FORUM: Valuation issues in M&A
June 2015 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
FW moderates a discussion on valuation issues in M&A between Mike Thornton at Grant Thornton UK LLP, Yvette Austin Smith at The Brattle Group, and Gardner Dudley at Liquidity Services.
FW: How important is the valuations process to the successful outcome of an M&A transaction? To what extent does the process assist senior executives to make or approve decisions?
Thornton: Valuation is core to an M&A transaction for the buyer and the seller. Ultimately, the transaction will only complete when both parties to the transaction are satisfied with the valuation from their own viewpoints. Assessing the valuation of the business can act as a starting reference point and bring a degree of independent perspective to the overall M&A process. We are frequently asked to undertake detailed analysis of the company, and establish valuation benchmarks, to help our clients understand value and to be able to support the decisions taken. This then also helps senior executives in their communications with the different stakeholders involved.
Dudley: A valuation is now a common feature of an M&A transaction, providing information on the potential transaction price and a fairness opinion that may be subject to scrutiny by a range of parties. But asset and business valuations in their various forms can form a pivotal component before, during and after a major business transaction on a wider scope. One of the key reasons mergers and acquisitions fail is a poor understanding of the target business and the consequences of the transaction. A valuation of the assets at the early stages that also incorporates some level of asset discovery forms part of the due diligence procedure to progress understanding of the target. The asset valuation report can start to test the reasons for the transaction as well as establish post-transaction strategy, helping senior executives and their professional advisers stay within the regulatory accounting framework. For a manufacturing business, the asset discovery process can help ascertain whether the target company offers a strategic expansion with additional market share, or represents a duplication of existing production capacity that may offer scope for restructuring and generation of capital post transaction.
Austin Smith: A well-executed valuation process initiates and advances an M&A transaction, though it is not dispositive of whether a transaction will ultimately be consummated or at what price. Strategic considerations and market conditions drive M&A transactions. However, the valuation process has come under increased scrutiny given the prevalence of M&A litigation and the frequency with which the litigation claims centre on a conflicted or otherwise inadequate valuation process.
FW: How is the current legal and regulatory environment impacting on the calculation of company value in M&A transactions? What effect will regulatory implications have on valuations and fairness opinions going forward?
Dudley: While the regulatory environment drives the process of valuation and fairness opinions, the high frequency of litigation relating to M&A transactions and the judicial approach to reviewing the analysis underlines the importance of obtaining a genuinely independent valuation from an experienced valuation expert. While historically a report that simply said “this is my opinion” was enough, now it is more important than ever to outline the reasons that led to the conclusion when arriving at a fairness opinion.
Austin Smith: Apart from a few heavily regulated industries, such as banking, the legal environment is having the greatest impact on M&A valuation. For public company M&A transactions in the US, litigation is near-certain. Most commonly the plaintiff alleges a breach of fiduciary duty resulting in an inadequate transaction price, or in other words, that the sellers did not receive sufficient value or that the buyers paid excess value. However, it is not just fiduciaries that face challenges. Increasingly, professional advisers face claims of aiding and abetting such a breach.
Thornton: Company valuation is around business fundamentals which will take account of legal or regulatory requirements that impact on the business – in recent years, for example, pension issues have been a major consideration in valuing businesses. We are seeing increased demand for independent valuations and fairness opinions driven by regulation, and I would expect this to continue, especially as companies come under pressure to demonstrate increased shareholder value. This then also places pressure on the independent valuation opinion to be properly supported and robust.
FW: Could you provide a brief overview of how the M&A valuation process is conducted? What considerations determine whether an asset-based, income-based or market-based approach is the most appropriate in terms of calculating an accurate enterprise value?
Austin Smith: The valuation process will almost always consider more than one method of valuation. The resulting value, or more commonly, range of values, will reflect a weighting of these methods. The weight accorded to a specific valuation method is primarily determined by the industry in which the subject company operates and may secondarily reflect the financial condition of the subject company or industry. A company with fairly regular or predictable cash flow, for example, may be more accurately valued by placing greater weight on a discounted cash flow methodology – an income-based approach. Industries in which it is easier to identify comparable companies, or in which transactions are frequent, may be more accurately valued using market-based approaches. The valuation of a distressed company experiencing declining sales and a build-up of excess inventory may place greater weight on an asset-based approach. However, when different methods of valuation produce significantly different estimates of enterprise value, it is important to understand why. The explanation may provide insight – and the opportunity to assess – implicit assumptions underlying the estimates of value under each approach.
Thornton: First of all you have to understand the business that you are valuing, the industry in which it operates and what drives value. Then you can assess the most appropriate method by which to value the business taking into account issues such as business lifecycle, expected growth and sector considerations. In valuing any business, there are three main methods of valuation that can be used: asset, income and market. Each method has advantages and disadvantages and ideally more than one method should be used as this will help triangulate value. You also have to understand any industry benchmarks that might apply. Valuation has often been referred to as an art rather than a science and, given that there is always some subjectivity involved, that is understandable, but valuation opinions should always have some analytical support. It is not just a financial modelling exercise – it has to be backed up with experience and a real world view.
Dudley: While the overall entity will be reviewed primarily using a market approach, taking into account similar transactions and with research into the wider industry context, and an income based approach using a discounted cash flow analysis, any underlying asset value in tangible and intangible assets may focus on a market approach but also incorporate the cost approach where appropriate. For asset-based valuations, a full and thorough site-based asset discovery process may be necessary; while the fixed asset register is an audited document, it can be misleading as a true indication of the company asset base in terms of more informative factors such as production capacity. Experience in the specific industry is essential. A wide range of approaches provides further justification of the conclusion; if a single comparable transaction is viewed to be inappropriate for any reason, the supporting arguments from the other approaches can provide validation for the overall outcome.
FW: In today’s market, what are the main challenges facing parties undertaking an M&A valuation? What options are available for parties looking to understand and manage underlying risks?
Dudley: There is a broader scope that a valuation provider can assist with across all stages of the business transaction. An understanding of the target requires a thorough appraisal of the associated risks and opportunities, including options to raise financing, potential restructuring and asset discovery and verification. We firmly believe that you should leverage the expertise of your valuation expert across all of these areas. M&A transactions have a high risk of failure for many reasons, and the insight that a valuer can provide throughout the process should not be underestimated. Let’s be clear, though: a key risk to any transaction is litigation, given Cornerstone’s recent research which found that over 90 percent of M&A deals valued over $100m in 2014 were litigated. The valuation expert needs to be explicit in their statements of analysis, inputs and assumptions to mitigate the associated risks. A lack of clarity is effectively the same as an incorrect assumption, and leaves the combined company open to future litigation.
Austin Smith: M&A litigation risk continues to impact the valuation process and the scrutiny under which that process will come. As a result, financial advisers have instituted more rigorous internal review processes that involve greater involvement of senior bankers. Law firms have responded to this risk by involving litigators early in the deal process. A second challenge to the valuation process is the impact of an uncertain global economic outlook on estimates of long-term company or industry growth rates. Declining or staccato growth and more cautious consumer spending, even where unemployment rates have moderated, produce significantly divergent estimates of long-term growth that, in turn, drive divergent estimates of value.
Thornton: Valuation relies on information so the biggest challenge can be having enough information from which to draw a sensible conclusion and to support the key assumptions underpinning valuation. Understanding the business and its growth prospects is critical – valuation is forward looking and certainly buyers acquire businesses on the basis of what they expect to achieve from the business. The key is therefore to identify the competitive advantage and how that can be brought into the valuation. As Warren Buffet has stated “Price is what you pay. Value is what you get.”
FW: Do second opinions in M&A transactions provide a worthwhile benefit for the board, in terms of evaluating a valuation or fairness opinion? How do objectivity and potential conflicts of interest come into play?
Austin Smith: The emphasis on ‘second opinions’ has shifted to second ‘financial advisers’. A second fairness opinion was viewed as an answer when the most acute conflict of interest was thought to arise from a contingent M&A advisory fee. As the focus on so-called banker conflicts has shifted to the multifaceted relationships that financial advisers maintain with targets, acquirers and sources of deal financing, the second financial adviser is now expected to fulfil a more robust advisory role that expands beyond providing a fairness opinion. A common example is that a second bank may be retained to run a ‘go-shop’ process. The use of a second financial adviser appears to have provided some additional protection to boards. However, the rising risk to financial advisers of breach of fiduciary duty aiding and abetting claims is likely to alter the scope of engagement and compensation to second advisers in M&A deals. Incidentally, the broader definition of relationship-based conflicts and its impact on aiding and abetting claims is now starting to impact legal advisers to M&A and other significant corporate transactions.
Thornton: Much of the demand for an independent opinion is driven by the need to address conflicts of interest whether actual or perceived. There are often different groups of stakeholders involved in a transaction who will have different perspectives. Equally, there may be connected parties involved and a need to confirm that the transaction is fair and reasonable. The opinion from an independent firm can therefore be essential to provide comfort to the parties involved and provide a degree of protection to the board. We have also seen the need for an independent opinion arise where the transaction is led by the company’s internal M&A team and the board need support for its recommendation.
Dudley: The issue here is when a party that is already an integral part of the transaction is also instructed to provide a fairness opinion – their independence and objectivity could be questioned if there is potentially a conflict of interest, especially when they benefit from a successful conclusion of a transaction. In this case, a second opinion would be sought from another party. Although the immediate benefit may not be clear to the board, ultimately this action is to prevent future issues that could stem from any doubt over the fairness opinion which could jeopardise the success of the transaction.
FW: To what extent does the establishment of an independent special committee help boards meet their fiduciary duties during M&A transaction negotiations?
Dudley: The key factors are independence and objectivity. If deemed necessary, the special committee should incorporate both directors with no financial interest in the success of the transaction, as well as independent advisers. The process and remit of the special committee should also clearly direct all members toward an independent decision. This approach is useful where there are actual or perceived conflicts of interest for the board or individual directors, and in the event of future litigation it can prove invaluable to both a shortened and successfully resolved legal process.
Austin Smith: From the perspective of a financial adviser, the effectiveness of a special committee in facilitating the satisfaction of fiduciary duty depends, in part, on two factors. The first is the scope of mandate by which the special committee can retain and direct financial advisers throughout the deal process. The second is a documented, high level of engagement between members of the special committee and the financial advisers, both as it pertains to deal process and valuation analysis.
Thornton: An independent special committee will bring an independent impartial view and will often be supported by its own advisers. Where there are potential conflicts for the directors or issues such as connected parties, a committee has a valuable role to ensure the transaction is fair to the different stakeholders.
FW: How do you see M&A valuation issues developing over the next 12 to 18 months? What trends should dealmakers be keeping an eye on?
Thornton: General expectations are that dealmaking will remain robust. Increasing cross-border activity means competition for acquisitions from companies and funds, domestic and international, which would support increasing valuations, particularly with the current appetite of the debt market. Sectors such as technology with high transaction activity are likely to continue to show high valuations. Potentially though, there could be an increase in the difference in value expectations of buyers and sellers with the challenge for buyers to achieve value accretion through acquisition.
Austin Smith: There are likely to be at least two key developments in the US deal markets over this time period, one more general and one more specific. First, the next 12 to 18 months should provide greater clarity as to the magnitude and pace of interest rate increases. On a net basis, this will likely stabilise and deflate equity markets. The cost of debt financing will increase but continuing availability of capital – at least in the short- and mid-term – will exert countervailing downward pressure. The second factor that may emerge to impact US deal markets over this time period stems from judicial and legislative developments regarding dissenting shareholder actions, especially in Delaware. Questions that are currently before the legislature and the courts are: When is deal price the best indication of fair value? Is so-called ‘appraisal arbitrage’ consistent with legislative intent and good public policy? Under what circumstances will large public company M&A transactions – for example, Dole Food – face significant appraisal risk?
Dudley: M&A activity traditionally increases during periods of greater economic activity, especially when organic growth is hard won, and as investors chase greater returns, inevitably this also draws greater scrutiny on individual deals. More than 80 percent of respondents in a recent KPMG survey said they were planning at least one acquisition in 2015, and activity is almost at pre-recession levels with more and larger deals. Arguably, in this economic environment boards should take steps to be prepared for some kind of business transaction, either as the acquiring party or as the target. They should also be prepared to implement an action plan in the event of any such transaction, especially if they are in an industry subject to abnormally high M&A activity, such as healthcare.
Mike Thornton leads the UK valuation team and is the global leader for valuations for the Grant Thornton International Limited network. Mr Thornton joined Grant Thornton in 1999 and has over 20 years’ corporate finance experience. He advises companies worldwide with the experience of having been a principal in a private equity firm as well as in corporate finance advisory. He can be contacted on +44 (0)20 7728 2644 or by email: firstname.lastname@example.org.
Yvette Austin Smith specialises in M&A and bankruptcy disputes with expertise in valuation and credit and solvency analysis. She has provided expert services in high-profile litigation matters related to recapitalisations, going-private transactions, M&A, dissenting shareholder actions, and adversary proceedings in bankruptcy. She has testified as an expert in the Lehman Brothers bankruptcy and in M&A litigation matters before the Delaware Court of Chancery. She can be contacted on +1 (212) 789 3650 or by email: email@example.com.
Gardner Dudley serves as president for Liquidity Services’ Capital Assets Group, shaping the way that surplus capital assets are managed, valued and sold. Mr Dudley obtained his BBA from the University of Texas at Austin and is a member of the Independent Petroleum Association of America (IPAA). He can be contacted on +1 (202) 467 6868 or by email: firstname.lastname@example.org.
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