FORUM: Valuations and fairness opinions in M&A
June 2014 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
June 2014 Issue
FW moderates a discussion on valuations and fairness opinions in M&A between Nancy Czaplinski at American Appraisal, James Dimech-DeBono at Grant Thornton UK LLP, Jennifer Muller at Houlihan Lokey, and Andreas Mackenstedt at PwC.
FW: How important are reliable valuations and fairness opinions in today’s M&A transactions? What role do they play in the process?
Czaplinksi: History suggests it is virtually certain that an M&A deal will be challenged by shareholders. A challenge presents a risk to the transaction and may result in expense and delay. With so many deals challenged, board of directors’ decisions face intense scrutiny. A supportable, high-quality fairness opinion or independent valuation introduces an objective perspective to the board of directors’ actions and provides support for the board’s position in defending against a shareholder lawsuit, giving the board valuable ammunition to establish that it is entitled to the protection afforded by the business judgment rule.
Dimech-DeBono: Valuations have always been important but since the financial crisis the issues around independence and transparency have certainly come to the fore. More often than not stakeholders demand that transactions are value additive or else seek to minimise value diminution, in case of a forced sale. During the financial crisis, we worked on a number of deals where boards of funds of funds had concerns on the amount of discounts to accept on positions they had in hedge and private equity funds. This trend has continued since and is becoming more of the norm to have an independent valuation adviser, whether it is for a transaction or as part of BAU. This is very evident especially in investment management, where impendent advice is sought on Level Three assets on a regular basis due to both investor and regulatory pressures.
Muller: Fairness opinions have been ubiquitous in US corporate control transactions since the 1985 Smith v. Van Gorkum decision, which found the target company’s directors in breach of their duty of care, due in part to their failure to obtain valuation advice. More recently, two factors have conspired to cast a more intense spotlight on the importance of obtaining a high quality, unbiased fairness opinion from a reputable financial adviser in an M&A transaction: first, the increasing prevalence of litigation related to M&A transactions, and second, heightened scrutiny by the courts of fairness opinions and underlying analyses. Fairness opinions are obtained in virtually all US public M&A transactions, but are also often obtained in private situations involving controlling stockholder or related party transactions; a large number of shareholders; different classes of stock with different rights – for instance convertible, preferred, common; or terms and conditions departing from customary ones in similar transactions.
Mackenstedt: In Germany we distinguish between an M&A valuation and a fairness opinion. A fairness opinion is a professional statement on the result of a decision-making process, particularly on the financial fairness of an intended or an agreed transaction price. The purpose is not to calculate a transaction price, like advisers in the M&A valuation process do. Fairness opinions are obtained for important corporate decisions in order to provide protection against risks of liability. Fairness opinions are increasingly gaining relevance for managements and supervisory boards. This has to be seen especially in connection with the so-called ‘business judgment rule’ which in Germany is established in §§ 93, 116 of the German Stock Corporations Law.
FW: To what extent can valuations and fairness opinions assist corporate directors in making or approving decisions about potential M&A transactions?
Dimech-DeBono: Both valuations and fairness opinions play a key role in the decision making process around a transaction. It sounds simple enough that the valuation range should inform the transaction price and the fairness opinion should inform the reasonableness of such price and general terms of the transaction. The two exercises should be separate and distinct as the independent fairness opinion gives both executive and non-executive directors an insight into the reasonableness of the transaction terms. Instances where transaction opinions are more relevant include times where there are either perceived conflicts of interest on the part of the transaction adviser, a significant transaction that has a major impact on the business or some statutory requirement. However, directors are resorting more to requesting such opinions as a matter of best practice.
Muller: In general, a fairness opinion serves two purposes. First, it provides the board with information to assist it in making its decision. Second it serves as factual evidence in litigation of the board’s exercise of due care in reaching its decision. Although there is no legal requirement for the board to obtain a fairness opinion, the courts have generally looked with favour on their receipt by the board. A fairness opinion is typically delivered to a board at the time that the board makes its decision on whether or not to approve a proposed transaction. Often the fairness opinion is delivered orally in a meeting with the board and followed subsequently with a formal letter.
Mackenstedt: As an independent analysis of corporate initiatives by a third party expert, a fairness opinion provides impartial support on protecting management and supervisory bodies against risks of liability; documenting the management decision; verifying and communicating the reasonability of corporate initiatives within a certain context; reducing discrepancies in information between management and stakeholders; and checking the feasibility of parameters such as the business plan, and cost of capital.
Czaplinksi: Although a fairness opinion or independent valuation is not required in M&A transactions, the analysis undertaken, as part of such opinions or valuations, can result in alternate actions by the board of directors or provide an independent opinion that supports the board’s business judgment. A fairness opinion or independent valuation can conclude a value range above or below the potential deal value, thereby leading to revised deal terms. In situations where the target is non-public, infrequently traded, or a multigenerational family business, opinions of the business’s value may vary, and an independent valuation may assist all parties in separating the emotion from the value. For non-public subsidiaries of public companies, and in situations whereby stock may be exchanged for non-public debt, valuations are extremely important as a means of establishing the transactional price.
“Valuations have always been important but since the financial crisis the issues around independence and transparency have certainly come to the fore.”
FW: What limitations and expectations should a firm be aware of when requesting a valuation or fairness opinion for M&A purposes?
Muller: First and foremost, it is important to note that a fairness opinion is not a substitute for the ultimate judgment of the board and should be one of a number of factors considered by the board in formulating a recommendation on how to proceed in a transaction. In addition, a fairness opinion is not, among other things: an indication that the price paid is the highest price attainable; an evaluation of the business rationale to proceed with the proposed transaction; a recommendation to proceed with the proposed transaction; or an opinion that the proposed transaction was the result of a fair process or is otherwise fair from a legal or normative point of view.
Mackenstedt: Fairness opinions are not a substitute for the firm’s independent assessment of the transaction price. They do not contain a recommendation to complete or abandon an M&A process. In contrast an M&A valuation gives the management an indication or recommendation for the transaction price.
Czaplinksi: A fairness opinion is limited to fairness from a financial point of view, as the individuals providing the opinion are financial and valuation professionals. However, a fairness opinion or a valuation does not address the underlying business decision of the board, its shareholders or any other party to proceed with the transaction. A fairness opinion or valuation does not opine as to whether the transaction is fair from a legal point of view. It is not a recommendation for or against the transaction and it does not address the relative merits of the transaction as compared to alternatives including any other transaction or business opportunity. A fairness opinion or a valuation is definitely not an insurance policy or any type of guarantee related to the transaction, nor does it ensure that the deal is being consummated at the highest value possible. A fairness opinion or valuation does not replace the consent of shareholders, if required, as to proceeding with the transaction.
Dimech-DeBono: Limitations always exist, especially in valuation. Valuation is not a science but an exercise that involves a degree of judgement and is always based on a set of assumptions that have been provided by management. Similarly, the same could be said in the case of fairness opinions. Furthermore, given that the fairness opinion is sought at the very end of the transaction process, time pressure may have a significant role to play. Without sounding too simplistic, the scope has to be looked into and set out carefully in terms of what is being valued, what assets are excluded and what the limitations in scope are. Such limitations would form part of the caveats that would be included in the fairness opinion.
FW: Have there been any major legal or regulatory developments that will affect valuations and fairness opinions going forward?
Mackenstedt: In Germany we have observed legal and regulatory developments for fairness opinions over the past few years. This can be seen especially in connection with the ‘business judgment rule’. These rules specify the duties of care for members of supervisory boards and executive boards by listing the conditions under which there is freedom from liability. Therefore, the Institute of Public Auditors in Germany has, for the first time, established comprehensive guidelines for the preparation of fairness opinions by publishing the IDW Standard Principles for the Preparation of Fairness Opinions (IDW S 8) in 2011.
Czaplinksi: The most significant recent legal development relating to fairness opinions is the Delaware Chancery Court’s opinion in the In re Rural Metro Corporation Stockholders litigation on 7 March 2014. Although the opinion is wide-ranging, the takeaway for corporate boards relating to fairness opinions is to ensure the financial adviser retained to provide a fairness opinion is free from conflicting interests, such as contingent success fees, fees from financing the transaction or related business involving the transaction participants. The Rural Metro financial adviser had significant financial interests that were not consistent with the company’s interests and that of its shareholders, potentially causing substantial liability and expense that could have been avoided through the use of an experienced, independent professional firm free of such conflicts.
Dimech-DeBono: From a legal perspective, if the adviser providing the opinion is judged, in a court of law, to have a conflict of interest, and as a consequence reliance on the fairness opinion is somewhat diminished, the legal costs and negative publicity received by the financial firm can be significant. Various legal cases in the US are testament to this. Although there may not be specific statue that regulates such opinions, in this day and age when regulation is all about independence and transparency in order to protect stakeholders, it becomes very intuitive what likely consequences would ensue.
Muller: Both the increasing prevalence of litigation related to M&A transactions and heightened scrutiny by the courts on fairness opinions and supporting analyses underscore the importance of obtaining a high quality, unbiased fairness opinion from a reputable financial adviser. Based on research compiled by Cornerstone, in each of the last four years, over 90 percent of announced US public M&A deals over $100m have been litigated. In 2013, 94 percent of such deals were litigated. In addition, the courts have become increasingly critical in their scrutiny of fairness opinions and the analyses underpinning them. In Koehler v. Netspend Holdings Inc. the Delaware Court highlighted several elements in a banker’s fairness opinion that rendered the opinion “unreliable and ambiguous”. Similarly, the Delaware Court was highly critical of the fairness opinions to the board of Rural Metro Corporation in In re Rural Metro S’holders Litig., in which opinions were found to be predicated on flawed analyses.
“It is good practice to develop all relevant approaches to value and also to undertake sensitivity analysis within each approach.”
FW: Could you provide an insight into how M&A valuations and fairness opinions are conducted? What kinds of methods and processes are used?
Czaplinksi: Transactional valuations and fairness opinions usually begin with a complete understanding of the terms of the deal, the economy, the industry the company operates in and the competitive landscape, as well as governmental and regulatory issues. The deal itself is compared to historical sale transactions of the company stock – or asset – as well as to competing offers or alternate transactions. Site visits and management interviews are conducted. Historical financials are analysed and operating ratios are developed. Valuation approaches generally encompass the income and market approaches – both publicly traded and merged or acquired companies. If sufficient information is available, asset-based approaches can be considered to value the company’s underlying tangible and intangible assets. It is good practice to develop all relevant approaches to value and also to undertake sensitivity analysis within each approach.
Dimech-DeBono: Valuations are typically conducted using both an income and market approach. Under the market approach consideration would be given to multiples arising from comparable business or recent comparable transactions. The income approach is based on discounted cash flow. A certain degree of due diligence is performed as part of the valuation process and this entails looking into the reasonableness of the assumptions against any market or industry data that is available. This is a very crucial aspect of the valuation process – sometimes distressed businesses appear to make miraculous recoveries in light of a transaction. For a fairness opinion, details are scrutinised under extreme time pressure.
Muller: The foundation for a fairness opinion is a valuation analysis that presents a range of valuation indications derived from several valuation approaches and methods, which may include a discounted cash flow analysis, a comparable company analysis and a comparable transaction analysis. Other financial analyses that may be relied on in assessing fairness include a premiums paid analysis, relative contribution analysis, ‘has/gets’ analysis, LBO analysis and accretion/dilution analysis. In the case of transactions involving public companies, historical stock price performance and other relevant trading data will be reviewed. In all cases, substantial business and financial due diligence should be undertaken with management and advisers of both the target and acquirer, where possible. Unlike an appraisal, a fairness opinion does not synthesise value indications into a single valuation conclusion. Instead, the consideration to be paid or received is assessed as falling within a range of fair values.
Mackenstedt: The financial fairness of the transaction price must be assessed from the client’s perspective, considering individual client-specific factors, such as expected synergies and planned value contributions from restructuring activities, as of the opinion date. The client is either the buyer or seller. The assessment is based primarily on income approaches, such as discounted cash flow or capitalisation of earnings methods, and also market approaches including analyses of stock market prices of the transaction target and transaction or trading multiples. Finally, other related information derived from the capital and transaction markets – ‘supplementary information’ – must be considered. A fairness opinion is a statement on an intended or an agreed transaction price. An M&A valuation technically follows almost the same approaches mentioned before. But this could be individually developed.
FW: In what ways can the process help to maximise deal value?
Dimech-DeBono: There is anecdotal evidence that when a fairness opinion is sought on a deal, a lower premium is usually paid. There is additional evidence that the likelihood of a deal closing increases when an independent fairness opinion is presented. Both cases implicitly help optimise the deal value. Furthermore, from a fees perspective, if an independent firm is providing the fairness opinion, the fee is usually fixed and as such lower than that the deal adviser would charge if the latter was providing this opinion. The reason being that basis of the calculation would be different.
Mackenstedt: The key objective is not to maximise the deal value number in all cases. If the conclusion of a fairness opinion is that, for example, the offered price is financially not fair from a seller’s perspective, this may lead to a renegotiation of the price offered, resulting in a higher price. In other cases the intended purchase price is assessed as too high – and financially unfair – so the better option can be not to do the deal.
Czaplinksi: A fairness opinion does not ensure that the transaction being consummated is at the highest value possible. However, a thorough analysis of the range of values for a proposed transaction and a similar analysis for competing offers and alternative transactions by the financial adviser will provide the board of directors with an independent yet consistent perspective, from a financial point of view, and allow comparison of competing offers and alternative transactions in order to maximise deal value. This is integral in management buyouts, for example, where management steps back from its role of enhancing shareholder value and offers to purchase the company. The due diligence, various valuation approaches and related sensitivity analyses can shed light on aspects of value that the board of directors may not have considered when reviewing management’s offer and may result in actually shopping the company and reviewing competing bids.
FW: What kinds of contentious issues and potential objections might follow a valuation in today’s market? How can experts manage these risks?
Muller: Recent court cases such as Del Monte, El Paso and Rural Metro have cast a more intense spotlight on the integrity of analyses provided by financial advisers. Criticisms by the courts in these and other cases have typically focused on two key themes: failure to properly disclose and manage financial adviser conflicts of interest, and flawed inputs used in the valuation and financial analyses. Experts can manage these risks by advising clients of and fully disclosing any potential conflicts of interest; monitoring for any new conflicts of interest that could arise over the course of advising on a transaction or providing a fairness opinion; building internal information walls where appropriate; ensuring appropriate staffing on engagements; ensuring that valuation inputs and analyses are well thought out, defensible and carefully reviewed; and establishing and following a rigorous and well-documented internal review process in the case of fairness opinions.
Mackenstedt: It has to be noted that after a false decision by management, the willingness to hold management personally responsible has increased over the last years. Therefore, fairness opinions performed by an expert were and are gaining more importance. To manage these risks, the fairness opinion has to follow the underlying standards and principles – independence, sufficient analysis and comprehensive documentation – to prove the appropriateness of the work performed.
Czaplinksi: Selection of comparable companies used in the market approach is a common area of contention. Some of the comments made by the Court regarding the fairness opinion delivered to the board of NetSpend – Brenda Koehler v. NetSpend Holdings Inc. et.al. – indicated that the comparable companies used in the market approach were dissimilar to NetSpend. Selection of comparable companies was also a plaintiff argument in In Re JCC Holding Co., Inc. Shareholders Litigation. Some of the issues surrounding the selection of comparable companies could be mitigated by a more in-depth analysis of the comparable companies. For example, information on geographic concentration, product lines, customers or distributors of each of the comparable companies is easily available in public disclosure documents through Edgar.gov or through paid subscription databases such as CapIQ. Although companies may share the same primary NAICS or SIC they may not be truly ‘comparable’. The income approach and the underlying projections, sensitivity analysis and discount rate utilised in the income approach are often further areas of contention.
Dimech-DeBono: Experts manage such issues in a number of ways. To start with, the valuation expert has set the right expectations of what the work entails. This is achieved through agreeing a very well-defined scope while highlighting where the limitations lie. Once the work is completed, limitations in scope have to be explicitly stated in the valuation report or fairness opinion. The fairness opinion should give an indication as to whether the transaction value is reasonable or not – any discrepancies between the advisers would have to be looked into irrespective of which methodologies are used.
“To manage these risks, the fairness opinion has to follow the underlying standards and principles – independence, sufficient analysis and comprehensive documentation – to prove the appropriateness of the work performed.”
FW: What factors should boards consider when selecting a firm to provide a valuation or fairness opinion?
Czaplinksi: The most important factor boards should consider is the independence of the adviser. Advisers that have recently been engaged by one or both parties to a transaction or who have relationships with key shareholders, board members or management may not be perceived as independent. Second, the board should be sceptical of an adviser’s fee that is contingent on the successful completion of the transaction. If the adviser’s fee is based on success, the adviser could be perceived as having an interest in consummating the transaction. Usually the fairness portion of an adviser’s fee is fixed; however, if the remainder of the fee is based on the success of the transaction and a percentage of transaction value, this could create the perception that the fairness opinion is highly contingent on the ‘success’ of the transaction. Third, the board should ensure that the financial adviser is not set to receive significant fees from assignments that result from the consummation of the transaction. Fourth, the financial adviser should be qualified in rendering valuations or fairness opinions – industry and transaction experience are important. Fifth, boards should ensure that the adviser issuing the fairness opinion has written procedures for approval of fairness opinions and that the fairness opinion was approved or issued by a fairness committee. FINRA Rule 5150 safeguards independence and requires disclosures related to success fees, fairness committees and material relationships.
Dimech-DeBono: The primary factors relate to the independence and the objectivity of the firm providing the fairness opinion. The benefits are self-evident as having an independent firm to issue such an opinion avoids any conflicts of interest and any potential reputational damage. In the case of something being wrong with the transaction and the transaction being aborted, having had an independent firm helps with any adverse publicity. Other factors to consider are the reputation and expertise that the firm has.
Muller: Boards should consider the same sorts of factors that they would when hiring a deal adviser – expertise in the relevant sector of the industry, excellent valuation and banking credentials, strong understanding of the M&A process and reputation for excellent client service – but they should also ensure that they give strong consideration to a firm’s experience, track record and reputation in delivering fairness opinions. In addition, boards should take the adviser’s compensation structure into account. Finally, conflict-free advisers should be sought out, particularly in situations where an existing deal adviser may have actual or perceived conflicts of interest.
Mackenstedt: It is key that the expert providing a fairness opinion is independent, experienced in preparing fairness opinions and has deep sector knowledge. These duties of care are to be followed by experts helping to justify the management decision; in the worst case in a court proceeding.
FW: How relevant are second opinions in M&A situations in mitigating risk to the board – especially in situations where the deal adviser is also rendering a fairness opinion?
Dimech-DeBono: If the deal adviser is also rendering the fairness opinion, a second opinion is extremely important. Without being too cynical, we would place less reliance on a fairness opinion issued by the deal adviser as there is certainly a ‘perceived’ independence issue. The roles of the deal adviser and the independent financial adviser are distinct and as such we strongly believe that these should be performed by difference parties.
Muller: While boards may obtain second fairness opinions for a number of reasons, these opinions are most frequently sought in situations in which the primary financial adviser faces a perceived or actual conflict of interest. For example, if the sell-side adviser is providing financing to the winning bidder – or has a longstanding history of providing services to the winning bidder, boards should strongly consider obtaining a second opinion – if not hiring a second adviser to assist in running the process. Interestingly, we are seeing an increase in situations where second opinions are being requested, even though the primary adviser does not have relationships with other parties to the transaction. The reality is that recent scrutiny on the part of the courts is causing boards to rethink whether contingent fees earned by primary advisers create a conflict of interest that warrants an independent opinion. The courts have made clear that a second opinion does not justify failing to disclose conflicts on the part of the primary adviser or running an otherwise flawed process. However, the courts have stressed that providers of fairness opinions should be ‘qualified and independent’, and second opinions are likely to be most effective if the financial adviser is brought in earlier rather than later in the transaction process.
Mackenstedt: The acceptance of the fairness opinion can be scrutinised if the deal adviser provides other material deal services in addition to the fairness opinion – for example, if the deal adviser is paid on a success fee basis. In this case it is highly recommended that firms assign an expert not involved in the transaction to prepare a fully independent second opinion.
Czaplinksi: Second opinions are extremely relevant where the primary fairness adviser, who has served as the sell-side adviser, receives fees that are contingent on the success of the transaction; has a history of working with the company, key shareholders or management; or has been ‘on retainer’. In these situations, selection of an independent adviser who has no financial interest in the outcome of the transaction through a success fee, and therefore no real or perceived conflict, can provide an unbiased fairness opinion that may better withstand a future challenge or dispute.
“The devil can often be in the details, and sometimes forming a special committee is not, in and of itself, sufficient. ”
FW: How important is it for the board to establish an independent special committee to negotiate a transaction?
Muller: Generally speaking, it makes a lot of sense for boards to establish an independent special committee, particularly in a related party situation – where some board members can find themselves on both sides of the transaction. The Delaware Courts generally look favourably on the establishment of special committees in such situations – for example, Chief Justice Strine of the Delaware Supreme Court has, in recent years, lauded boards such as those of Dell Inc. and Cox Communications for special committee processes undertaken in related party deals. That said, the devil can often be in the details, and sometimes forming a special committee is not, in and of itself, sufficient. For example, in the case of Southern Peru Copper Corp., the Delaware Courts criticised the special committee of Southern Peru for having too narrow a mandate and not considering strategic alternatives aside from a bid made by Grupo Mexico. Special committees need to ensure that they are empowered by an appropriate scope and sufficiently broad authority.
Mackenstedt: In our opinion it is important for the board to build up its own assessment in order to comply with the duty of care set out in the business judgment rule. Such an assessment can be operationally supported by a committee.
Czaplinksi: The purpose of a special committee is to mitigate risk of liability on behalf of the board of directors; therefore, establishing a special committee and a robust process can be crucial to withstanding judicial scrutiny of a transaction and avoiding liability for breach of a transaction or fiduciary duties. If the majority of the board is disinterested in a transaction and has no conflicts of interest, a special committee may not be needed. However, since 1983, when the Delaware Supreme Court decided Weinberger v. UOP, Inc., in situations where the majority of the board in some way has an interest in the transaction, a special committee has been established with board members that have no interest in the potential transaction. A board member is considered disinterested if he or she will not gain any financial benefit from a transaction that would not otherwise be received by all shareholders of the corporation.
Dimech-DeBono: In a transaction environment, especially in the case of a major transaction, the board should look into getting the best independent advice – this can certainly be achieved by setting up an independent committee for negotiation purposes. At the end of the day, board directors need to feel comfortable with the decision they are taking to safeguard the interests of the stakeholders. The independent committee would add value to the process as it would consider different perspectives or angles that may have not otherwise be considered.
Nancy Czaplinski is senior managing director at American Appraisal. She provides solvency and fairness opinions, financial analyses and business valuations. She has presented testimony as an expert witness for the Court of Chancery with the State of Delaware, the US Bankruptcy Court for the Eastern District of Wisconsin, and the US Tax Court, among others. She has experience with income tax and financial reporting audits and has been deposed on valuation matters.
James Dimech-DeBono is lead partner of Complex Asset Valuation & Advisory Services at Grant Thornton UK LLP. He specialises in the valuation of complex assets and illiquid securities including private equity, derivatives, asset-backed securities (CDOs, CLOs, RMBS, CMBS, etc), commodities and energy contracts. Dr Dimech-DeBono has more than 22 years advisory experience. Throughout his career his clients have included banks, investment managers, regulatory authorities, insurance and energy companies.
Jennifer Muller is a managing director at Houlihan Lokey. She heads Houlihan Lokey’s Financial Advisory Services for the San Francisco Bay Area, as well as the firm’s Technology Group. She is also a member of the firm’s Financial Advisory Services, Fairness, Solvency and Technical Standards Committees. Ms Muller is responsible for business development and reviews financial opinions for the firm’s clients, including analysing and valuing closely held and publicly traded businesses, securities and intangible assets for leveraged buyouts, M&A, and general corporate planning.
Andreas Mackenstedt is leader of PwC Germany’s Valuation & Strategy practice. His focus is mainly on valuations, for example for purchase and sale transactions, tax planning, shareholder disputes, fairness opinions and other corporate finance activities. As a qualified German Certified Public Accountant (Wirtschaftspruefer) Mr Mackenstedt is also a member of the Technical Committee for Business Valuation and Economics (FAUB) of the Institute of Public Auditors in Germany, Incorporated Association (IDW).
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