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help you and your family manage the transaction process.

July 2021 SAAR

The July 2021 SAAR was 14.8 million units, roughly flat compared to July 2020, but down 12% from July 2019. SAAR was expected to fall for the third straight month, but this figure is lower than many experts predicted in June. As far as contributing factors to this slip, automotive manufacturers continue to struggle producing enough vehicles to meet insatiable demand that is emptying car lots around the country. Inventories continue to be drawn down and consumers are beginning to abandon their preferred color and trim selections as well as their preferred model and production year in favor of similar vehicles simply because they are actually available for purchase.As we detailed in last week’s blog, retail sales have crowded out fleet sales with an estimated 90% of total sales volumes in July, and this trend is also expected to continue as dealers no longer need to sell larger blocks of inventory at discounted prices. Dealers are doing everything they can to get new cars in the hands of consumers, as elevated prices continue to boost profits on a per unit basis.The average new-vehicle retail transaction price in July is expected to reach a record $41,044. The previous high for any month, $39,942, was set last month in June. Dealers are also capturing a greater share of these transactions prices as average incentive spending per unit, a measure of financial inducement used by manufacturers to motivate sales of specific vehicles, is expected to fall to $2,065, down from $4,235 in July 2020 and $4,069 in July of 2019. However, this doesn’t necessarily translate to skyrocketing costs for consumers as high trade-in values and low interest rates mean average new vehicle monthly payments of $622in July are only up 6.4% while transaction prices have increased 17%.Despite lower volumes, dealers are seeing record revenue levels as supply/demand imbalances have led to these surging prices. It also illustrates the relatively inelastic demand for consumers. Record vehicle prices have been noted across mainstream media outlets, yet customers continue to buy what little inventory dealers have. Consumers who can wait to buy a vehicle may be starting to hold off. But for those returning to the office in the wake of a public health crisis, there may not be many functional alternatives to personal vehicles. As noted above, monthly vehicle payments also haven’t surged as much as sticker prices.The trends outlined above tell the story of what auto dealers have been experiencing for months now. Tight supply unable to keep up with demand are leading to a red hot market, and it looks like price and turnover metrics may continue to reach new heights until supply issues are alleviated.Pickup Truck Market Share StumblesOne effect that these current market conditions have had on the automotive industry involves sales of pickup trucks. According to Wards Intelligence, large-pickup truck market share was 13% of total sales in July 2021, down from 15.2% in July 2020. This was the lowest market share figure for the vehicle class since July 2016. In April of this year, Ford decided to prolong its production shutdown for the F-150 pickup truck, citing parts shortages as the primary cause. During this period of shutdown for Ford, General Motors pressed forward with its production of the GMC Sierra, mentioning the importance of its pickup truck sales to the firm’s bottom line. Ford was able to restart truckproduction in June, but the decision by General Motors to sink available resources into its truck models eventually resulted in its own forced production shutdown in late July.Stories like these have dominated automotive news cycles over the last several months and it is not hard to believe that, despite the importance of pickups to the profitability of these firms, trucks are equally as hard to produce during this period of input shortages as other vehicle classes, particularly for the larger trucks as compared to other trucks and crossovers. Manufacturers are having to make decisions regarding which models to prioritize, and it seems like start-stop production has already become normal for most manufacturing plants around the country. Manufacturers are expected to continue to intermittently shut down truck production until automotive supply chains recover, while production of other best sellers are prioritized for weeks at a time.With a more complete understanding of the lumpy nature of model-specific production during the last several months, it can be expected to see large swings in market share for under-produced vehicle classes. Shutdowns in April and May related to the F-150 and shutdowns in July and August for the GMC Sierra have resulted in fewer trucks hitting lots, and therefore less market share in the sale of all vehicles for an underrepresented truck class. For the ones that are sold, many may not even see lots as pre-selling has become increasingly important. Once the dust settles and the necessary inputs for vehicle production become more readily available, the market share for pickups is expected to normalize at historical levels or even expand in response to pent-up demand. Until then, expect volatility in metrics like market share going forward.What To Expect? ForecastOver the last three months, many experts have tried to predict vehicle production rates to no avail. Mercer Capital’s own December 2020 Forecastfor the 2021 SAAR was in the range of 16 million units, quite bullish at the time. Looking forward to the end of supply shortages and heightened demand has proven a difficult task, and many previously bullish analysts are rolling back their expectations for a third quarter rebound. For example, the LMC Automotive forecast was reduced by 200,000 units on its last iteration. With more frequent announcements on manufacturing stoppages hitting the presses each week, the industry should not expect inventory levels to change much over the next month. With this in mind, total light vehicle sales are still expected to be around 16.5 million unitsin 2021.ConclusionIf you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

Benefits of Hiring an Advisor When Selling Your Business

While many business owners have a general sense of what their business may be worth and a threshold selling price in mind, going at it alone in a transaction process involves more than a notion on pricing – it involves procedural awareness, attention to detail, as well as a good measure of patience despite the desire for an immediate outcome. In most external transactions (i.e., a business owner selling to a third party rather than to family or employees) there is an acute imbalance of savvy and experience between buyers and sellers. For certain sellers who owe their business successes to personal effort, brute force, and honed skills, it’s a difficult decision and an act of faith to turn the business asset over to an advisory team. Buyers, both financial or strategic in nature, have completed many transactions while most sellers have never bought or sold a business. Given this near universal lop-sidedness in experience and resources, sellers need to assemble a team of experienced advisors to assist in navigating unfamiliar terrain. The time intensity and distractions of the process can cause the business to suffer if ownership sacrifices on operational oversight and foregoes the attention to detail that made the business an attractive acquisition target in the first place. We strongly recommend hiring a full transaction team composed of, at a bare minimum, three primary players: Transaction attorneyTax accountantFinancial (sell-side) advisor By securing a turnkey transaction team, business owners benefit from the multi-perspective expertise and overlapping skillsets of the team. The diversity and breadth of the team often facilitates proactivity and response capability for a wide variety of developments that can derail or compromise the timing, process and financial outcome of the final deal.Benefits of Hiring a Financial AdvisorThe following are a few of the many benefits of hiring a qualified sell-side advisor to assist in the transaction process.Maximize Net ProceedsThe core components and key terms of a transaction are often complicated and sometimes deceptively obscured in the legal rhetoric of an LOI, APA or SPA. Hiring a sell-side advisor with the right experience and expertise can help business owners maximize the net proceeds from the transaction. Financial intricacies and other points of negotiation, such as working capital true-ups or contingent consideration arrangements, often require careful analysis and modeling in order to foster clear decision making regarding competing and differently structured deals.A good sell-side advisor encourages objective comparative assessment of competing offers, negotiates key points, and helps acclimate sellers to certain realities of getting a deal done.Negotiate Best Possible TermsSell-side advisors have years of experience reviewing purchase agreements and will work with ownership’s legal counsel to ensure the transaction documents accurately reflect the agreed upon value and terms. These documents can often be cumbersome and need to be reviewed and crafted with the utmost attention to detail. Experienced advisors can help streamline the fine-tuning of these documents to assist the business owner(s) in negotiating favorable (or acceptable) terms of sale.At some point in most deals, a seller has to pick the fights worth fighting and concede on those terms that aren’t likely to change or have no real benefit. A good advisor should be frank and forthright with sellers, even when the recommendations or choices are not entirely satisfying. Sellers must be aware that a buyer needs a few wins and concessions to justify their investment. An informed seller, using the advice of a good seller representative, can better identify and prioritize the issues that impact the deal.Drive Transaction to ClosureSeasoned sell-side advisors have often worked on hundreds of transaction engagements. This range of experience can be of great help if and when unexpected issues arise, and unexpected issues almost always arise. Sell-side advisors will work with the rest of the transaction team to manage these issues and provide the information necessary to make critical decisions regarding proposed solutions with the end-goal of driving a transaction to closure.Confidentiality and Ownership BurdenRevealing a contemplated transaction to your employees and stakeholders can often lead to undue stress, which compounds the strain already present on ownership and management during a transaction process. With the help of a sell-side advisor, ownership and management can maintain their focus on running the business and generating profits while knowing that the transaction process is progressing in the background.Ownership can also gain peace of mind in knowing that the transaction will become “public information” at the appropriate time, which allows the business to function normally throughout the entire process. Many of the delays and sensitivities involved in the selling process, represent the potential for unexpected breaches of information to employees and other stakeholders. Owners can avoid many water cooler dilemmas by using an outside representative who collects, organizes, and disseminates information and manages exchanges between the parties.ConclusionAdmittedly, we are valuation and transaction advisory providers – go figure, that our advice is to retain us, if you desire strong representation that we believe will pay for itself. If you have a good business asset to sell, it’s likely you have been highly concentrated in your capital investments and your personal efforts to create that wealth. Selling such an asset is not only the opportunity to diversify your wealth but to outsource much of the pain and worry that accompanies the process of selling.Mercer Capital offers a seasoned bench of professionals with a diversity of experience unmatched by most pure-play brokers and M&A representatives. We combine top-shelf valuation competency with a vast array of litigation, transaction advisory and consulting experience to facilitate the best available strategic outcomes for our clients. To discuss your situation in confidence, give us a call.

DUC Clock Ticks On Cheap Production: Low-Cost Cash Flow Won’t Last

As we await second quarter earnings for publicly traded upstream producers, there are several markers and trends that suggest cash flows and profits will swell. Investment austerity and the recently resulting profits will almost certainly be bandied about on management calls. However, what might not be touted as loudly will be how much longer this can last? Existing U.S. production, much of it horizontal shale, is declining fast, operational costs and inflationary pressure are rising again, and the only way to augment production is through some combination of drilling and fracking.Cash Flow Crowned KingAccording to the latest Dallas Fed Energy Survey, business conditions remain about as optimistic as they were in the first quarter whilst oil and gas production has jumped. In the meantime, U.S. shale companies are on the precipice of delivering superior profits in 2021: in the neighborhood of $60 billion according to Rystad. How are they doing that? A combination of revenue boosts and near static investment levels. Analysts are pleased and management teams are crowing about cash. The industry should be able to keep it up, but only for a finite period. How long is that? Nobody knows for sure, but a good proxy may be the shrinking drilled but uncompleted (DUC) count of wells in the U.S. Overall DUC counts peaked in June of 2020 at 8,965, with the Permian leading the way. June 2021 statistics show DUCs at 6,252 or a 2,713 (30%) drop in one year. Just last month 269 DUCs disappeared with nearly half of those coming out of the Permian. This matters because DUC wells are much cheaper to bring online than fully undeveloped locations. Around half the drilling costs are already sunk and therefore it is incrementally cheap to complete (frack) and then produce from a DUC well. It’s low hanging fruit and producers with high DUC counts can profitably take advantage of recent price surges. However, these easily accessed volumes can’t be tapped forever. Last month’s DUC drawdown pace leaves less than a two-year backlog of DUC’s remaining, and it’s worth remembering that companies like to keep some level of inventory on their books, so the more realistic timing may be before 2022 ends. Inventory On The DeclineAll this is in conjunction with permit counts way below even 2019 levels (although rising – particularly among private companies). There’s likely going to be supply shortages in the future, as most producers in the Dallas Fed Survey suggest - but who will pick up that slack? OPEC may not be the only answer here. Granted, not every OPEC country has the spigot capability Saudi Arabia does and some other OPEC+ members have not been above cheating on their production limits in the past.Nonetheless, global inventories continue to decline. The U.S. Energy Information Administration’s short term energy outlook expects production to catch up due to OPEC+ recent production boost announcements, but nobody exactly knows what that will look like in the U.S. The EIA acknowledged that pricing thresholds at which significantly more rigs are deployed are a key uncertainty in their forecasts. There’s no certainty the U.S. shale industry will be able to pick up the demand slack either. They are preparing to live on what they have already drilled. Producers are under immense pressure to keep capital expenditure budgets under wraps and focus on investor returns. As such not much external capital is chasing the sector right now. A good example is this respondent to the Dallas Fed’s Survey: “We have relationships with approximately 400 institutional investors and close relationships with 100. Approximately one is willing to give new capital to oil and gas investment…This underinvestment coupled with steep shale declines will cause prices to rocket in the next two to three years. I don’t think anyone is prepared for it, but U.S. producers cannot increase capital expenditures: the OPEC+ sword of Damocles still threatens another oil price collapse the instant that large publics announce capital expenditure increases.” Pretty said. As a result industry analysts at Wood Mackenzie say U.S. crude production will grow very modestly during 2021 and likely 2022. OPEC+ is adding production, but not a lot – only 400,000 barrels per day being added back compared to the nearly 10 million per day cut in 2020. That leads to price pressure and the market has been catching on. Valuations on the AscentThese industry forces have contributed to the E&P sector having an outstanding year from a stock price and valuation perspective. Returns have outpaced most other sectors, and Permian operators have performed at the top of the sector. However, it is important to note that much of this gain is recovery from years of prior losses.An interesting observation (and consistent theme of mine) is that proven undeveloped reserves (PUDs) are the biggest beneficiary of this value boost. As production from existing wells declines, the value from tomorrow’s wells is getting a big bump. Mergers and acquisitions in the past year at what now appear to be attractive valuations, often paid very little if anything for PUDs, but buyers got them anyway. They are gaining valuation steam now. What were out of the money options are now moving into the money. Acreage values are intrinsically going up in West Texas (both Delaware and Midland basins), South Texas (Eagle Ford) and recovering in other areas such as the Anadarko basin in Oklahoma.Companies like Diamondback Energy have acquired acreage recently (QEP and Guidon deals) that surround or is contiguous with legacy acreage positions. This will come in handy when new wells come into view of capex budgets, and as I mentioned – there is a visible path whereby they could come into view in the next couple of years with oil above $70 per barrel.Investors appear to be cautious in view of OPEC+ perceived sword of Damocles hanging overhead, which is logical. However, the fundamentals remain lopsided towards high prices for some time, barring another catastrophic event, which of course could always be lurking around the corner.Originally appeared on Forbes.com.

The Fundamental Value of RIAs? Scarcity.

If the Choice Is Buy vs. Build, "Build" Doesn’t Even Come Close

Are RIA transaction multiples getting out of hand? Contrary to the usual laws of supply and demand, each week it seems like we hear about another blockbuster deal rumored to have happened at an astronomical price, and correspondingly, we meet a new capital source we hadn’t known previously who is looking for a way to implement an acquisition strategy in the RIA space. Is this FOMO on a grand scale, or just part of a grander moment in market dynamics? If you weren’t hiding under a rock last week, you probably read plenty about the Robinhood ($HOOD) IPO. Robinhood is a noteworthy counterpoint to the RIA space because it is practically the anti-RIA. RIAs target high net worth investors who want returns and capital preservation; $HOOD targets young speculators with money to burn. RIAs develop recurring revenue streams from investment management; $HOOD builds transaction volume by hyping "opportunities." RIAs follow a fiduciary standard; $HOOD monetizes clients with margin accounts and payment for order flow. If you wanted to define the typical RIA business model, you would do well to just assume the opposite of Robinhood.If you wanted to define the typical RIA business model, you would do well to just assume the opposite of Robinhood.Yet, $HOOD’s initial few days of trading bear out a revenue multiple that is mind-numbing, even compared to the high-watermark transactions in the RIA space. I can’t explain it, and I’m tempted to dismiss it as a sideshow altogether. But, a glance at Robinhood, digital assets, or 10 year treasuries for that matter, suggests that the wall of money that has moved an array of asset valuations higher over the past 15 months has yet to abate.Valuation practitioners are wired to respect intrinsic value. We can’t help but view assets like Bitcoin and Meme-stockbrokers with a curmudgeonly air. And it’s hard to get excited about bond yields measured in basis points instead of percentage points, regardless of your inflation outlook. RIA valuations, on the other hand, we can defend.RIAs remain the ultimate growth AND income play.RIAs remain the ultimate growth AND income play. What other business model produces a coupon in the upper single to low double digits, and then increases the dollar amount of that return with market and organic growth? Even at EBITDA multiples that would have made people blanche a few years ago, the return profile on RIAs is hard to match. Low yielding treasuries don’t come close, even on a risk adjusted basis.This isn’t to say that investing in RIAs is without risk. Investment management is labor intensive so much that we’ve been told by one very experienced buyer that he feels one can "rent" an interest in an RIA, but never really "own" one. Many RIAs struggle with genuine organic growth, and the most recent Schwab industry study shows AUM growth outstripping revenue growth, suggesting that realized fees are eroding – even in wealth management. Nevertheless, looking back over the past 18 months, it’s hard to find a business that was more adaptable and resilient than investment management – what looked like bottomless downside turned into banner performance.Our perspective isn’t unique. The problem is that for all the interest in acquiring RIAs, there aren’t that many to be had. While the total count of RIAs is debatable (about 15,000 to 40,000 – depending on who’s counting), what is easier to see is that the portion of substantial RIAs, especially those in the wealth management space (where much of the acquisition interest is these days) is small. There are maybe 500 wealth management firms with AUM in excess of $1.0 billion, and a good portion of those see themselves as acquirers rather than sellers. You can always consolidate smaller firms, of course, but it’s hard to build a $100 billion shop with $300 million add-ons.Acquisition activity is hot, multiples are strong, and there’s no end in sight.Bitcoin aficionados can talk about verifiable scarcity all day, but most people aren’t qualified to audit the bitcoin algo that limits the number of coins. We know what it takes to build multi-billion dollar AUM firms – time – a lot more time than it takes for server farms to mine digital coins. The best growth for RIAs is still organic, but life is short, and most grandiose investment strategies in investment management don’t budget the decades it takes to do it from scratch. Ergo, acquisition activity is hot, multiples are strong, and there’s no end in sight.The Aston Martin DB4 GT pictured above looks very similar to the ones produced in the early 1960s, but it was actually built in 2019. The GT version (more power, less weight) of the DB4 was supposed to total 100 cars, compared to the 1200 or so regular models. The DB4 GT production run ended early, though, as Aston Martin introduced the DB5 (the model ultimately mythologized in James Bond movies) after building only 75. As a consequence, auction prices of the GT version usually had an extra digit compared to those of comparable non-GT series cars.Five years ago, Aston Martin decided to do a special production run of the final 25 cars. Each car took an estimated 4,500 man-hours to build, and all were presold at £1.5 million. Interestingly, the 33% increase in supply didn’t dent auction prices for original DB4 GTs, and I suspect a similar increase in larger RIAs would just add to buyer enthusiasm.I wonder if crypto-investors would have a similar experience.

First Half 2021 Review of the Auto Dealer Industry

What Are Key Statistics Saying?

As we enter into the second half of 2021, first half statistics are being released and second quarter earnings calls are on the horizon for the public auto companies. We’ve all read the headlines of the auto dealer industry in 2021: heightened profitability, historic gross profits per unit and soaring retail sales prices for new and used vehicles, and inventory shortages and challenges caused by plant shutdowns and the microchip shortage. What are some of the key statistics saying about the current and future health of the auto dealer industry? Have they peaked, are they continuing to increase or beginning to decline, and/or how long will the current conditions hold?Back in December, we analyzed the state of the auto dealer industry through the use of various statistics/metrics: Retail Gross Profit Per Unit – New Vehicles, Retail Gross Profit Per Unit – Used Vehicles, and Used to New Vehicle Sales Unit Ratio. In this post, we revisit and examine those statistics through the first half of 2021 and discuss other key statistics including Average Days’ Supply, Fleet Sales, and Vehicle Miles Traveled.According to Dealership Profiles reported by NADA, average dealerships have posted pre-tax earnings at 5.1% of revenues as of May 2021 (most recently published data at the timing of this post). This figure has climbed through the start of 2021 and is higher than any reported annual figure since 2010, (when the NADA began publishing the data). How long can this continue and what are the key drivers of the historic profitability?New VehiclesThe sale of new vehicles continue to be impacted by imbalances between supply and demand. While auto dealers are selling fewer new vehicles, the average selling price and the retail gross profit per unit ("GPU") are at all-time highs.Let’s revisit retail gross profit per new vehicle: the numerator is gross profit achieved on the retail sale of new vehicles (as measured by the retail selling price less the cost paid to the manufacturer to acquire the vehicle) and the denominator is the total number of new vehicles retailed (fleet sales are excluded).As seen in the graphic below, the new vehicle GPU rose throughout late 2020 and has continued that rise through May 2021, to a total of $3,139 per unit. New vehicle GPU has risen every month in 2021, but will/can it continue? To answer that question, let’s start with the average days’ supply of the new vehicle equation. Average days’ supply is a metric used to measure the amount/supply of new vehicles that either an auto dealership or the auto dealer industry as a whole holds in relation to the average daily demand. The ratio is calculated by first determining the average monthly daily units of new vehicles by taking the prior month’s or average month’s unit sales divided by 30 days to arrive at average daily units. Finally, the number of new units in inventory at any given point in time is divided by the average daily units to determine the average days’ supply. This ratio is tracked on both new vehicles and used vehicles. Historically, the auto industry operated at an average days’ supply for new vehicles around 60 days. Average days’ supply on new inventory continues to plummet in 2021, reaching a low of 25 days’ supply as of June 2021. At the two state auto conventions that we attended last month, every auto dealer that we spoke with reiterated these conditions. It was very common to hear dealers state inventory unit numbers in the single digits for most of their franchise’s best models. Industry experts are predicting that July numbers will continue to follow these trends. July sales are expected to decline due to a lack of inventory, putting downward pressure on both the numerator and denominator. If the average days’ supply for new vehicles continues to fall, that means supply is falling faster than demand. Some early highlights from the Q2 earnings calls from the public auto companies indicate that they are experiencing average days’ supply less than 20 days and in some extreme cases, less than 10 days. New vehicle production and inventories are not anticipated to stabilize until the latter part of 2021 or perhaps not until 2022. In the next few months, the lack of supply will eventually cut into the heightened profitability that auto dealers have experienced for the first half of 2021. Even if GPUs are high, eventually such a decline in volume will necessitate a decline in overall gross profit levels, even if margins remain solid. It will be interesting to see how the OEMs respond to new vehicle production and average days’ supply when plants and conditions return to normal. The industry has proven it can operate more efficiently at leaner levels of inventory, but will the OEMs return production to the historical levels of 60 average days’ supply? While profits are higher, consumers are unlikely to be as understanding to the lack of inventory after the difficulty of reopening post-pandemic is solved. Used VehiclesLike new vehicles, used vehicles have also been impacted by supply and demand. Demand for used vehicles has increased rapidly due to shortages of new vehicle inventory and also changing consumer preference for those impacted financially by the pandemic.According to Cox Automotive, the average retail price of a used vehicle climbed to an all-time high above $25,000 for June 2021. As a result, auto dealers are experiencing record highs for retail gross profit per used vehicle.GPU for used vehicles is calculated the same as new vehicles discussed earlier, just for used vehicles. As seen in the graphic below, the used vehicle GPU rose in late 2020 and continued to rise through May 2021, to a total of $3,275 per unit. Used vehicle GPU has also risen every month in 2021, but will/can it continue? To answer, we again turn to average days’ supply. According to data published by Cox Automotive, the average days’ supply of used vehicles ranged between 55-66 as seen by actual data from November 2019 (pre-pandemic) and December 2020 (during the pandemic). Average days’ supply on used inventory has shown signs of improvement from a low of 33 units in March 2021. June 2021 levels have risen to 41 days supply as seen below. The bigger impact for auto dealers continues to revolve around sourcing for used vehicle units. Historically, auto dealers have sourced used vehicles from trade-ins, purchasing wholesale units at auction, buying back rental car fleets, and purchasing off-lease vehicles. With fewer new vehicle sales, there are fewer trade-ins. Sourcing vehicles at auction can be tricky for auto dealers in a market where used vehicle prices are at all-time highs and will likely revert back to normal at some point. Dealers must be cautious not to purchase large amounts of used vehicles at these elevated prices for the fear that they won’t be able to sell all of those units before prices return to more normal levels. As we will discuss later, the number of used vehicles available from rental car fleets has been drastically reduced from historical levels. Finally, there are fewer off-lease vehicles available for repurchase as customers are choosing to purchase those vehicles outright once the lease term ends. As discussed in our December post, the ratio of used vehicles to new vehicles sold approached 1:1 as dealers experienced heightened GPUs on both sides. That ratio continued to climb in the early part of 2021 topping out at 98.2% in January but has declined slightly to 87.5% in May 2021. Historically, the gap between GPU earned on used vehicles to new vehicles was wider than it has been in recent months. Now auto dealers are seeing margins nearly as high on new vehicles. This ratio continues to be impacted by shortages in inventory supply, increased retail prices, and uncertainty of financial constraints caused by the pandemic. We can think of two potential demand-related reasons GPUs earned by dealers on new vehicles are catching up to used vehicles. Surging auto prices have made it into the headlines; consumers continuing to shop likely have some level of inelastic demand and if they have to pay heightened prices, they may as well pay a little more to get a new vehicle. Also, with the “K-shaped recovery” we’ve seen during the pandemic, it’s possible those with more disposable income, who may be more likely to buy a new vehicle than a used vehicle, are composing a greater percentage of buyers, tilting demand and thus profits, towards new. Fleet SalesFleet sales consist of sales to large rental car companies, commercial users and government agencies.Historically, fleet sales allowed auto dealers to sell surplus inventory and to sell larger blocks of units at one time. While fleet sales typically occurred at reduced margins compared to retail sales, they allowed auto dealers to put more vehicles in service to hopefully benefit the fixed operations of an auto dealer as those vehicles will eventually require service maintenance and parts. Auto dealers anticipate that buyers of new vehicles will continue to return to the same dealership for those services during the lifetime of the warranty period and hopefully beyond.During the height of the pandemic, fleet sales declined significantly. Rental car companies weren’t just canceling orders, they actively sold off their existing fleet to build up cash as cities endured temporary shutdowns and much of domestic travel was halted or significantly curbed. While travel has returned in the second quarter of 2021, overall fleet sales remain depressed.As discussed earlier, auto dealers no longer have excess inventory, and so OEMs are prioritizing all the vehicles they can produce to be sold at heightened retail prices and gross profit margins to individuals.Fleet sales for the first half of the year totaled 969,751 units according to Cox Automotive. This figure represents an increase of nearly 5% compared to the same period in 2020 as demand has increased. However, comparisons to 2020 are not as meaningful due to the interruptions in the auto dealer industry caused by the pandemic. For a truer comparison, 2021 fleet sales represent a decline of over 40% from the same six month period in 2019 as seen below. So far, auto dealers have not been fazed by the lack of fleet sales. Perhaps the biggest impact of fleet sales has been felt by consumers. If anyone has traveled recently and tried to obtain a rental car, you likely have experienced an overall lack of supply and a dramatic increase in rental car prices. The impact felt by the fleet market on auto dealers has been on the used vehicle side of operations. While rental car companies sold off large portions of their fleets in 2020 with the lack of travel, they have not been able to replace that inventory as travel demands have increased. In turn, rental car companies are currently no longer a source of used vehicle units for auto dealers since those purchases were pulled forward in 2020. It will be interesting to see how these conditions evolve over the latter half of 2021 and 2o22 as manufacturing begins to return to normal from the OEMs. Vehicle Miles TraveledAnother key indicator that portrays the health of the automotive industry is the number of miles driven or vehicle miles traveled ("VMT"). As with the number of vehicles in service, the number of miles driven contributes to the fixed operations of an auto dealer as vehicles require more parts and service as they are driven more frequently or for longer distances. Increased miles will also lead to the eventual purchase of a new vehicle either from new or used vehicle inventory.VMT has been tracked since 1971, and a graphical view of the rolling 12-month average can be seen below.Over time, VMT has generally increased as the population has grown and more vehicles have been put in service. Since 1971, there have only been a few occasions where the rolling-12 month average has declined, which as noted above, tend to correlate with recessions: 1974, brief periods in the late 1970s and the early 1980s, the Great Recession in 2008 and 2009, and the pandemic in 2020.During the height of the pandemic, the rolling-12 month VMT average dropped below 3 trillion miles for the first time since mid-2014 and even below 2.8 trillion for the first time since the early 2000s. The rolling-12 month average bottomed out in February 2021 at approximately 2.77 trillion miles and has steadily climbed back up to 2.97 trillion miles as of May 2021.During the pandemic, a report from KPMG highlighted some of the factors impacting the VMT and also hinted at longer-term trends that could eventually push that figure back up to historical levels. Obvious factors from COVID-19 included temporary stay-at-home orders and restricted travel. As the pandemic continued, work and commute habits also changed as more individuals either worked from home initially, or others have continued to work from home in some capacity. These behaviors drastically contributed to fewer and shorter work commutes. An additional factor impacting VMT was fewer shopping trips. Digital platforms and e-commerce continue to grab market share from traditional shopping trips to the store. This phenomenon was already occurring prior to the pandemic but continues to persist as some consumer behaviors may have been permanently altered due to long-term health and safety concerns.Is it all bad news as far as VMT is concerned? As mentioned above, the rolling-12 month average has been steadily climbing since January 2021. Shutdowns and stay-at-home orders have all mostly expired and there is pent-up demand in domestic travel.As a result of the pandemic, more people could eventually decide to move out of larger metropolis areas into smaller suburbs. Moving out of the city could create longer commute times and miles driven. Additionally, people may continue to avoid public transportation and rideshare services due to the health impact scares of the pandemic. Both of these trends could lead to more individuals purchasing vehicles, which would eventually contribute to more miles driven.Conclusions The first half of 2021 has been a memorable one for auto dealers highlighted by all-time profitability, heightened gross margins on new and used vehicles, and shortages of new and used inventory. How long will these trends continue and have some trends already shown reversion back to normal levels?As we’ve discussed, certain metrics such as gross margins per unit continue to rise, while others such as average days’ supply of used vehicles, overall auto sales, and vehicle miles traveled appear to be trending toward historical levels. Industry experts are mixed on predicting when inventory conditions stabilize; some indicate later this year, while others indicate it could be 2022 before inventory/supply issues return to normal.For an understanding of how your dealership is performing along with an indication of what your dealership is worth amidst the noise, contact a professional at Mercer Capital to perform a valuation or analysis.

Estate Planning Changes Update

It’s been over six months since we last took inventory of where we stood in the face of tax changes (increases) affecting estate planning. We are happy to report that in that time we have gained a firm understanding of the changes that are set to occur. Estate planners should have clarity on how to work through the changes with their clients in a timely manner and at a leisurely pace before the end of the year. Hey look, flying pigs!As Paul wrote to the Corinthians, "For now we see through a glass, darkly." While we may have some ideas on what is coming with the current tax policy, the full picture remains murky. Here’s what we are reading and listening to regarding tax changes and other factors affecting family businesses and estate plans.What Are the Exact Changes as Proposed?Fiduciary Trust International highlighted the key tax issues currently at hand regarding estate planning. These included:The top individual federal income tax rate could increase from 37% to 39.6%.Long-term capital gains tax rate could increase from 23.8% to as high as 43.4% when including the net investment income tax of 3.8%.Cost basis ‘step-up’ could be removed for gains of over $1 million on inherited assets.The federal estate tax rate could increase on a progressively sliding scale for assets transferred over $3.5 million. A reduction in the gift and estate tax exemption has not been explicitly included in the current round of changes. Given that the current limits are set to expire in 2025, one may wonder if conserving political capital was not part of the equation in leaving the current $11.7 million exemption ($23.4 million for a married couple) in place. One piece of advice the article gives: consider using your full estate and gift tax exemption before the exemption amount is set to decrease.Tax Update: How Proposed Tax Changes Could Impact Family-Owned BusinessesFamily Business Magazine sponsored a webinar featuring two members from BMO Family Office discussing tax planning and tax changes that could affect family businesses – including tax considerations for buying and selling, the tax impact for C corporations vs. S corporations, and 1031 exchanges. The webinar is free for replay when you sign up. Overall, the speakers are 'bullish' (read: not convinced) at the likelihood of the full tax changes coming to fruition. One of the speakers highlighted that the step-up in basis at death has been repealed multiple times legislatively, all to be reversed shortly thereafter. He cited the administrative nightmare of determining basis in family businesses/assets that have been held by families for decades.Bipartisan Infrastructure Deal Still Faces a Long, Uncertain RoadMarketWatch highlighted the recent U.S. Senate movement on the stand-alone infrastructure bill coming in at a cool $1 trillion in new infrastructure spending. However, the Biden Administration’s proposed tax increases would be included in the larger $3.5 trillion budget reconciliation process and are not currently part of the bipartisan traditional infrastructure bill. Benjamin Salisbury, director of research at Height Capital Markets, relayed the following in an investment note:"We maintain our estimate of a roughly 35%-45% probability of passing a joint bipartisan infrastructure bill and slimmed down reconciliation bill, although the situation is highly fluid.""A lesser probability (20%-30%) is that either the infrastructure bill or reconciliation bill pass on their own.""Lastly there is an ever present risk (25%-45%) that the entire effort will collapse under its own weight. We continue to regard the inflation narrative as the largest risk to passage."Moderate Democrats Remain SkepticalElected moderate Democrats remain the most watched politicians in the U.S. today, with multiple congressmen giving pause to the full slate of tax increases and new spending. Senator Kyrsten Sinema (D-AZ) said to the Arizona Republic, "I have also made clear that while I will support beginning this process, I do not support a bill that costs $3.5 trillion." Senator Joe Manchin (D-WV) indicated months ago that he does not support raising the corporate tax rate to 28%. House Agriculture Committee Chairman David Scott (D-GA) has criticized Biden’s plan to get rid of the so-called step-up basis, worrying about its impact on family farms and small businesses. Senator John Tester (D-MT) shared a similar sentiment regarding the basis step-up.Further ReadingNational Law Review – President Biden's Tax Plan Impacts Estate Planning, Capital GainsNorthwestern Mutual – With Gift Taxes and Estate Taxes in Congress’ Sights, Consider Revisiting Your Estate PlanningBarnes & Thornburg LLP - Unprecedented Changes Proposed to Gift and Estate Tax LawsKiplinger – Biden Hopes to Eliminate Stepped-Up Basis for MillionairesFinal ThoughtsOne of my favorite books in 2020 was Radical Uncertainty: Decision-Making Beyond the Numbers. The authors make the distinction between risk (quantifiable: think roulette tables) and uncertainty. Most of life is uncertain, and we are naïve to place numbers and probabilities on all aspects of our lives. The authors note, "Radical uncertainty cannot be described in the probabilistic terms applicable to a game of chance. It is not just that we do not know what will happen. We often do not even know the kinds of things that might happen." Tax changes are quantifiable risks, political machinations in Washington represent uncertainty. Our actions need to represent this distinction.Thus, we leave you with the same advice we provided six months ago: take care of your family and make sure your current estate plan makes sense today. We provide valuation services to families seeking to optimize their estate plans. Give one of our professionals a call to discuss how we can help you in the current environment.

How to Value an Oilfield Services Company

As the volatility continues with oil field service companies (the OSX has nearly doubled since November 2020), valuation and techniques associated therewith are important to consider right now. Therefore, this week we are reposting our blog post and whitepaper as it pertains to how to understand and value oil field service companies. When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of oilfield service (“OFS”) companies is important in establishing a credible value for a business operating in the space. Our blog strives to strike a balance between current happenings in the oil and gas industry and the valuation impacts these events have on companies operating in the industry. After setting the scene for what an OFS company does and their role in the energy sector, this post gives a peek under the hood at considerations used in valuing an OFS company.Oil and Gas Supply ChainThe oil and gas industry is divided into three main sectors:Upstream (Exploration and Production)Midstream (Pipelines and Other Transportation)Downstream (Refineries)Source: Energy Education Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. To do this, E&P companies utilize oilfield service (OFS) companies to help with various aspects of the process including pumping and fracking, land contract drilling, and equipment manufacturers. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Finally, refiners convert raw crude and natural gas into products of value. Oilfield Services OperationsE&P companies may own the rights to the hydrocarbons below the surface, but they can’t move them down the supply chain without the help from OFS companies in the extraction process. We can think of various OFS companies being subcontractors in the upstream process much like a general home builder might bring in people specially trained to set the foundation or wire electrical or plumbing. Because the services provided often require sophisticated technology or extensive technical experience, it stands to reason OFS companies would be able to charge a premium price. Thus, OFS would appear to be insulated from the commodity pricing that is inherent in the industry. However, E&P companies are the ones contracting these companies, and if oil prices decline enough, they are pressured to decrease production (and capex budgets), reigning in activity for OFS companies. This is where the specific service provided matters.Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.As previously shared in May of 2019, there are a variety of different services provided by OFS companies. Companies that fall into the category of OFS can be very different from one another as the industry is fragmented with many niche operators. For example, companies servicing existing production are less impacted by changes in commodity prices than OFS companies that service drilling, as these activities are the first to decrease. Regardless of service provided, or industry for that matter, there are certain aspects of a business that should always be considered.Oilfield Equipment and Service Financial AnalysisA financial analyst has certain diagnostic markers that tell much about the condition of a business both at a given point of time (balance sheet) and periodically (income statement).Balance Sheet. The balance sheet of an OFS company is considerably different from others in the energy sector. E&P companies have substantial assets attributed to their reserves. Refiners predominantly have high inventory and fixed assets. OFS companies will depend on the type of product or service, but generally, they tend to have a working capital balance that consists more of accounts receivable than inventory, like other service-oriented businesses. According to RMA’s annual statement studies, A/R made up 22.3% of assets while inventory was 9.3% for Drilling Oil and Gas Wells (NAICS #213111).[1] These figures were 26.6% and 10.8%, respectively for Support Activities for O&G Operations (#213112). Notably, drilling operations had a higher concentration of fixed assets (46.8%) compared to other support services which comprised 35.7% of assets. Broadly speaking, this illustrates the different considerations within the OFS sector as far as the asset mix is concerned.Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment. Cost of goods sold is a significant consideration for other subsectors in the energy space, particularly as the product moves down the supply chain towards the consumer. This is not the case for OFS companies. RMA does not even break out a figure for gross profit, but instead combines everything under operating expenses. Still, OFS companies deal with significant operating leverage. If expenses are less tied to commodity prices that means costs may be more fixed in nature. That means when activity decreases and revenues decline, expenses don’t decline in lock-step resulting in margin compression and profitability concerns. While the balance sheet does not directly look at income, it can help determine sources of return. Fixed-asset heavy companies like drillers tend to be more concerned with utilization rates as the more their assets are deployed, the more money they will earn. On the other hand, predominantly service-based companies that rely on their technology and expertise tend to be more concerned with the market-determined prices they are able to charge and terms they are able to negotiate. Additionally, OFS companies may have significant intangible value that may not be reflected on the balance sheet. Intangible assets developed internally are accounted for differently than those that are acquired, and a diligent analyst should be cognizant of assets recorded or not recorded in developing an indication of value.How to Value OFS?There are fundamentally three commonly accepted approaches to value: asset-based, market, and income. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining an indication of value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value.The Asset-Based ApproachThe asset-based approach generally represents the market value of a company’s assets minus the market value of its liabilities.The asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, so the asset-based approach is not instructive for all businesses. However, the capital intensive nature of certain OFS companies does lend some credence to this method, generally setting a floor on value. If companies have paid off significant portions of their debt load incurred financing its equipment, the valuation equation (assets = liabilities + equity) tilts towards more equity and higher asset approach indications of value. Crucially, as time goes on and debt is serviced, the holding value of the assets must be reassessed. Price paid, net of accumulated depreciation may appear on the balance sheet, but if the equipment or technology begins to suffer from obsolescence, it will have less value in the marketplace. For example, due to the shale revolution in the United States and the increased demand for horizontal drilling, equipment and services that facilitate vertical drilling have less market value than it did less than a decade ago. Ultimately, the asset-based approach is typically not the sole (or even primary) indicator of value, but it is certainly informative.The Income ApproachThe income approach can be applied in several different ways. Generally, analysts develop a measure of ongoing earnings or cash flow, then apply a multiple to those earnings based on market risk and returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate. Stated plainly, there are three factors that impact value in this method: cash flows, growth, and risk. Increasing the first two are accretive to value, while higher risk lowers a company’s value.The income approach allows for the consideration of characteristics specific to the subject business.To determine an ongoing level of earnings, scrutiny must be applied to historical earnings. First, analysts must consider the concentration of revenues by customers. A widely diversified customer base is typically worth more than a concentrated one. Additionally, an analyst should adjust for non-recurring and non-normal income and expenses which will not affect future earnings. For example, disposing of assets utilized in the business is not considered an ongoing source of return and should be removed from the company’s reported income for the period when the disposition occurred. The time period must also be considered. Assuming cash flows from last year will continue into the future may be short-sighted in the energy sector. Instead of using a single period, a multi-period approach is preferable due to the industry’s inherent volatility, both in observing historical performance and projecting into the future. Discounted cash flow (DCF) analyses are an important tool, but factors such as seasonality, cyclicality, and volatility all call for a longer projection period.After developing the earnings to be capitalized, attention is given to the multiple to be applied. The multiple is derived in consideration of both risk and growth, which varies across different companies, industries, and investors. When valuing an OFS company, customer concentration is of particular concern to both risk and growth. Developing a discount rate entails more than applying an industry beta and attaching some generic company risk premium. Analysts must look deeper into the financial metrics addressed earlier and consider their market position. Are they financially stable or over-levered by either fixed costs or debt? Are they a sole provider or one of many? If more players are entering the market, prices charged may be lower than those historically observed. If a company stops investing in its equipment and technology, demand for the company’s products and services declines. Again, metrics such as utilization and day rates are important to analyze when developing a discount rate.Income is the main driver of value of a business as the goal is to generate a reasonable return (income) on its assets. People don’t hang a sign above their door and go into business if they don’t think they will eventually turn a profit. Still, differences of opinion on risk and growth can occur, and analysts can employ a market approach as another way to consider value.The Market ApproachAs the name implies, the market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it. The OFS subsector is a fragmented industry with many niche, specialty operators. This type of market lends itself to significant acquisition activity.However, transactions must be considered with caution. First, motivation plays a role, where a financially weak company may not be able to command a high price, but one that provides synergies to an acquirer might sell for a premium. Transactions must also be made with comparable companies. With many different types of companies falling under the OFS umbrella, analysts must be wary of comparing apples to oranges. While they work in the same subsector, there are clearly important differences between equipment manufacturers and pumpers and frackers. Untangling the underlying earnings sources of these businesses is important when looking at guideline transactions as well as directly comparing to guideline companies.In many ways, the market approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.Larger diversified players, such as Schlumberger and Halliburton, are more likely to provide similar services to companies an analyst might value, but their size, sophistication, and diversification of services likely renders them incomparable to smaller players. Given the relative considerations and nuances, taking their multiples and applying a large fundamental adjustment on it is crude at best and may miss the mark when determining a proper conclusion of value.Analysts using a market-based approach should also be judicious in utilizing the appropriate multiple and ensuring it can be properly applied. Industries focus on different metrics and it is important to consider the underlying business model. For E&P companies, EV/EBITDAX may be more insightful as capital expenditure costs are significant and can be throttled down in times of declining crude prices. For OFS companies, potentially relevant multiples include EV/Revenue and EV/Book Value of Invested Capital, but there is no magic number, and these useful metrics cannot be used in isolation. Ultimately, analysts must evaluate the level of risk and growth that is implied by these multiples, which tends to be more important than the multiples used.The market approach must also consider trajectory and location. There’s a difference between servicing vertical wells that have been producing for decades as opposed to the hydraulic fracturing and long horizontal wells in the Delaware Basin. Distinctions must also be drawn between onshore and offshore as breakeven economics are similar (don’t produce if you can’t earn a profit), but costs related to production vary significantly.Ultimately, the market-based approach is not a perfect method by any means, but it is certainly insightful. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be. When comparable companies are available, the market approach should be considered in determining the value of an OFS company.Synthesis of Valuation ApproachesA proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules of thumb” or back of the napkin calculations are dangerous to rely on in any meaningful transaction. Such calculation shortcuts fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.A thorough approach utilizing the valuation approaches described above can provide significant benefits. The framework provided here can facilitate a meaningful indication of value that can be further refined after taking into account special considerations of the OFS industry that make it unique from other subsectors of the oil and gas industry.ConclusionWe have assisted many clients with various valuation needs in the oil and gas space for both conventional and unconventional plays around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.[1] 2018-2019 RMA Statement Studies. NAICS #213111 and 213112. Companies with greater than $25 million in sales.Originally posted on Mercer Capital's Energy Valuation Insights Blog June 3, 2019

Strong Quarter Propels Alt Managers to New Highs

The second quarter was especially kind to the alt manager sector, which benefited from favorable market conditions and growing interest from institutional investors. Heightened volatility creates more opportunities for hedge funds to generate alpha (when their positions aren’t concentrated in meme stocks), and market peaks often spur interest in alternative asset classes, like private equity and real estate. These trends initially took root last fall before gaining considerable momentum in the second quarter. Much of this momentum is attributable to the VC space as investors turn to private equity and start-up tech firms for higher returns than more traditional asset classes. According to CB Insights, a record 249 firms achieved the $1 billion “unicorn” valuation status in the first half of 2021, almost doubling the total tally from last year.Growing interest in the sector also stems from the fact that alt managers are often better positioned during a prospective downturn than their traditional asset management counterparts. Alt assets aren’t directly correlated to market conditions and are often held in illiquid investment vehicles, which means their investors are locked up for years at a time with no withdrawal rights.While sticky assets can provide a cushion for alt managers in a downturn, the longer-term performance of many of these managers depends on their ability to raise new funds and put that money to work. Raising institutional capital is often a long and involved process in the best of circumstances. For many managers, the economic interruption of last year’s global shutdown presented challenges to their fundraising process that often involves extensive in-person due diligence. And if new funds are raised, there is the question of how fast managers can put that money to work without sacrificing proper due diligence.M&A declined significantly in the second and third quarter of last year, leaving deal teams at many PE firms on the sidelines before rebounding sharply over the last nine months or so.It’s also important to keep in mind that these alt managers and their assets are still vulnerable to bear markets. Public alt managers were particularly affected during the selloff last March, reflecting the decline in portfolio asset values and reduced expectations for realizing performance fees. From February 19, 2020 (the prior market peak), our index of alt managers declined nearly 45% in just over a month. Since then, an outsized recovery has pushed the index back to all-time highs.Such a sharp gain in alt manager stock prices means the market is increasingly optimistic about the sector’s prospects. Performance fees and carried interest payments are likely to increase with rising asset prices. Strong investment performance also tends to entice inflows from institutional investors, which will buoy AUM balances and management fees for most of these firms. The market is therefore anticipating higher revenues for the industry, which should be accompanied by even greater gains in profitability given the sector’s relatively high level of operating leverage (fixed costs).Many alt manager funds also have high levels of financial leverage (debt) that can augment returns when things go well. The trouble is that both forms of leverage can exacerbate earnings when revenue dips or investments underperform. These attributes are what make the alt management industry so volatile and are part of the reason why the sector lost nearly half its value last March before doubling over the next year.On balance, we believe the recent run-up is justified, but it’s important to remember what can happen when alt asset prices go the other way. Expect volatility to remain as investors weigh the impact of a recovering economy and rising inflation on alt asset returns.

5 Trends Facing Family Businesses Today

Back in the spring of this year, we discussed five broad economic indicators family businesses needed to keep their eye on. In this week’s post, we wanted to revisit those trends and see where we have come over the last four months, as well as what we are hearing from our clients on the ground.COVID-19 Cases and VaccinationsSince March, over 120 million people have received at least one dose of the various COVID-19 vaccines, pushing the COVID vaccination rate for U.S. adults to nearly 70%. Daily cases troughed in mid-June and have begun rising once again. However, daily death counts remain 90% below their mid-January peak, and a confluence of vaccinations and estimated infections has pushed a level of ‘herd immunity’ to over 70%, according to J.P. Morgan’s reading of the data. While there is some trepidation regarding the recent increase in infections, the majority of our family business clients are operating at the most "business as usual" we have seen since the genesis of the pandemic.Interest RatesIn March, a consensus was beginning to form that interest rates would continue their ascent unabated. However, as rates took a dive my colleague, Jeff Davis, posed whether or not the “reflation trade” could be coming to an end, with fears of economic growth stalling out and (thankfully) inflation fears perhaps overblown (more on that below).Current rate movements present a double-edged sword for family businesses. If broad rates continue their decline it could portend less-than-stellar economic growth. However, low interest rates still represent an opportunity for financing capital projects and are favorable to gift and estate strategies. Our advice given the backdrop is similar from the gifting side as it was last year: gift now.Labor MarketsBroadly speaking, the labor market has improved dramatically since the height of the pandemic, with most major indicators pointing toward a stronger labor market. This trend is exacerbating one of the main issues facing our family business clients: labor shortages. From electrical supply distributors to medical suppliers, general contractors, and HVAC companies, finding and maintaining talent remains a sticking point for many of our clients. Our clients are quick to point out these are not minimum-wage jobs, with industries most affected looking for labor in pay ranging between $20 to $30 an hour.An article in the Wall Street Journal highlighted Americans are leaving unemployment rolls more quickly in states that were set to end expanded benefits early and reentering the job market. According to NFIB’s monthly jobs report, “46% of small business owners reported job openings they could not fill in the current period, down two points from May but still above the 48-year historical average of 22%.” Expanded benefits are set to expire nationwide in early September, which should create an influx of workers if the states ending benefits early, serve as a guide.Inflation"The Gipper" once said, “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” While perhaps it’s not really quite as bad as those things, readers who lived through the early Reagan years likely recall the economic pain brought about by inflation rates topping 10% annually. Tighter labor markets, supply chain constraints and disruptions, and a red-hot economy boosted inflation fears during the second quarter.Many of our clients who operate in the energy, hard goods, distribution, and construction fields have seen input costs rise sharply. Inflation rose in June at its fastest rate since the U.S. housing market crash in 2008. The fed continues to monitor inflation levels, but still views the current increase as "transitory". We will have to wait and see: while lumber prices have fallen precipitously and steel stabilized below recent peaks, absolute levels for many inputs goods (soybeans, copper, resin,) and services (container shipping rates) remain high (or as the Reddit-ors would say “To the Moon”). Family businesses would be wise to keep an eye on the ball and revisit pricing assumptions on forecasts more than a few months out.Sentiment IndicatorsWhen we last took a look at sentiment indicators, the concerns of CEOs of larger businesses, could not have been more optimistic, whereas small businesses saw numerous challenges ahead. While the difference in outlook still exists, overall confidence has risen across the board. Consumer confidence (related to consumer spending, which represents nearly 70% of annual U.S. GDP) is expected to continue driving a strong economic expansion. This mirrors many of the conversations we are having with our clients, and family businesses are beginning to shift from "cash preservation" mode, back to smart growth and expansion.SummaryWhile we don’t pretend to play economists, Mercer Capital maintains a sharp watch on national and global economic trends to better advise you and your family businesses. Give us a call to discuss how economic trends are likely to affect your family business.

Formula Clauses for Auto Dealerships

Pros and Cons of Using Formula Clauses in Buy-Sell Agreements

In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents. Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information. For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods. Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric. These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business. This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets. No long division required.This can also lead to less contentious transfers if everything goes smoothly. If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly. However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven. Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million. Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%. Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%. These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn. ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Formula Clauses for Auto Dealerships

Pros and Cons of Using Formula Clauses in Buy-Sell Agreements

How Long Will It Take to Sell My Business?

That Depends on the Type of Transaction…Ownership transitions, whether internal among family and other shareholders or external with third parties, require effective planning and a team of qualified advisors to achieve the desired outcome. In this article, we examine some “typical” timelines involved in various types of transactions.Internal TransitionsSale to Next GenerationInternal transitions are often undertaken in accordance with provisions outlined in the Company’s existing or newly minted buy-sell agreement. A buy-sell agreement is an agreement by and between the owners of a closely owned business that defines the terms for the purchase when an owner requires liquidity. Buy-sell agreements typically specify how pricing is determined, including the timing, the standard of value used, the level of value, and the appraiser performing the valuation.As a matter of practicality, the timing for transfers using an existing buy-sell agreement is often dependent on the readiness of financing and the service level of the assisting legal and valuation advisory professionals. Experience suggests this can take as little as four to eight weeks, but often involves processes that can require three to six months to carry out.In circumstances where a newly crafted buy-sell agreement is being developed, you should expect a lengthier process of at least several months so that the attending financial, valuation, and legal frameworks are satisfactorily achieved.Mercer Capital has published numerous books on the topic of buy-sell agreements, which readers of this article should avail themselves of, or better yet, contact a Mercer Capital valuation professional to make sure you get directed to the most useful content to assist in your circumstance.Companies with an existing buy-sell agreement and those that obtain regular appraisal work, stand the best chance of achieving a timely process. Those Companies that are embarking on their first real valuation process, and that have stakeholders who require a thorough education on valuation and other topics, should allow for a deliberate and paced process.In the event of an unexpected need for ownership transfer (death and divorce to name a few), it is sound advice to retain a primary facilitator to administer to the potentially complex sets of needs that often accompany the unexpected.Employee Stock Ownership PlansThe establishment of an Employee Stock Ownership Plans (ESOP) is a necessarily involved process that requires a variety of analyses, one of which is an appraisal of the Company’s shares that will be held by the plan.For a Company with well-established internal processes and systems, the initial ESOP transaction typically requires four to six months. In a typical ESOP transaction, the Company will engage a number of advisors who work together to assist the Company and its shareholders in the transaction process. The typical “deal team” includes a firm that specializes in ESOP implementation, as well legal counsel, an accounting firm, a banker, and an independent trustee (and that trustee’s team of advisors as well).Most modern-day ESOPs involve complex financing arrangements including senior bankers and differing types and combinations of subordinated lenders (mezzanine lenders and seller notes). There are numerous designs to achieve an ESOP installation. In general, the Company establishes and then funds the ESOP’s purchase financing via annual contributions.ESOPs are qualified retirement plans that are subject to the Employee Retirement Income Security Act and regulated by the Department of Labor. Accordingly, ESOP design and installation are in the least, a time consuming process (plan for six months) and in some cases an arduous one that requires fortitude and an appreciation by all parties for the consequences of not getting it right up front. The intricacies and processes for a successful ESOP transaction are many.A more detailed assessment of ESOPs is provided here on Mercer Capital’s website. The following graphics depict the prototypical ESOP structure and the flow of funds.External SalesMany entrepreneurs cannot fathom why success in business may not equally apply to getting a deal done. In most external transactions, there is a significant imbalance of deal experience: today’s buyers have often completed many transactions, while sellers may have never sold a business. Accordingly, sellers need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Without exception, we recommend retaining a transaction team composed of at least three deal-savvy players: a transaction attorney, a tax accountant, and a sell-side financial advisor. If you do not already have some of these capable advisors, assembling a strong team can require time to accomplish. Since many transactions with external buyers originate as unsolicited approaches from the growing myriad of private equity and family office investors, it is advisable to maintain a posture of readiness.Up-to-date financial reporting, good general housekeeping with respect to accounts, inventory, real property maintenance, information technology, and the like are all part of a time-efficient transaction process. These aspects of readiness are the things that sellers can control in order to improve timing efficiency. As is often said in the transaction environment - time wounds all deals.Sellers doing their part on the readiness front are given license to expect an efficient process from their sell-side advisors and from buyers. We do caution that selling in today’s mid-market environment ($10-$500 million deal size) often involves facilitating potentially exhaustive buyer due diligence in the form of financial, legal, tax, regulatory and other matters not to mention potentially open-ended Quality of Earnings processes used by today’s sophisticated investors and strategic consolidators. A seasoned sell-side advisor can help economize on and facilitate these processes if not in the least comfort sellers as to the inherent complexity of the transaction process.The sell-side advisor assists ownership (or the seller’s board as the case may be) in setting reasonable value expectations, preparing the confidential information memorandum, identifying a target list of potential motivated buyers, soliciting and assessing initial indications of interest and formal bids, evaluating offers, facilitating due diligence, and negotiating key economic terms of the various contractual agreements.The typical external transaction process takes four to seven months and is done in three often overlapping and recycling phases. While every deal process involves different twists and turns on the path to consummation, the typical external transaction process takes five to seven months and is completed in the three phases depicted in the following graphics.CLICK HERE TO ENLARGE THE IMAGE ABOVECLICK HERE TO ENLARGE THE IMAGE ABOVEConclusionAs seasoned advisors participating on both front-end and post-transaction processes, we understand that every deal is unique. We have experienced the rush of rapid deal execution and the trying of patience in deals that required multiple rounds of market exposure. A proper initial Phase I process is often required to fully vet the practical timing required for an external transaction process.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help manage your transaction.

The Potential Buyers of Your Business

An Overview of the Different Types of Buyers for Closely Held, Mid-Market CompaniesWe regularly encounter business owners contemplating the dilemma of ownership transition. After years (maybe even decades) of cultivating the business through hard work, determination, and perhaps a bit of luck, many prospective sellers believe now is a sensible time to exit.Tax changes are looming, pandemic and post-pandemic winners see solutions to a myriad of operational challenges, and valuations remain favorable in most industries. However, a seller’s timing, the readiness of the business, and the readiness of the marketplace may not be aligned without careful seller preparation and real-time market awareness.Little do most sellers realize that their preparation, their tolerance for post-deal involvement, their health and ability to remain active, and their needs for liquidity will influence the breadth and priorities of their options and will influence who the potential buyers might be and how they might target the business. Proactivity (or backfilling for the lack thereof) will also influence the design and costs of the process for effective M&A representation.Under ideal circumstances, the planning process for an exit will begin well before the need for an actual ownership transfer arises. One of the first steps in planning for an eventual sale is to understand who the potential buyers might be and the different characteristics of these buyers.In this article, we discuss some exit options and summarize some of the specifics of certain types of buyers and what that could mean for transaction structure and economic outcomes.Internal Ownership TransitionWhen done carefully, an internal transition can be desirable in order to protect both the existing employees and the culture of the business. Potential buyers in an internal transition generally include the next generation of the owner’s family or key employees of the company (or a mix thereof).These transactions generally occur one of two ways: through a direct sale from the exiting owner to the next generation or through the establishment of an Employee Stock Ownership Plan (ESOP).While these transactions may not yield the pricing or turnkey liquidity that selling to an outside buyer might, they can provide comfort to exiting owners regarding their legacy and the continuing prospects of the business as an independent going concern. Sale to Next GenerationA key consideration in selling to family members or to employees is price. Equally important is the question of how the transaction is financed.Internal transactions are often achieved by share redemptions in installments and/or through a leveraged buyout process. Often, the seller will provide financing using one of many potential structures.Seller financing carries the risk of the buyer’s inability to pay, which often requires the seller to reinsert into active leadership. Many may view seller financing as acceptable, if not necessary or desirable, in order to control the terms and costs of the arrangements and to benefit from the interest payments and other terms of the financing.As noted, a seller’s liquidity requirements and the underlying fundamental borrowing capacity of the business play a big part in determining how much third party capital can be employed. Many sellers want their buyers, family or otherwise, to have real skin in the game by way of at least partial external financing.If the next generation of family members and/or employees are not well-situated to achieve a buyout as a concentrated ownership group, then the feasibility of a more formal collective buyer group may be a good alternative. Following is a brief overview of Employee Stock Ownership Plans, which can serve as an alternative to a concentrated internal transition.Establishing an Employee Stock Ownership PlanESOPs are a proven vehicle of ownership transfer. They can provide for either an incremental or a turnkey ownership transfer. They also facilitate the opportunity for legacy owners to continue contributing to the stability and success of the business while allowing employees to reap the rewards and benefits of capital ownership.Assessing the feasibility of an ESOP requires the advisory support of experienced financial and legal professionals who help ensure that best practices are implemented and that compliance awareness governs the transaction. To that end, owners contemplating an ESOP need to be keenly aware of the importance of following a well-designed process that satisfies the requirements of the Department of Labor and adheres to governing rules and regulations.As a qualified retirement plan subject to regulations set forth by ERISA (Employee Retirement Income Security Act), ESOPs are regulated using strict guidelines for process, fairness, and administration. Accordingly, the entire life cycle of a contemplated ESOP needs to be studied in a process generally referred to as an ESOP Feasibility Study. Valuation, financing, plan design, plan administration, future repurchase obligations, and many other concerns must be assessed before venturing down the ESOP path.In function, the establishment of an ESOP includes the creation of an ESOP trust, which, using one of many possible transaction structures, becomes the ultimate owner of some or all of the stock of the sponsoring ESOP company. ESOPs are unique in being the only qualified retirement plans allowed to use debt to purchase the shares of the employer corporation.Once an ESOP is in place, the qualifying employee participants are allocated interests in the trust annually according to the Plan’s design. As employees cycle through their employment tenure, they trigger milestone events that allow for the effective sale of their accumulated ownership positions, providing a nest egg for retirement.During their tenure of employment, the employee’s account is mostly concentrated in company stock, the valuation of which determines the amount they receive when nearing and eventually reaching retirement age. The stock accumulated during active employment is converted to cash and the plan shares are either redeemed or recycled to perpetuate the ESOP.There are certain tax-related and transaction design features in an ESOP transaction that can benefit sellers in numerous different ways. Sellers in ESOP installations must understand the necessary complexities and nuances of a well-run ESOP transaction. Sellers lacking the patience and gumption for an ESOP process or those who require turnkey liquidity in their ownership exit should likely consider an alternative liquidity strategy.External SaleIn general, the ability to sell your business to an external party yields the highest proceeds. If you have succeeded in creating a sustainable business model with favorable prospects for growth, your business assets may generate interest from both strategic and financial buyers.The Strategic BuyerA strategic buyer is usually a complementary or competitive industry player within your markets or looking to enter your markets.Strategic buyers can be generally characterized as either vertical or horizontal in nature. Such buyers are interested in the natural economies of scale that result from an expanded market area (cost and operational leverage in our terminology) and/or from specific synergies that create the opportunity for market and financial accretion (think 1 + 1 = 3).There is a good chance that a potential strategic buyer for your business is someone or some group you already know. Such buyers don’t require the full ground-up familiarization process because they are already in tune with the risk and growth profiles of the business model. Accordingly, owners interested in a turnkey, walk-away sale of their business are often compelled toward a strategic buyer since strategic buyers can quickly integrate the seller’s business into their own.The moving parts of transaction consideration paid by strategic buyers can cover a broad spectrum. We see simple, nearly 100% cash deals, as well as deals that include various forms of contingent consideration and employment/non-compete agreements.Most sellers in strategic deals are not inclined to work for their buyers other than in a purely consultative role that helps deliver the full tangible and intangible value the buyer is paying for. In many cases, strategic buyers want a clean and relatively abrupt break from prior ownership in order to hasten the integration processes and cultural shift that come with a change in control.Additionally and/or alternatively, strategic deals may include highly tailored earn-outs that are designed with hurdles based on industry-specific metrics. In general, earn-outs are often designed to close gaps in the bid/ask spread that occur in the negotiation process. These features allow sellers more consideration if post-transaction performance meets or beats the defined hurdles and vice versa. Sellers must be aware of the sophisticated means by which larger strategic buyers can creatively engineer the outcomes of contingent consideration.In certain industries strategic buyers may structure consideration as part cash and part or all stock. Sellers in the financial sector are often selling equity ownership as opposed to the asset sales that dominate most non-financial sectors. In such deals, sellers who take equity in the merged entity must be cognizant of their own valuation and that of the buyer. The science of the exchange rate and the post-closing true-ups that may apply are areas in which sellers should seek skilled professional advisory guidance.The Financial BuyerFinancial buyers are primarily interested in the returns achieved from their investment activities. These returns are achieved by the conventions of 1) traditional opportunistic investment and 2) by means of sophisticated front-end and back-end financial engineering with respect to the original financing and the subsequent re-financings that often occur.Most traditional buy-out financial investors are looking to satisfy the specific investment criteria of their underlying fund investors, who have signed on for a targeted duration of investment that, by nature, requires the financial investor to achieve a secondary exit of the business within three to seven years after the original acquisition (the house flipping analogy is a clear but oversimplified one). Financial investors may have significant expertise acquiring companies in certain industries or may act as generalists willing to acquire different types of businesses across different industries.In general, there are three types of financial buyers:Private Equity Groups or other Alternative Financial InvestorsPermanent Capital ProvidersSingle/Multi-Family Offices Despite their financial expertise, financial buyers usually do not have the capacity or knowledge to assume the management of the day-to-day operations of all of their business investments. As such, the seller’s management team at the time of a sale will likely remain involved with the Company for the foreseeable future. A sale to a financial investor can be a viable solution for ownership groups in which one owner wants to cash out and completely exit the business while other owners remain involved (rollover) with the business. With respect to work force and employee stability, financial investors will ultimately seek maximum efficiency, but they often begin the process by making sure they secure the services of both frontline and managerial employees. In many cases, the desired growth of such investors can bolster the employment security of good employees while screening out those that resist change and impede progress. The value of the assembled workforce is becoming a more meaningful asset to prospective buyers in the marketplace, whether they be strategic or financial in nature. Further, larger acquirers often can present employees with a more comprehensive benefit package and enhanced upward mobility in job responsibility and compensation. All this said, financial investors will ultimately seek to optimize their returns with relentless efficiency. Lastly, as the financial buyer universe has matured over the past 20+ years, we have witnessed directly that many strategic consolidators are platform businesses with private equity sponsorship, which blurs or even eliminates the notion of a strictly strategic or financial buyer in many industries.ConclusionAn outside buyer might approach you with an offer that you were not expecting, you and your partners might decide to put the business on the market and seek offers, or you and your partners might opt for an internal sale. Whatever the case may be, most owners only get to sell their business once, so you need to be sure you have experienced, trustworthy advisors in your corner.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries.Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor to inform sellers about their options and to encourage market-based decision making that aligns with the personal priorities of each client.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help you manage the transaction process.

Pioneer Natural Resources Pay to Play

A Tale of Two Transactions

As noted in our June 2021 blog post covering Permian M&A activity, M&A transactions picked up in the twelve months ended mid-June relative to the twelve-month period preceding it. Perhaps more importantly, there seemed to be an inflection point in transaction multiples that hinged around the U.S. elections in November 2020.Among all the transactions that occurred over this period, one pair jumped out involving a common buyer and for which valuation metrics were available. These related to Pioneer’s acquisition of Parsley Energy in October 2020 and DoublePoint Energy in April 2021, with implied transaction metrics well above the average and median values in the the respective sub-periods of the reviewed period. Statistics of the valuation metrics for the transactions occurring between mid-June 2020 to mid-June 2021 and the bifurcated sub-periods, both including and excluding Pioneer transaction data, are as follows:Click Here to Enlarge the ImageWe note that, as compared to the transactions table in the aforementioned Permian M&A activity blog post, the transaction counts and statistics presented exclude four transactions for which acquired assets were working interests, as opposed to a property or corporate acquisition. We also note that only one of the four excluded transactions involving the acquisition of a working interest had any useful transaction data available, and the metrics for this one transaction tended to be outliers (on the high side) in the context of the full set of transactions.Tech talk aside, the main point here is Pioneer consistently paid top dollar for its acquisitions from the perspective of the transactions’ valuation metrics. Why?Easy Answer: Pioneer Is a Large Strategic BuyerIn Pioneer’s October 2020 press release covering its acquisition of Parsley Energyand April press release for its acquisition of DoublePoint Energy, the strategic nature of the acquisitions was cited. Prominent in both releases was mention of significant synergies and “unmatched scale” with respect to Pioneer’s footprint in the Permian play.Regarding the Parsley acquisition, Pioneer’s President and CEO, Scott D. Sheffield, stated, “This combination is expected to drive annual synergies of $325 million and to be accretive to cash flow per share, free cash flow per share, earnings per share and corporate returns beginning in the first year.…” It was further noted that, “The combined company will be the leading Permian independent exploration and production company with a premium asset base of approximately 930,000 net acres [representing an approximately 37% increase over its pre-transaction net acreage] with no federal acreage and a production base of 328thousand barrels oil equivalent per day (“MBoepd”) and 558 MBoepd as of the second quarter of 2020. Additionally, based on year-end 2019 proved reserves, this transaction will increase Pioneer’s proved reserves by approximately 65%.”Similarly, synergies were noted in the DoublePoint acquisition, including expectations annual cost savings over the next 10 years of $175 million, stemming from increased operational efficiencies and reduced G&A and interest expenses, with a total present value of savings of approximately $1 billion. This transaction also expanded Pioneer’s Permian footprint by an additional 97,000 net acres to over 1 million total net acres in its core Permian position. This addition implies an increase of 10% over its 930,000 total net acreage holdings following the Parsley Energy acquisition, and further fortifies the company’s position as a premier Permian E&P operator.While the strategic argument makes sense fundamentally, arguably any transaction involving an existing E&P company entering or expanding their presence in the Permian could be deemed a “strategic” acquisition. Let’s dive a little deeper into the numbers behind Pioneer’s acquisitions to see if there may be another differentiating factor.Deeper Answer: Production DensityIn our analysis of Permian M&A activity over the past twelve months, we presented deal values and valuation metrics such as deal value per acre and per production (Boepd). As might be gleaned from those metrics, our data set included the net acreage and production values associated with the acquisitions, though these specific data points were not presented outright.Utilizing the full set of data to examine the transactions, we developed and reviewed certain indicators beyond the presented valuation metrics. In particular, we calculated the implied annual production (total implied Boe) per acquired acre for each transaction. We’ll refer to this as “production density.” The following table presents the full data set which will be referenced:Click Here to Enlarge the ImagePioneer’s acquisition of Parsley Energy indicated a production density factor of 267 Boe/acre. Among the six transactions that occurred from July to October 2020, this was the second highest value, being only 7 Boe/acre lower than the highest indicated value implied by the Devon Energy-WPX Energy transaction. Conversely, this production density factor of 267 Boe/acre was 26% greater than the next highest factor of 212 Boe/acre implied in the ConocoPhillips acquisition of Concho Resources, which was announced the day prior to the Parsley acquisition announcement.Among the transactions announced from November 2020 through mid-June of this year, the production density factor of the Pioneer-DoublePoint Energy acquisition was 376 Boe/acre, which was just over 13% higher than the production density of the next highest value of 332 Boe/acre implied by the Vencer Energy-Hunt Oil acquisition, and was the highest value among all the acquisitions in the Permian listed over the full 12-month period ended mid-June.ConclusionIn our prior analysis of Permian M&A activity from mid-June 2020 to mid-June 2021, several points came to light:Transaction multiples appeared to have an inflection point, with significantly lower multiples indicated from the transactions announced after October 2020 relative to the indicated multiples for transactions announced prior to November 2020.Given the publicly available information, Pioneer was the only buyer in both sub-periods noted (for which useful transaction data was available).The transaction multiples stemming from the Pioneer acquisitions were among the highest, if not the highest, in the respective sub-periods, making them among the highest multiples for the entire 12-month period reviewed. While commodity prices could have been a factor, we note that WTI futures as of April 2021 were, on average, 30% higher than WTI futures as of October 2020 when looking at a 12-month span consecutively for nine annual periods that followed the respective measurement dates. On one hand, this could be interpreted to mean that valuations should have been greater in the latter sub-period (with higher futures prices). On the other hand, the higher prices in the future might have been indicative of uncertainty regarding the Biden Administration’s rhetoric and possible actions that would more than likely prove to be headwinds to the oil and gas industry overall. Commodity prices notwithstanding, the data available and subsequent information gleaned from it suggest Pioneer was able to act on two prime opportunities that would further enhance the quality of its acreage and production portfolio. We have assisted many clients with various valuation needs in the full stream of the oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

RIA M&A Q2 Market Update

Whispered Numbers Shout

RIA MIA activity slowed somewhat in the second quarter of Q2, but RIA markets are still on track to record the highest annual deal volume on record.In the latest RIA M&A Deal Report, Echelon Partners attributes the pace of RIA M&A to (1) secular trends, (2) supportive capital markets, and (3) potential changes in tax code in the future. As we discussed last quarter, fee pressure in the asset management space and a lack of succession planning by many wealth managers are still driving consolidation. But the increased availability of funding in the space, in tandem with more lenient financing terms, has also caused some of this uptick. Further, the Biden administration’s proposal to increase the capital gains tax rate has accelerated some M&A activity in the short-term as sellers seek to realize gains at current tax rates. But could some of this activity be attributable to the RIA rumor mill and the hype of double-digit multiples in the space? He Says, She Says … "They sold their firm for 12x"Although there are over 13,000 RIAs in the U.S., during times like these, the investment management world feels pretty small. Word travels far and fast, and often with minimal detail.Clients have been asking us about double-digit deal multiplesOver the last few months, more of our clients are asking us about double-digit deal multiples and many owners of small firms are understandably confused when they see our comparably lower indications of value.So how does all this transaction activity affect valuations?Guideline Transaction MethodAs independent valuation analysts, we are tasked with finding market transactions of privately held companies in the same or similar business that may provide a reasonable basis for valuation of the company we are valuing. Market transactions are used to develop valuation indications under the presumption that a similar market exists for the subject company and the comparable companies. Activity and earnings multiples developed using the market transactions method are used to capitalize appropriate estimates of AUM, revenue, and earning power for the subject company.In most of our valuations of investment management firms, we seek perspective on the M&A market’s pricing of closely held investment management firms by evaluating transactions involving acquired U.S.-based investment management firms with between $1 billion and $25 billion of AUM. However, given the lack of publicly available information for transactions in the industry, the data from guideline transactions has limited significance for making inferences.Even when deal multiples are “known,” they can be misleadingEvery transaction has different motivators that affect the buyer’s willingness to accept a certain price and the seller’s willingness to pay up. Most RIA transactions include some form of earnout, which can skew the implied deal multiples. And more frequently, deals include some form of an earn-more consideration that may or may not be reasonable to include when calculating implied deal multiples.Even when deal multiples are “known,” they can be misleading. A transaction priced at, say, nine times pro forma earnings – with normalized compensation, back-office synergies, anticipated changes in fee schedules, and other adjustments – might also be viewed as fifteen times earnings, as reported. So, is the deal multiple nine or fifteen?RIA buyers are, for the most part, very sophisticated, and not disconnected from realityUnfortunately, there is a perverse incentive to talk about the higher multiple. Sellers want to brag about how much they got. Buyers want to be seen as the most generous to attract other sellers into the process (reality can wait until after the LOI is signed). And in a market with surplus of buyers, intermediaries (the investment bankers), naturally, want to encourage sellers however they can.Don’t get us wrong, the RIA market is very strong, and multiples are very high. But RIA buyers are, for the most part, very sophisticated, and not disconnected from reality.Much of the confusion we see in expectations is being fueled by dozens and dozens of deal announcements with undisclosed terms. In the absence of real information, imagination fills the void. Although we have knowledge of the pricing of many undisclosed deals, we can’t directly rely on this information in a business Appraisal (with a capital “A”) – as it doesn’t constitute known or knowable information to hypothetical buyers and sellers. But all this transaction activity and the increase in observed deal multiples has, nonetheless, impacts investment management valuations. This conflict between publicly available pricing information and rumored deal multiples makes it even more important to hire a valuation firm experienced in this space.There is no argument that multiples across the investment management space have increasedBecause reliable guideline transaction information is scarce, it is essential to build the factors driving the volume of transaction activity and heightened pricing into projections and the cost of capital. Improved equity markets have been driving AUM growth. The inherent operating leverage in the business along with the realization over the last year that RIAs can operate just as efficiently with less or cheaper office space, is driving margin expansion. While it is harder to model increased demand for these businesses into a discounted cash flow model, it can serve to minimize risk and reduce discount rates. Overall, these changes to valuations are generally more subjective.But there is no argument that multiples across the investment management space have increased. As our president, Matt Crow, has said before about RIA transaction multiples, “an option has value, even if you don’t exercise it.”

June 2021 SAAR

The June 2021 SAAR totaled 15.4 million units, which is up 12.4% compared to June 2020 (the lowest June figure in recent memory due to the COVID-19 pandemic) but down 9.9% from May 2021. New light vehicles sales fell for the second straight month in June, highlighting the ongoing supply and demand imbalances in the market for new cars and trucks.After a strong start to the year, driven by feverish demand from retail and fleet consumers, a shortage of new car and truck inventory has started to weigh on sales. The Inventory to Sales Ratio, published along with SAAR, continues to fall, as seen in the graph below. This ratio captures what many auto dealers already know: demand has been strong and supply chain issues have not gotten any better. With such strong demand intersecting low supply, many vehicles are selling at or above MSRP. According to J.D. Power, in mid-June, 75% of vehicles sold for MSRP or above, up from 67% in May 2021 and up even more from the pre-COVID-19 pandemic average of 36%. SAAR ran hot from 17.0 million to 18.6 million from March to May this year, making supply even shorter. Inventories have plummeted as dealers are not able to replenish their lots. While this has led to lower floor-plan costs and higher GPUs, the decline in SAAR in June shows dealers may finally be experiencing what people were concerned about. Business owners can draw down inventories to maintain sales levels, but eventually, those inventories will run out. Lower inventory levels are expected to continue to limit the sales pace of dealers around the country. Microchip Issues PersistAccording to the NADA, the inventory crunch is likely to get worse before it gets better. Average inventories are expected to remain flat in June compared to May at around 1.5 million units, before dropping again to around 1.3 million units by the end of July. Microchip shortages continue to plague the industry and are a predominant factor in the slowdown, though dealers have noted other parts and areas of vehicles are in short supply as well. With little to mitigate the situation on the horizon, it has become clear that this shortage will impact the manufacturing of new vehicles for months to come. This chip shortage is not unique to the United States or to the Automotive industry, as Automotive News Europe recently reported that the “exponential increase in demand for microchips will need a long term solution.”We note the “end” to the microchip shortage continues to be kicked down the roadMany sovereign governments are considering taking steps to increase production, as the number of industries that require microchips continues to grow. Economic agents are considering economy-wide solutions to this sweeping problem, but relief is not expected until sometime in early 2022. Until then, dealers will most likely have to continue to operate at lower-than-normal inventory levels or focus on vehicles that utilize less chips. We note the “end” to this shortage continues to be kicked down the road, so even the expectation this situation will be alleviated in early 2022 may not comfort dealers that have seen expectations continue to get pushed out.Several U.S. automotive manufacturing plants have had to suspend operations in response to the chip shortage. For example, the Ford plant in Chicago that produces the Ford Explorer will be shut down from the week of July 5th to the week of July 26th. Additionally, the Ford plant in Kansas City that produces the best-selling F-150 pickup truck announced it will be shuttering the production line for a few weeks in July as well. Ford’s Michigan assembly plant that recently started shipping the Ford Bronco will also be down for two weeks in July due to parts shortages. These shutdowns are not specific to Ford, as most auto manufacturers have been trying to find ways to react to the ongoing situation.It’s Not Just Microchips Many automotive plants have temporarily shut down due to the microchip shortage, but microchips are not the only input that has been scarce. Seating foam, plastics, and other petroleum-based products have been harder to acquire over the last several months due to longer lead times on orders, historically high prices, and very tight supplies.According to Industrial Specialties Manufacturing, the market is currently unable to supply the U.S. demand for plastics. Experts say that the complete restoration of the plastics industry could come in late 2021 or early 2022, but certain factors must be in play for this recovery to occur, like repairing oil and gas infrastructure, returning to normal volumes of chemical feedstock for plastics production, and repairing plastics compounding and extruding machinery in plants that have yet to ramp up to full production capacity.Used Vehicles In High DemandWhile the story surrounding new cars and trucks has been characterized by supply constraints over the last two months, used cars have stepped into a more prominent role at most car lots to fill this gap. Pent up demand for new cars is pushing car buyers into the used-car market, driving up prices of used cars in the process. Edmunds reported that the average price for used vehicles jumped from $20,942 to $25,410 from this point last year, the highest price jump on record for the auto research firm. This has had ripple effects throughout the economy.Edmunds reported that the average price for used vehicles jumped from $20,942 to $25,410 from this point last yearThe Consumer Price Index jumped 5.4% in June, stoking concerns about runaway inflation. However, the Federal Reserve has maintained its view that inflation is transitory, which appears to be supported by the significant year-over-year increases in used vehicles, gas, and airfare, which have played a large role in the jump in CPI. Excluding these, month-over-month core CPI would have only risen by 0.18% in June according to Bank of America.Used vehicle prices have climbed at a steep pace due to similar supply and demand-related pressures as the new car market, with scarcity issues coming in the form of hotly contested wholesale markets where dealers typically acquire most of their used inventory. Dealers are being forced to spend more to fill their lots with used vehicles, making it harder for buyers to negotiate on used car prices than in the past. Jonathan Banks, Vice President of Valuation Services at J.D Power had this to say about the used market:"After increasing for 24 consecutive weeks, wholesale auction prices peaked in June, attaining their highest level on record, and have now begun to gradually decline. Despite the recent cooling, the used market remains incredibly strong and, at the end this year, prices are expected to be up by approximately 29% on a year-over-year basis. The used market’s continued strength is driven primarily by the expectation that used supply will remain a challenge and that new-vehicle market challenges will remain in place for the foreseeable future."What Forecast to ExpectAfter an unusually hot start followed by a tightened market environment, this year has been unpredictable for dealers and manufacturers in the automotive industry. As far as demand is concerned, it is unlikely that the desire for new and used vehicles will cool off any time soon, as many consumers return to work and may be in search of a new or used vehicle to get them there. However, new light vehicle sales for the remainder of the year will likely continue to be supply-constrained. If production can recover and exceed expectations, we could see sales close to 17 million units by the end of the year. However, given the more likely outcome, total light vehicle sales are expected to be somewhere between 16.3 and 16.5 million units in 2021.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

A (Not So) Bold Prediction

The Rise of Non-Family Equity Capital in Family Businesses

The rise of the family office has been one of the most significant themes in family enterprise over the last decade. Looking forward, we believe that the number of family businesses raising non-family equity capital will grow dramatically in coming years.We don’t think we are going too far out on a limb with this prediction. In this post, we take a quick look at the growing supply of capital seeking minority investments in family businesses, the sources of growing demand from family businesses for such investment capital, and how directors can best position their family businesses to thrive.Growing SupplyWith an abundance of dry powder to invest, private equity firms are increasingly willing to acquire non-controlling stakes in family businesses. Governance and exit mechanisms vary, but more and more PE investors are willing to ride in the passenger’s seat rather than the driver’s seat.Family offices also represent a growing source of capital for family businesses. Following the old investment adage of “Invest in what you know,” some enterprising families seek to diversify their portfolios by acquiring minority stakes in other family businesses.Finally, in last week’s post, we commented on Amazon’s strategy in acquiring equity warrants for minority investments in suppliers. While we focused on the issue of customer concentration in that post, it is also an example of strategically motivated capital available to family businesses.Growing Demand?But will there be demand for the supply of non-family equity capital? For decades, many families have perceived a stigma to using non-family equity capital. What factors could cause that stigma to fade?We sense an increasing willingness to consider using non-family equity capital in our discussions with clients. This inclination seems to be especially pronounced among shareholders in the third and subsequent generations. Among those members of the family, we find more of a tendency to evaluate risk and return from the family business in the context of other investment alternatives. In other words, many shareholders want to treat the family business as an important part of their personal portfolios but are not enthused about having all their investment eggs in the family business basket.These family shareholders tend not to be enamored by either of the traditional family business capital management strategies: (1) constrain growth to that which is supportable by retained earnings, or (2) rely on periodic "bet the farm" debt levels to fund more aggressive growth plans. Using non-family equity capital opens a third path along which businesses can grow without starving family shareholders of current income or using uncomfortable levels of debt financing.Finally, given the challenges of managing family dynamics, the need to prune the family tree of unaligned shareholders will probably never go away. Exchanging Uncle Joe for a non-family equity investor can ease family tensions without adding to the financing constraints facing the managers of the family business.Questions for Family Business Directors to ConsiderWhat questions should family business directors begin asking themselves about this trend? Let us suggest five:Where is your family business going? What is your strategy for meeting the challenges and opportunities that are likely to arise in your industry? If long-term sustainability and family control is your goal, what should your family business look like in ten years?What is the return profile of your family business? Investment returns come in two – and only two – forms: current income from dividends and capital appreciation. What mix of these return components are you providing to your family (or prospective) shareholders? How do those return components compare to other investment alternatives available to your shareholders?Who should own your family business? Your current shareholder list is likely of function of time and chance more than intention. If you could start from scratch today, who would your family shareholders be, and why? Are some of your existing family shareholders a better fit for the return profile of your family business than others?How will investors value your family business? What are the expected cash flows, risk factors, and growth prospects that are relevant to your existing shareholders? To a potential equity investor? Remember that your family business has more than one value.When will your family business need outside capital? For many years, our colleague, Chris Mercer, has been asking, “Is your business ready for sale?". Opportunities often arise unexpectedly, and Chris’ point to business owners is that there are significant benefits to being ready to sell even when you don’t intend to do so. The same idea applies to family businesses that may need outside capital: the time to prepare for that day is now. We don’t make a lot of predictions here at Family Business Director, but the growing use of non-family equity capital in family businesses is one that we are confident making. Family business directors would do well to begin thinking about how to leverage this trend to their benefit. Look for more on this trend in future posts.

Does Vine Debut Portend Ripe Market for More E&P IPOs?

It’s been tough out there for equity capital markets bankers covering the upstream sector. Since 2016, there have only been five U.S. exploration & production company IPOs. [1] The dearth of activity is driven by a number of factors, including poor historical returns from the space, special purpose acquisition companies (SPACs) supplanting the traditional IPO process, and environmental, social, and governance (ESG) pressures resulting in less capital availability. Three U.S. E&P IPOs took place in late 2016 and early 2017. Berry Petroleum, a California producer focused on conventional production methods, went public in mid-2018. Nearly three years would pass until the next IPO: Vine Energy. Vine IPOVine Energy, a pure-play Haynesville gas producer, broke this nearly three-year dry spell with their IPO in March of this year. However, Vine had a rough start as a public company. The IPO priced at $14 per share, below the anticipated offering price of $16 to $19 per share indicated in Vine’s S-1. Once trading began, there was no typical IPO pop, as the stock opened at $13.75. The stock continued to trade down over the next several weeks, closing below $11 in mid-April. However, Vine’s stock price performance since the nadir has been relatively strong. The stock price rose to almost $16 in late June, up more than 44% from its low. Overall, the stock is up 8% from its IPO price, outperforming the broader E&P sector (as proxied by XOP, the SPDR S&P Oil & Gas Exploration & Production ETF), though still lagging the S&P 500. Are More E&P IPOs Coming?While we don’t have a crystal ball, there several are factors that could lead to additional E&P IPOs over the next several years.Restraint Leading to Returns: E&P companies were maligned for a “drill, baby, drill” mentality which led to huge amounts of capital being deployed to generate suboptimal returns. However, they seemed to have learned their lesson and are now showing capital discipline, even in light of a much-improved commodity price environment. The result is that shale drillers are actually delivering free cash flow. That appears to be impacting stock prices, as the year-to-date performance (through 7/13/2021) of XOP has trounced the S&P 500 (shown in the following chart). If this performance holds, investors who previously shunned the industry may begin dipping their toes back in with increased allocations to the sector.Need for Private Equity to Exit: Between 2015 and 2019, private equity funds raised approximately $86 billion of capital to deploy on U.S. oil & gas assets. However, that capital raising has slowed, and traditional oil & gas PE sponsors (including Riverstone, EnCap, and NGP) have begun focusing on energy transition investments. With less private equity capital in the ecosystem, and public E&Ps showing restraint with respect to capital spending, public markets may be the best exit opportunity for certain larger PE-backed companies. It Might Be Another Long Dry Spell Before We See Another E&P IPOLack of Public S-1 Filings: The IPO process is an involved and lengthy affair. One of the first steps required to go public is filing an S-1, which is the initial registration form for new securities required by the SEC. The S-1, which is usually filed well in advance of an actual public offering, describes the company’s operations and includes financial information. According to data from Capital IQ, there do not appear to be any U.S. E&P companies with active registration statements for material sized (>$50 million) offerings. The most recent S-1 filings for uncompleted offerings are from Tapstone Energy and EnVen Energy Corporation. However, both of those registration statements have been withdrawn. With no E&P companies currently teed up to go public, it will likely be a while before one makes it through the process.Less Need for Growth Capital: As previously discussed, with many shale drillers generating free cash flow, there is less need for growth capital to support operating activities. As such, private operators may eschew the scrutiny and pressure of public markets and remain private.Continued ESG Pressures: With increasing emphasis on ESG issues, it could be challenging to generate the typical level of investor appetite necessary to successfully execute an IPO, especially among large institutional investors who typically anchor many IPO processes.SPAC Alternative: SPACs have emerged as a viable alternative to the traditional IPO process. Several E&P companies were early adopters of SPACs as a means to go public, including Centennial, Alta Mesa, and Magnolia. While many energy-focused SPACs indicate that they are seeking opportunities in the energy transition space, there are a handful that may be seeking to acquire E&P companies.ConclusionVine’s public market debut brought an end to a long-running drought of E&P IPOs, though it may be more of an anomaly than a harbinger of things to come. With no public S-1 filings among upstream energy companies and continued investor focus on ESG issues, we don’t expect to see any new public E&P companies any time soon.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.[1] We note that there have been other upstream companies that have gone public via a SPAC (e.g., Centennial, Alta Mesa, and Magnolia) as well as mineral-focused companies that have had traditional IPOs (e.g., Brigham Minerals and Kimbell Royalty Partners). However, this post is focused on traditional IPOs of exploration & production companies.

Asset / Wealth Management Stocks See Another Quarter of Strong Market Performance

Publicly Traded Asset / Wealth Managers See Continued Momentum Through Second Quarter as Market Backdrop Improves

RIA stocks continued to have strong performance during the second quarter, with most individual stocks in our indices hovering near 52-week highs today. Performance varied by sector, with alternative asset managers faring particularly well over the last quarter. Our index of alternative asset managers was up 26% during the quarter, reflecting bullish investor sentiment for these companies based in part on long-term secular tailwinds resulting from rising asset allocations to alternative assets. The index of traditional asset and wealth managers rose 15% during the quarter, with performance driven by rising AUM balances and favorable market conditions. The stock price performance of RIA aggregators trailed other categories, with the aggregator index increasing only 6% during the quarter. Weak relative performance for the RIA aggregators may be reflective of mixed investor sentiment towards the aggregator model.While the opportunity for consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising competition for deals and high leverage at many aggregators which may limit the ability of these firms to continue to source attractive deals. The upward trend in publicly traded asset and wealth manager share prices over the last quarter is promising for the industry, but it should be evaluated in the proper context. Many of these public companies continue to face headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded asset managers, while larger scaled asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance during the second quarter was generally better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts. As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class. LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first and second quarters last year—reflecting the market’s anticipation of lower earnings due to large decreases in client assets attributable to the overall market decline. Multiples have since recovered as prospects for earnings growth have improved with AUM balances. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Many smaller, privately held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Like the public companies, value likely declined during the first quarter of last year, but these were largely paper losses (not many transactions were completed based on value during the height of the downturn). Likely, not more than a quarter or two of billing was impacted last year by the market downturn. Since then, revenue and profitability have recovered rapidly, and value has likely improved as well similar to the publicly traded asset/wealth managers.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are somewhat tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. With markets near all time highs, most RIAs are well positioned for strong financial performance in the back half of the year.

The Electric Vehicle Race

Tesla vs. Everyone

Is Tesla’s Grip On the EV Market as Iron Clad as It Once Seemed?Electric vehicles have continued to gain momentum, forecasted to reach 3.55% of the U.S. market share of total vehicles by the end of this year. While this is still a relatively small portion of total auto sales, manufacturers continue to invest in their electric technology to prepare for a future in which electric vehicles may be the norm. When you think “electric vehicles,” there has been one brand that has established itself as a clear leader: Tesla. Elon Musk, Tesla CEO, when he’s not tweeting about Dogecoin or other memes, is solidifying the company as the go-to manufacturer for electric vehicles. According to data from Experian, Tesla accounted for 79%of U.S. EV registrations in 2020, with 200,561 of its electric battery operated vehicles registered. This is an increase of 16% from 2019 when owners registered 172,438 Teslas. Tesla has dominated the industry, with the three highest selling EV models since 2018 as seen in the graph below. Tesla’s Model 3 alone has more sales than all the other electric vehicles combined and when you consider the Model S and the Model X, there have been three times more Tesla vehicles sold than the trailing top 5 competitors. While Tesla’s dominance in the U.S. is clear, the graph below helps illustrate that Tesla’s lead may not be as iron clad as it once was when looking at market share on a year-to-year basis. Tesla’s Model 3 has been losing market share since 2019, largely attributable to the influx of new EV options in the marketplace. In 2021, Model 3 market share is anticipated to drop even further, with expected new EV options diluting the market. With more auto groups intent on gaining a slice of the pie, competition is expected to continue to steepen going forward. CompetitorsWho is challenging Tesla in the EV space? We have laid out the top competitors:VolkswagenAfter half a million diesel Volkswagen models were cited for violations in the 2014 emissions scandal, the company is clearly trying to clean up its image. One way they are doing this is in electric vehicle initiatives. In 2020, the brand delivered nearly three times as many pure-electric vehicles as they did the year before, up to 134,000 electric vehicles and 212,000 electrified cars in total worldwide. By 2030, the company hopes that their fully-electric vehicles will account for more than 70% of the brand’s European sales and a market share of over 50% in U.S. and China.Deutsche Bank analysts have bullish predictions for Volkswagen. As a team of analysts led by Tim Rokossa noted that with a new target for electric vehicles of 1 million this year, the majority of which will be electric battery vehicles, the German automobile maker should come “very close to Tesla’s battery electric vehicle sales.” Volkswagen is already taking a lead in European markets, as they accounted for more than 22%of the market shares after 10,193 vehicles were registered. This compares to Tesla’s market share in 2020 of only 13% across the pond. Looking forward, Volkswagen’s ability to convert customers in the U.S. market will be crucial in gaining market share.StellantisLike Volkswagen, Stellantis presents a substantial threat to Tesla’s electric vehicle dominance in the United States after it has performed impressively in Europe. The world’s fourth largest car maker’s electric vehicle share accounts for nearly 17% of the market share in Europe, trailing only Volkswagen. The company announced last Thursday that it would invest more than $36 billion through 2025 as a plan to accelerate in the EV race. The company had already announced in April that they set out targets to offer an electrified version of nearly 100% of its models by 2025. With this investment initiative is the bold plan of targeting 70% of European sales and 40% of U.S. sales coming from low emission vehicles by 2030. The company has significant ground to make up in the U.S. markets in order to achieve this goal, and like Volkswagen, will need to focus efforts on conversion in this market.FordFord’s sales of EVs expanded 117% in June, reaching a new first half sales record of 56,570 vehicles. Behind these figures were the success of Ford’s fully electric Mustang Mach-E and F-150 PowerBoost Hybrid. More importantly than just the recent increase is the fact that 70% of customers who bought the battery electric SUVs are new to Ford, meaning the additions may be helping them to capture market share.Ford’s ability to produce an electric pick-up, the F-150 Lightning Electric truck, makes them dangerous in a U.S. auto market driven by light truck sales (light trucks accounted for 75.9%share of U.S. auto sales in 2020). With Ford having thesecond largest total vehicle market share in the U.S., trailing only GM, their ability to convert current users of their traditional vehicles to electric will be just as important as gaining new customers in expanding their EV market share reach.General MotorsThe largest auto manufacturer of traditional vehicles in the U.S. is hoping to have success in the EV space as well. The Chevy Bolt has the highest number of sales in the U.S. of non-Tesla brand vehicles. Additionally the company has committed to becoming an all-electric vehicle company by 2035, meaning there is significant investment in this business line that is occurring. The company is also hoping to cut costs through making their own battery cells through a joint venture with LG Chem in Ohio. A facility is under construction and expected to be completed by 2022. Like Ford, a key component in gaining electric vehicle market share will be converting some of their current users of traditional vehicles.Batteries Are KeyDespite the encroachment of other traditional OEMs on Tesla in the EV space, the hurdle that they will have to overcome to catch up lies in one specific part of the vehicle: the battery. It is currently a race to the bottom, with the battery costs in an electric vehicle being a primary reason that electric vehicles continue to be pricier more costly than traditional vehicles. However, this price has been dropping, with Tesla leading the way. Tesla has managed to drop their cylindrical cell battery pack down to around $150 per kWh last year, nearly an 87% decline from 2010 as seen in the graph below: Tesla is the only automaker to use this type of cylindrical battery cells in its battery pack. Its competitors, like those discussed above, use battery packs containing pouch or prismatic battery cells. According to Cairn, these cost on average more than $200per kWh in 2019. Automakers are aware that even though they are throwing billions of dollars at batteries and EV production, Tesla’s lead on the technology of these vehicles is undeniable. Colin Rusch, auto analyst for Oppenheimer notes, “At core there is really incredible battery technology within the organization and that is material science that they have been working on for well over a decade. We think they have some substantial advantages on that.” Tesla competitors eager to get the edge on the EV giant will have to continue to invest in their battery technology in order to drive down prices. The Real WinnersThough uncertainty remains surrounding whether or not Tesla will be dethroned in the U.S. EV space, there is one clear winner among all of this investment and competition: the consumer. More investment into EV technology and competition between brands means that electric vehicles likely will become more readily available to car buyers at more affordable prices. While Tesla is the largest player in the U.S. market, their image of luxury vehicles prevents many people interested in electric from joining the market. Larger offerings of mass market vehicles will help to show the true demand that is there for these types of cars and trucks.Additionally, auto dealerships also stand to benefit from this push. With two thirds of car consumers interested in electric vehicles, they may present a unique opportunity for dealerships particular those whose OEM is able to produce the most attractive models. However, there are some concerns about how EV’s will affect the bottom line on the service portions of the business. A 2019 reportfrom AlixPartners estimates that dealers could see $1,300 less revenue in service and parts over the life of each EV they sell. If electric vehicles ultimately gain the market share that they are anticipated to, dealerships may need to become more savvy in mitigating these service and parts revenue declines. Like NADA, we remain bullish on the role of auto dealerships in the EV sales process despite concerns regarding direct-to-consumer sales channels from the OEMs. Additionally, dealership owners have expressed some concern over how OEMs will handle the EV units from their traditional dealership models. If OEMs continue to allocate units to each dealership, this presents an opportunity. However, if they instead follow Tesla’s lead and adopt a more direct to market approach to selling new units, this may pose a problem for dealerships.If you would like to know more about the electric vehicle industry and what this all may mean for your auto dealership, feel free to reach out to anyone on Mercer Capital’s Auto Team.

Customer Concentrations and the Value of Your Family Business

With a new CEO ascending to power and an old CEO ascending to space, there has been no shortage of Amazon-related headlines this week. But amid the leadership transition news, a less-prominent Amazon story is equally relevant to family business directors. AWall Street Journal article revealed how Amazon uses its dominant negotiating position to extract warrants to purchase equity in suppliers.For years, our clients have told us how purchasing groups at Wal-Mart pushed aggressively for price cuts. Our clients were grateful for the business but knew that holding on to that business and earning a profit on it required them to identify and root out inefficiencies in their own operations. Several clients reported that the discipline of supplying Wal-Mart had spillover benefits on other areas of their business. Now Amazon has added a page to Wal-Mart’s playbook, seeking to capture a portion of the upside accruing to shareholders by acquiring warrants in those suppliers.A warrant gives the holder the right – but not the obligation – to purchase shares in a company at a fixed price at some future date. Because the price is established today, but doesn’t have to be paid until the future, the warrant holder shares in the benefit of upside with the shareholders but does not bear the burden of the downside. For example, if the warrant has a fixed price of $100 per share and the company performs well, pushing the stock price to $200 per share, the warrant holder will exercise her purchase right and realize a gain from the increase in value. On the other hand, if the company performs poorly and the share price falls to $50, the warrant holder will simply decline to exercise the purchase right and thereby avoid the loss borne by the shareholders.Since warrants have such an attractive investment profile, why are suppliers willing to give them to Amazon? Obviously, they think the opportunity to do business with Amazon is worth the dilution to future returns. Amazon’s negotiating leverage is an example of the perils of customer concentration.When we value family businesses, we focus on three things: expected cash flow, risk & growth prospects. Large customer concentrations can boost expected cash flows, but also increase the risk of those cash flows. All else equal, higher risk translates into a lower valuation multiple. For many clients, this is a “high class” problem: would you rather have a business with $100 of EBITDA and a 6x multiple, or $200 of EBITDA and a 5x multiple? The challenge for family business directors is to identify strategies for mitigating the risks of customer concentration while retaining the business of the large customer.We have observed two strategies that have worked well for our clients seeking to mitigate customer concentration risk.The first, and probably most obvious, is to leverage what you learn from dealing with the large customer into new business with other customers. Just as the most demanding teacher is probably the one that you learned the most from, the most demanding customer is probably the one to teach you the most about your own business. As we mentioned at the beginning of this post, several clients have confessed to us that, while selling to Wal-Mart was not exactly enjoyable, the challenge of doing so forced them to improve their processes and cost structure. As a result, they were in a better position to secure profitable business from other customers.Continuing our example, suppose the company leverages its experience with the large customer to capture additional profitable business from other customers and EBITDA grows from $200 to $300 (a 50% increase). As the customer concentration risk recedes in the wake of a more diversified customer base, the valuation multiple is restored to 6x, resulting in an 80% increase in value ($1,000 to $1,800).The second, and more difficult strategy, is to rebalance the negotiating leverage in the supplier/customer relationship. Does your customer have leverage because they can “push” your product through to the end user? This is how most large customer concentrations start. But some of our clients have been able to take back some of that leverage by investing effectively in their brand so that the end user “pulls” the product through the customer’s channel. Successful brands are less susceptible to the power of large customers because those customers need the brand as much (or more) than the brand needs them. Strengthening the family business brand to this point is likely the work of decades, not years, but can pay significant dividends in both higher cash flows and higher valuation multiples. Does your family business have a significant customer concentration that is reducing the valuation multiple? If so, what steps are you and your fellow directors taking to mitigate this risk? Give one of our valuation professionals a call today to discuss how customer concentrations are affecting the value of your family business.

Summer 2021 Reading

Family Business Director is off enjoying 4th of July festivities this week. For our readers that are looking for some beach reading, we thought we would direct your attention to some of our more popular posts in case you missed them the first time around.Valuation Principles Family Business Directors Should Know in 2021Family business directors will make plenty of difficult decisions in the remainder of 2021, and many of those decisions will require assessing the value of the company’s shares, a particular business segment, or a potential acquisition target. What should you and your fellow directors know about valuation? In our experience, there are six basic valuation principles that can guide directors as they make tough valuation-related decisions in the coming year.Click Here to ReadNavigating Tough Family Business ConversationsHow should your family business have discussions around sensitive topics? Perhaps it is a patriarch who has run one too many strategic board meetings, the cousin who refuses to take their Vice President role seriously, or the aunt who is rather loose in defining what a “business meal” is. “No Aunt Millie, this is not a case of defining what ‘is‘ is”.Click Here to ReadThe Three-Legged Stool of Family BusinessOur family business advisory practice is focused on three strategic financial questions that weigh on family business directors and can keep them awake at night. Clients often solicit our advice because they are struggling with one of these questions. But, in our experience, the questions can’t really be tackled in isolation. Each question comprises one leg of the three-legged stool of the family business. As an engineering-minded client recently pointed out to us, while it is impossible for a three-legged stool to wobble, it can be crooked. If the three legs are not designed to work together, the stool won’t be level, and won’t hold anything valuable for long.Click Here to ReadAll EBITDA Is Not Created EqualIn the world of family-owned and other private businesses, EBITDA is the most commonly cited performance measure. Every company has EBITDA, but some EBITDA is better than others. Why is that?Click Here to ReadThe Economics of Family Shareholder RedemptionsRegardless of the reason, significant shareholder redemptions are among the least understood corporate transactions. In this post, we consider the economics of family shareholder redemptions from three perspectives: the selling shareholder, the family business, and the remaining shareholders.Click Here to ReadWe hope you have a relaxing and enjoyable summer break. If you know a family business director or advisor that might benefit from our content, forward this note or email us and we will be sure to add them as a subscriber. Happy reading!

Navigating Tax Returns: Tips and Key Focus Areas for Family Law Attorneys and Divorcing Individuals/Business Owners – Part I

Part I of III- Form 1040

E&P Third Quarter 2021

Bakken

Bakken // Oil prices were relatively stable in Q3 2021 following a significant run-up in the first two quarters.

Transportation & Logistics Newsletter

Third Quarter 2021

Industry Trends From the Road

Key Takeaways from State Automotive Annual Conventions

We recently attended the annual conventions of two state automotive groups – Kentucky and the Tri-State Convention consisting of Tennessee, Alabama, and Mississippi. It was refreshing to attend live events again after the virtual world we have all grown accustomed to over the last fifteen months. Live events like these serve as a great venue for shared information about industry trends and cultivating business relationships.In this post, we summarize certain sessions that our readers might find of interest. If the topics were similar, we present those topics together. We also layer in highlights from our conversations with dealers and other industry participants.Cybersecurity for Auto Dealerships and Fraud and the Distracted EmployeeCybersecurity IssuesOver the last year, there have been several high-profile instances of cybercrimes and fraud, including the ransomware hacks on Colonial Pipeline and JBS. These topics that typically lurk in the shadows have been brought into the national discourse, and there were two sessions devoted to best practices to protect against cybercriminals and how to detect fraud from within an organization.While we typically think of these sorts of things as something that happens to other people, speakers showed just how much they can impact the auto dealer industry and how the economic fallout of the COVID-19 pandemic has increased the motivation and prevalence of fraud.Auto dealers experience nearly six times the amount of cyber criminal activity than other industriesIdentity Theft crimes account for $50 billion in damages and recovery expense annuallyOne of the most common methods for committing a cybercrime in auto dealers is through the use of business emailOne of the most common methods for committing a cybercrime in auto dealers is through the use of business email. Key management and particular controllers, payroll managers, and accounts payable clerks should pay special attention to the spelling of names in emails received and also the domain name portion of the address. The strongest defenses against compromises in cyber crimes attempted through business emails are the following:Strong Password – have unique and lengthy passwords for all of your various accountsTwo-Factor AuthenticationTelephone confirmation for fund transfers before wiringBeware of unexpected urgency – Phishing emails prey on the urgency of the situation they create by saying that funds must be wired within a short amount of time to guilt the recipient into immediate actionCyber Security Training – Create a culture of training and accountability for your staff. Create a message from the top that permeates throughout your dealershipHow to Understand and Protect Your Dealership from FraudUnfortunately, these threats are not exclusively external threats. Too often internal and trusted employees can be the culprits. Auto dealers should consider the following statistics.Over 50% of companies have been victims of embezzlement by their own employeesTypical organizations lose 5% of their top line revenue to fraudOver 50% of employees committing fraud have been with the company over five yearsMedian length of time to detect fraud is 18 months58% of fraud cases have no recovery at allAnonymous tip lines are one of the greatest ways to detect fraud because someone within the organization is probably aware of what is going on If fraud is occurring in your dealership and it is most likely being committed by longer tenured employees. What behaviors should you be observing as possible red flags?Employees living above their means, or the opposite, experiencing financial difficultiesEmployees that are unwilling to share their duties with other members of the organization and/or rarely take time offEmployees who have recently divorced or are experiencing other family problemsEmployees that have an unusually close relationship with a particular vendorKey TakeawaysAuto dealers should communicate to their employees the potential damage to the business from a ransomware attack or other similar threats. This includes training employees on what these schemes look like and creating a culture to protect against external and internal threats. Auto dealers must confront conflicting agendas to protect their dealerships: while you want to empower your employees to do their jobs well and trust them without micromanaging, it’s also important to not be too detached and “inspect what you expect” might be potential fraud. Finding that balance is critical. A three-pronged approach to internal fraud is key: deter, detect and prevent.How can auto dealers put this approach into practice? Set up internal controls so that one employee isn’t responsible for all elements of transactions. Segregate duties among various employees. Rotate functions so that the same person doesn’t handle the same aspect of the business at all times. Besides being good practice against fraud, this also reduces systemic risk of the dealership that we in the valuation world discuss as a “key person risk.” Businesses whose operations are not specifically reliant on one person tend to be less risky and therefore more valuable. While typically this is thought of as the dealer principal or upper level management, it’s important to have these considerations throughout your organization.The Dealership of Tomorrow and Regulatory Items in the Biden EraFuture Trends and Their Possible ImpactThe pandemic had an acute economic impact on many Americans, and it accelerated many trends from before 2020. One of our speakers took a long view at these trends and offered his view of the future of traditional auto dealers.Then, we look at recent trends in the industry from a more regulatory point of view. When the White House administration changes, particularly to a different party, there is likely to be change to regulations at the federal level, particularly considering Biden was a part of the administration that preceded his predecessor. How will these changes impact dealerships?Despite the ebbs and flows of trends that come and go, dealerships have utilized all of their profit centers to their advantage, so when one area of the business is declining, another is likely benefiting. Even through challenges such as electric vehicles, autonomous vehicles, rideshare, and connected cars, the industry has proven it can adapt and remain viable.No country in the world exclusively utilizes a direct sales model for retail automotive salesWhen it comes to electric vehicles, speakers at our conferences offered some rebuttals to some prevailing arguments, particularly those proffered by proponents of direct to consumer sales. No country in the world exclusively utilizes a direct sales model for retail automotive sales. While some upstarts like Tesla have adopted that model, all countries still maintain and utilize some OEM/dealership model. While direct sales proponents insinuate that franchise laws are the only thing preventing a shift in the market, countries without these laws do business very similarly. If EVs are going to be successful, it will likely be dealers who have made the investment in personal relationships in their community who can help consumers understand the benefits and challenges of the new technology.There has been plenty of talk around the topic of consolidation in the industry, but the total number of automobile dealerships or stores has only declined approximately 1.9% from 1970 through 2019. There are approximately 18,000 stores in the U.S., and it looks like this number may stay relatively consistent.In the past decade, the number of owners has declined from 10,000 to 7,500. Despite the challenges related to the pandemic, the auto dealer industry only lost 31 dealers in 2020, or ~0.2%. While some dealers may capitalize on heightened valuations and exit with more Blue Sky value, there’s a sense that the total number of rooftops nationwide won’t similarly decline. Despite the recent uptick in investment by the public auto dealers, their share of the entire automotive market is less than 10% by location. If Lithia and others continue to acquire and Blue Sky values stay high, this could change. However, years of evidence does not seem to clearly indicate that public dealers necessarily can operate more efficiently than their privately held counterparts.Will OEMs exercise restraint with their facilities and imaging requirements? The buying experience for consumers and their preferences shifted during the pandemic. Shutdowns and health fears led to more investment in the digital/online channels for vehicle retail sales. With dealers seeing less foot traffic at their dealership locations, will they want to downsize their facilities, or will the OEMs continue to require continuous upgrades and imaging requirements? Trends surrounding facilities that could evolve after the pandemic include unbundling facilities (i.e., sales and service operations not being conjoined on the same property), placing greater importance on convenience and flexibility.From a regulatory standpoint, there appear to be more threats than opportunitiesPossible RegulationFrom a regulatory standpoint, there appear to be more threats than opportunities:Trade can be an area of opportunity now with the removal of 25% tariffs, but dealers should be aware of how the USMCA, which replaced NAFTA, may impact themLabor constraints have made operations more difficult across all industries, but the speaker pointed to the classification between W-2 employees and independent contractors as a regulatory issue to watchFuel economy standards have changed depending on the current administration, which can make it hard for OEMs and dealers to make long-term plans when the goals for 2035 and beyond continue to be a moving target. Hopefully for dealers, these requirements will be tied to economic viability50-60% of dealers report on LIFO, which is beneficial when inventory levels and/or values are increasing. When volumes dropped during the pandemic (which have been extended by the chip shortages), LIFO dealers are stuck recognizing income, which is unlikely to be changed despite NADA lobbying effortsF&I has increasingly become a profit source, with dealers recognizing more and more of overall profit from F&I rather than the sale of the actual vehicle itself. Will that lead to concerns from the Consumer Financial Protection Bureau that dealers are in effect selling products with interest rates too high, or is this just semantics of how profit is allocated?Key TakeawaysWhile the external alternatives to traditional automobiles continue to arise and the imaging requirements may change in the future, traditional auto dealerships appear to be stable and on solid footing for years to come. Auto dealers should become active and stay in communication with their state associations and politicians to ensure their best interests are being protected during periods of regulatory changes.Succession PlanningGeneral succession planning forces individuals to confront uncomfortable topics including their personal financial circumstances and needs, circumstances and feelings of other family members, and circumstances of the business, age, and quality of key managers/employees. Auto dealers face additional decisions contemplating the OEM requirements for their children or other family members to become a dealer and what will be required for them to become a successful dealer. The approval of a second generation or other family member as a dealer principal is not guaranteed by the OEM. We have encountered this situation at the untimely death of a dealer principal.A critical element of succession planning is determining the value of the business to implement the particular action stepsOne of our speakers demonstrated the difference between “having a plan” and succession planning. Having a plan is more like the noun, or the passive part of the process. Succession planning is the verb, or the active part of the process.A plan can consist of a Buy-Sell Agreement. The success of the process is to live by the terms of the Buy-Sell Agreement or plan and make it a living document rather than have it become a static document that resides in a file cabinet. A Buy-Sell Agreement may appear stronger if it includes a mechanism for the pricing of a dealership that accounts for its Blue Sky value. However, if the document simply indicates a static multiple (say 5.0x, for example) from when the document is drafted, it may not capture how the dealership and the market for dealerships change over time.Key Takeaway: At the risk of appearing self-serving, we offer this truth: a critical element of succession planning is determining the value of the business to implement the particular action steps. Mercer Capital assists auto dealers around the country by performing business valuations to assist with succession planning and wealth transfers. Do you have a plan or have you engaged in succession planning with a financial advisor?ConclusionWe’re glad to be back attending in-person conferences and talking with dealers in person. This leads to a better exchange of ideas on current trends and best practices. If you would like to discuss any of information in this post and how your dealership might be impacted, please contact any of the members of the Mercer Capital auto team.Sources“Cybersecurity for Auto Dealerships,” John Iannerelli, former FBI Special Agent – KADA Convention“Fraud and the Distracted Employee,” Lori Harvey, CISA, CISM, PCI QSA, DHG – Tri-State Conference“Dealership of Tomorrow,” Glenn Mercer, Glenn Mercer Automotive – KADA Convention“Regulatory Items in the Biden Era,” Paul D. Metrey, NADA – Tri-State Conference“Plan Now or You Could Lose Everything,” Loyd H. Rawls, Rawls Group – KADA Conference

What Is Your Firm’s “Brand” Worth?

Building the Value of an RIA Involves Making it More Than a Group of Professionals

This week we look back at a post from November 2018. Don't let the dates fool you, the topic is still very relevant today. The announcement from Merrill Lynch last week that it was cutting advisor compensation stood in stark contrast to a lawsuit filed in October by former Wells Fargo brokers, alleging that their practices had been impaired by association with the bank. While Merrill feels comfortable flexing their brand muscles by redirecting advisor cash flow back to the firm, Wells Fargo is accused of actually having negative brand value. These two situations highlight the dynamic interaction between investment management professionals and the firms they work for while demonstrating the significance of branding to build professional careers and advisory firm value.An Ensemble Product With an Ambiguous BrandA couple of weeks ago I was driving around Memphis and spotted a unicorn, or, more specifically, a Bricklin SV-1, an independently produced sports car with a small-block V-8 engine, two seats, a fiberglass body, and gullwing doors. Malcolm Bricklin debuted his eponymous car at a celebrity-studded event at the Four Seasons restaurant in New York in the summer of 1974. Despite the innovative nature and affordable price of the Bricklin, it wasn’t terribly quick (not unusual for cars of that era), reliable (the hydraulic pump for the gullwing doors would sometimes break if you tried to open two doors at once), or practical (it lacked both a spare tire and a cigarette lighter). Only 3,000 or so Bricks were sold in 1974 and 1975, and fewer than half of those are extant today.If the Bricklin were a metaphor for a cohort of RIA practice, it would be an “ensemble” practice. The company was run from Arizona but manufactured cars in Canada, shared taillights with the DeTomaso Pantera and the Alfa Romeo 2000, sourced its engine from American Motors and Ford, transmissions from Ford and Borg Warner, brakes that included parts from three manufacturers, and a steering wheel from Chevrolet. What Bricklin lacked was a compelling brand to pull it all together, so instead of projecting the image of a “best of everything” product, it came off as more of a Frankenstein.Brand substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Reading through the industry news of late, we’ve been thinking about the role of branding in the investment management industry. Branding is more than a firm name or logo, it encompasses the identity of an RIA such that the practice is elevated above the practitioner, with the potential to benefit both. As such, we consider brand to be more than tradenames or logos; it is a concept that substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Personal Goodwill and Corporate GoodwillIn the valuation community, there are techniques for determining whether a portion of a given enterprise’s goodwill is (in reality) allocable to one professional or to a group of professionals instead of the company. I’ll spare you the technical details, but suffice it to say that when an RIA matures to the stage that it can report a legitimate bottom line – i.e. that there are profits left over after covering both non-personnel costs and paying a market rate of compensation to all staff – then it has brand value that has generated a return on corporate goodwill. Profitability is evidence of brand value.Returns to Labor Versus Returns to CapitalWhen the C suite at Merrill Lynch decided to cut advisor payouts a few years ago, they were shifting cash flow returns from labor to capital. Advisors probably felt like they were being devalued, and arithmetically they were. But Merrill was also testing its brand value. Could they enhance their return on corporate goodwill by retaining more client fees from existing brokers at the risk of either disincentivizing their advisor network or even running them off to other wire-house firms or RIAs? Merrill’s opting to remain in the broker protocol can be seen as confidence in its brand to attract, grow, and retain an advisor network.Negative Goodwill?At the other extreme, the Wells Fargo lawsuit from about the same time suggested the possibility that negative brand value at the firm level can impinge on an advisor’s income. Two brokers alleged that the string of negative publicity at Wells Fargo made it difficult for them to build their books of business or even to maintain the level of business they built previously. Investment management is a reputation business, and the lawsuit indicated that even association with a tarnished brand can impair a career. It was an interesting lawsuit, because in blaming the firm for advisor performance, it suggested that the advisor/client relationship was more significant than the client’s relationship with the firm – otherwise the advisor could mend the relationship simply by changing firms. Yet the lawsuit was basing the damage claim on the bad reputation of the firm.Brand Value in the Independent ChannelOutside of the bulge-bracket broker channel, it is more common for personal goodwill and firm goodwill to overlap. There is a thread of conventional wisdom that suggests small RIA practices aren’t salable (i.e. don’t have enterprise goodwill). The reality is more nuanced, of course, but to the extent that the identity of a small RIA is really just that of the founder and principal revenue producer, then clients are difficult to transfer and the business is more difficult to transact. Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.There’s more than one way to build brand value beyond the founder, as shown by high profile firms like Edelman Financial and Focus Financial. Edelman employs a highly centralized approach, with uniform and templated marketing programs and client service techniques. While Edelman has successfully built a large and profitable platform from this, the risk is that the secret sauce is vulnerable to being copied. Focus Financial, on the other hand, has employed a highly decentralized approach of acquiring cash flow interests in independent RIAs and then leaving their client-facing identities intact. You won’t find Focus’s name (much less than name of its founder, Rudy Adolf) on any of its partner firms, and thus individual firms (and Focus itself) are far less exposed to reputational risk from bad actors in individual offices. Besides this, Focus doesn’t base its business model on intellectual property that could be replicated elsewhere. What Focus lacks is a certain level of corporate identity and efficiency that comes from uniformity.In the End, Brand Value Is Defined by Your ClientMuch of the debate over the value of investment management firms can be distilled into one question: what is the value of a firm’s brand? More than “what’s in a name?”, the question is an investigation into the relationship between client and investment management service provider. Do clients of your firm define their relationship as being with your firm, or with an individual at your firm? If you can answer that question, you know where your RIA is on the journey to building firm value.

Estate of Michael J. Jackson v. Commissioner - Key Takeaways

It is imperative for estate planners to engage valuation analysts that perform the proper procedures and follow best practices when performing valuations for gift and estate planning purposes. It is necessary to have a well-supported valuation because these reports are scrutinized by the IRS and may end up going to court. The recent decision by the U.S. Tax Court in Estate of Michael J. Jackson v. Commissioner provides several lessons and reminders for valuation analysts, and those that engage valuation analysts, to keep in mind when performing valuations for gift and estate planning purposes. Michael Jackson, the “King of Pop,” passed away on June 25, 2009. His Estate (the “Estate”) filed its 2009 Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, listing the value of Jackson’s assets. After auditing the Estate’s tax return, the Commissioner of the Internal Revenue Service (the “Commissioner”) issued a notice of deficiency that concluded that the Estate had underpaid Jackson’s estate tax by a little more than $500 million. Because the valuation of some assets were considered to be so far off, the Commissioner also levied penalties totaling nearly $200 million on the Estate. The IRS and the Estate settled the values of several assets outside of court. The case involved three contested assets of Michael Jackson’s estate: Jackson’s Image and LikenessJackson’s interest in New Horizon Trust II (“NHT II”) which held Jackson’s interest in Sony/ATV Music Publishing, LLC, a music-publishing companyJackson’s interest in New Horizon Trust III (“NHT III”) which contained Majic Music, a music-publishing catalog We discuss the key topics that the Tax Court ruled on and addressed that inform valuation analysts in the preparation of quality valuation reports.Known or KnowableIt is important that valuation analysts only rely on information that was known or knowable at the valuation date.In the decision, the Tax Court rejects the analysis of experts on several occasions for using information that was “unforeseeable at the time of Jackson’s death.”The Tax Court goes on to state that “foreseeability can’t be subject to hindsight.”It can be difficult to distinguish and depend on only the information known or knowable at the valuation date especially when a significant amount of time has passed between the current date and the valuation date.Therefore, a careful examination of all sources of information is necessary to be sure that it can be relied upon in the analysis.As can be seen from the Tax Court’s opinion, valuation analysts and experts can undermine their credibility by relying on information that was not known or knowable at the valuation date.Tax Affecting S CorporationsThe Tax Court, in this specific case, did not accept the tax affecting of S Corporations: “The Estate’s own experts used inconsistent tax rates.They failed to explain persuasively the assumption that a C corporation would be the buyer of the assets at issue.They failed to persuasively explain why many of the new pass-through entities that have arisen recently wouldn’t be suitable purchasers.And they were met with expert testimony from the Commissioner’s side that was, at least on this very particular point, persuasive in light of our precedent.This all leads us to find that tax affecting is inappropriate on the specific facts of this case.”The Tax Court did, however, leave room for the possibility of tax affecting being appropriate by stating, “we do not hold that tax affecting is never called for.”At Mercer Capital, we tax affect the earnings of S corporations and other pass-through entities.Given that this issue continues to be a point of contention, it is imperative that valuation analysts provide a thorough analysis and clear explanation for why tax affecting is appropriate for S corporations and other tax pass-through entities.Developing Projected Cash FlowsIn the valuation of NHT II, the Court found it more reasonable to use the projections of Sony/ATV in the development of a forecast used in the income approach rather than relying on historical financial performance to inform the projection.The Tax Court based its decision on the fact that “the music-publishing industry was (and has remained) in a state of considerable uncertainty created by a long series of seismic technological changes. We think that projections of future cashflow, if made by businessmen with an incentive to get it right, are more likely to reflect reasonable estimates of the short-to-medium-term effects of these wild changes in the industry that even experts, much less judges, are unlikely to intuit correctly.”This decision makes it clear that valuation analysts need to fully understand the industry in which the company operates and develop a forecast that is most reasonable given the information available as of the valuation date.In cases where analysts have access to a projection developed by management, valuation analysts should have a clear, well-reasoned rationale for not relying on the forecast should they decide not to use it in the analysis.However, valuation analysts should not blindly accept management’s forecasts as truth but should perform proper due diligence to assess the reasonability of the forecast and clearly articulate any deviations from management’s forecast.Other Topics AddressedA few other topics of note are addressed throughout the decision that can help valuation analysts provide reliable valuation analyses.On more than one occasion, the Tax Court sided with the expert that provided a compelling explanation for the use of a certain assumption rather than arbitrarily using an assumption without explanation.The Tax Court also sided with one expert simply because they provided a clear citation for their source when another expert did not.The Tax Court also called out the inconsistency of an expert in their report and testimony.These topics addressed by the Tax Court demonstrate that consistently explaining and citing the sources of assumptions and key elements of the valuation analysis help to produce a supportable valuation analysis.Finally, the expert for the Commissioner seriously damaged their credibility in the eyes of the Tax Court when the expert was caught in a couple lies during the trial.The Tax Court found that the expert “did undermine his own credibility in being so parsimonious with the truth about these things he didn’t even benefit from being untruthful about, as well as not answering questions directly throughout his testimony.This affects our fact finding throughout.”Takeaways & ConclusionThe table below presents the valuation conclusions of the Estate, Commissioner, and the Tax Court at trial. This decision has shown that it is critical for valuation analysts to present quality valuation reports that are clear, supported, and follow accepted best practices.At Mercer Capital, estate planners can be confident that we follow the proper procedures, standards, and best practices when performing our valuations for gift and estate planning.Mercer Capital has substantial experience providing valuations for gift and estate planning as well as expert witness testimony in support of our reports.Please do not hesitate to contact one of our professionals to discuss how Mercer Capital may be able to help your estate planning needs.

What Does the Step-Up in Basis Tax Proposal Mean for High Net Worth Individuals and Family Businesses?

Recently, the Biden Administration announced elements of its tax agenda in the American Families Plan. The Biden Administration aims to make some significant changes to current tax law.These changes are highlighted by the following:Increasing the top capital gains tax rate to 39.6%Increasing the top federal income tax rate to 39.6%Increasing the corporate tax rate to 28% Another substantial proposal includes the elimination of the step-up in basis. The potential elimination of the step-up in basis presents an estate planning opportunity to high-networth individuals and family business owners or should at least spur them to contemplate revisiting their estate plans.What Is the Step-Up In Basis?The step-up in basis refers to the current tax environment that allows individuals to transfer appreciated assets at death to their heirs at the current market value without heirs having to pay capital gains taxes on the unrealized capital appreciation of those assets that occurred during the individual’s life. In other words, heirs currently benefit from a “step-up” in tax basis of inherited assets to the market value on the day of death, and no taxes are paid on unrealized capital appreciation of the assets.Biden Administration ProposalThe Biden Administration is proposing to eliminate this step-up in basis. This means that the heir would be responsible for the taxes on the unrealized capital appreciation of the assets being transferred as if the assets had been sold. This would result in a large tax burden on the heir especially when considering that the Biden Administration is also aiming to increase the top capital gains tax rate to 39.6%. Specifically, the proposal would end the step-up in basis for capital gains What Does the Step-Up in Basis Tax Proposal Mean for High Net Worth Individuals and Family Businesses? in excess of $1 million (or $2.5 million for couples when combined with existing real estate exemptions). So, the first $1 million of unrealized capital gains would be exempt from taxes and only the excess would be taxed. However, the proposal does state that “the reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.” These protections and exemptions seem to provide some relief for family businesses, but the details of the protections have yet to be specified.TakeawaysThese proposals are certainly not set in stone and may change as the proposals are debated and legislature eventually makes its way through Congress. However, the Biden Administration’s current tax proposals could have a significant impact on the estate planning environment.The potential elimination of the step-up in basis is yet another reason for high-net-worth individuals and family business owners to make estate plans or revisit their current estate planning techniques. When considered alongside other Biden Administration proposals such as an increase in the capital gains tax and the fact that the increased lifetime gift and estate tax exclusion limits are set to sunset in 2025, now is a great time to have a conversation about planning. Contact a professional at Mercer Capital to discuss your specific situation in confidence.

Permian Production Pushes Higher

The economics of Oil & Gas production vary by region. Mercer Capital focuses on trends in the Eagle Ford, Permian, Bakken, and Marcellus and Utica plays. The cost of producing oil and gas depends on the geological makeup of the reserve, depth of reserve, and cost to transport the raw crude to market. We can observe different costs in different regions depending on these factors. In this post, we take a closer look at the Permian.Production and Activity LevelsEstimated Permian production increased approximately 8% year-over-year through June, though current production remains below the peak observed in March 2020. Production in Appalachia increased 5% year-over-year, while the Eagle Ford’s production was essentially flat. The largest production gain was observed in the Bakken (up 26%), as the Bakken saw a high level of shut-in wells(in response to low commodity prices) which have subsequently been brought back online. Permian production has generally been increasing over the past year, but there was a meaningful decline in February driven by Winter Storm Uri that disrupted power supplies throughout Texas. The Permian’s production increase is the result of more drilling activity in the basin. There were 237 rigs in the Permian as of June 18th, up 73% from June 12, 2020. Bakken and Eagle Ford rig counts were up 55% and 146%, respectively, while the Appalachia rig count was down 3%. Permian production should continue to increase modestly over the next several months based on the current rig count, legacy production declines, and new-well production per rig. Commodity Prices Grind HigherThe second quarter of 2021 saw rising commodity prices, driven largely by accelerating travel and economic activity amid the vaccine rollout and fewer COVID cases in many parts of the world. Front-month WTI futures began the quarter at ~$60/bbl and broke above $70/bbl before the end of the quarter. The rise in prices was generally slow and steady, with the exception of a dip in mid-May, though that was likely driven by short-term dislocations caused by the shutdown of the Colonial Pipelinein response to a ransomware attack. Henry Hub natural gas front-month futures prices began the quarter at approximately $2.60/mmbtu and have been above $3/mmbtu for all of June thus far. However, the current commodity price environment may be short-lived. WTI futures prices are in backwardation (meaning that current prices are higher than future prices), implying some near-term tightness that is expected to subside. This sentiment is echoed by the U.S. Energy Information Administration, which stated that “continuing growth in production from OPEC+ and accelerating growth in U.S. tight oil production—along with other supply growth—will outpace decelerating growth in global oil consumption and contribute to declining oil prices” in their June 2021 Short-term Energy Outlook.Financial PerformanceIn a nice change of pace for energy investors, the Permian public comp group saw strong stock price performance over the past year (through June 22nd). All of the Permian companies except Pioneer outperformed the broader E&P sector, as proxied by XOP (which was up 73% during the past twelve months). That stock price performance is probably more reflective of the dire straits of some companies last year in the aftermath of the Saudi/Russian price war and COVID-19 lockdowns, as small, leveraged companies like Centennial and Laredo have had the biggest gains. However, stock prices for all of the Permian comp group companies remain below all-time highs.Federal Lands Drilling Ban Could Shift Production Within the BasinPart of President Biden’s environmental platform was banning new oil and gas permitting on public lands. An initial action under this platform was a 60-day moratorium on permitting activity, though that was recently blocked by a federal judge. While many think a ban would haverelatively modest impacts at a macro level, the impacts could be more severe for companies and areas with a high level of exposure to federal lands.The Federal Reserve Bank of Dallas performed an analysis to look at the potential impact to the Permian Basin. Under a restrictive policy scenario, production growth would slow (relative to no change in policy), though overall production from the basin is still expected to increase.[1] However, approximately half of New Mexico’s Oil & Gas production comes from federal acreage. As such, the impacts to New Mexico are much more acute under a restrictive policy scenario. The consequence is a shifting of drilling activity (and associated employment and spending) from New Mexico to Texas. ConclusionThe Permian was not immune to the impacts of historically low oil prices observed in 2020, though it has proven to be resilient. Production, while still below peak levels, is growing, and growth is generally expected to continue. Activity levels are improving, though companies’ current emphasis on returning cash to shareholders may lead to less investment than has been seen in previous periods with similar commodity price environments.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.[1] The Dallas Fed describes the policy scenarios as follows:Reference Case: This serves as the benchmark and assumes little-changed leasing, permitting and drilling from first-quarter 2021 levels.Hybrid Case: It assumes no new federal leasing, but existing leaseholders continue receiving drilling permits. Permit reviews are more rigorous, leading to slower approvals and a costlier operating environment beginning in 2022. Based on companies’ public statements, firms that hold acreage across the basin gradually relocate drilling rigs and completion crews to their nonfederal locations.Restrictive Case: No new federal permits or extensions are granted starting in 2023. This is when the most-recently issued permits will expire. The existing permitting freeze adversely affects production in the near-term due to a lack of approvals of permit modifications and pipeline rights-of-way. As in the Hybrid Case, companies shift their focus to nonfederal acreage.

Whitepaper: Understand the Value of Your Auto Dealership

If you’ve never had your auto dealership valued, chances are that one day you will. The circumstances giving rise to this valuation might be voluntary (such as a planned buyout of a retiring partner) or involuntary (such as a death, divorce, or partner dispute). When events like these occur, the topic of your auto dealership’s valuation can quickly shift from an afterthought to something of great consequence.The topic of valuation is of particular importance to owners of auto dealerships due to the complex and unique nature of the industry. In our experience working with auto dealers on valuation issues, the need for a valuation is typically driven by one of three reasons: estate planning, transactions, or litigation.The situation giving rise to the need for a valuation could be one of the most important events of your professional career. Familiarity with the various contexts in which your dealership might be valued and with the valuation process and methodology itself can be advantageous when the situation arises. To this end, we’ve prepared a whitepaper on the topic of valuing interests in auto dealerships.In the whitepaper, we describe the situations that may lead to a valuation of your auto dealership, provide an overview of what to expect during the valuation engagement, introduce some of the specific industry information and key valuation parameters that define the context in which an auto dealership is valued, discuss value drivers of an auto dealership, and describe the valuation methods and approaches typically used to value auto dealerships.If you own an interest in an auto dealership, we encourage you to take a look. While the value of your dealership may not be top of mind today, chances are one day it will be.Our hope is that this whitepaper will provide you with a leg up towards understanding the valuation process and results, and further that it will foster your thinking about the valuation of your auto dealership and the situations—good and bad—that may give rise to the need for a valuation.Editor's Note: This whitepaper was originally published in August 2020. WHITEPAPERUnderstand the Value of Your Auto DealershipDownload Whitepaper

Family Business Purpose and Transactions

In this post, we offer a unique perspective from Atticus Frank, CFA who worked in his family’s business for nearly three years prior to returning to Mercer Capital and joining the team’s Family Business Advisory Group. We hope the stories illuminate special issues family business directors need to consider from someone who lived them day-in and day-out. NYU Professor Aswath Damodaran has highlighted the mixed bag on value creation through acquisitions. However, McKinsey & Company suggests that family businesses are more prudent in their M&A activity, and don’t necessarily seek the home run deals, but instead seek value creation. My family’s business did its best to be prudent when engaging in M&A transactions. We developed objectives for selling and buying within the framework of our business’s meaning and family goals. During my stint in the family-business, the company was going through radical changes. We divested significant operating assets and acquired new businesses in a span of four months. Over the same period, the shareholder base was reduced from 30+ individuals to a select handful. But why? Framing the question in terms of the following four meanings of family business can help answer it.Give Me One ReasonAs we have previously written, the meaning of a family business is a function of both family and business characteristics. Most family businesses hold one of four “meanings” for their family shareholders, which we have summarized below:Economic Growth Engine - Create economic growth for future generations. Less emphasis on distributable income for the current shareholders; focus on growth opportunities for business to grow along with the family.Store of Value - Preserve the family’s capital. Serve as a stabilizing component of the family’s overall balance sheet.Source of Wealth Accumulation – Focus on significant current distributions that family shareholders are expected to allocate to unrelated investments.Source of Lifestyle – Priority on stability of dividend payments and the business is managed to protect the company’s dividend capacity to help facilitate travel, philanthropy, education, or other family objectives. With the above framework in mind, where did my family’s business fit in?The Times - They Are A-Changin’The family business was going through big changes when I arrived. A major part of the business was being sold to another family and the shareholder base was in the process of consolidation. From the mid-70s through mid-2010s, the business had been the economic growth engine for the family: minimal distributions and earnings plowed back in to achieve growth. But with the passing of the patriarch (first generation), the new shareholders (majority control in second-generation) experienced a shift in their objectives for the business.After nearly 40 years of growth, many of the new controlling shareholders were ready to "de-risk" their personal balance sheets. The family business could help provide that, but the most immediate way to do that was to sell part of the operating assets.Thinking in terms of the “Four Meanings” framework, this transaction represented a radical wealth accumulation transition. If the family were to develop more diversified personal balance sheets, either distributions from the legacy family business would have to increase in a hurry, or a sale of at least a portion of the business would be required (at the right price). It just so happened the right price came along.Turn The PageAs we were spinning off a large part of the business, I was preparing to move to Florida to jump into the family business with my wife. We knew we were joining a company that was different than the one my wife had known her whole life.But what company would we be joining? For one, it would have a consolidated shareholder base, with our CEO, my father-in-law, the primary shareholder. Second, it would be considerably smaller. The assets we were selling to generate cash flow for the other major shareholders represented the lion’s share of the company’s revenues. Our objectives for the future, while not “to-the-moon,” were more ambitious than maintaining a “lifestyle” family business. We wanted the remaining company to scale to a level that could support the remaining shareholders’ goals and objectives.Following the divesture, we completed a smaller acquisition relative to the business units sold to achieve an expected cash flow level suitable for the new, smaller shareholder base. Our impetus was to grow to ensure the longevity and stability of the overall family enterprise for the remaining family shareholders and allow our family to pursue other strategic investments outside the business. Getting there will require a growth mindset for the next several years. I’ll report back on our progress.Here Comes the Sun: What Will Family Business Directors Do?We have noticed that our wisest clients demonstrate patience and know where they are and what they are trying to accomplish through transactions. These clients have focused on what the family business means to them: growth engine, store of value, wealth accumulation, or lifestyle. This framework helps them make the right deals at the right times for the right reasons. Otherwise, a “deal” can become a four-letter word for your family.ConclusionMercer Capital has a long history of working with companies on both the buy and sell-side of transactions. Let us know if we can help you and your fellow directors evaluate the transaction opportunities and challenges facing your family business.

Permian M&A Update: A Buyer's Market

Pocketbooks Open for More Deals and Larger Positions

Transaction activity in the Permian Basin picked up in earnest this past year, indicating greater optimism in extracting value from the West Texas and Southeast New Mexico basin.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below. Relative to 2019-2020, deal count increased by five transactions, representing an increase of 23% over the 22 transactions in the prior period. Furthermore, median deal size nearly tripled from $138 million to $405 million, period-over-period. The median acreage among these transactions increased 2.5x from 14,500 acres to 36,250 acres (not shown below). Given the concurrent increase in transaction values and greater acreages acquired, the median price per net acre was down a slight 4% period-over-period.The big story though, was production. The median production among transactions from June 2018 to June 2019 was 2,167 barrel-oil-equivalent per day (“Boepd”); while over the past twelve months, the median production value was 8,950 Boepd (not shown). As buyers “purchased in bulk” this period relative to the prior twelve-month period, the median transaction value per production unit declined nearly 41% from $53,584 per Boepd to $31,886 per Boepd. Transactions came in waves. There was one transaction announced regarding Permian properties between June and August 2020. September saw three deal announcements, and 10 transactions were announced during Q4 2020. Activity fell silent in Q1 2021 as the industry waited for the Biden Administration to settle in Washington. Deal announcements then resumed in earnest in Q2 as WTI crude oil and Henry Hub natural gas prices showed signs of fairly stable upward trajectories, with the exception of a temporary spike in gas prices due to the mid-February freeze.Click here to expand the imageLooking a bit closer at the data, it appears there may have been an inflection point in deal valuations over the past twelve months. First and foremost, there was a notable concentration of larger-than-average deals, in terms of transaction values, from July to October 2020. Except for the Pioneer Natural Resources DoublePoint Energy transaction in early April, all deal values after October 2020 pale in comparison to those in the early period. As presented in the comparative statistical tables below, bifurcating the presented metrics further between the periods of July to October 2020 and November 2020 to the present reveals the potential pivot in valuations.The post-October median transaction value declined 95% to just $294 million from the pre-November median value of $5.6 billion. However, more tellingly, the cost per acre nearly halved with the median metric value declining from $20,449/acre in the July-October 2020 transactions to $10,482/acre in the post-October transactions. If you remove the outlier value of the Northern Oil and Gas transaction ($180,303/acre), the nearly 50% decline is slightly reduced to an indicated decline of 45% in the price per acre. I am not a gambler, but without soliciting direct commentary from the respective management of the buyers listed above, I would wager that the inbound Biden Administration and the uncertainty surrounding potential regulatory changes were a significant factor in this valuation decline.Click here to expand the imageOne noteworthy pair of transactions, which may receive further Mercer Capital analysis sooner than later, relates to acquisitions made by Pioneer Natural Resources, including the October 2020 announcement of a definitive agreement to acquire Parsley Energy and its April 2021 announcement of a definitive agreement to purchase the leasehold interests and related assets of DoublePoint Energy. Pioneer was the only buyer to appear more than once on our list of transactions with a major transaction before November and one after (for which deal metrics were available), with indications of significant increases in the cost-per-net-acre and cost-per-Boepd valuation metrics.Northern Oil and Gas Enters the Delaware BasinIn September 2020, Northern Oil and Gas announced its entrance into the Permian with its acquisition of non-operated working interests in Lea County, New Mexico from an undisclosed seller. The deal consisted of 66 net acres, with an initial 1.1 net wells proposed to be spud in late-2020 to early-2021 and production expected to start in Q2 2021. The total acquisition costs (including well development costs) were expected to be $11.9 million. At first blush, these metrics indicate a cost per net acre of approximately $180,300, which suggests a notable premium.The next highest cost per net acre value among the transactions listed was $67,000 forthe Pioneer Natural Resources-DoublePoint Energy dealannounced in April. A premium was paid as far as net acreage acquired is concerned. However, at the expected peak production rate of 1,400 Boepd, the cost per production unit was $8,500 per Boepd, the second-lowest metric after Contango Oil & Gas’s acquisition in late November, and one-third of the minimum $-per-Boepd metric among the transactions listed in the June 2019-2020 season. Despite recent volatility in the industry due to energy prices and domestic regulatory changes–whether real or proposed–the economics of the Permian have remained attractive enough to induce Northern Oil and Gas, a stalwart Bakken E&P company, to try its hand in Southeast New Mexico.Vencer Energy Acquires Hunt Oil Company’s Midland Basin AssetsIn late April, Vencer Energy, the U.S. upstream Oil & Gas subsidiary of the Dutch energy and commodity trading giant, Vitol, announced its first investment in the Midland Basin. While the total transaction value was not disclosed, the acquisition included approximately 44,000 net acres with a total estimated production of 40,000 Boepd. This represents an estimated total annualized production of approximately 332 Boe per net acre. This “production density” value (annualized production per net acre) is the second-highest value among the listed transactions, only behind the comparable metric of 376 Boe per net acre indicated from the Pioneer-Double Point deal (with acquired/estimated production of 100,000 Boepd across 97,000 net acres).Ben Marshall, Head of Americas – Vitol, commented on the transaction: “This is an important day for Vencer as it establishes itself as a significant shale producer in the U.S. Lower 48. We expect U.S. oil to be an important part of global energy balances for years to come, and we believe this is an opportune time for investment into an entry platform in the Americas. This acquisition represents an initial step to building a larger, durable platform in the U.S. Lower 48.”ConclusionM&A transaction activity in the Permian was a bit of a roller coaster over the past year in terms of deal timing, but the overall story is one of resurgence over the past twelve months relative to the twelve months before it. Still, despite a renewed interest in acquiring greater acreage and production positions, even greater changes could be on the horizon. This past week, it came to light that Shell was reviewing its Permian holdings for potential sale, according to certain people familiar with the matter. However, it is pure speculation at this juncture as to what option(s) Shell may pursue regarding the partial or full sale of the company’s estimated more-than-$10 billion of Permian holdings. Assuming any dispositions, though, this news could portend even more opportunities for continued buy-in into the Permian by existing regional E&P companies and potential new entrants.

Five Questions with Paul Hood

L. Paul Hood, Jr., JD, LL.M, CFRE, FCEP is a long time friend of the firm and an experienced and thoughtful estate planner. He has considerable experience working with family business continuity planning. A native of Louisiana (and a double LSU Tiger), after obtaining his law degrees in 1986 and 1988, Paul settled down to practice tax and estate planning law in the New Orleans area. Paul has spent over 30 years specializing in taxes and estate planning. He has taught at the University of New Orleans, Northeastern University, The University of Toledo College of Law and Ohio Northern University Pettit College of Law. The proud father of two Eagle Scouts and LSU Tigers, Paul has authored or co-authored seven books and over 500 professional articles on estate and tax planning and business valuation. We hope you enjoy this brief Q&A with Paul.Welcome, Paul. Tell us a little bit about yourself and your practice.Paul Hood: I like to describe myself in two ways. First, I’m a recovering tax lawyer. Second, I’m a purposeful estate planner. I believe in focusing much more attention on the human side of estate planning because it’s the most challenging part of estate planning, much more so than the tax planning and property disposition aspects of estate planning. But very few estate planners want to delve sufficiently deeply into the human side because it involves dealing with real human emotions, including our own.Along the course of my life, I’ve been a father, husband, lawyer, trustee, director, president, partner, trust protector, director of planned giving, expert witness, agent, professor, judge, juror and a defendant, and I use this life experience in these myriad roles to guide others. I help people pursue a "good estate planning result" in every case, whatever that looks like in each unique situation.You’ve written extensively about the "psychology of estate planning." In your experience, what is the single biggest psychological hurdle for family business shareholders to begin estate planning?Paul Hood: Perhaps the greatest hurdle to estate planning is most people lack sufficient self-awareness. By self-awareness, I mean that almost no one realizes the power that each of us has with respect to our estate planning decisions. One of my most important beliefs and philosophies about estate planning is that a person’s estate plan will have effects on the relationships of those who survive them, whether they want them to or not.One of the reasons why I preach the gospel of intergenerational communication from every pulpit that’ll have me is because the best estate plans I’ve ever witnessed all involved honest two-way communication between givers and receivers. Perhaps the biggest reason for post-death estate or trust litigation is the parties didn’t communicate about the estate plan.After the testator’s death, if an heir is unhappy about the estate plan, they too often entertain what I call the parade of horribles because what happened didn’t meet their expectations, and they immediately too often blame someone still alive and come out suing.A simple explanation of why the testator arranged their estate plan the way they did can eliminate a lot of post-death litigation and hurt feelings and ended relationships. A simple conversation could cut off heartbreak and family cutoff, yet most estate planners don’t implore their clients to have these essential conversations.Estate planning tends to focus primarily on minimizing transfer taxes. While that is a laudable goal, what other objectives should family business shareholders think about when it comes to estate planning?Paul Hood: A "good estate planning result" is one in which property is properly transmitted as desired, and family relations among the survivors aren’t harmed during the estate-planning and administration process.Notice that conspicuously absent from this definition is any mention of taxes. Taxes have always been the easiest piece of the estate-planning puzzle, yet the overwhelming majority of estate planners still focus their attention almost solely on the tax piece, probably because it’s easiest to solve and easiest to demonstrate quantifiable, tangible results. This misfocus has contributed to several problems for planners and clients alike.The sad fact is that perfectly confected and properly drafted estate plans render families asunder every single day in this country because the estate planners failed to address the human side of estate planning. Sadly, many of these problems are easily predictable. Frankly, I don’t know how some estate planners sleep at night.In one of your articles, you describe a "Path of Most Resistance" to achieving a good estate-planning results. Once a family business shareholder decides to engage in estate planning, what are the pitfalls that they need to watch out for?Paul Hood: The Path of Most Resistance is a model that I developed to illustrate graphically what has to happen in order to achieve the "good estate planning result" that I defined earlier. As the Path model illustrates, there are psychological machinations at work in every participant in the estate planning play, which includes the estate planners. As I have already discussed, intergenerational communication is essential in my opinion, particularly in a family business. Where there’s a family business involved, I view a frank and honest keep-or-sell discussion involving the entire family as perhaps the most important conversation that too few families in business ever have. Why is that? I view such a discussion as a means of gauging the family members’ individual and collective interests in continuing to be in business together. However, it’s a loaded question that can open up some family wounds, so caution is in order. Done correctly, the discussion can reinvigorate a business family’s overt commitment to the business in its current form. Unfortunately, lots can go wrong and can hasten or cause loss of the family business and family relationships because the keep or sell discussion can get very emotional and bring out hidden or suppressed feelings that have been harbored in silence and allowed to simmer past the boiling point upon their invitation to the surface. An estate plan should provide a system of checks and balances on power and authority, particularly in a family business. Estate planning necessarily involves a passing of the torch of leadership and control. As Lord Acton observed long ago, power tends to corrupt, and absolute power corrupts absolutely. Power shifts can expose people and leave them vulnerable to oppression, even to being terminated in employment or as a beneficiary through, for example, a spiteful exercise of a power of appointment (POA). The purposeful estate planner will build in a series of checks and balances that simultaneously allow exercise of authority and provide protection to those who are subject to that authority, which can be in the form of veto powers, powers to remove and replace trustees, co-sale or tag along rights, accounting rights or similar types of protections. Who are the different parties involved in the estate planning process? Do you have any tips for ensuring that all these parties work together for a successful outcome?Paul Hood: As the Path model illustrates, there are several "players" in the estate-planning play. I realize that most clients have more than two estate-planning professionals or advisors assisting them, but the larger point is that having more than one advisor itself creates potential obstacles in the path toward a good estate-planning result.In addition to the interested parties (the giver and one or more receivers), achieving a good estate planning outcome often involves one or more attorneys, an accountant, a valuation professional. Depending on the structure of the plan and the clients' needs, life insurance or other professionals may be involved in the process as well.The client should have as many advisors as he feels is necessary or appropriate. I’m a big believer in referrals and collaboration simply because it was my experience that clients get better service and a better estate plan. However, having more advisors creates a situation that must be watched and managed. I’ve seen estate-planning engagements fall apart because the advisors were incapable of cooperating and collaborating, which is a bad result for the client and can add to the negative experiences that the client will take to the next advisor, if any.Each of the estate-planning sub- specialties have their own ethical rules and conventions. These ethics rules impact subspecialties differently. The legal ethics rules insert some additional complexities in the estate-planning process, particularly in the areas of confidentiality and conflicts of interest. It’s imperative that the planner’s engagement letter permits complete and total access to all of a client’s advisors.Moreover, different advisors in the same subspecialty may have vastly different philosophies about estate planning. It’s critical that advisors check their egos and biases at the door before getting down to work with an open mind and collaboratively on a client’s situation. With collaboration comes diversity of professional backgrounds, educational and experiential pedigrees; different manners of training; and significant knowledge about a certain aspect of the client’s estate plan. This diverse strength of the group exceeds the strength of the sum of its individual members. This excess is called synergy.Estate planning is one of the most important tasks a business owner will face. Assembling the right team, and making sure they can work together, can increase the odds that you achieve a good estate planning result.

May 2021 SAAR

After three straight months of impressive gains, the SAAR fell 9.6% in May from 18.8 million units to 17.0 million units. The summer is typically a strong season for auto sales, but several supply-side factors have limited the availability of vehicles over the last month.May 2020 SAAR (12.1 million units) is a poor comparison to this year’s rate, as the pandemic’s impact was still sending shock waves through the industry at that time. In comparison to May 2019, SAAR is down roughly 2%.The dip in SAAR from April highs should not be viewed in a totally negative light, as many industry experts have spoken to the adaptability and resilience of the industry during a period of record high demand and increasingly less inventory. As seen in the graph below, the inventory to sales ratio has hit record lows as dealers cannot keep inventory on the lots. As noted in JD Power’s Automotive Forecast for May, the average number of days a new vehicle sits on a dealer lot before being sold is on pace to fall to 47 days, down from 95 a year ago. Dealers are also selling a larger portion of vehicles as soon as they arrive in inventory, with 33.4% of vehicles being sold within 10 days of arrival, which is up from 18.2% in May of 2019. Rising vehicle prices continue to reflect this supply and demand imbalance and benefit retailer profits. As reported by JD Power, total aggregate retailer profits from new vehicle sales will be $4.5 billion, the highest ever for the month of May, and up 162% from May 2019. Fleet customers are continuing to suffer as OEMs prioritize deliveries to retail customers over fleet customers. NADA reported that fleet deliveries accounted for just 10% of new-vehicle sales in May, after averaging 16% the first four months of the year. Notably, this was already depressed in 2021 as pre-pandemic levels were closer to 20% of monthly sales. As we noted in our April SAAR, rental cars will continue to be hard to come by. These high prices on rental cars and limited selection will most likely continue until the chip shortage has been straightened out and supply has stabilized. Consumer ReactionsConsumers are having to get creative in order to secure a vehicle. As we mentioned on our April SAAR blog post, manufacturers are hoping that consumers will be flexible and purchase models with less features to save on chips.Consumers seem to be going the extra mile however, with Cars.com finding that nearly 1 in 3 recent buyers drove 100 miles or more to secure the car they want. Kelsey Mays, Cars.com assistance managing editor, noted “With the current auto inventory challenges, recent car buyers are going to great lengths to find the car they want…I don’t anticipate this trend slowing down, either. Of consumers currently in the market and shopping for a car, 65% said they would consider purchasing in another state.”While the extra mileage to find car options presents a clear inconvenience for consumers, they may reap some benefits as well. Over half (53%) of those looking for a new car also plan to trade in their current vehicle to the dealerships. As the inventory shortage has limited the availability of cars on lots, the dealerships are often willing to pay a premium for new inventory. The extent to which consumers are willing to travel to find a car sheds further light on the current supply and demand incongruencies.Government ReactionsThe chip shortage has reached such an extent that the U.S. government is trying to assist. According to Automotive News, the Senate has passed an expansive bill to invest nearly $250 billion in bolstering U.S. manufacturing and technology to meet the economic and strategic challenge from China. More specifically for auto dealers, the bill includes $52 billion in emergency outlays to help domestic manufacturers of semiconductors expand production, which was a bipartisan addition sought by Republican Senators John Cornyn (Texas) and Tom Cotton (Arkansas) and Democrats Mark Kelly (Arizona) and Mark Warner (Virginia). The addition of the semiconductor expansion was cheered by those in the industry who have been struggling to meet demand for months. Though the bill would be welcomed with open arms by the auto dealer industry, its fate is still uncertain as support in the House of Representatives is somewhat unknown. However, Senate Majority Leader Schumer has indicated that he believes the House will be able to get something passed through to President Joe Biden’s desk.When It Will End?With 93%of respondents to a survey conducted by Automotive News about the global chip shortage finding that they believe the chip shortage will have a severe impact on the auto industry, the question on everyone’s mind is when is the end date.While 72% of respondents believe that it will last the rest of the year, Goldman Sachs chief Asia economist Andrew Tilton believes the worst may be over. He has noted that there has been “noticeable tightening” of supply chains and shipment delays in North Asia, which will ultimately have an impact on downstream sectors such as auto production. He and his team believe the chip shortage could improve in the second half of 2021. However, this is a continuously evolving situation as multiple aspects of the supply chain are being disrupted, most recently in Taiwan. Chip manufacturing plants use large amounts of water, and Taiwan, home of the world’s largest contract chipmaker, is facing its worst water shortage in 56 years. This, as well as the continuing COVID-19 pandemic, will need to be monitored closely as the auto dealer industry hopes to move out of this ongoing chip shortage.ForecastWith the chip shortage still in full effect, inventory constraints are going to continue to be an issue through the remainder of the summer. Thomas King, president of the data and analytics division at J.D. Power notes:“Looking forward to June, with sales continuing to outpace production in aggregate, falling inventory levels may start to put pressure on the current sales pace. However, based on what we have seen so far, retailers may continue to adapt by turning inventory more quickly to maintain sales velocity. However, regardless of inventory position, manufacturers and retailers will continue to benefit from strong consumer demand and a higher profit per unit sold.”Through June and the rest of the year, ability to turnover what inventory auto dealers are able to get their hands on will be critical to maintaining profitability levels. Consumer’s willingness to go the extra mile (literally) in order to secure a new car is a positive tailwind, and a continuation of this trend will be beneficial for dealerships. However, the chip shortage continues to need to be monitored closely, though expectations of it easing and government assistance are providing some optimism to the situation.ConclusionIf you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

To the Moon or Back to Earth?

RIA Valuations Have Increased Substantially Over the Last Year, but That Doesn’t Necessarily Mean These Stocks Are Overpriced

To the Moon?A few weeks ago we blogged about how RIA stock prices have increased over 70% on average over the last year. This rapid ascent begs the question if valuations have gotten too rich with the market run-up during this time. To answer this question, we have to analyze the source of this increase.Click here to expand the table aboveMoving from left to right on the table above, we see that financial performance actually deteriorated over this time – revenue declined and margins compressed, leading to a 20% drop in EBITDA on average for this group of publicly traded RIAs with less than $100 billion in AUM. The increase in the EBITDA multiple more than compensated for the decline in profitability and is the primary driver of the overall increase in value from March 31, 2020 to March 31, 2021. At first glance, a 70% increase in value (when year-over-year earnings have actually declined) suggests that current pricing may be overstretched.Back to Earth?When we observe historical levels of RIA valuations, however, we get a much different perspective. Even after the recent run-up, EBITDA multiples are still at the lower end of their historical range. The multiple expansion follows an all-time low for the industry last March when these businesses were trading at 4x EBITDA during the bear market. There’s also a logical explanation for the multiple doubling over this period. These multiples are directly related to the outlook for future revenue and profitability, which tend to fluctuate with AUM since management fees are typically charged as a percentage of client assets. AUM balances have risen with the stock market over the last year, so the outlook for future revenue and earnings has rebounded accordingly. Trailing twelve-month (TTM) earnings in March of last year were also suppressed by the bear market’s impact on profitability during the first two quarters of 2020, so a higher TTM multiple is justified when historical earnings lag ongoing levels of profitability. This trend marks a complete reversal of what happened last March when AUM and run-rate performance declined with the market but trailing twelve-month earnings had not yet been impacted. As earnings figures lagged the abrupt price declines, multiples hit all-time lows. Because of this phenomenon, RIA multiples can be especially erratic during volatile market conditions. ConclusionWhile the significant gains in RIA valuations over the last year is fairly alarming, the fundamentals warrant such an increase. The market’s significant rise over the last year buoyed AUM and ongoing profitability, so investors are rationally anticipating higher earnings relative to recent history. Another correction or bear market would certainly reverse this trend, but at the moment, all industry metrics are pointing to the moon.

How to Value Oil Companies in the Biden Era

Like a small boat navigating a big sea, oil & gas valuations are impacted by a plethora of factors that can change almost instantly. Some factors help in arriving at a shareholder’s destination, others do not. Some factors the crew can control, others not so much (and some factors are more predictable than others). As this vessel heads for the destination shores of high returns, it must navigate through natural economic influencers such as production risk, commodity prices, supply logistics and demand changes. In addition, it also must face regulatory shifts that the Biden Administration is and could generate in the future such as tax changes, policy shifts and more. Most likely, these policies will create some volatility and headlines, but in the aggregate will not change valuations much. Let us examine a few of these regulatory items and how they might change the course of an oil and gas company’s valuation going forward.HeadwindsThere are several recent policy actions, and some that are being debated that are affecting the industry, primarily by disincentivizing new U.S. production. Actionsalready taken include a moratorium on federal oil & gas drilling permits and a construction stoppage of the Keystone XL pipeline. While it can grab a headline, from a valuation perspective it should not be a direction changing headwind. Most drilling is not done on federal lands, and a lot of companies with existing permits that will allow multiple years of drilling. Even if this becomes an enduring policy, the impact would likely be a revision too, rather than a material reduction of planned drilling activity.There are also some long-standing tax incentives that may be ended as well: the intangible drilling cost deduction and the percentage depletion allowance. Theintangible drilling cost deduction (which expenses as opposed to capitalizes certain drilling costs) has been around for over 100 years, and thepercentage depletion allowance (15% reduction in gross income of a productive well) has also been around nearly that long. The rationale behind both is to encourage investment by allowing tax breaks for development activity by delaying or decreasing cash taxes in any given year. This is an enjoyed benefit for investors and has allowed cash flows to either be higher or come faster than if the tax breaks were nonexistent. This is considered a headwind for the industry However, since many upstream companies are not cash taxpayers these days, and capital expenditure budgets have already been slashed in the past year, this issue (if it comes to pass) may end up being not much more consequential than a slight breeze.Another matter on U.S. producers’ radar is the expectation that Iranian oil sanctions will be lifted. Iran’s president Hassan Rouhani has said that a broad outline to end sanctions has been reached. Since November 2020 Iran’s crude and condensate exports have already gone up and the global market must contend with another 500 thousand barrels a day of exports. The good news is that the market may have already priced this in and WTI is still over $68 per barrel with Brent Crude over $70.TailwindsNot everything coming out of Washington is detrimental to upstream producers. In fact, some of it may end up being materially beneficial over the course of time. One example is the budget proposal to utilize federal funds for plugging old wells. Biden’s $2 trillion infrastructure proposal includes $16 billion for cleaning up disused wells and mines. Long a balance sheet issue for producers, this can has been kicked down the road for decades. The opportunity to be addressed from a subsidized standpoint would be a welcome development for producers. Even if it is executed inefficiently (North Dakota plugged 280 wells for $66 million: approximately $236k per well) as many government actions can be, it could help producers clean up over 50,000 “orphan” wells that can be over 100 years old in some cases. Considering the beating that oilfield service companies have taken in recent years, this initiative could be a shot in the arm for them as well.The other major tailwind is less about a direct policy, but more an indirect derivative of it. As the Biden Administration restricts drilling on federal lands, the supply of oil is (at least somewhat) constrained. Coupled with the multi-trillion dollar federal budget being proposed, these bring about inflationary pressures that are positive for commodities such as oil. As Sir Isaac Newton once said: “For every action there is an equal and opposite reaction.” Oil and gas companies have been consistently sailing towards capital discipline for several years now, as growth is out of favor in comparison to free cash flow. This strategy is expected to start showing fruit as cash flow and dividends become more prevalent in the industry, something that investors have been awaiting.Tempests on The Horizon?One area where headwinds and tailwinds could clash into a storm system is how inflationary pressures could impact production costs. As commodity prices rise, labor and material costs will impact production (particularly new drilling costs). There are varying opinions as to how much and how long the impact of inflation will be, but most analysts I have read agree that it is either coming or already here. One thing to consider is that while oil prices are global, development costs will be more constrained to the U.S.. Another disturbance will also be the costs of mineral rights payments as the shift of production moves to private lands and away from federal lands. Those items could counterbalance some of the expected commodity price gains and are something that should be on management teams’ radars.Mythical KrakensThere are two things that have been mentioned that could have seismic effects on the industry: banning fracking and limiting LNG exports. However, at this point the odds are low enough to place them in the fabled category. There have been state level fracking policies for years already (New York for example), but nothing about banning fracking has ever gone very far federally. Still, some voices who echo this idea are now close to the Biden Administration. Even with the 50/50 Senate split, most think Senator Manchin (D-WV) would never let it happen.The other idea is to choke the nascent Gulf Coast LNG export industry for ESG or other related priorities. However, that is also highly unlikely. A few months ago Energy Secretary Jennifer Granholm said:“[U.S. LNG is often headed to] countries that would otherwise be using very carbon-intensive fuels, it does have the impact of reducing internationally carbon emissions. However, I will say there is an opportunity here, as well, to really start to deploy some technologies with respect to natural gas in the Gulf and other places that we are siting these facilities for that we are obligated to do under the law.”While an argument can be made that there may be some environmental reasons for shutting this down, pragmatically there is little to no way it will happen anytime soon. If it did somehow, the natural gas business in the US would take yet another ship sinking blow.Heading For Home: High ReturnsWhile upsetting a few, the Government’s action is mostly having the effect of accelerating a lot of things investors have pressed for some time now. Capital discipline is positive for prices. Prices have crept up for months, but announcements for more aggressive drilling plans have been sparse. Matador added a rig in February, but the stock price quickly dropped 5%. Most US producers are more wary of OPEC and Russia than they are of the Biden Administration. Besides, many producers have multiple years of drilling inventory already permitted so federal permit moratoriums do not stop drilling in any substantive sense. Capital has already fled the industry, some for economic reasons, some for more ideological reasons. However, if the prices keep going up and cash flow returns become the norm in an inflationary economy, this vessel could make itself a popular destination for high returns in the future.Originally appeared on Forbes.com.

Crypto, Meme Stocks, NFTs and Your Family Business

Italian artist Salvatore Garau made headlines last week with the reported sale of his invisible sculpture at an auction. It is probably not our place to wade into heady debates surrounding the ontology of art, but the reported winning bid of $18,000 is admittedly hard to evaluate relative to something which, in at least a material sense, does not exist. Nonetheless, the sculpture did come with instructions for its proper display.Mr. Garau’s innovation is in some ways the perfect embodiment of several valuation-related stories over the past year or so.Cryptocurrencies have been garnering headlines for several years, but the rise to prominence of Dogecoin during 2021 has been noteworthy, with spectacular daily price volatility and a year-to-day (as of June 7, 2021) return of over 7,500%. While other cryptocurrencies stress limited supply as support for value, Dogecoin eschews supply limitations and is described as "intentionally abundant" with a reported 10,000 new coins mined every minute.Interest in so-called meme stocks has ballooned in 2021, with retail investors buying shares in companies with less-than-inspiring fundamental stories in an effort to squeeze short sellers. While buyers of GameStop (up approximately 1,500% year-to-date) and AMC (capital appreciation of over 2,500% year-to-date) have certainly made shorting those stocks unprofitable, it remains to be seen whether the shares can hold onto current valuations over the long-term.NFT’s or non-fungible tokens blur the line between cryptocurrencies and real assets. NFTs are digital assets that represent ownership rights to digital artwork, highlight clips, music or the like. Unlike units of a cryptocurrency, NFTs are unique (hence the "non-fungible" element of the name). At the extreme end of the market, digital artist Beeple sold an NFT through Christie’s for $69.3 million. Despite not owning the NFT, you can view it here. What does the well-publicized market activity for cryptocurrencies, meme stocks, and NFTs suggest for the value of your family business? Valuation specialists like to distinguish between "price" and "intrinsic value." Prices can be observed in transactions; intrinsic values cannot. For some asset classes, there is no meaningful difference between the two notions. For example, individual investors in the U.S. treasury market are essentially price takers, so attempting to distinguish between price and intrinsic value doesn’t make much sense. Intrinsic value generally relies on a belief that there is a "fair" rate of return on an asset and it hard to argue that the "fair" rate of return on treasuries is anything other than the prevailing yield in the market. When we move to the market for publicly traded shares, there are two dominant schools of thought. The first argues that public stock markets are efficient enough that any differences between price and intrinsic value do not persist long enough for investors to reliably profit from them. The logical conclusion from this belief is that one should invest in passively managed vehicles (index funds and the like). Active managers, in contrast, believe that they can successfully identify instances in which price and intrinsic value diverge. We suspect that as one moves into more esoteric asset classes like crypto, meme stocks, and NFTs, the wild observed price volatility reflects the higher degree of difficulty associated with estimating intrinsic value. Investor returns come from cash flow yield and capital appreciation. When cash flow yield is negligible or not expected, value depends on expected future exit prices. Is GameStop a good investment at $280 per share? It is if you can sell it for $300 per share next week. If you can’t find that next buyer, it may prove to be a bad entry price for a long-term hold. Where do family businesses fit in to this picture? The sort of "momentum" investing that powers market moves in crypto and meme stocks depends on liquidity: an investor can buy today and sell tomorrow if his mood changes. This same liquidity does not exist for family businesses, much less for minority shares in them. As a result, when you are thinking about the value of your family business, it’s probably best to turn off CNBC and think about three fundamental factors:Cash flow. How much cash flow does your family business generate after necessary reinvestments to sustain operations?Risk. How does the risk of your family business compare to that of other investments? By other investments, we don’t mean crypto or NFTs, we mean alternative investments of broadly comparable risk. The market for those assets determines the return required by potential investors: the higher the risk, the lower the value.Growth. What opportunities are available to sustainably grow the cash flows generated by your family business over time? Higher expected growth rates result in higher values. The sale of Mr. Garau’s sculpture is a "man bites dog" sort of story and therefore generates a lot of headlines. For better or worse, the value of your family business is much more of a "dog bites man" story. Our advice is to ignore the headlines and keep focusing on the fundamentals: cash flow, risk, and growth.

Fairness Opinions

Evaluating a Buyer’s Shares From the Seller’s PerspectiveM&A activity in North America (and globally) is rebounding in 2021 after falling to less than $2.0 trillion of deal value in 2020 for just the second time since 2015 according to PitchBook; however, deal activity has accelerated in 2021 and is expected to easily top 2020 assuming no major market disruption due to a confluence of multiple factors.Most acquirers whose shares are publicly traded have seen significant multiple expansion since September 2020;Debt financing is plentiful at record low yields;Private equity is active; and,Hundreds of SPACs have raised capital and are actively seeking acquisitions. The rally in equities, like low borrowing rates, has reduced the cost to finance acquisitions because the majority of stocks experienced multiple expansion rather than material growth in EPS. It is easier for a buyer to issue shares to finance an acquisition if the shares trade at rich valuation than issuing “cheap” shares. As of June 3, 2021, the S&P 500’s P/E based upon trailing earnings (as reported) was 44.9x compared to the long-term average since 1871 of 16x. Obviously trailing earnings were depressed by the impact of COVID-19 on 2020 earnings, but forward multiples are elevated, too. Based upon consensus estimates for 12 months ended March 31, 2022, the S&P 500 is trading for 21x earnings. High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares have to be issued to achieve a targeted dollar value. As such, it is no surprise that the extended rally in equities has supported deal activity this year. However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be as obvious as it seems, even when the buyer’s shares are actively traded. Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.” A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated. Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares - What is the capacity to sell the shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends - The analysis should consider the buyer’s historical growth and projected growth in revenues, operating earnings (usually EBITDA or EBITDA less capital expenditures) in addition to EPS. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Pro Forma Impact - The analysis should consider the impact of a proposed transaction on revenues, EBITDA, margins, EPS and capital structure. The per share accretion and dilution analysis of such metrics as earnings, EBITDA and dividends should consider both the buyer’s and seller’s perspectives.Dividends - In a yield starved world, dividend paying stocks have greater attraction than in past years. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. If the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed? Worse would be if the market expected a dividend cut. These same questions should also be asked in the context of the prospects for further increases.Capital Structure - Does the acquirer operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Will the proposed acquisition result in an over-leveraged company, which in turn may lead to pressure on the buyer’s shares and/or a rating downgrade if the buyer has rated debt?Balance Sheet Flexibility - Related to the capital structure should be a detailed review of the buyer’s balance sheet that examines such areas as liquidity, access to bank credit, and the carrying value of assets such as deferred tax assets.Ability to Raise Cash to Close - What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates - If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation - Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance - Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position - Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities - Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too. The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.

Tax Planning for Auto Dealerships

Why Auto Dealers Might Not Pay “Market” Rent

In business valuation, appraisers seek to normalize historical earnings to establish the level of earnings an investor might reasonably expect from an investment in the subject company. These adjustments may increase or decrease earnings, and they can be for a variety of reasons. Normalization adjustments include surveying various expense categories and determining whether the amount historically paid is considered “market rate.”Rent paid to a related party is frequently judged to be above or below market, which can be for a variety of reasons. Dealers’ priorities lie more with sales and operating efficiency than tracking what the market says they should pay in rent. The rent paid also may be artificially high or low for tax purposes. In this post, we examine what exactly this means, and why auto dealers may hold real estate in a separate but related entity from the one that owns the dealership operations.What Are the Options and Are Taxes in Play?To understand why paying above market rent might be advantageous for an auto dealer, we need to know the options available and the tax implications. There are a few ways for gross profits to end up in the pockets of dealers:Retain as profit and pay a distribution (corporate income tax and personal dividend tax)Pay as compensation to owner (personal income tax and payroll tax)Pay as rent to related pass-through entity that owns the real estate (personal income tax)Pay Corporate Taxes on Profits and Pay a DividendMaking the decision for “tax purposes” has frequently implied avoiding the double taxation inherent in C corporations. A dealership organized as a C corporation would owe approximately 25% in state (assuming a 5% state tax rate) and federal corporate income tax, meaning $1,00,000 in pre-tax earnings would equate to a dividend of about $750,500. Then, the owner would likely owe an additional 15-20% in dividend taxes, meaning $1,000,000 may be closer to $600,400 in after-tax(es) proceeds. An all-in tax rate of approximately 40% in 2021 is much lower than what dealers would have paid prior to the 2017 Tax Cuts and Jobs Act as shown below:The reduction in the federal corporate income tax itself was a fundamental change to how business owners think about these excess profits. While it significantly increased after-tax proceeds under this payment structure, many owners had already been using more advantageous tax strategies. That’s why most private dealerships aren’t organized as C corporations.Pay Excess Profits as Compensation to DealerIf excess profits are paid as compensation, a dealer is likely to owe the top marginal personal tax rate of 37%. While this appears better than the ~40% tax contemplated above, this fails to capture payroll taxes. Up to certain income levels, a payroll tax of 15.3% is split by employers and employees to fund Social Security (6.2% each) and Medicare (1.45% each). While companies’ exposure to the social security tax is capped at $142,800 in compensation, there is no limit for individuals; in fact, there is an additional Medicare tax of 0.9% added on to the 1.45% on income over $200,000. These calculations can become more complicated depending on the level of payment, and the analysis gets further muddied by the level of pre-bonus compensation to the dealer (below analysis assumes no base salary).As seen above, the analysis becomes more nuanced, but there does not appear to be a huge opportunity for tax savings as the implied all-in tax is near the 40% calculated above post-TCJA.Pay Excess Profits as Rent to a Pass-Through Owned by the DealerPaying higher rent is likely the cleanest way to transfer profits from the dealership to a separately held entity. If the rent paid on the property was $1,000,000 more than it otherwise would be with no commensurate increase in expenses to the entity, income would be passed through at personal rates, like compensation just without payroll taxes. While pass-through entities may also be able to benefit from the Qualified Business Income Deduction, we have not considered this in our calculations because the deduction phases out well before the contemplated $1,000,000 in excess profit/rent. While this appears most advantageous, we should caveat that the IRS may not take to kindly to egregious overpayments of rent to shelter income. Regardless, income and payroll taxes aren’t the only reason a dealer might own the dealership’s real estate operations in a separate entity. There are other strategic reasons it makes sense for auto dealers to have the real estate held in a separate entity, as is common in the industry. An example of this is legal protection from creditors by separating assets. It also enables dealers to retain upside in valuable real estate if they choose to divest of their dealership but retain steady income. As discussed below, there are also other tax planning benefits from this structure. Tax Planning Benefits of Using Multiple EntitiesEarnings on real estate may receive a higher multiplein the marketplace than a business, including auto dealership real estate. This is because rents are paid before equity holders and are therefore viewed as less risky. These steady earnings streams can be beneficial from a financial planning standpoint. In the case of a divorce, the “out-spouse,” or the divorcing party that doesn’t actively participate in the business, might receive alimony, or an equitable division of the marital estate. It may make sense for an auto dealer’s spouse to receive an interest in a real estate entity, receiving more steady cash flows, while the auto dealer would retain the upside of their work in the business.There may also be estate planning benefits that similarly align incentives. If an auto dealer has numerous children and one works in the business, it may similarly make sense for them to either purchase or be gifted an equity interest in the dealership as they actively contribute to its profitability. For a child not involved in the business, it may be the most equitable solution to instead allow them to receive an interest in the real estate, receiving both a steady income and also passive appreciation.ConclusionAs we’ve seen, auto dealers have numerous considerations and options when it comes to excess profits that might be paid as a bonus, dividend, or rent. As appraisers, we are unlikely to opine a higher or lower valuation to a dealership’s operations based on these decisions. While the calculations can become more complex, it is unlikely one of these will increase the value of the enterprise for two reasons: a buyer is less likely to care about the current ownership structure, and if one structure always resulted in greater value, wouldn’t everyone simply choose that structure?As we’ve discussed previously, it appears the Federal Corporate tax rate does not materially impact valuations. If tax rates change again, auto dealers will again have to consider what works best in their unique situation. This can be complicated when there are numerous owners and other life events can impact what makes the most sense from a strategic standpoint.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers understand the value of their business as well as the greater implications of its value. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Succession Planning for Independent RIAs

The Best Time To Plan Is Now

Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The demographics suggest that increased attention to succession planning is well warranted: over 60% of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. Yet, when RIA principals are asked to rank their firm’s top priorities, developing a succession plan is often ranked last.What Is a Succession Plan?Despite the headlines suggesting that there is a wave of strategic takeovers that will ultimately consolidate the investment management profession into a few large firms, the reality we’ve encountered suggests that most RIAs will transition ownership and leadership from one generation to the next internally. The reasons for this are fairly obvious.Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor. Internal transitions allow RIAs to maintain independence over the long-term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned. Further, a gradual transition of responsibilities and ownership to the next generation is usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit. While this option typically requires the most preparation and patience, it allows the founding shareholders to handpick their successors and future leadership.When managers at RIAs start thinking about succession, they immediately jump into who buys out whom at what price and terms. While this is one piece of a succession plan, we would suggest, instead, that the starting point is strategic planning for the business.One of the keys to understanding succession planning is understanding what it is not.A Succession Plan Is Not…A succession plan is not a continuity plan. A continuity plan ensures that your clients will have uninterrupted services in the event of a disaster. Your eventual retirement should not be treated in the same manner as a sudden death or earthquake.A succession plan is not an exit plan. An exit plan is a business owner’s strategic plan to sell their ownership to realize a profit or limit losses. This line can be fuzzy, but strategic transactions rarely obviate the need for succession planning. Leadership transition issues can loom large even in strategic transactions.The Time To Plan Is NowIf you’re a founding partner or selling principal, you have several options, and it’s never too soon to start thinking about succession planning. Proper succession planning needs to be tailored, and a variety of options should be considered. See our recent whitepaper for more information on succession planning.ConclusionSince our founding in 1982, Mercer Capital has provided expert valuation opinions to over 15,000 clients throughout the U.S. and six continents. We are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, and independent trust companies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

Book Review: When Anything Is Possible

Over 80% of trust beneficiaries believe their trust has a negative impact on their lives. Really? That is one of the numerous counterintuitive findings presented by David C. Wells, Jr. in his new book When Anything Is Possible: Wealth and the Art of Strategic Living. Wells does something that not many financial books aim to do.Most financial literature focuses on one of three areas:Help, I have a problem! Think Dave Ramsey.How do I get more money? This includes The Millionaire Next Door and other DIY investing books.How do I learn more? Consisting of deep dives into REITS, stock selection, or portfolio construction. Your practitioners. Wells aims to tackle a new frontier: how to live a full life strategically with wealth in hand."All I ask is for the chance to prove that money can't make me happy."The affluent do not naturally inspire pity, but Wells highlights the unique challenges associated with accumulated wealth. Wells poses a compelling question that family business advisors and business owners should consider: how does wealth allow one to live well on a personal and fundamental level as human beings?Wells provides numerous examples of wealthy people living rather poorly. Divorce, depression, anxiety, and other issues seem to plague those who are free from the financial constraints most people face. This is the gap Wells hopes to fill with When Anything Is Possible – how can we have our wealth serve those who have it, and not the other way around."The unexamined life is not worth living."When Anything Is Possible is structured in three sections: Wealth Structure, Wealth Identity, and Wealth Strategy. Wealth Structure, found in Part I, focuses on defining wealth and the common psychological issues that befall those with considerable wealth, leaning on Nobel laureate Daniel Kahneman, the Bible, and other resources. One highlight of the book for me was the 25 or so recommendations provided at the conclusion of each section. On the strength of these recommendations, I encouraged others to read the book before I had even finished reading it myself. Wealth Identity is dissected in Part II. Wells highlights the "Self-and-Money Framework" he developed and currently uses in his family business consulting practice to help families and wealthy individuals define themselves. Wells advocates for a personal family wealth "mission statement" – akin to the guiding principles spelled out at companies like Nike or Coca-Cola – as well as "vision statements." These are meant to define the "why" and the "where we are going" questions that define the wealth journey for enterprising families. Family businesses would be well served to give serious thought to mission and vision. Avoiding the dreaded "shirtsleeves to shirtsleeves" cycle can only be accomplished by giving heed to both next quarter's P&L and the vision of the family members in the company."Money brings some happiness, but at a certain point it just brings more money."Part III covers Wealth Strategy and how wealthy individuals spend, invest, gift (to family), and give (charity). Wells highlights several great anecdotes, books, and data points to drive home a singular point: consumption and wealth without a "why" brings happiness only to a point.A single image that shows the living patterns of individuals in homes drove this point home to me perfectly. Families spend most of their time in two rooms: the kitchen, and the family/living room. Based on square footage and usage, formal dining rooms might cost $1,500 per use. How about a private room at the Capital Grille instead? As Wells points out: no dishes.Wells provides great tools in the final chapters for thinking about our consumption, estate planning, investing, and giving decisions. The book does a good job continually re-centering decisions back to a key question: Why?ConclusionWells sells himself short by claiming the book is not for everyone. While not a member of the two or three-comma club, I found his study of psychology, purpose, and faith as it applies to wealth both enriching and a cause for self-reflection. In our family business advisory practice at Mercer Capital, we help our clients navigate the intersection of family issues and business realities. Built around the framework of wealth structure, identity, and strategy, When Anything Is Possible is a timely guide for business owners thinking about the role of wealth in their families.

Purchase Price Allocations for Asset and Wealth Manager Transactions

There’s been a great deal of interest in RIA acquisitions in recent years from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. These acquirers have been drawn to RIA acquisitions due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer. Following these transactions, acquirors are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.A purchase price allocation is just that—the purchase price paid for the acquired business is allocated to the acquired tangible and separately-identifiable intangible assets. As noted in the following figure, the acquired assets are measured at fair value. The excess of the purchase price over the identified tangible and intangible assets is referred to as goodwill.Transactions structures involving RIAs can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset and wealth management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fees, profit margins, etc). It is important to understand how the characteristics of the asset management industry in general and those attributable to a specific firm influence the values of the assets acquired in these transactions. Because most investment managers are not asset intensive operations, the majority of value is typically allocated to intangible assets. Common intangible assets acquired in the purchase of private asset and wealth management firms include the existing customer relationships, tradename, non-competition agreements with executives, and the assembled workforce. Customer RelationshipsGenerally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.Due to their long-term nature, relatively low attrition rates, and importance as a driver of revenue in the asset and wealth management industries, customer relationships often command a relatively high portion of the allocated value. We can see this in the public filings of RIA aggregator Focus Financial. Between 2016 and 2020, Focus completed 106 acquisitions of RIAs. Of the aggregate allocated consideration for these transactions, a full 53% was allocated to customer relationships and 3% was allocated to other assets, with the remaining 44% comprising goodwill.Expand ChartTradenameThe deal terms we see employ a wide range of possible treatments for the tradename acquired in the transaction. The acquiror will need to decide whether to continue using the asset or wealth manager’s name into perpetuity or only use it during a transition period as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on a number of factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the asset/wealth manager’s existing client base. In any event, for most relatively successful small-to-medium sized RIAs, the tradename has some positive recognition among the customer base and in the local market, but typically lacks the “brand name” recognition that would give rise to significant tradename value.In general, the value of a tradename can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the tradename value.Noncompetition AgreementsIn many asset and wealth management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current employees of the company. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement (for example, if the individual is a beneficiary of an earn-out agreement or received equity in the acquiror as part of the deal, the probability of competition may be significantly lessened).Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in relationship-based industries like asset and wealth management, getting a new portfolio manager or advisor up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network may often command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the value of an assembled workforce is valued as a component of valuing the other assets. It is not recognized or reported separately, but rather is included as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset or wealth manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for RIA acquirors, we frequently see earnouts structured into the deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer, while rewarding the seller for continuity of performance or growth. Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation and transaction work for the investment management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.

Why Involve a Financial Expert in Divorce Mediations

Most family law cases settle at mediation or prior to trial. For example, Tennessee requires that parties must attempt to settle their cases at mediation prior to granting a trial date. Considering both of these facts, when should a family law attorney involve a financial expert in divorce mediations?

Issue No. 8 | Data as of Mid-Year 2021

Feature Articles: Tax Planning for Auto Dealerships and M&A, Reinvesting in Core Operations, or Paying Dividends

Issue No. 9 | Data as of Mid-Year 2022

Feature Articles: In 2022, How Is the Auto Industry Doing and What Does the Future Hold? and Earnings Calls: Executive Summary

Issue No. 10 | Data as of Year-End 2022

Feature Articles: 2022 Auto Dealer Industry Metrics Review and Q4 2022 Earnings Calls

Not All MOEs Are Created Equal

In the December 2020 BankWatch, we provided our M&A outlook for 2021 and touched on themes that we believed would drive deal activity for the year.Our view was that the need to reduce costs in the face of revenue pressure would create urgency for banks to engage in M&A and lead to increased deal activity, given that credit quality remained stable and the economy avoided a double-dip recession. Specifically, we noted that these drivers may cause mergers of equals (“MOEs”) to see more interest.Indeed, four of the largest bank deals in 2020 were structured as MOEs or quasi-MOEs (low premium transactions), and we believed the trend would only gain more traction as economic clarity emerged. Thus far in 2021, against the backdrop of economic reopening, stable asset quality, and favorable bank stock performance, deal activity in the industry has picked up, and MOEs remain a hot topic.S&P Global Market Intelligence reported 53 U.S. bank deals year-to date through April 30, compared to 43 during the same period in 2020.The pace increased notably in April as 19 deals were announced in the month, including two large MOEs.BancorpSouth (BXS) announced a merger with Cadence (CADE) on April 12, and Webster (WBS) announced a deal with Sterling Bancorp (STL) one week later on April 19.U.S. Bank MOEs by Year # of Announced DealBank MOEs are not a new concept, but they have occurred more frequently over the past several years, with the most notable being the BB&T – SunTrust combination to form Truist Financial (TFC).The BB&T-SunTrust combination has been reasonably well received, while it is perhaps early to judge some of the more recent deals.These types of transactions certainly have their merits and can appear strategically and financially compelling.However, MOEs involve a number of risks that should not be overlooked.For management teams considering an MOE, it is important to assess both the benefits and potential risks of such a deal.CLICK HERE TO ENLARGE THE CHART ABOVEBENEFITSReduce CostsPerhaps the most apparent benefit is the opportunity to reduce costs and improve operational efficiency.This is especially valuable in the current environment as revenue growth opportunities are limited.Reported estimates for cost savings in recent MOEs have been on the order of 10% to 15% of the combined expense base.These savings are often achieved by consolidating back office and administrative functions and/or right-sizing the branch network.With the increased adoption of digital banking, branch networks have become less central to banks’ business models and can be a drag on efficiency.MOEs provide management teams an opportunity to re-evaluate their banks’ physical distribution systems and reap the benefits of optimizing the branch network.CLICK HERE TO ENLARGE THE CHART ABOVEInvest in TechnologyThe savings from efficiencies and branch consolidation can be invested in upgrading the bank’s technological capabilities.Almost all recent merger press releases include some type of statement indicating management’s intent to invest in the pro forma bank’s digital capabilities.While the specifics of such investments are often not disclosed, it is clear that management teams view the ability to invest in technology as a key piece of the rationale for merging.By gaining scale, banks can dedicate the necessary resources to develop sophisticated financial technology solutions. Expand FootprintWith a challenging loan growth outlook, many banks are considering entering new markets with favorable demographic characteristics.Unlike a de novo strategy or a series of small acquisitions, an MOE provides an opportunity to quickly establish a sizeable presence in a desired market.In merging with Cadence, BancorpSouth will in a single transaction more than double its deposit base in Texas where it previously had been acquiring smaller banks, with three sub-$500 million asset bank acquisitions since 2018.As banks look to position themselves for growth, MOEs are a potentially attractive option to gain meaningful exposure to new markets. Diversify Revenue StreamA merger offers opportunities to diversify the revenue stream by either gaining new lending expertise or entering a new fee income line of business.The more retail-focused First Citizens Bancshares will significantly diversify its lending profile when it completes its combination with the commercial-oriented CIT Group, announced in October of last year.Similarly, IberiaBank diversified its revenue stream by combining with First Horizon which has a sizeable fixed income operation.As revenue growth remains challenging, management teams should consider if a transaction might better position their bank for the current environment. RISKSWhile an MOE can offer benefits on a larger scale, it also presents risks on a larger scale.The risks detailed below largely apply to all mergers and are amplified in the case of an MOE. CultureCulture is often the arbiter between success and failure for an MOE.Each of the subsequent risks detailed in this section could be considered a derivative of culture.If two banks with conflicting management philosophies combine, the result is predictable.The 1994 (admittedly before my time) combination of Society Corporation and KeyCorp was considered a struggle for several years as Society was a centralized, commercial-lending powerhouse while KeyCorp was a decentralized, retail-focused operation.Potential merger partners need to honestly assess cultural similarities and differences and evaluate the proposed post-merger management structure before moving forward. It is also important that merging banks be on the same page regarding post-merger ambitions.If one views the merger as “fattening itself up” for a future acquirer while the other desires to remain independent, they will likely diverge in their approach to other strategic decisions.When executives or board members frequently clash, the pro forma entity will struggle. Staff RetentionThere is usually some level of employee fallout with an acquisition, but if enough key employees leave or are poached by competitors, the bank’s post-merger performance will suffer.This is an especially important consideration when acquiring a bank in a new market or with a unique lending niche.If employees with strong ties to the communities in a new market leave for a competitor, it will be difficult to gain traction in that market.Likewise, a new lending specialty or business line can fail if those with the knowledge and experience to run it do not stick around for long. Execution/IntegrationAcquiring a bank of the same or similar size requires a tremendous amount of effort.Loan and deposit systems must be consolidated, customers from the acquired bank must be onboarded to the new bank’s platforms, and branding must be updated across the franchise.If the acquirer’s management team has little experience with acquisitions, successfully integrating with a large partner may prove difficult.When considering an MOE, the acquiring bank must assess what tasks will be necessary to combine the operations of the two organizations and achieve the projected cost savings.Management teams must consider whether their organization has the expertise to do that or, if not, what external resources would be needed. CreditCredit quality issues from an acquired loan portfolio can come back to bite a bank years after the acquisition.Merger partners need to be sure they have performed thorough due diligence on each bank’s loan portfolio and are comfortable with the risk profile.While recent credit quality concerns in the industry have not materialized and greater economic clarity has emerged, would-be acquirers need not be lulled to sleep by the current credit backdrop.The past year has shown that the future is unpredictable, and that forecasts are not always correct. CLICK HERE TO ENLARGE THE CHART ABOVEAdverse Market ReactionIn recent MOEs and low premium transactions, acquirers’ shares have faced an adverse reaction from investors with declines of 5% to 7% in the days following announcement.First Citizens is an exception as its shares were up 34% five days after announcing its acquisition of CIT, which largely reflects the favorable price paid (44% of tangible book value).While it is not uncommon for buyers’ shares to decline following the announcement of an acquisition, these drops could reflect the market’s concerns around the heightened execution and integration risk of an MOE.It is early to judge whether the deals will create value in the long run or if the market’s initial reaction was justified. CONCLUSIONWe believe M&A will continue at a strong pace in the coming months as the economy continues to reopen and banks dust off previously shelved pre-Covid deals.We also expect MOEs will continue to garner more interest due to the aforementioned benefits.Management teams may be more willing to negotiate now than before on price, management roles, board composition, branding, etc.A balanced consideration of the benefits and risks of an MOE is imperative for making the optimal decision.Mercer Capital has significant experience in advising banks as buyers and sellers in transactions, including MOEs.

Mineral Aggregator Valuation Multiples Study Released

With Market Data as of May 26, 2021

Post-Pandemic Tax Planning for RIAs

Is It Time To Consider a Change in Your Corporate Structure, or Your Address?

Most of our colleagues at Mercer Capital live in Texas or Tennessee – two states with very low tax burdens. This is not by design so much as by circumstance: our firm grew up where we already lived. Until recently, the relatively low cost of living, short commutes, and moderate climate came with a tradeoff: most of our clients are on the coasts, so regular travel away from home was a necessity.Now that the pandemic has made geographic proximity for many meetings a non-issue, we’re beginning to wonder how many of our clients are ultimately going to join us. Dynasty’s move from New York to Florida and UBS’s relocation to Tennessee got plenty of attention. And we’re starting to hear of smaller RIAs contemplating similar moves. This isn’t a crowded trade yet though; most investment management firms still call high-cost, high-tax states home.Texas and Florida have been climbing the rankings of states with the most RIAs, but two states still dominate this survey – New York and California. New York’s position is even stronger if you include adjacent communities of investment management firms in Connecticut, New Jersey, and Pennsylvania.California is in an enviable position as the fifth largest economy on the globe, not to mention mostly-beautiful weather. That hasn’t been enough for Schwab, which has been migrating staff to Texas, Colorado, and Arizona for years. Now we’re starting to hear from California clients with staff members who moved out of state during the worst of the pandemic and would like to continue working remotely. When will their employers follow?Manhattan is another story altogether, with city tax burdens layered on top of state taxes. With all due respect to Manhattan’s theme song, in the post-pandemic, remote-work world, if you can make it anywhere, why make it there? We have another wealth management client who just relocated from New York to Tennessee – cost structure and concern over the quality of life in Manhattan for the foreseeable future were key factors.What the table above doesn’t show is the value of the talent pools already established in financial hubs like San Francisco and New York. But the relative cost of living may be enough to convince some of that talent to relocate. If that becomes a trend, all bets are off.The wrong corporate structure can exacerbate the state tax differential. Imagine the extreme scenario of a Manhattan based C Corporation that considers moving to Florida and converting to an LLC.After-tax dividends/distributions to the Florida LLC member are about 30% higher than for a shareholder in a New York City C Corporation with the same EBIT (earnings before interest and taxes). But this differential is far greater if you consider the cost of living in Florida versus New York – a difference that will widen further if President Biden successfully rolls back some or all of the reduction in corporate taxes enacted in 2017.As for proximity to clients, there are reasons to expect ultra-high net worth families in California and New York to relocate. Florida still has no estate tax, while New York just raised theirs. Tennessee and Texas (two states with no personal income tax) also have no estate tax, and Tennessee has strong and well-developed trust laws considered on-par with South Dakota.Anecdotal experience supports this trend. Friends on the west coast and in the northeast have told me they have a recurring conversation with their neighbors that revolves around the question: “how much longer are you going to stay here?” The implication of this question is that, as soon as they could, they would decamp for a lower-tax, lower-cost of living part of the U.S. Just as the pandemic accelerated many trends, we expect to see a migration of wealthy clients to more cost-effective jurisdictions, as well as the firms that serve them.

Making Sense of 2020: Part 4

History, Valuation & the Future

It makes sense that stock prices reflect financial performance, and over the long run they do. So how to explain 2020, which saw corporate earnings devastated by the pandemic and stock indexes soaring to all-time highs? We’ve covered the pandemic’s affect on the operating, investing, and financing decisions made by public companies in our last three posts. This week, we conclude by examining shareholder returns.Chart 20 summarizes the performance of the Russell 2000 index (small cap shares) during 2019 and 2020. At the onset of the pandemic, the index fell precipitously. This is pretty easy to understand: investors don’t like risk, and risk was everywhere in the spring of 2020. During the second and third quarters, investors began to feel that they had a handle on the pandemic. In other words, investors grew increasingly comfortable that the long-term economic impact of the pandemic could be reasonably estimated. By the end of 3Q20, the index value had returned to pre-pandemic levels. When thinking about valuation, it is important to recall that the emphasis is always on the future. When the end of 3Q20 rolled around, it was clear that earnings for 2020 would be impaired because of the pandemic – so how could share prices be at the same level? Because the lower earnings for 2020 no longer mattered; the market was focused on earnings expectations for 2021 and beyond. Chart 21 shows that, while the market as whole had recovered by the end of 3Q20, not all companies did. Different industries fared differently. For example, healthcare shares increased sharply while energy shares were devastated. The storyline changes when we turn our attention to market performance in the fourth quarter of 2020. As shown on Chart 20, the index value surpassed pre-COVID levels by almost 20%. Chart 22 summarizes average share price changes by industry for the fourth quarter of 2020. In contrast to the share price performance during the first three quarters, the uplift in market prices during the fourth quarter was broad, with all sectors posting substantial average share price gains. Share prices change when earnings change and/or earnings multiples change. As shown in Chart 23, increasing earnings multiples played a significant role in the share price gains during the fourth quarter of 2020. Earnings multiples are defined by investor expectations for growth and returns. Growth. From the existing base, how fast are earnings expected to grow in the future? The faster the expected growth, the higher the earnings multiple. As visibility into vaccine pipeline increased during the quarter, investors may have been willing to credit companies with higher growth prospects.Returns. What return are investors demanding? Returns are the sum of the yield on risk-free assets plus a premium to compensate investors for taking risk. All else equal, investor returns are inversely related to earnings multiples. The increase in multiples during 4Q20 suggests that required returns decreased. Since risk-free returns increased during the period, the return premium received for taking risk likely fell more dramatically.Takeaways for Family Business DirectorsWhat does all of this mean for family business directors? The effect of the pandemic on business operations has been well-documented. However, for most family businesses it is time to move on from the survival mindset required during 2020.How will your family business grow in a post-pandemic world?One message from the stock market run-up during 4Q20 is that public market investors are expecting growth. Even if you think your family shareholders are different, public market sentiment likely shapes the behavior of your competitors and will influence what happens in your industry whether you want it to or not. In the wake of changes to supply chains and distribution channels, what new strategies will your family business need to adopt to compete and grow in the post-COVID world?How will you adapt to a lower cost of capital?The cost of capital is the price of money, and family businesses are ultimately price takers in the capital markets. While family shareholders may be protected from short-term public market volatility, public capital market trends do affect family businesses in the long-term. Regardless of whether you assign the cause to central bank actions or shifting investor sentiment, the overall cost of capital was probably lower at the end of 2020 than at the beginning of the year. This has significant implications for how family businesses evaluate and make distribution, investment, and capital structure decisions.These questions rarely have simple answers. Give one of our family business professionals a call to discuss what adjustments may be appropriate to help your family business thrive in the post-COVID world.

Valuation and M&A Trends in the Auto Dealer Industry

Full Speed Ahead or Partly Cloudy?

A few weeks ago, I sat down with Kevin Nill of Haig Partners to discuss trends in the auto dealer industry and the release of their Fourth Quarter 2020 Haig Report. Specifically, I wanted to focus on the unique conditions impacting the industry, and also the changing methodology that buyers are utilizing to assess dealership values. Haig Partners is a leading investment banking firm that focuses on buy/sell transactions in the auto dealer industry, along with other transportation segments. As readers in this space are familiar, Haig Partners also publishes Blue Sky multiples for various auto manufacturers based on their observations and data from participating in transactions in this industry.The Haig Report mentions many buyers are utilizing a three-year average of earnings to calculate the expected performance of the dealership. Why has this new trend occurred and how has a buyer’s pricing methodology shifted in 2020/2021?KN: Prior to the pandemic, the auto retail market had effectively plateaued with sales declining slightly and dealership profitability fairly stable. The roller coaster of 2020 - a lockdown, then a big upswing as pent up demand and stimulus money flowed through the system in the summer, followed by continued retail demand and tight inventories, created a lot of “noise” in dealer financial statements. Even with exclusion of PPP fund impact, overall dealership profitability was incredibly strong with many stores achieving all-time record profits. This created a challenge for buyers as they attempted to identify the correct income to base their buying decisions. When you apply a multiple against expected earnings to determine value, one needs to have confidence the earnings will materialize. Given the volatility in performance, buyers have been reluctant to price a deal solely on 2020 results, making the argument the performance was artificially inflated. Sellers counter by illustrating the strong results were not a summer phenomenon but have continued into 2021 and no end is in sight. Going forward inventory availability remains an issue creating nice margins, interest rates will remain low for the foreseeable future, and expense controls have taken some of the bloat out of the business. As a result, many buyers are using a three-year average (2018-2020) as their earnings baseline. This gives the seller credit for the strong 2020 numbers but reflects expectations that future results will likely settle back to pre-pandemic numbers. Notably, some markets that were harder hit by the pandemic did not generate record numbers, and some buyers are utilizing 2019 as their baseline so as not to punish a seller for a down year in 2020. Regardless, it takes more massaging of past performance to establish a baseline for future results. SW: The methodology described by Kevin compares to our longer-term view of a dealership’s earnings and profitability. A valuation considers the expected ongoing earnings or cash flow of the dealership, and as such, several factors should be considered including historical, current, and expected operations in the future. We are cautious not to overvalue a dealership in its best year or undervalue a dealership in its worst year, if neither are sustainable. As to the impact of the pandemic on dealership valuations, we think it is relative to each individual dealership and their unique set of factors.Will buyers revert to Trailing 12 Months (TTM) as their baseline or will the three-year average method remain for some time?KN: Adjusted TTM earnings became the primary baseline for applying a multiple because the industry performance had been fairly stable for some time. Yes, there were specific dealerships that had better or worse results, and those were valued with appropriate modifications to forecasted earnings. Given the aforementioned volatility in 2020, the expectations of a strong 2021 and a potential gradual return to pre-pandemic levels, using a three-year average of earnings has become a more accepted strategy. Until we see stability in the automotive retail sector for some time, it’s unlikely TTM will return as the primary earnings metric. Of course, there are always exceptions including unique market dynamics, identified changes to the business or a highly competitive market for a dealership that may require buyers to give more credit for 2020 and 2021 results.Has there been a prior time when a three-year average was the preferred method for calculating earnings and, if so, what were the underlying conditions at the time?KN: Using a three-year average was a fairly standard method until recently but as dealership performance became stable and predictable, both buyers and sellers gradually settled on TTM as an effective proxy to base their valuation. Simplicity and the lack of variance in performance made it an easy calculation and removed some of the tension during negotiations. Of course, there has and will continue to be discussion and debate on add-backs and proforma earnings when strategic shifts at the dealership might yield better results. In general, the more consistent the performance, the more likely the buyer can get comfortable using the most recent financial period to calculate a value. SW: As we discuss on a monthly basis, the auto SAAR (number of lightweight automobiles and trucks sold on an annual basis) is one of the general indicators of the conditions in the industry. To view Kevin’s rationale behind the stability in the industry through the lens of SAAR, SAAR was fairly stable and roughly averaged between 16 and 18 million units from mid-2014 through the first few months of 2020 prior to the pandemic. SAAR collapsed to 11.361 million units in March 2020, before bottoming out at 8.721 million units in April 2020.What other changes or areas of focus are buyers concentrating on given the unique 2020 environment?KN: As buyers look to 2021 and beyond and evaluate how a target might perform going forward, there are certainly some areas of the business that are receiving attention:New vehicle margins – Given industry constraints on production, new inventory levels on dealer lots are quite low, allowing dealers to increase transaction prices and realize stronger margins. This is expected for most of 2021 and possibly into 2022. There is also dialogue that given improved profitability at OEMs, suppliers, and dealers, a more balanced production vs. demand market may continue, maintaining improved margins.Used vehicle margins – The used vehicle market dropped initially during the pandemic lockdown, spiked again, and has remained fairly strong since the fall. Now with new vehicle shortages, we are hearing dealers are driving up acquisition prices on used vehicles. The lack of new availability could drive consumers to used and keep margins strong or the frenzy to buy inventory could lower margins if consumers balk at the higher costs of the vehicle.Fixed operations – Most dealers saw a drop in 2020 fixed operations as the lockdown cost them weeks and months of customers. Given most dealership service bays are at or near capacity, you can’t make the business up. However, the 4Q of 2020 saw fixed revenue return to pre-pandemic levels. Thus, we expect 2021 to show nice growth in fixed operations over a lower 2020 and the past trend of annualized revenue increases should continue in 2022 and beyond.SG&A expenses – Key expense categories including floor plan interest, advertising and personnel saw nice declines in 2020. It is likely interest rates will remain close to zero, possibly into 2023. Many dealers see lower advertising as a continued theme for the foreseeable future given demand is exceeding supply. Finally, as dealers refine their sales and delivery channels and more transactions move online, we hear a number of dealer principals indicate their staffing levels will be permanently lower.SW: Gross profit per unit numbers for new and used vehicles continues to be very strong, with average reported figures for March at $2,764 and $2,859 per unit respectively, according to the average dealership statistics published by NADA Dealership Profiles. As daily reports of inventory shortages and challenges due to the microchip crisis continue, it will be interesting to see if/when these constraints catch up to the industry and halt the record profitability. Perhaps, we will begin to see some of these hiccups finally materialize in the financial performance either in the April or May figures when they are published.With rumors of tax rates rising, what impact could this have on Blue Sky multiples?KN: The Biden administration platform includes a material increase in capital gains taxes which directly impacts sellers of dealerships. As a result, some sellers who have been considering a sale are accelerating their plans and pursuing a sale in 2021 before a likely tax change in 2022. There are a number of attractive opportunities for buyers and dealers looking to expand so its expected values will remain robust. If/when tax rates rise, several situations might occur:Fewer sellers come to market, reducing dealership inventory and putting upward pressure on valuations.Less after tax proceeds to the seller pressures them to require higher valuations to sell their store.Higher taxes reduce consumer spending, lower sales, reduce dealer profits and bring valuations down. As a result, it’s difficult to predict the future but there’s no doubt higher taxes will have a ripple effect throughout the dealer buy/sell market. SW: My colleague David Harkins previously authored a post highlighting the proposed tax changes and their impact on valuation by comparing expected earnings under several tax bracket structures.Looking back, how did the Tax Cuts and Jobs Act (TCJA) affect multiples and values?KN: Lower taxes certainly provided a boost to consumers and helped ensure stability in vehicle sales in an environment where we were beginning to see declining sales. Corporate tax rate changes did little to help dealers as most are not C-corporations, and some dealers saw personal taxes go up due to the changes in deductibility of certain items. Overall, the rates kept the momentum rolling, nice profits for dealerships, and stable valuations for stores. Buyers were also able to forecast higher after-tax proceeds from their stores to justify paying more. We thank Kevin Nill and Haig Partners for their insightful perspectives on the auto dealer industry. While the last year has been a turbulent one for the industry, auto dealers have been resilient in navigating the changing conditions. The first four to five months of 2021 have continued the momentum of the last half of 2020 in terms of dealership profitability and transaction volume. It will be interesting to see how long these trends will continue, or if auto dealers will experience any hiccups as market constraints threaten current profitability. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

Themes from Q1 2021 Earnings Calls

Part 2: Mineral Aggregators

Last week, we reviewed the first quarter earnings calls for a select group of E&P companies and briefly discussed the macroeconomic factors affecting the oil and gas industry. In this post, we focus on the key takeaways from mineral aggregator first quarter 2021 earnings calls.Favorable M&A OutlookTransaction volume was largely muted throughout 2020 as the depressed pricing environment drove bid-ask spreads wider. Buyers were offering what they believed was supportable based on current market conditions, and sellers were convinced that their assets were being undervalued. This led to sellers holding onto assets for dear life unless they were forced to liquidate. As mineral aggregators have the reputation to reinvest capital, participants on the earnings calls were intrigued to learn about their strategy in what many believe may be a price recovery environment.“We had a stock price where we didn't really feel like the equity was a usable acquisition currency, and I think sellers still had higher expectations than the environment warranted. And so with prices and equity recovering, and frankly where sellers were sitting on those assets for another 12 to 18 months, we think the environment is just getting much more constructive.” –Jeffrey Wood, President & CFO, Black Stone Minerals“Since the third quarter of last year, we've continued deploying capital to mineral acquisitions and believe the assets we've acquired over the past three quarters will generate differentiated performance over the next several years. We will continue to employ our disciplined underwriting of deals to enhance shareholder value and at the same time see more of our acquisitions internally funded via retained cash.” –Bud Brigham, Founder & Executive Chairman, Brigham MineralsHedgingHedging strategies differed among the aggregators. Some companies, like Black Stone and Viper, executed hedges that mitigated risk in 2020, but have been a detriment to recent financial performance. On the contrary, Brigham Minerals stated that their hedging portfolio was minimal which allowed them to participate in the positive pricing environment seen in the first quarter.“As most of you are aware, we have always been active hedgers of our commodity risk. Those hedges benefited us greatly last year when prices cratered, but also tempered the impact of the dramatic rise in prices for us during the first quarter.” –Jeffrey Wood, President & CFO, Black Stone Minerals“First, we did not need to panic at any point during the rollercoaster year of 2020 and execute hedges, which today are currently serving as strong headwinds to numerous companies in the energy space. Here at Brigham, we are managers of a premier mineral portfolio, non-commodity traders and we prefer to give our investors full exposure to the commodity.” –Bud Brigham, Founder & Executive Chairman, Brigham Minerals“Also, we believe our hedging strategy is a prudent methodology for managing the company’s future price risks on oil and natural gas. Having substantial hedges in place on a rolling two-year basis before the price shocks that occurred in 2020 proves to be a very effective risk mitigation strategy.” –Davis Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“We had a lot of ‘21 hedges put on this year that are unfortunately, underwater because of the recovery. But I think as you think about 2022 and beyond, putting some sort of floor under the low end of distributable cash flow is something we’re thinking about.” –Kaes Van’t Hof, President, Viper Energy PartnersDebt SituationAggregators continued to pay down debt and improve liquidity, which was a major priority heading into the new year. Relationships with lenders was a concern during 2020, but Jeffrey Wood, President and CFO of Black Stone Minerals, stated that the company was able to execute a favorable extension to their existing debt facility. This is a positive sign for the industry moving forward. Aggregators will continue to allocate free cash flow between debt paydown and shareholder return as the year progresses.“After the end of the quarter, we finalized an extension of our existing revolving credit facility last week. We added 2 years to the maturity date of that facility, which is now November of 2024. It's been a very difficult bank market over the past year, so we're really happy to get this extension done with relatively minor modifications to the terms of the facility and we appreciate the continued support from our long-term lending relationships.”–Jeffrey Wood, President & CFO, Black Stone Minerals“As we have done in previous quarters, the company utilized 25% of its Q4 2020 cash available for distribution to pay down a portion of the credit facility in Q1 2020. Since May 2020, the company has paid down approximately $25 million in debt by allocating a portion of its cash flow to debt paid down. We expect to continue to allocate 25% of our cash available for distribution for debt pay down in the future.” –Davis Ravnaas, President, CFO & Chairman, Kimbell Royalty Partners“As a result, Viper generated almost $55 million in net cash from operating activities, which enabled us to reduce debt by $27 million during the quarter. We have now reduced total debt by over $136 million, or roughly 20%, over the past 12 months.” –Travis Stice, CEO, Viper Energy PartnersConclusionIt is safe to say that sentiment among the participants was positive in the first quarter earnings calls, especially relative to last year. Aggregators seemed to grind through 2020 and flip the script for a new year. Although a price recovery may be in sight, challenges remain, specifically with the Biden Administration taking office. The calls largely glossed over political implications of the new administration but those issues may come into focus as the year unfolds.Mercer Capital has its finger on the pulse of the minerals market. An important trend has been the rise of mineral aggregators, which have largely supplanted the trusts as the primary method of publicly traded minerals ownership. Contact a Mercer Capital professional to discuss your needs in confidence.

Q1 2021 Earnings Calls

Improved Profitability, Online Tools and Market Share, and High Valuations

The earnings calls in Q1 began with a focus on many of the same trends as prior quarters: increasing or record EPS despite inventory struggles as gross margin improvement drove operating leverage. The chip shortage has taken center stage, with cloudy expectations of when inventory levels might normalize. Contrast to factory shutdowns last year, dealers are faring much better as strong demand has improved vehicle pricing, benefiting both dealers and manufacturers. OEMs have tried to mitigate the impact of the chip shortage by removing certain features requiring chips, while others have prioritized more in-demand models to maximize profits.A couple of other trends require the proper framing of the subject to truly understand what’s happening. First, many execs talked about “pent-up demand” for parts and service work. If “pent-up demand” means parts and service revenue is expected to increase in the coming months, then that appears likely as vaccination rates increase and mandates are relaxed. However, on previous calls, many discussed the notion of consumers deferring maintenance on their vehicles since they could get by because they were driving less. Deferred maintenance has not been discussed as much, suggesting deferred maintenance activity has not meaningfully presented itself. In many instances such as the winter storms, execs noted that unit sales may have been delayed but service revenue losses would not be recovered.We also need to appropriately frame the degree to which online sales are truly “incremental,” or not cannibalizing traditional in-person sales. Execs highlighted online sales to customers who had not previously bought from them before as evidence that online tools were incremental. Given the long life cycle of vehicles, we are less convinced this necessarily says a consumer only purchased from their company because of the online feature. While Lithia noted nearly 98% of its online sales were to first time Lithia purchasers, we believe the 43% sold to customers outside of their retail market presence is a better representation of incremental sales, which is to say the company is improving its market share. While there were technical difficulties throughout the Sonic call reducing our ability to pull meaningful quotes, their investor deck similarly noted 30% of customers of its EchoPark segment (its stand-alone Pre-Owned operations) traveled more than 30 minutes to shop their inventory.On the other hand, Penske casts doubt on the notion that these sales were truly additional in the sense that consumers aren’t buying cars they didn’t otherwise need solely because the option to buy online now exists. While we tend to agree, it is meaningful if larger players are able to poach customers with the scale provided by their online platforms. Over the longer term, this could negatively impact unit volumes for smaller dealerships who choose to not take advantage of online options or are not able to meaningfully compete. Simply having a website may not be enough for the local Honda dealership to compete if comes up 5th on a Google search.The franchised auto dealer space is fragmented by nature. As such, the few publics are frequently asked about consolidation in the industry, as they have both the experience to operate at scale and a liquid market for their equity which allows acquired dealers to achieve liquidity without necessarily losing the upside of their dealership in a transaction (either receiving stock or investing cash from the deal into that stock). However, despite plenty of transactions in the industry, public auto dealers have not typically provided much financial information on their targets aside from revenues. In a recent investor deck, Lithia took things a step further, quantifying its intangible investment as a percentage of revenues as shown below: Many noted increasing valuations, and an analyst on the AutoNation call mentioned his M&A modeling at about 15% to 30% of sales. CFOs for multiple companies noted their focus on EBITDA multiples when doing deals, which are highlighted in theme #4. For perspective, the market ascribes about a 7.7x EV/EBITDA multiple for AutoNation with floor-plan interest treated as an operating expense as calculated below: Theme I: Microchip shortages have extended longer than initially anticipated, but strong demand, in part due to stimulus funds, has supported robust sales and gross profits. The industry’s limited chip supply has led to retail customer, particularly in hot selling models, getting vehicles first.“As it relates to the hot selling products as you point to, the OEMs are really great at this. And while the chip shortage is there, they've really been shifting their production to the faster selling vehicles. […] everyone is showing high margins. We didn't all of a sudden get that much better, it's simplistically supply and demand. There is that point where you're missing a lot of sales because you just don't have the inventory. […] the industry performs well and stability exist when there's probably a 60 to 70 days supply in the market. And right now with all the government spending that's going on and people coming out, the demand is going to be high right now, and the fear is the inventory won't be there to match the demand.” -David Hult, CEO, Asbury Automotive Group“As of the end of the quarter, we had a 41-day supply of new vehicle inventory, indicating we have well over a month's supply of vehicles on the ground and an adequate supply of in-transit that are replenishing our on-ground inventory every day. However, new vehicle margins may remain elevated in the near term due to continued microchip and other supply chain shortages, coupled with elevated consumer demand levels driven by additional stimulus funds. While select OEMs are experiencing reduced level of inventory, we currently have sufficient inventory to balance the current supply and demand trends expected over the coming months.” – Christopher Holzshu, President, and CEO, Lithia Motors“There is no question that there is more demand than supply, that is the headline. On the new vehicle side, there supply is tight, but shipments and production are disrupted with the chip crisis and will be for the rest of the year. But it's nothing like a year ago during the pandemic when we had the factory shutdowns. […] we've adjusted pricing to reflect that, and you've seen the improvement in our front-end gross. […] There is no reason to rush things out the door. You can’t easily replace it.” - Mike Jackson, Chairman & CEO, AutoNation“I've been amazed in the recent months, how we've continued to maintain pretty impressive sales levels with declining inventory levels. […] Also, the OEMs have adjusted. It seems that the only vehicles they're making are the ones that sell the fastest. So when they come off the truck, they go right to a retail customer. […] we're getting to the point where inventory is a problem, if not at this moment very soon. So ideal for us is about 45 days supply when we mix all of our different brands together. And as you saw, we ended the quarter at little over 30. And we're actually fine in the 30s. But we're a big truck market. When you get very far below 30 days of supply, you have trouble having many of the configurations that the truck customers want. And so that's where it starts to get a little challenging for some of our brands.” - Earl Hesterberg, President and CEO, Group 1 AutomotiveTheme 2: Service and parts continue to lag vehicle sales for many dealers, though those struggling for inventory are relying more on fixed ops. While a return to “normal” levels of miles driven should increase service demand, opinions among public dealers were mixed as to the degree there was pent-up demand from consumers deferring maintenance during the pandemic.“Obviously pent-up demand is a big driver. And we are starting to see that coming out of March where we actually started to finally see some real big volume increases year-over-year were great, but what we're really trying to do is figure out when will we start to get to a normalized recovery over what was really the 2019 kind of year, if we use that as a base case. And in the quarter, we saw ourselves about 5% up over that 2019 level. And prior to the pandemic last year, we were projecting a double-digit -- a low double-digit increase in our parts and service business. So we definitely see that trend continuing into April and we expect that to continue through the summer months as we kind of rally into customers coming -- normalizing their lives again and getting back on the road and driving their vehicles and then needing parts and service work.” – Christopher Holzshu, President, and CEO, Lithia Motors“We expect good things out of parts and service for the rest of the year. We see the traffic counts building. Our gross for RO is quite good as we've made some adjustments during the pandemic on that better inspections, better reporting, better selling skills with customers. And we we've added over 300 technicians back to our dealership base in the last 12 months. Very few hourly technicians, which tend to be less productive than flat rate technicians, and that helps us be more productive as a business. And we expect good things as miles driven continue to increase. And if vehicle supplies do become an issue, people will hold on to their cars and they will be in our shops more. […] The customer pay business is extremely strong […] but warranty we don’t control, and warranty has been a bit weak. […] it’s been collision and warranty, which had been soft over recent quarters.” - Earl Hesterberg, President and CEO, Group 1 Automotive“Well, there is no question that miles driven have come down […] in January, we were down 16% in parts and service revenue. Now, that’s really swung around. So, people are getting out. […] So, I think we’ve got to look sequentially how we’re going to look from March to April. This year will give us probably a better picture. But, I can say that there is definitely more momentum and more interest in the shop. […] So we still have some real opportunity there and just a matter of getting people out and that's strictly miles driven will drive that.” - Roger Penske, Chairman & CEO, Penske AutomotiveGroup“March came back so strong, it was actually ahead of '19 pace numbers. And as we sit here in April, we're experiencing the same. So, the customers are back on the road, the service business is back. […] while we're feeling it on the variable side with some shortages with inventory, thankfully Parts and Service is picking up on that. […] We think there’s a lot of pent-up demand.” -David Hult, CEO, Asbury Automotive GroupTheme 3: While many dealers tout incremental sales on their online platforms, it’s important to understand which sales replace would-be in-person dealership transactions and which the company would not have been able to achieve, such as sales to customers where the dealer doesn’t have a physical dealership.“97.8% of our Driveway customers during our first quarter were incremental and had never done business with a Lithia dealership before. […] 43% of our [Driveway] sales are out of region and our average shipping distance is 732 miles […] so we're not really getting into that cannibalization of our existing pipeline.” -Bryan DeBoer, President and CEO, Lithia Motors“There is a lot of incremental [online] sales that we would not have received, and I made that comment, because looking at the information we weren't doing business with [those customers] before.” -David Hult, CEO, Asbury Automotive Group“I think that to a certain extent, it's substitutional where people have the opportunity to buy online, delivery at home, come to the dealership. […] we’re really not growing the business at this point incrementally. And I think that’s going to be the true test where we can tell the analysts in the market, we’ve actually grown our overall business by using the online tool.” - Roger Penske, Chairman & CEO, Penske AutomotiveGroupTheme 4: While Lithia at least reports transactions in terms of price to revenue, multiple companies specified they think in terms of EBITDA multiples. While this might not be true for smaller acquirers, it may affirm the reasonableness of correctly applied EBITDA multiples from the publics.“[W]e generally think more about it as a multiple of EBITDA than revenue. And it's kind of in that high single-digit range, and returns are mid-teens.” - Joe Lower, CFO, AutoNation“[W]hen we evaluate an opportunity, we're looking at EBITDA multiples and then factoring in the synergies we think we can achieve, and then we look at the IRR relative to our cost of capital. And we need to see a margin there to deliver an accretive deal.” - PJ Guido, CFO, Asbury Automotive GroupConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace. These give insight to the market that may exist for a private dealership which informs our valuation engagements. To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

FAIR … The F-word in RIA M&A: Part 2

What Is a Fairness Opinion?

Last week we explained why RIA principals and board members should consider getting a Fairness Opinion; FAIR … The F-word in RIA M&A: Part I; When Do You Need A Fairness Opinion?.Under U.S. case law, the so-called “Business Judgment Rule” presumes directors will make informed decisions that reflect good faith, care, and loyalty. If any of these criteria are breached in a board-approved transaction, then the directors may be liable for economic damages.RIA boards hire valuation and advisory firms like ours to opine on the fairness of contemplated transactions in an effort to protect themselves from potential liability.In a challenged transaction, the “entire fairness standard” requires the court to examine whether the board dealt fairly with the firm and whether the transaction was conducted at a fair price to its shareholders. As a result, Fairness Opinions seek to answer two questions:Is a transaction fair, from a financial point of view, to the shareholders of the selling company?Is the price received by the Seller for the shares not less than “adequate consideration” (i.e. fair market value)? Process and value are at the core of the opinion. A Fairness Opinion is backed by a rigorous valuation analysis and review of the process that led to the transaction. Some of the issues that are considered include the following.ProcessProcess can always be tricky in a transaction. A review of fair dealing procedures when markets have increased should be sensitive to actions that may favor a particular shareholder or other party.Management ForecastsA thorough analysis of management’s projections is a key part of a fairness analysis. After all, shareholders are giving up these future cash flows in exchange for cash (or stock) consideration today. Investment managers’ revenue is a product of the market, which over the past year has withstood significant volatility. A baseline forecast developed in the middle of the COVID-19 pandemic may be stale today. Boards may want to consider the implications of the V-shaped market recovery on their company’s expected financial performance and the follow-through implications for valuation.TimingDeals negotiated mid-COVID, when it was unclear whether the market was in a V-shaped or W-shaped recovery, may leave your shareholders feeling like money was left on the table. It is up to the board to decide what course of action to take, which is something a Fairness Opinion does not directly address. Nevertheless, fairness is evaluated as of the date of the opinion, such that the current market environment is a relevant consideration.Buyer’s SharesIf a transaction is structured as a share-for-share exchange, then an evaluation of the buyer’s shares in a transaction is an important part of a fairness analysis. The valuation assigned to the buyer’s shares should consider its profitability and market position historically and relative to peers. If the purchaser is a public company, it is imperative that all recent public financial disclosure documents be reviewed. It is also helpful to talk with analysts who routinely follow the purchasing company in the public markets.It is equally important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where an RIA’s shares may trade in the future.The reasonableness of compensation that may be paid to executives as a result of the transaction. Due diligence work is crucial in the development of the Fairness Opinion because there are no rules of thumb or hard and fast rules that determine whether a transaction is fair. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock). We believe it is prudent to visit the selling RIA (if feasible), conduct extensive reviews of documentation, and interview management (either in person or virtually). Fairness Opinions are often memorialized in the form of a Fairness Memorandum. A Fairness Memorandum examines the major factors of the Fairness Opinion in some detail and summarizes the considerations of each factor for discussion by the board of directors. In many cases, the advisors rendering the Fairness Opinion will participate in these discussions and answer questions addressed by the board.ConclusionMercer Capital’s comprehensive valuation experience with investment managers enables us to efficiently provide reliable, unbiased Fairness Opinions that provide assurance to stakeholders that transactions underway are fair and reasonable. We’re happy to answer any preliminary questions you have on Fairness Opinions and when it makes sense to get one.

Making Sense of 2020: Part 3

Benchmarking Cash Flow From Financing Activities

In previous posts, we analyzed the operating performance and investing decisions of the companies in our benchmarking universe. This week, we examine the financing decisions of those companies and apply those observations to family businesses.Big Picture FindingsThe difference between operating cash flow and investing cash flow creates a “gap” that is filled by financing activities.When operating cash flows exceed investing outflows, cash is available to distribute to capital providers, whether in the form of repaying debt, repurchasing shares, or paying dividends.When investing outflows exceed operating cash flows, a business must finance the resulting shortfall by borrowing from lenders or selling new shares to investors. A company’s cash balance serves as the release valve when financing cash flows do not perfectly align with the “gap” between operating and investing cash flows. Table 14 summarizes the aggregate sources and uses of cash for the small cap companies in the Russell 2000 during the three years ending with 2020. In “normal” years (i.e., 2018 and 2019), the small caps typically invest a bit more than cash flow from operations, leaving a net hole to be filled by financing activities. Of course, 2020 was far from “normal.” As we have described in the previous two posts in this series, operating cash flow increased during the year despite weak earnings because of non-cash impairment charges and reduced working capital balances. Meanwhile, companies were cautious on the investment front, curtailing both capital expenditures and M&A activity. The net result is that during 2020, operating cash flows exceeded investing cash flows by approximately $46.6 billion. So what did the companies in our universe do with this cash windfall? Net debt issuance. Although it was not necessary to fill a financing gap, the companies in our dataset continued to borrow money in 2020, albeit at a slower pace than prior years. Rather than repaying debt, small cap public companies elected to borrow more funds during 2020.Net share issuance. During 2018 and 2019, the small caps were hesitant to issue net new shares. However, in 2020 share repurchase volume fell over 20% (from $22 billion to $17 billion) while share issuance volume doubled from $22 billion to $44 billion. The net result is that – as with debt – the companies in our dataset elected to raise new equity despite not “needing” it.Dividends paid. The companies in our sample also took a conservative posture regarding dividends paid. In the aggregate, dividend payments fell by nearly one-third, from $13 billion to $9 billion. Aggregate financing inflows supplemented the positive financing gap to boost cash balances for the small caps by nearly $76 billion, compared to a net change of about $2 billion in 2018 and 2019.Digging a Bit DeeperTable 15 summarizes the same sources and uses of cash data, but on a quarterly basis during 2020.Net Debt IssuedAs the reality of the pandemic began to dawn on corporate managers in March 2020, the first action item for many companies was drawing down credit facilities to boost cash reserves to help weather a storm of unknown length. After loading up on proceeds from borrowings, the companies in our dataset returned some of the funds to lenders in the second half of the year as the economic impact of the pandemic became a bit more transparent. Net Share IssuanceAfter tapping the debt markets in the first quarter, companies turned their attention to the equity markets to secure pandemic funding over the balance of the year, as shown in Chart 17.In the second quarter, share repurchases slowed to a trickle while proceeds from share issuance more than doubled from Q1 levels. Share issuance proceeds remained at elevated levels through the remainder of the year although repurchase volumes did approach more normal levels as corporate managers became more optimistic about the prospects for the economy. Dividends PaidChart 18 compares aggregate per share dividends paid in the fourth quarter of 2020 to the fourth quarter of 2019.During 4Q19, 336 small cap companies paid common dividends (approximately 30% of the total dataset). During 4Q20, 103 of those companies (31%) either suspended dividends entirely or reduced the amount paid. While 98 of the companies increased dividend payments, the typical increase was modest. The remaining 135 dividend payors made no changes to the amount of per share dividends between the two periods. On a net basis, the number of small cap companies paying common dividends shrank by approximately 20% from 4Q19 to 4Q20. Change in Cash BalancesAs shown in Chart 19, the small cap companies stopped hoarding cash in the third and fourth quarters of 2020.In total, the small cap companies in our sample added almost $76 billion to their cash offers during 2020. As the economy recovers from the pandemic, we will monitor how management teams elect to put their cash stockpiles to work. Questions for Family Business DirectorsOur analysis of the financing decisions of public small cap companies during 2020 highlights some important questions for family business directors to deliberate during 2021.How did your lenders treat you during the pandemic? Were your existing credit facilities flexible enough to meet your needs, or should your family business be shopping for new lender relationships? It continues to be a borrowers’ market, and now may be the time to lock in favorable rates.What does your family think about issuing equity to non-family investors? For many decades, this was an automatic “no” for most families, but we expect the increasing availability of capital from family offices and other potentially “friendly” equity investors to be one of the biggest trends in family business over the next decade.Have your family shareholders accumulated liquid wealth outside of their holdings in family business stock? Having a nest egg outside the family business can reduce the overall risk of the family even if it means using a prudent amount of leverage inside the family business. When bad things happen (and COVID isn’t the last bad thing we will see), family shareholders with more diversified personal balance sheets tend to sleep a bit better.Do you have plans to deploy any excess cash balances that may have built up on the family businesses balance sheet? While rushing into ill-conceived investments is not a good idea, harboring lazy capital can weigh on long-term family returns. It is important for family businesses to make financing decisions with strategic intent rather than out of convenience. Did the financing decisions your family business made in 2020 promote the long-term sustainability of the family business, or were they short-term decisions reflecting emergency conditions? Use the more favorable business conditions of 2021 as an opportunity to make sure your financing decisions “fit” your family business.

Making Sense of 2020: Part 3

Benchmarking Cash Flow From Financing Activities

Themes from Q1 2021 Earnings Calls

Part I: E&P Operators

Things appear to be on the upswing, albeit with cautious optimism, in the exploration and production (“E&P”) space.Most of the eight E&P operators we tracked reported that operations in the first quarter were relatively stable. This was in spite of winter storm Uri, which wreaked havoc from New Mexico and Texas northeast through upstate New York and New England.It may be worth examining the effects of Uri on E&P operators’ Q1 performance more in-depth, with a focus on how natural gas prices may have affected revenues vs. any associated increase in operating expenses or the intangible costs stemming from marketing and sales disruptions.Regardless of Uri’s net effect on financial performance, the ultimate trending phrase in E&P operators’ earnings calls was “positive free cash flow,” indicating continued upward trajectory out of the crude abyss.Deleveraging remains a primary goal for many operators. Several have resumed their dividend programs, while others have announced special (i.e., non-recurring) dividends to project their positive outlook to investors.In tandem with this bullish perspective, few E&P operators seemed overly concerned with the potential tax implications stemming from regulatory changes brought forth by the Biden Administration.ESGContinuing the trend we saw in the 2020 Q3 and Q4 E&P operator earnings calls, the Q1 earnings calls featured increased discussions regarding ESG topics. For some operators, the commentary covered basic items such as reduced greenhouse gas ("GHG") emissions and quarter-over-quarter reductions in flaring. Other operators had more comprehensive talking points related to ESG topics in the context of company operations on a forward-looking basis.“In March, we issued a press release announcing changes to our executive compensation program and outlining our new greenhouse gas emissions reductions targets. Comprehensive changes to our executive compensation program included accountability for achieving both quantitative and qualitative ESG goals in the near and medium term.”–Joe Gatto, President & CEO, Callon Petroleum“[This year] we introduced methane-related KPIs into our executive compensation program. We've committed to make a substantial multi-year community investment of $30 million over the next six years to widen the path for the middle class in our local community while growing the local talent pipeline. We have redoubled our efforts to spend local and hire locally. 100% of our new hires will be from our area of operation and will maintain that - we will maintain at least 90% local contract workforce.” –Yemi Akinkugbe, Chief Excellence Officer, CNX Resources“This year will also be an exciting year for Antero's ESG initiatives as we make progress toward our 2025 best in class goals. These … include achieving net zero carbon emissions, reducing our industry leading GHG intensity and methane leak loss rates. We also plan to complete and publish our TCFD analysis with our 2020 ESG performance results later in 2021.”–Glen Warren, CFO, Antero ResourcesReturn of Capital to ShareholdersIn recent earnings calls, many E&P operators suggested that they would resume dividend and share buyback programs when positive free cash flow, and in some cases higher-priority deleveraging initiatives, made it conducive to do so. As noted in the introduction, this time has come for many operators in Q1.“We reinstated a quarterly dividend of $0.11 per share, … this is double our previously issued dividend, which has been temporarily suspended at the onset of the global pandemic. We believe this is expected to be sustainable given our strong cash flow generation and interest expense savings from our significant debt reduction.”–William Berry, CEO, Continental Resources“Going forward, our goal is to continue growing the regular dividend. We have never called for suspending the dividend and we remain committed to its sustainability. … Now, EOG is positioned to address other free cash flow priorities by returning additional cash to shareholders. The $1 per share special dividend [announced May 6] follows through these consistent long-tailed priorities.”–Tim Driggers, CFO, EOG Resources“So, for the quarter we repurchased 1.5 million shares at an average price of $12.26 per share at a total cost of $18 million. We still have ample capacity of around $240 million under our existing stock repurchase program…”–Nick Deluliis, CEO, CNX ResourcesProposed Tax ChangesAmong the potential energy tax changes under the Biden-Harris Administration,the most prominent talking point discussed by E&P operators in the Q1 earnings calls was the proposed change to disallow the reduction of taxable income stemming from intangible drilling costs (“IDCs”), and the subsequent increase in taxes and reduction in future free cash flow. The discussion and response to questions about these proposed tax changes overwhelmingly suggest that most of the operators we tracked do not foresee any material tax payments for at least the next four years, due primarily to substantial net operating losses (“NOLs”) that may be used to offset future taxes.“We are not a cash taxpayer in the U.S. this year. And at prevailing commodity prices, we don't expect to be paying U.S. cash federal income taxes until the latter part of this decade. This holds true even if the tax rules for IDCs are changed or if the corporate tax rate has increased. We have significant tax attributes in the form of NOLs in addition to foreign tax credits. These attributes will be used to offset future taxes.”–Dane Whitehead, CFO, Marathon Oil“Our plan through '26, we're not material cash taxpayers during that plan. Most of it's the way we treat sort of the NOLs and utilize those as regards to the cash taxes that we would have to pay, and managing and optimizing that versus sort of the IDCs and the other attributes that you have on the tax side. So, the color we've given to date is no material cash taxes through 2026 is the current plan.”–Don Rush, CFO, CNX Resources“We have substantial NOL carryforwards at a federal and a state level. So, if you look at it in a current regime, putting off a free cash flow at the level that we are, certainly, you convert to cash taxes at some point. We see it being five to seven years in the future in a current regime.”–John Hart, CFO, Continental ResourcesOn the HorizonWhile we selected three primary themes among the Q1 E&P operator earnings calls, several other notable topics were also discussed. Perhaps chief among them, the general consensus is that significant production growth is not desirable at this juncture. Steady operations is the name of the game at the moment. Furthermore, operators are seeing inflation in field service provider costs, which are expected to continue growing, though it remains to be seen just how those may affect future margins.ConclusionMercer Capital has its finger on the pulse of the E&P operator space. With increased volatility in the energy sector these days, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream. For more targeted energy sector analysis to meet your valuation needs, please contact the Mercer Capital Oil & Gas Team for further assistance.

April 2021 SAAR

SAAR has continued its impressive run in 2021, increasing for the second straight month to 18.5 million. This is a 3.1% increase from March 2021. As we have mentioned in our previous SAAR blog post, comparing spring 2021 SAAR to 2020 does not hold much merit, especially in April which experienced the weakest sales of the pandemic in 2020.For those of you who are curious however, April SAAR is up 112% from last year.Compared to April 2019, a better comparison in our view, April 2021 is up 12.1%. Because of strong demand, OEMs continue to rely less on incentive spending. According to JD Power, average incentive spending per unit in April is anticipated to be $3,191, a decline of $1,762 from April 2020 and $382 from April 2019. Still, average transaction prices are expected to reach another month high, rising 6.8% from last month to $37,572. This is the highest ever for the month of April and the second highest of all time behind December 2020. Incentive declines and price increases serve as a major win for dealerships this month.In regards the expected April statistics, Thomas King, president of the data and analytics division at JD Power notes:“While falling numbers of vehicles in inventory at retailers is the primary risk to sales results in the coming months, to date, low inventories have not had a material effect on aggregate sales results. Instead, they have enabled manufacturers and retailers to reduce discounts and consumers are demonstrating a willingness not only to buy vehicles closer to MSRP, but also to buy more expensive vehicles.”Inventory Scarcity Continuing to be in PlayThough pent-up demand and higher levels of disposable income continued to drive SAAR growth this month, a surprising factor we considered to be a headwind may have actually boosted sales for the month: the microchip shortage. As the shortage continues to drag on and has started affecting other industries and big names (such as Apple), the shortage has become a household topic and consumers are taking notice. Behind the increase in April SAAR may be consumers rushing to dealerships to snag a vehicle before they become more difficult to find in the coming months.Automakers, keen on not having to completely shut down productions, are trying to work around the chip shortage by removing features, which may be incentivizing consumers to pay up for them now.As Automotive News reports, Nissan is leaving navigation systems out of thousands of vehicles that typically would have them because of the shortages. Ram no longer offers its 1500 pickups with a standard "intelligent" rearview mirror that monitors for blind spots. Renault has stopped offering an oversized digital screen behind the steering wheel on its Arkana crossover. All of these feature cuts being for the same reason: to save on chips. This may become more prevalent going forward this year as the chip shortage is anticipated to continue.Despite automaker’s best efforts, inventory levels are suffering. While April inventory levels are not available yet, NADA forecasts that they likely will be at a decade-long low with no relief in sight. According to BEA, the inventory to sales ratio for March (the most recent data available) is at the lowest levels of the reported data going back to 1993, at 1.36 (though the chart below only shows data through 2015). According to Auto Forecast Solutions, the semiconductor microchip shortage has caused worldwide production to fall off to 2.29 million vehicles. Current forecasts put projected total vehicle production losses from the global chip shortage at 3.36 million units, with 1.11 million from North American production. With production flagging, dealers are having to draw down inventories to maintain and grow sales. However, April’s strong sales figure is unlikely to be sustainable as inventories cannot be drawn down forever, which explains why NADA forecasts 2021 SAAR of 16.3 million, or 11.9% below the April figure. Fleet Customers SufferingWhile the inventories of auto dealers are down, inventories for fleet customers are down even more, as OEMs continue to prioritize production for retail customers over fleet customers. Retail sales in April are estimated to be up 114% from April 2020 and up 23% from April 2019 according to Wards Intelligence. Meanwhile, fleet deliveries increased by 88% from April 2020, but fell by 42% from April 2019.This is especially poor timing for fleet customers as travel has begun picking up again and rental car companies and other fleet buyers are in need of inventory as many had to sell chunks of their fleets in order to preserve money during Covid-19, creating a situation that many are referring to as “car-rental apocalypse.” Due to the new car shortages, they are having to look elsewhere.As Yahoo News reports, Hertz is "supplementing its fleet by purchasing low-mileage, pre-owned vehicles from a variety of channels including auctions, online auctions, dealerships, and cars coming off lease programs," a Hertz spokesperson told Insider in an email statement.The result of all of this is that rental cars may cost consumers over $500 a day for an SUV, compared to prices of $50 a day 2 or 3 years ago. Until the chip shortage is back under control, travelers may be stuck having to pay sky high prices for rental vehicles on their next vacation.Looking ForwardThe best phrase we can think of to describe the auto industry going into May is “something’s got to give.” While demand for vehicles is still being fueled by pent up demand and traveling picking back up due to Americans getting vaccinated and a return to normalcy, the microchip shortage isn’t going away anytime soon.According to Mike Jackson, AutoNation’s CEO, that expiration date might even be 2022, as he notes “we performed despite the disruption from the shortages created by the chip disruption, which we expect to fully continue for the rest of this year."Stay turned for our blog next week when my colleague David Harkins breaks down the Q1 earnings calls and what the other leaders in the industry are noting about this year’s prospects.However, despite the lack of chips, if consumers are willing to make some sacrifices in terms of the number of features their vehicle has, SAAR may not see huge declines. If that is not something they are willing to do, the supply constraints may hinder SAAR’s recent run.

FAIR ... The F-word in RIA M&A: Part I

When Do You Need A Fairness Opinion?

Fair. It’s the first-four-letter word that most children learn, and it often leads to more arguments than other choice words. Although children eventually learn that life is not always fair, we spend a lot of time ensuring that major economic events are. Transactions are rarely straightforward, and as the pace of M&A activity in the investment management community continues to accelerate, more shareholders are scrutinizing both the pricing and terms of transactions. Over the next two posts, we will explain when you should consider getting a Fairness Opinion and what that involves.What Is a FAIR Transaction?Under U.S. case law, the concept of the “Business Judgment Rule” presumes directors will make informed decisions that reflect good faith, care, and loyalty to shareholders. If any of these three are not met, then the “entire fairness standard” requires that, in the absence of an arms-length deal, transactions must be conducted with fair dealings (process) and atfair prices.Directors are generally shielded from challenges to corporate actions the board approves under the Business Judgement Rule provided there is not a breach of one of the three duties. However, once any of the three duties is breached, the burden of proof shifts from the plaintiffs to the directors. If a Board obtains a Fairness Opinion in significant transactions, they are more likely to be protected from this liability.Questions of value and fair dealing are subject to scrutiny, even in bull markets. Rapidly improving markets may lead your shareholders to question whether the price accepted in the context of negotiating and opining on a transaction could have been better. Below, we outline some circumstances when you should consider getting a Fairness Opinion before closing a deal.9x EBITDA in a 15x EBITDA World Fantasy The prominence of headlines touting impressive deal multiples has led to some unrealistic shareholder expectations around valuation. Yes, average deal multiples have increased over the last decade, more prospective buyers for your RIA exist today than there were five years ago, and maybe an irrational buyer with capacity will stroke checks for double-digit multiples. But the increase in average valuation multiples is being driven by a myriad of factors that do not perfectly correlate with the valuations of small to mid-sized RIAs.Echelon Partners 2020 RIA M&A Deal Report noted that the number of $1B+ transactions has doubled over the last five years. Most of these acquisitions, and especially the ones that attract headlines, warrant these higher multiples due to their sheer scale, rarity, and strategic significance. Not every RIA has the scale, growth pattern, and risk profile to warrant top-tier pricing. And, ultimately, no two asset managers, wealth managers, IBDs, OCIOs, or independent trust companies are alike.Nevertheless, boards facing a mismatch between shareholder expectations and market realities are in a tough position justifying a transaction. The evaluation and negotiation process is tricky when markets continue to climb day after day. Yet, Fairness Opinions can be used as one element of a decision process to evaluate significant transactions.Would You Prefer $10M or $7M Today, and $2M Each Year for the Next 3 Years?Most acquisitions of investment managers involve some form of contingent consideration. When evaluating multiple offers that involve varying amounts of upfront cash; equity consideration; and earn-out payments, periods, and terms, a Fairness Opinion can help Boards evaluate the economic merits of the terms being offered.Unsolicited OffersMany RIAs receive unsolicited offers from their friends, competitors, or institutional consolidators. When there is only one bid for the company and competing bids have not been solicited, the fairness of the transaction can more easily be disputed. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The objective of an unsolicited offer is to get the seller’s attention and cause them to start negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time. As the head of our investment management group, Mercer Capital President, Matt Crow, explains, “An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market.”The Investment Management Community Is SmallAlthough there are over 13,500 SEC-registered investment advisors in the U.S., the investment management community within a given sector or geography is fairly close-knit. Many RIAs join forces or sell to other RIAs they have known for many years. This is part of the reason deals work. In a relationship-driven business, it is hard to merge with or sell to someone with whom you don’t have an existing relationship. But anytime insiders or related parties are involved in a transaction, a Fairness Opinion can serve as a confirmation to a company’s shareholders that improper acts of self-dealings have not occurred.ConclusionWe have extensive experience in valuing investment management companies engaged in transactions during bull, bear, and boring markets. Mercer Capital’s comprehensive valuation and transaction experience with investment managers enables us to provide unbiased fairness opinions that directors can rely on to assure their stakeholders that the decisions being made are fair and reasonable.

Making Sense of 2020: Part 2

Benchmarking Cash Flow From Investing Activities

Recent SPAC Boom Largely Leaves Out Oil & Gas Companies

The rise of SPACs, or special purpose acquisition companies, has been the hottest trend in capital markets during the past year. However, after years of poor returns and increasing investor emphasis on ESG (environmental, social, and governance) issues, oil & gas companies were largely left out of the recent SPAC mania.We look at a few oil & gas companies that were early adopters of the SPAC structure, the recent pivot of SPACs towards energy transition companies, and take a look forward to see what the future might hold for the few remaining oil & gas-focused SPACs.Previous Energy SPAC TransactionsEnergy companies were early adopters of the SPAC structure as a means to go public.Private equity firm Riverstone was one of the first to launch an energy-focused SPAC with Silver Run Acquisition Corp. in 2016. The SPAC combined with Centennial Resource Production later in the year and renamed itself Centennial Resource Development. Riverstone followed with Silver Run Acquisition Corp. II in 2017, which acquired Alta Mesa Holdings and Kingfisher Midstream to form Alta Mesa Resources. However, Alta Mesa filed for bankruptcy in 2019. Another early energy SPAC suffered the same fate. KLR Energy Acquisition Corp., which went public shortly after Silver Run in 2016, acquired Rosehill Resources and filed for bankruptcy in 2020.Fortunately, some have fared better. TPG Pace Energy Holdings merged with Magnolia Oil & Gas in 2018. Currently, the Eagle Ford operator’s stock price is well above the initial SPAC IPO price of $10. Vantage Energy Acquisition Corp., sponsored by energy-focused private equity firm NGP, announced acquisition of QEP’s Bakken assets for $1.725 billion in 2018. The transaction later fell through, and Vantage liquidated, with shareholders receiving $10.22 per share. QEP’s Bakken assets wererecently acquired by Oasis (from QEP’s new owner Diamondback) for $745 million.The Pivot Toward Energy TransitionGiven the troubled performance of oil & gas SPACs, overall poor returns from the sector, and increasing emphasis on ESG issues, several SPACs that were originally targeting oil & gas companies have pivoted and acquired (or announced acquisitions of) “energy transition” companies.Apollo touted its expertise “in the upstream, midstream and energy services sectors” in Spartan Energy Acquisition Company’s prospectus, though ultimately acquired electric vehicle manufacturer Fisker. Switchback Energy Acquisition Corporation, sponsored by NGP (which previously sponsored Vantage), was rumored to be targeting companies in the minerals space, but recently completed its acquisition of ChargePoint, which develops electric vehicle charging stations. And Alussa Energy Acquisition Corp., headed by James Musselman (former CEO of offshore E&P company Kosmos), has announced its planned acquisition of FREYR, a Norwegian battery manufacturer.The trend of capital moving away from traditional oil & gas companies and toward energy transition companies does not look like it will abate soon. Several private equity funds historically focused on oil & gas have sponsored SPACs specifically targeting energy transition companies.Riverstone has moved away from the Silver Run naming convention and now has three “Decarbonization Plus” entities that are publicly traded, with a fourth that has filed an S-1. While the entities reserve the right to seek a business combination with a company operating in any sector, I think it’s safe to assume that an acquisition of a company focused on developing hydrocarbons is off the table.First Reserve, which has historically invested in traditional oil & gas companies, launched their first SPAC, First Reserve Sustainable Growth Corp., in March. As the name implies, the SPAC’sstated focus areawill be “opportunities and companies that focus on solutions, processes, and technologies that facilitate, improve, or complement the ongoing energy transition toward a low- or no-carbon emitting future.”After NGP’s success with Switchback’s acquisition of ChargePoint, it sponsored Switchback II, which intends to search for target companies “in the broad energy transition or sustainability arena targeting industries that require innovative solutions to decarbonize, in order to meet critical emission reduction objectives.” That language wasn’t included in the original Switchback prospectus. Another NGP SPAC, Switchback III, has a similar language in itsS-1but has not yet gone public.Warburg Pincus sponsored two SPACs that went public in March. While no specific industry focus was discussed in the prospectuses, the documents did specifically state that “oil and gas companies are not anticipated to be the target.” This is consistent with Warburg’s recent transition away from investment in the oil & gas sector.Is SPAC Capital Available for Oil & Gas Companies?While most recent energy-focused SPACs are seeking business combinations in the energy transition space, there are a few remaining SPACs that may target more traditional oil & gas companies or assets.East Resources Acquisition Company went public in July 2020, raising $345 million. It is headed by Terry Pegula, who sold his previous company, Appalachian operator East Resources, Inc., to Shell for $4.7 billion in 2010. The SPAC’s prospectus states that “there is a unique and timely opportunity to achieve attractive returns by acquiring and exploiting oil and natural gas exploration and production (‘E&P’) assets in proven basins with extensive production history and limited geologic risk.”In November 2020, Breeze Holdings Acquisition Corp. raised $115 million. Managed by several former EXCO executives, the SPAC intends “to focus on assets used in exploring, developing, producing, transporting, storing, gathering, processing, fractionating, refining, distributing or marketing of natural gas, natural gas liquids, crude oil or refined products in North America.”Most recently, Flame Acquisition Corp. raised $287.5 million in February 2021. The SPAC intends to target“a business in the energy industry, primarily targeting the upstream exploration and production (‘E&P’) sector, midstream sector and companies focused on new advancing technologies that are transformative and provide the potential for and means to achieve greater profitability in the broader energy sector,” adding that “many businesses in the E&P industry or broader energy value chain could benefit from access to the public markets but have been unable to do so.” The company is headed by James Flores, the former CEO of Sable Permian. Gregory Pipkin, former head of Barclays’ upstream investment banking team, is a member of the board.It remains to be seen whether these SPACs will endure their oil & gas focus or try to capitalize on the trend towards renewables (like so many other energy-focused SPACs). However, with multiple SPACs targeting that space and increasing investor skepticism regarding lofty growth projections (as evidenced by the stock price performance of former SPACs Nikola, Hyliion, Romeo Power, and XL Fleet, among others), the acquisition of oil & gas assets at an attractive valuation may be well received by investors.ConclusionThe increasing popularity of SPACs helped push tremendous amounts of capital toward energy transition companies, with traditional oil & gas companies largely sitting on the sidelines. However, the tide may be turning, as SPAC IPOs have slowed and some energy transition company valuations have come crashing down from their previous (stratospheric) levels. While SPACs aren’t the complete solution to the dearth of capital available to oil & gas companies, a well-received transaction by one of the few remaining oil & gas-focused SPACs would certainly be a welcome development.Mercer Capital cannot help you sponsor a SPAC, though we have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

Multiple Expansion Drives 70%+ Returns for RIA Stocks Over Last Year

Over the last year, many publicly traded investment managers have seen their stock prices increase by 70% or more. This increase is not surprising, given the broader market recovery and rising fee base of most firms. With AUM for many firms at or near all time highs, trailing twelve month multiples have expanded significantly, reflecting the market’s expectation for higher profitability in the future. For more insight into what’s driving the increase in stock prices, we’ve decomposed the increase to show the relative impact of the various factors driving returns between March 31, 2020 and March 31, 2021 (see table below).Click here to expand the table aboveFor publicly traded investment managers with less than $100 billion in AUM, trailing twelve month (TTM) revenue for the year ended March 31, 2021 declined about 8% year-over-year. Due to the operating leverage in the RIA business model, the decline in revenue also resulted in a lower EBITDA margin. The net effect is that TTM EBITDA declined about 20% on average year-over-year for these firms. The fundamentals for the larger group (firms with AUM above $100 billion) fared better, with profitability generally increasing despite the market downturn during the year ending March 31, 2021. These firms saw positive revenue growth across the board, although in many cases the revenue growth was partially offset by margin compression.For both groups, expansion in the TTM EBITDA multiple was the primary driver of the stock price increases. The larger group (AUM above $100 billion) saw the median multiple increase 70%, while the smaller group (AUM below $100 billion) saw the median multiple more than double.The multiple expansion between March 31, 2020 and March 31, 2021, while extreme, is not surprising given the trajectory of the market over the last year. While EBITDA was down ~20% year-over-year for the smaller group (and up ~5% for the larger group), the market values these businesses based on expectations for the future, not on LTM performance. As of March 31, 2020, AUM (and run-rate profitability) was down significantly, and depressed market prices continued to impact revenue for 2-3 quarters for many firms. But the market recouped its losses relatively quicky and continued to trend upwards. Today, AUM for many firms is hovering at or near all time highs.What’s Your Firm’s Run-Rate? The multiple expansion seen in the publicly-traded investment managers over the last year illustrates the importance of expected future performance on RIA valuations. The baseline for estimating future performance is the firm’s run-rate performance today. RIAs are unique in that run-rate revenue can be computed on a day-to-day basis using the market value of AUM and the fee schedules for client accounts. After deducting the firm’s current level of fixed and variable costs, run-rate profitability can also be determined.Market participants tend to focus on the run-rate level of profitability because it’s the most up-to-date indication of a firm’s revenue and profitability and the baseline from which future performance is assessed. As AUM has increased for many RIAs, so too has the run-rate revenue and profitability. The significant improvement in run-rate revenue and profitability (and expectations for the same) is a driving factor behind the multiple expansion observed over the last year.Consider the financial results for a hypothetical firm (ABC Investment Management) shown below. While illustrative, the growth of this firm since March 31, 2020 is not unusual relative to that exhibited by publicly traded investment managers and many of our privately-held RIA clients. During the second quarter of 2020, ABC Investment Management billed on $1.75 billion in AUM at an effective realized fee of 65 basis points, resulting in revenue for the quarter of $2.8 million. After subtracting compensation expenses and overhead, ABC generated $660 thousand in EBITDA for the quarter. AUM grew rapidly as the market recovered, such that by the first quarter of 2021 the firm was billing on $2.8 billion in AUM at the same fee of 65 basis points. For the full year, ABC Investment Management generated $14.2 million in revenue and $4.6 million in EBITDA.As of March 31, 2021, however, the firm’s run-rate performance was significantly higher than its performance over the last twelve months. ABC’s $2.8 billion in AUM was generating $18.0 million in annualized revenue at the effective realized fee level of 65 basis points. Assuming the same level of fixed costs and the appropriate increase in variable costs to reflect the higher revenue, ABC was producing run-rate EBITDA of $7.3 million at the end of the first quarter. That’s a 57% increase relative to EBITDA over the last twelve months.Implications for Your RIAAs always, valuation is forward looking. In relatively stagnant markets, there might not be much of a difference between LTM and ongoing performance. But given the shape of the market recovery over the last year, the difference today can be material, as the example above illustrates. If you’re contemplating a transaction in your firm’s stock, it’s worth considering where your firm is at today, not just what it’s done over the last year.

Year-End 2020 Auto Dealer Industry Newsletter Release

We are pleased to release our latest issue of Value Focus: Auto Dealer Industry Newsletter. The newsletter features a commentary on industry data from year-end 2020.Additionally, this issue includes two timely articles. The first article discusses the seven factors of a highly effective Buy-Sell Agreement for auto dealerships. When present, these factors can help reduce the risk of litigation upon a triggering event or business divorce.The second article discusses the computer chip shortage, including how computer chips are used in the automotive industry, how the chip shortage came to fruition, how it is currently affecting the industry, and what it all might mean for auto dealers going forward.Click the link below to download this latest issue.Value Focus: Auto Dealer IndustryDownload the Year-End 2020 Newsletter

Making Sense of 2020: Part I

Benchmarking Cash Flow From Operations

Here at Family Business Director, we believe in the power of benchmarking for family businesses. Done well, benchmarking provides managers and directors with valuable insight and context for evaluating the operating performance of the family business and the strategic investing and financing decisions made by the directors. We published benchmarking guides in 2019: The 2019 Benchmarking Guide for Family Business Directors, and 2020: The2020 Benchmarking Guide for Family Business Directors.We are organizing the 2021 edition of our benchmarking guide using the statement of cash flows as our guide.This week, we review the components of cash flow from operations.Next week, we will consider investing activity, turning to financing decisions the following week.In our final installment, we will look at market performance and shareholder returns. It is no secret that COVID-19 was the story of 2020. To assess more clearly the effect of the pandemic of the firms in our universe, we analyze results on a quarterly basis. We’ve drawn our data this year from the SEC filings of revenue-generating companies in the Russell 3000 index (excluding financial institutions, real estate companies, and utilities).Operating PerformanceEverything good in business starts with revenue. In Chart 1, we summarize aggregate revenue trends during 2019 and 2020. Chart 1 demonstrates that – in the aggregate – smaller companies felt more pain from the pandemic than their larger counterparts. For the large cap companies, revenue fell less than 10% during the second quarter before resuming year-over-year growth in the back half of the year. In contrast, revenue growth for the small caps turned negative in the first quarter, bottoming out with a nearly 20% reduction in the second quarter, with lower revenues persisting into the third and fourth quarters. Financial analysts refer to the relationship between the change in revenue and change in operating expenses as operating leverage. Simply put, if some portion of a company’s operating costs do not vary directly with revenue (i.e., are fixed), revenue growth is likely to trigger expanding margins, while decreasing revenue reduces the operating profit margin. Chart 2 compares the relationship between change in revenue and change in operating expenses for the small cap companies in our data set for 2019 and 2020. Throughout 2019, expense growth outpaced revenue growth, causing operating margins to compress on a year-over-year basis. This trend was exacerbated in the first half of 2020 before moderating in the second half of the year. Chart 3 illustrates the impact of operating leverage on the operating margins of the large and small cap companies. Since the revenue shortfall in 2020 was greater for the small cap companies than the large caps, the negative effect of operating leverage was more pronounced for the small cap firms in 2Q20, with the aggregate operating margin for the group decreasing by 542 basis points from 2Q19, compared to a 218 basis point reduction for the large cap companies.Working Capital to the RescueIn contrast to operating income, net income is burdened by interest costs, income taxes, impairment charges, and other unusual items. As shown in Chart 4, the small cap companies reported an aggregate net loss in the first two quarters of 2020. After breaking even in the third quarter, the group crept back into the black in the fourth quarter. However, as shown in Chart 4, the earnings weakness in 2020 did not prevent these companies from generating more operating cash flow than in 2019 ($127 billion compared to $117 billion). How was that possible? Table 5 summarizes the composition of operating cash flow for 2018 and 2019. Net income was $61 billion lower in 2020 than 2019 for the small cap companies in our data set. However, $36 billion (60% of that difference) was attributable to non-cash charges to earnings (i.e., impairment charges). The balance of the difference is primarily attributable to working capital. One silver lining to the cloud of shrinking revenue is the release of working capital. As shown in Chart 6, cash provided by liquidating working capital was augmented by more diligent cash management practices, as the cash conversion cycle for small cap companies fell from 52 days at the end of 1Q20 to 39 days at the end of 4Q20. Of note, the large cap companies in our data set generally manage working capital more aggressively than their small cap counterparts, as shown in Chart 7. Questions for Family Business DirectorsThe benchmarking data raises some critical questions for family business directors as the U.S. economy continues on the path to recovery.It’s clear that larger firms fared better than smaller firms. What is less clear is why. Assuming your family business is not the size of a large cap public company, what steps did you take to preserve existing revenue sources and find new revenue sources in the pandemic? If you found new revenue sources (for example, e-commerce), what steps are appropriate now to preserve those revenues as the pandemic recedes?Operating Leverage: We suspect that operating leverage ultimately has more to do with flexibility, creativity, and ingenuity than the traditional dichotomy of “fixed” versus “variable” costs. What did the pandemic teach you about your family business’s ability to adapt and manage operating expenses in the event of a negative shock to earnings? Looking forward, are there any “austerity measures” that should probably become the new normal for your family business?Working Capital: If your family business did generate less revenue in 2020, was it able to liquidate working capital accordingly? Do you adopt any working capital management techniques during the pandemic that should continue? If you are expecting revenue to recover in 2021, have you identified and secured the necessary financing sources to support the accompanying increase in working capital needs? What appeared to be a large cash balance at the end of 2020 can be depleted quickly if strong revenue growth triggers larger working capital balances.The pandemic did not affect all industries equally. As shown in Chart 8, revenue for some industry sectors actually increased during the year.ConclusionThe observations in this article relate to the data set as a whole. For more targeted insights and observations, give one of our professionals a call to talk about a more customized benchmarking analysis for your family business.

Prepping for a Potentially Big M&A Year in 2021

Barring another recession or material reduction in bank stock valuations in the public markets, M&A activity should improve as 2021 progresses.However, some boards that would like to sell may have a hard time accepting a lower price versus what was obtainable a couple of years ago.One way to bridge the bid-ask gap is to consider transactions with more rather than less consideration consisting of the buyer’s common shares. Cash deals “cash-out” shareholders who then reinvest after-tax proceeds. Stock deals allow the target’s shareholders to remain invested in a sector that still trades cheap to longer-term valuations.This session, presented as part of the 2021 Acquire or Be Acquired Conference sponsored by Bank Director, addresses these issues.Click here to view the video!

Capital Gains Taxes and Family Businesses

Don’t Let the Tax Tail Wag the Family Business Dog

“The perfection of taxation consists in so plucking the goose as to procure the greatest amount of feathers with the least possible amount of squawking.” So said Jean-Baptiste Colbert, King Louis XIV’s finance minister in regard to 17th century tax policy.As it stands, your family goose may be subjected to some additional plucking soon. It was “leaked” last week (in his 2020 campaign plan) that the Biden administration is planning to nearly double the federal capital gains tax rate on taxpayers earning more than $1 million from 20% to 39.6%. In states with high taxes, the combined blended rate could top 50%.Are you and your directors about to start squawking? Or are you already hoarse? While we steer clear of politics here at Family Business Director, we do aim to inform business owners on the three key financial decisions family businesses face: dividend policy, capital structure, and capital allocation. Clearly a move of this magnitude could leave certain planning strategies less advantageous and could possibly affect key financial decisions. Below we briefly touch on the capital gains tax and provide some helpful reminders for family business owners.What Is the Capital Gains Tax?From the Tax Policy Center, a capital gain is realized when a capital asset is sold or exchanged at a price higher than its basis. Capital gains and losses are classified as long term if the asset was held for more than one year, and short term if held for a year or less. Under current law, short-term capital gains are taxed as ordinary income at rates up to 37%; long-term gains are taxed at lower rates, up to 20%. Taxpayers with modified adjusted gross income above certain amounts are subject to an additional tax of 3.8% on long- and short-term capital gains stemming from the Affordable Care Act.Family shareholders face the prospect of capital gains taxes upon the sale of the business or other significant assets. This could be commercial property, stock holdings, or a business interest that has appreciated over time.Don’t PanicFrom a cursory reading of the financial press and the short-lived market dip, public equity markets appear to be buying gridlock and selling tax hikes. Barron’s writers, Goldman Sachs analysts, and financial twitter prognosticators all seem to point to either a more modest change (increase to 28%-30% rather than 39.6%) or some watered-down version of the proposal. We note that just two months ago eight Senators who caucus with the Democrats voted against a $15 minimum wage, giving further pause to the idea that 50 plus 1 is enough to ram anything through both chambers of congress. Family businesses would be mindful not to count their tax chickens before they hatch – or are even laid.Do Take a Second LookWhile we don’t want to talk out of both sides of our mouth, taking a look at some appreciated assets, especially if they are readily liquid, could take some tax risk off the table. Many of the family businesses we work with have considerable stock portfolios outside their main operating businesses. Consider having a second conversation with your financial advisor to see if you could take advantage in some large winners in the current environment. And for future planning, check with your advisors to see if you can spread events that trigger capital gains over multiple periods to avoid the $1 million income level. Like-kind exchanges and other tax-planning strategies may be worth a second read if the preferential tax treatment goes away.Remember the Big PictureAs we have written about continuously in the blog, family business directors have longer-term objectives than meeting next quarter’s numbers. Family business directors plan with long-term family wealth and succession in mind. As we noted in dissecting the world’s largest family businesses, almost half of the 750 companies in the list have been in business for over 70 years. Over that same time, the capital gains rates have changed dozens of times, oscillating between high teens to just under 40% (albeit briefly in the mid-to-late 70s). What your family business means to you, whether it’s a growth engine or a source of lifestyle, likely won’t change dramatically as a result of your capital gains tax exposure. Remember, running your business and fostering long-term wealth creation is the ultimate goal of any family business director.ConclusionWhen thinking about your current business situation, the toughest time horizon to have is short term. Should we accelerate plans to sell so we can avoid a larger tax bill? Should we realize some gains in the family securities portfolio to avoid the possibility of an increase in long-term capital gains rates? We think long-term minded family business directors are in prime position to ride through the tax waves and steer their family ships safely on their long voyages. Give one of our family business professionals a call today to talk about balancing tax concerns with the long view on your family business.

Out of the Crude Abyss

It has been almost a year since crude prices went into the abyss on last April 20th. What a day that was: OPEC’s shoe had already dropped, and the realities of COVID-19’s short term consequences panicked the global oil market into a historic backlog. Crude tankers were stranded on the seas, storage filled up, and for a short while production had nowhere to go.The havoc wreaked on markets was severe. Demand was projected to drop between 20% and 35% by some (consumption actually dropped about 22% per the EIA). Reserve lives for some major producers dropped by around 10 years and between them reported losses north of $60 billion in 2020. To be fair, there are a couple of ways to look at this: one is a market decline in interest in these commodities; another could be rooted in the demand from investors for more nimble balance sheets coupled with the growing ability to develop acreage relatively quickly. Beyond the decline of reserves, (both through production decline and economic characterization), the bankruptcy casualty counts also skyrocketed as I have discussed before. According to the latest Haynes & Boone data, the count was 35 new bankruptcies in the second and third quarters of 2020 and over $50 billion in total debt going into bankruptcy for the full year.What a difference a year makes.Recently WTI closed at over $63, and it has spent most of the past month at or above $60. Many analysts now predict oil to stay in the $60’s (or higher) for the rest of 2021 (EIA on the other hand projects the mid-$50’s). It appears that low prices may have been a cure for low prices. The Dallas Fed came out with their quarterly Energy Survey a few weeks ago and its results were quite shocking to many. Its business activity index was at its highest reading ever in the five-year history of the survey. Guarded optimism among industry players is creeping back into the picture: “We are optimistic that we will have a weaning of excess oil supply, and more importantly, suppliers of oil and gas, that will lead to a slightly higher sustainable price.” said a respondent to the Dallas Fed. The S&P’s SPDR Oil and Gas Production ETF which dropped to around $30 (split adjusted) in March 2020 is now trading around $80. Production and CapEx spending are emerging as well in response to rising demand. Global oil demand and supply are moving towards balance in the second half of this year, per the IEA’s latest monthly report. In fact, producers may then need to pump a further 2 million bbl/d to meet the demand. OPEC, which has been withholding supply in tandem with other producers including Russia, this week raised its forecast for global oil demand this year. OPEC expects demand to rise by 70,000 bbl/d from last month's forecast and global demand is likely to rise by 5.95 million bbl/d in 2021, it said. Upstream Economics: Back In BlackIt must be relieving to be “let loose from the noose” of low prices. A lot of producers should be singing AC/DC nowadays. It is now profitable to drill a lot more wells than a year ago. Heck, back then existing wells were not profitable, much less undrilled ones. In terms of reserve metrics, I have said before that value erosion usually starts at the bottom categories of a reserve report and moves upwards. Value accretion moves in reverse. The increased pricing is making larger swaths of reserves economic again. Even so, one thing that is different this time around may be the cautiousness of investors and producers to jump back on the drill bit right away. Investors have already been pulling valuations down as their standard tilted more towards shorter term returns as opposed to longer term reserves. Additionally, the Fed Survey was littered with comments expressing concern about the Biden administration’s policies being more aggressive towards regulation and ESG, thus promoting caution for aggressive drilling. In fact, the American Petroleum Institute (of all organizations) is now considering carbon pricing frameworks. Lastly, OPEC+ could yank the rug out from shale producers again if they are perceived as ramping up too quickly, according to Pioneer’s CEO. (It is notable though that Pioneer just bought West Texas producer DoublePoint for $6.4 billion. That’s approximately $30,000 per flowing barrel and $40,000 per undeveloped acre). Next StepsSo where does this leave us? Well, in a lot better place for producers and investors than last year – that’s to be sure. The companies that have hung in this past year and made it are starting to see some improvement. That’s also good because those that utilized PPP money have been in need of price help once the government subsidies ran out. In addition, with all of the attention towards electric vehicles replacing the combustion engine, we must remind ourselves that only 1% of the U.S. light fleet is EV and that light vehicles only make up 25% of crude oil use. Demand will not be chopped out from oil’s feet just yet.Markets are fast moving and unforgiving at times, but it appears with $60+ oil prices for 2021, that the upstream business can now start to slow down, look around, and evaluate what direction to go next.Originally appeared on Forbes.com.

Bull Markets Breed Complacency for Investors AND RIA Management Teams

Know Why Your Firm is Growing

Forty-three years ago, Mercedes Benz began offering anti-lock brakes as an option on its top-end S-class sedan. ABS had been the norm for commercial airliners and some commercial vehicles for years, but it took considerable development from supplier Bosch to make the feature “affordable” for passenger cars (equivalent to about $4500 today). Anti-lock brakes improved stopping distances in hard braking and wet conditions dramatically. Initially, however, it also increased the accident rate.As with “self-driving” or semi-autonomous features being developed today like automatic braking and lane-keeping, the early days of ABS found Mercedes owners a little too secure in the capabilities of their vehicles. Overconfidence leads to complacency, and complacency leads to accidents. Long before Tesla drivers were photographed asleep in their moving vehicles, Mercedes drivers were rear-ending cars (because they overestimated their brakes) and getting rear-ended (because they overestimated the brakes of the car behind them).The speed with which equity markets have recovered over the past year has the potential to lead to a similar level of complacency, and RIA management teams would be well advised to keep both hands on the wheel.The risk we not infrequently see is that lengthy periods of strong market performance necessarily lead to upward trends in AUM and revenue that mask underlying problems. Just as institutional asset management clients learned decades ago to evaluate portfolio performance on a relative basis, rather than absolute return, RIA management teams need to look a step or two beneath the surface to understand why their firm is growing.Gauging performance for an RIA is often thought of in terms of the portfolio, particularly for product companies that specialize in particular strategies. Even though performance, in theory, should drive AUM flows, capital markets are fickle, and so can be customer behavior. So, we prefer to start with a decomposition of AUM history, and then explore the “why” from there.Consider the following dashboard that breaks down the revenue growth of an example RIA. Over a five-year period, this RIA boasted aggregate revenue growth of nearly 40%, increasing from $3.7 million to $5.1 million. AUM growth was even more substantial, nearly doubling from $600 million to $1.1 billion. Revenue grew every year, which would lead one to have great confidence in the future of the firm.Looking deeper, though, we notice a couple of unsettling trends. The five-year period of measurement, 2016 through 2020, represents a bull market from which this RIA benefited substantially. Cumulative gains from market value were over $600 million, more than the total growth in AUM and masking the loss of clients over the period examined (net withdrawals and terminations of over $100 million). Markets cannot always be counted on for RIA growth, so client terminations, totaling $183 million over the five-year period, or nearly one-third that of beginning AUM in 2016, is cause for concern. This subject RIA only developed $35 million in new accounts over five years, and we notice what appears to be an accelerating trend of withdrawals from remaining clients.Further, there appears to be loss in value of the firm to the marketplace. Realized fees declined four basis points over five years. Had the fee scheduled been sustained, this RIA would have booked another $336 thousand in revenue in 2020, all of which might have dropped to the bottom line. Small changes in model dynamics have an outsized impact on profitability in investment management firms, thanks to the inherent operating leverage of the model. But the materiality of these “nuances” can be lost in more superficial analysis of changes in revenue or changes in total AUM.So, we would ask, what’s going on? Did this RIA simply ride a rising market while neglecting marketing? Are clients concerned about something that is causing them to leave? Does this RIA suffer from more elderly client demographics that accounts for the runoff in AUM? If the RIA handles large institutional clients, did some of those clients rebalance away from this strategy after a period of outperformance? Is their realized fee schedule actually declining, or is it not? Is the firm negotiating fees with new or existing clients to get the business? Did a particularly lucrative client leave? What is happening to the fee mix going forward?Decomposing changes in revenue for an investment management firm can prompt a lot of questions which say more about the performance of the firm than simply the growth in revenue or AUM. Yet when we ask for this information from new clients, it isn’t unusual for us to hear that they don’t compile that data. All should. Some drivers have too much confidence in new technology, and some RIA managers have too much faith in the upward lift of the market. The risk to both is the same: ending up in the ditch.

M&A Focus: The Pioneer-DoublePoint Deal

After what felt like an eternity of quiet transaction activity in the O&G industry, the M&A market in 2021 has been off to a more active start in 2021.According to S&P Global Market Intelligence, the industry announced 117 whole-company and minority stake deals in the first quarter of 2021, an increase of 28 transactions from the same period last year. The combined deal value has also increased from $3.86 billion to $26.4 billion, as supermajors like Exxon Mobil Corp., Royal Dutch Shell PLC and Equinor ASA divested assets and corporate consolidation continued. The trend continued early in the second quarter.In this post, we discuss the Pioneer-DoublePoint transaction (the “Transaction”) that could foreshadow for more M&A activity to come.Transaction Summary & Asset DetailsOn April 1, 2021, Double Eagle III Midco 2 LLC, wholly owned by DoublePoint Energy, LLC, announced that it entered a definitive purchase agreement to sell all leasehold interest, subsidiaries, and related assets to Pioneer Natural Resources Company (PXD) in a transaction valued at $6.4 billion. DoublePoint is a Fort Worth, Texas-based upstream oil and gas company that is backed by equity commitments from funds managed by affiliates of Apollo Global Management, Quantum Energy Partners, Magnetar Capital, and Blackstone Credit.According to Piconeer’s Investor Presentation, the Transaction adds approximately 100,000 Tier 1 Midland Basin net acres to Pioneer’s existing assets. The bolt-on acquisition will lead to the combined company owning approximately 920,000 net acres in the Midland Basin, making it the largest producer in that area. The deal is expected to close in the second quarter of 2021.The purchase price is comprised of the following:Approximately 27.2mm shares of Pioneer stock (PXD) based on Pioneer’s closing share price as of 4/1/2021 ($164.60). After closing, PXD shareholders will own approximately 89% of the combined company and existing DoublePoint owners will own approximately 11%.Cash of $1.0bnApproximately $0.9bn of liabilities that includes debt of $650mm at 7.75% and approximately $300mm of reserve-based lending and working capitalPer PXD Investor PresentationThe Transaction implies the following valuation metrics: Pioneer anticipates approximately $175 mm in annual synergies related to G&A, interest, and operations. The company expects to save approximately $15 mm in G&A by reducing DoublePoint’s expense by 60% in the second half of 2021. Pioneer also plans to refinance DoublePoint’s bonds after closing to save roughly $60mm. Last, the company projects about $100 mm in operational savings. According to Pioneer’s Investor Presentation, the acquired acreage is highly contiguous and largely undeveloped, adding greater than 1,200 high-return locations. Although the exact amount Pioneer attributed to PDPs and PUDs is unknown, this suggests that PXD most likely associated option value to the undeveloped acreage in their purchase consideration. Mixed Market Signals Investors responded relatively well the day of the announcement (prior to the press release), as PXD’s share price increased 3.64%, closing at $164.60 on April 1. However, the stock has since produced mixed signals. The next trading day, April 5, the stock closed at $152.18, a 7.55% decrease from the announcement. The stock closed at $147.10 on April 21, a 10.63% decrease from April 1. The company has still performed well in 2021, as PXD share price is up 29.63% year-to-date. PXD has followed similar trends to the broad E&P value index (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF, ticker XOP) since the beginning of year, so this decrease may be geared more towards industry sentiment rather than deal reaction. On April 5, 2021 Fitch Ratings released a statement that Pioneer’s ratings are unaffected by the company’s deal announcement with DoublePoint. On April 22, 2021 Fitch affirmed Pioneer’s long-term issuer default ratings and unsecured debt ratings at BBB. Fitch also assigned a BBB rating to Pioneer’s 364-day unsecured revolving credit facility. Fitch notes that their rating outlook for PXD is stable. Pioneer’s credit rating outlook is a testament to its strong balance sheet and 2021 estimated net debt / EBITDAX of 0.9x. ConclusionThe Pioneer-DoublePoint transaction could set the stage for an active M&A market relative to a quiet 2020. Also, Pioneer’s Fitch Rating could serve as a positive signal for utilizing leverage in future deals. It will also be interesting to monitor deal values as it relates to what buyers are willing to pay for specific producing and non-producing assets (to the extent that the information is disclosed). If an industry recovery is in sight, transaction activity could continue its healthy pace, but also has the potential to soften if uncertainty looms, causing the bid-ask spread to widen if buyers and sellers are not on the same page.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Dealership Working Capital

A Cautionary Tale Against Rigid Comparisons

We have previously written about six events that can trigger the need for a business valuation. In each of these examples, the valuation will consider the dealership as a going concern or a continuing operation. The valuation process considers normalization adjustments to both the balance sheet and the income statement, as we discussed in our whitepaper last summer. For the balance sheet, normalization adjustments establish the fair market value of the tangible assets of the dealership and also identify and bifurcate any excess or non-operating assets. Non-operating assets are anything of value owned by the company that is not required to generate earnings from the core operations of the dealership.Even if a dealer is considering a potential sale of the business, the other assets and liabilities not transferred in the proposed transaction still have value to the seller when they consider the total value of operations. These non-core assets would then be added back to the value of the dealership operations determined under the other valuation methods. Profitable dealerships will accrue cash on their balance sheets over time. While these profits tend to either be reinvested into the business or distributed to owners, we frequently find that auto dealerships will carry a cash balance in excess of the needs of the core operations which could but have not yet been distributed. This excess is considered a non-operating asset, and as we discuss in this post, there are numerous considerations in determining the extent that cash buildup may represent an excess.Working Capital on the Dealer Financial StatementCash (and contracts in transit) and inventory tend to be the two largest components of working capital (current assets minus current liabilities) for auto dealers. However, inventory is offset by floor-plan debt, requiring little actual upfront investment on the part of dealers. Still, there is a certain level of working capital required to maintain operations. Most factory dealer financial statements list the dealership’s actual working capital, along with the requirements or “guide” from the manufacturer on the face of the dealership financial statement, as seen in the graphic below. A proper business valuation should assess whether the dealership has adequate working capital, or perhaps an excess or deficiency. Comparisons to required working capital should not always be a rigid calculation. An understanding of the auto dealer’s historical operating philosophy can assist in determining whether there is an excess or deficiency as different sales strategies can require different levels of working capital, regardless of factory requirements. Often, the date of valuation coincides to a certain event and may not align to the dealership’s year-end. The balance sheet at the valuation date could represent an interim period and may reflect certain seasonality of operations. A proper assessment of the working capital should consider the sources and uses of cash including anticipated distributions, capital expenditures, accrued and off-balance sheet liabilities, etc. For many reasons, it may not be appropriate to simply take the $616,218 from above and call this amount a non-operating asset. Additional Challenges to Working Capital Assessment Caused by Industry ConditionsSince the start of the pandemic, the auto dealer industry has continued to rebound after initial declines caused by lockdowns and shelter in place orders. The industry has benefited from increased gross profit margins on new and used vehicles, reduced expenses in advertising, floor plan maintenance and staffing, and funds provided by the PPP. All have contributed to record performance for dealerships. The PPP funds pose additional challenges to assessing the working capital of a dealership; are the funds reported on the dealer’s financial statement or are they held in accounts not reflected on those financial statements? Is there a corresponding liability for the PPP loan on the balance sheet or has that loan been forgiven? The date of valuation and what was known/knowable as of that date frame the treatment of these and other items in business valuation. For dates of valuation later in 2020 and early 2021, the loan portion of the PPP funds may be written off to reflect either its actual or likely forgiveness, and the removal of the corresponding PPP loan can increase the dealership’s working capital.The increased profitability of dealerships can also be viewed in the rise of current ratios (current assets divided by current liabilities) over historical averages. According to the data provided by NADA, the average dealership’s current ratio has risen to 1.38, from prior averages around 1.24. Statistical data from 2014 through February 2021 can be seen below: So how should the working capital of an auto dealership be assessed? Let’s look to a case study of a recent project to determine the factors to consider. Certain figures have been modified to improve the discussion and protect client information. Case StudyConsider a dealership with a date of valuation of September 30, 2020 compared to their typical calendar year-end. In a review of historical financial statements and operational performance, the Company reported increasing cash totals as seen below. A quick review reveals that cash has increased by over $6 million in 2019 and $9 million from 2018 through the valuation date. Would the entirety of this increase represent excess working capital? Digging deeper, let’s examine the actual levels of working capital and working capital as a percentage of sales for the same company over the same historical period. As we can see above, working capital increased as a percentage of sales. A rigid comparison of the latest period’s working capital to the prior period might indicate excess working capital either on the order of $2.7 million or 1% of sales. We can also look at the manufacturer’s requirement. This particular dealership had a net worth requirement and the more traditional working capital requirement. These are simple figures indicating whether a dealership is properly capitalized considering both liquidity and solvency. All of these financial calculations and cursory level reviews of working capital and net worth fail to consider the specific assets and liabilities of the Company, the timing of the interim financial statements, and the anticipated uses of cash. It is critical to conduct an interview with management to discuss these items and the operating level of cash and working capital needed for ongoing operations. Importance of Management InterviewIn this example, management indicated that the ongoing cash needed to facilitate day-to-day operations would approximate $5 million. Deducting from the $14.7 million, would that indicate $9.0+ in excess cash based on comparison to the actual cash balance as of the date of valuation?Management also provided details of a related party note payable to one of its owners not readily identifiable on the dealer financial statement. The note was a demand note that was callable at any time and was expected to be paid in the short-term. This is considered a non-operating liability, offsetting the excess cash. Management also anticipated heightened capital expenditures for the fourth quarter in the amount of $325,000. This type of information would be nearly impossible to discern from just analyzing the financials as this expenditure is an off-balance sheet item.After learning this information, we chose to assess working capital utilizing three different methods. First, we assessed working capital in the context of net worth based upon the requirements from the manufacturer because the Company can’t distribute excess cash to the level that would reduce equity below this figure. This method resulted in an assessment of excess working capital of approximately $1.4 million as seen below: Next, we looked at the dealer’s working capital position compared to OEM requirements. This method showed closer to $2.4 million in excess working capital. While this shows the dealership may have ample liquidity to facilitate operations with less cash in the business, the excess cash cannot materially impair the required book value above. The final assessment of working capital focuses directly on the cash and equivalents. As discussed, management indicated that the Company had operational cash needs of $5 million. Additional uses of cash prior to year-end included the likely repayment of the related party demand note and the cash required for the capital expenditures. This method resulted in an assessment of working capital of approximately $1.3 million, compared to a rigid calculation of $9.6 million when only considering actual cash less operating level needs as seen below: Ultimately, we concluded the Company in this example had excess working capital in the form of approximately $1,350,000 in excess cash. While there was more cash on the balance sheet than historical periods, our other valuation methods assume appropriate investment in the business to sustain operations. As such, we would be double counting value to add back too much cash without considering necessary improvements to the business to generate profits in the future. This example highlighted a dealership with excess working capital that was reflected in excess cash. Occasionally, an analysis might indicate excess working capital, but the Company’s cash is not elevated above a sufficient level to fund operations. As discussed above, excess and non-operating assets are those that could theoretically be distributed while not affecting the core operations of the dealership. However, non-cash current assets, such as Accounts Receivable and Inventory, are either not readily distributable or doing so might jeopardize the core operations. For a valuation performed in March 2021, industry conditions would also impact these calculations. Many dealerships likely have excess cash from increased profitability caused by inventory shortages. While cash balances would be higher when compared to historical levels, overall working capital may not be too unchanged as dealers struggle to maintain adequate inventory. Extracting value in the form of excess cash in this environment would need to be balanced with appropriate consideration of ongoing sales abilities with constrained inventories. As we’ve shown throughout this case study, none of these figures can be viewed in isolation. ConclusionsWorking capital and other normalization adjustments to the balance sheet are critical to the valuation of an auto dealership. The identification and assessment of any excess or deficiency in working capital can lead directly to an increase or decrease in value. Valuable datapoints to measure working capital include the requirements by the manufacturer and the Company’s actual historical cash and working capital balances, along with its current ratio and working capital as a percentage of sales. None of these data points should be applied rigidly and should be viewed in the context of future sources and uses of cash, the presence of non-operating assets or liabilities, and the seasonality of an interim date of valuation. Additional challenges for current valuations can be posed by PPP funds and prevailing industry conditions including scarce inventory and heightened profitability.The professionals of Mercer Capital’s Auto Dealership Team provide valuations of auto dealers for a variety of purposes. Our valuations contemplate the necessary balance sheet and income statement adjustments and provide a broader view to determine the assumptions driving the valuation. For a valuation of your auto dealership, contact a professional at Mercer Capital today.

Dealership Working Capital

A Cautionary Tale Against Rigid Comparisons

Middle Market M&A Amidst a Recovering Economy

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