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Volume 35 1 Editor’s Column Issue 1 Dan McConaughy, PhD, ASA 2 Spring 2016 Part I: Appraiser Versus Real World Debates: How Many Appraisers Can Dance on the Head of the Private Capital Markets? John K. Paglia, PhD, CFA, CPA 12 Why Salvador Dali Would Not Have Made a Good Appraiser: BV and Real Estate Discount Rates Roger J. Grabowski, FASA, Jaime C. d’Almeida, ASA, and John A. Duvoisin, CFE 18 The Implied Private Company Pricing Line (IPCPL): On the Nature, Scope, and Assumptions of IPCPL Theory David H. Goodman, CPA/ABV/CFF, CVA, and Malcolm McLelland, PhD 30 Two Methods to Adjust Observed Control Premia for Purposes Vincent Covrig, PhD, CFA, Daniel L. McConaughy, PhD, ASA, and Mary Ann K. Travers, ASA 38 From the Chair William A. Johnston, ASA Subscribe Here for $140 Annually

Published by the American Society of Appraisers Copyright © 2016 American Society of Appraisers Society of the American of Appraisers Committee Valuation Quarterly Journal of the Business Review Volume 35 N Number 1 ’ 2016, American Society of Appraisers

Two Methods to Adjust Observed Control Premia for Valuation Purposes

Vincent Covrig, PhD, CFA, Daniel L. McConaughy, PhD, ASA, and Mary Ann K. Travers, ASA

The greater a target company’s leverage, the less cash, or acquirer’s shares, a buyer needs to control the target enterprise. Based on this idea, the Appraisal Foundation Working Group’s Discussion Draft, The Measurement and Application of Market Participant Acquisition Premiums, recommends as a best practice that appraisers adjust premia for leverage. Previous recent research found empirical results consistent with this, namely, that higher equity takeover premia are related to higher pre-deal leverage levels, controlling for size, industry, profitability, and other factors. In this article, we provide valuation professionals with two methods with which to adjust observed transaction premia, based upon the subject appraised company’s leverage along with other company and deal characteristics that can be captured through use of readily available market data.

Introduction are related to higher pre-deal leverage levels, consistent The greater a target company’s leverage, the less cash with theory. The results were robust with respect to size, or acquirer’s shares an acquirer needs to control the target industry, profitability, year of transaction, synergy enterprise. The benefits of the target derive from the potential, and type of acquirer (strategic, horizontal, or overall enterprise, not just the equity. Thus, in a more financial). The empirical analysis supports the Appraisal highly leveraged target, the equity takeover premium is Foundation’s Working Group recommendation for best spread over relatively more assets, thus reducing the practices that appraisers adjust takeover premia for premium paid relative to the entire enterprise. The best leverage. This article takes a more applied approach and practice that the Appraisal Foundation’s Working Group provides valuation professionals with two methods they recommends is that appraisers adjust takeover premia for can use to adjust equity takeover premia based upon an leverage. “Takeover Premia and Leverage: Theory, appraised subject company’s leverage. The methods are Empirical Observations and Recommendations,” by simple, easy to understand, and useful to any practitioner using data. We also provide an Covrig, McConaughy, and Travers (2015), analyzed illustrative example for each method. 1,020 transactions from the FactSet MergerstatH/BVR Control Premium Study database for the years 2003–2013 Valuation and the Use of Takeover Premia (all 100%, all-cash acquisitions made in the United States The prerogatives of control may provide additional that had premia from zero to 200%, omitting companies value over a situation in which control is not possible in SIC 6, which contains financial institutions) in order to (e.g., minority shareholder compared to a control share- examine the relationship between takeover premia and holder). The Appraisal Foundation Working Group’s leverage. They found that higher equity takeover premia discussion draft 2013, The Measurement and Application of Market Participant Acquisition Premiums, page 15, Vincent Covrig, PhD, CFA, is a professor at lists the prerogatives of control to be California State University, Northridge, and with Crowe, Horwath LLP. 1. Appointing or changing operational management; Daniel McConaughy, PhD, ASA, is a professor at 2. Electing members of the board of directors; California State University, Northridge, and with Crowe, 3. Determining management compensation and perqui- Horwath LLP. sites; Mary Ann K. Travers, ASA, is a partner at Crowe 4. Setting operational and strategic policy for the Horwath LLP, where she serves as the national business; Valuation Services Practice Leader. 5. Acquiring, leasing, or liquidating business assets;

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6. Selecting suppliers, vendors, and subcontractors; transactions data may result in an unreliable indication of 7. Negotiating and consummating mergers and acquisi- value. tions; The Appraisal Foundation’s Working Group makes 8. Liquidating, dissolving, selling, or recapitalizing the an important and insightful observation: “…the pre- company; rogatives of control…have no inherent value, but are 9. Selling or acquiring treasury shares; rather the means through which market participants 10. Registering the company’s equity securities for an implement strategies designed to generate economic initial or secondary ; benefits.” Here, the Working Group addresses a some- 11. Registering the company’s debt securities for public times-seen application of control premia to valuations to offering; get a higher control level value or to derive a minority 12. Declaring and paying dividends; discount based upon the 1 2[1/1 + CP] equation without 13. Changing the articles of incorporation or bylaws; any substantive discussion as to the underlying eco- 14. Selecting joint venture and other business partners; nomics for the adjustment. The practice of applying 15. Making product and service offering decisions; control premia or minority discounts in some cases 16. Making marketing and pricing decisions; appears to reflect a belief that there is an inherent value 17. Entering into licensing and other agreements re- to control or an inherent loss of value due to a lack of garding intellectual property; and control reflected in the takeover premia. The real world 18. Blocking any or all of the above actions.1 of is much more nuanced— a takeover premium depends upon the facts and Anticipating the prerogatives of control, a control circumstances of a given transaction, some of which acquirer may pay a premium over the current share price are known and some of which are not known to outside for a target public company for which it expects value- observers. The Working Group focused on one observ- creating opportunities to exist. The premium would be able target characteristic: leverage. based upon the expected value of the value-creating opportunities or synergies. Since an acquirer purchases The deep interest in equity premia is not a passing fad. the of a target, the value of the opportunities is Mergerstat has recorded, catalogued, and described the reflected in the stock price premium.2 The less the stock observed takeover premia of acquired public companies value relative to the value-creating opportunities, the for many years and sells the data through the FactSet greater the premium to equity that will be paid. This may MergerstatH/BVR Control Premium Study and the lead to takeover premia that vary based on leverage, as MergerstatH Review, an annual yearbook describing the the Working Group recognized. prior year’s mergers and acquisitions transactions. There are three common valuation-related uses for Business valuation practitioners frequently use these equity control premium data. First, there is the ability to references in preparing business valuations. adjust a non–controlling interest valuation to a control The Appraisal Foundation Board of Trustees formed level. For instance, one may want to adjust the indication the Appraisal Practices Board to deal with identifying of value based upon the guideline public company and issuing guidance on best practices for valua- method, which is commonly referred to as ‘marketable, tion professionals. The Working Group on Control minority’ value, to a control level valuation. Second, one Premiums developed a discussion draft in 2013, The may want to apply a to a control level Measurement and Application of Market Participant indication to get the value of a noncontrolling interest, Acquisition Premiums, to focus on best practices based upon a discount calculated as: 1 2 [1/(1 + Control regarding the application of control premia in business Premium [CP])]. Third, merger and acquisition firms may appraisals. This document provides an overview of the use equity takeover premia when they advise an acquiring issues of applying control premium data to business company’s managers and directors regarding the reason- valuations. The Working Group introduced the term ableness of an offer to acquire a publicly traded company “market participant acquisition premium” (MPAP) to or in formulating a for evaluating an “emphasize the importance of the market participant offer to buy their company. A misapplication of the perspective when measuring fair value, and to distin- guish this premium from the more general (and

1See also Pratt (2009), Business Valuation Discounts and Premiums, 2nd occasionally controversial) notion of control premium” ed., pp. 15 ff. for a discussion of the issues. (p. 10). With regard to publicly traded companies, 2For this discussion, we do not consider the acquisition of below-market debt, assuming that debt is at market rates or that its benefit is already MPAP is the difference between the pro rata fair value of reflected in the stock price. the subject interest and its “foundation,” which is the

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Exhibit 1 Descriptive Statistics quoted market price for the subject company’s shares leverage, the greater is the Equity Control Premium. (p. 11). The Working Group warns that “Relying solely This can be seen by rearranging the terms in Equation 1, on benchmark premium data to evaluate the reasonable- thus: ness of the MPAP in a fair value measurement is not Equity Control Premium MPAP TIC consistent with best practices” (p. 14). The Working ¼ ðÞ Group proceeds to discuss the factors that may be |ðÞTIC=Equity : ð2Þ associated with an observed MPAP. We refer the reader Given that the benefits of control accrue to the to The Measurement and Application of Market entity, the Equity Control Premium is related to Participant Acquisition Premium for the details, as the the pre-deal leverage (TIC/Equity), also known as the focus of this article is to develop two methods to adjust, Equity Multiplier used in the well-known DuPont or normalize, control premium data to apply to a subject Identity. company based on leverage and other company characteristics. Covrig, McConaughy, and Travers (2015) analyzed 1,020 transactions over the 2003–2013 time period. They Based on the Working Group’s discussion, one can found that there is a strong statistical relationship between express the MPAP based on the total invested capital takeover premia and leverage after controlling for size, (TIC) Foundation using an equity control premium profitability, industry, year of transaction, type of thus: acquirer, and synergistic potential. These results support MPAPðÞ¼ TIC Equity Control Premium the Working Group’s position. Exhibits 1 and 2 provide descriptive statistics for the |ðÞEquity=TIC ð1Þ transactions data used by Covrig, McConaughy, and where MPAP(TIC) is MPAP, based on a TIC Foundation, Travers (2015) as well as this article. Using the same expressed as a percentage; Equity Control Premium is nomenclature as in Covrig, McConaughy, and Travers expressed as a percentage; and (Equity/TIC) is expressed (2015), TIC is the target company’s implied TIC based on as a percentage on a pre-deal basis. the sum of implied market value of equity plus the face The implication is that the greater the leverage, the value of total interest-bearing debt and the book value of lower the MPAP (TIC). Likewise, the greater the outstanding prior to the announcement

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Exhibit 2 Descriptive Statistics: Quintiles Based on PCTUNAFFEQ date. PCTUNAFFEQ is Percent Unaffected Equity practice recommendation that appraisers should adjust calculated as pre-deal market value of equity to pre-deal their selected transaction premia based on size and TIC, calculated as industry and then re-lever based on the subject company’s leverage. Below we provide two methods ½Implied Market Value of Equity=ð1 þ Mergerstat to calculate an equity control premium taking into Control PremiumÞ=Unaffected TIC: ð3Þ account differing equity premia, as well as leverage among the comparable transactions, and applying it to Exhibit 1 shows that the sample ranges from a subject company. companies with $1.97 million to $59 billion in total invested capital, and the control premia range from 3% Method 1: de-levering and re-levering premia to 189% with a mean premium of 36%. Exhibit 2 shows Here, we provide an example of how to calculate an the descriptive statistics when we group the sample in equity control premium for a subject company if one were quintiles and sorted based upon leverage (PCTUNAF- using data found in the FactSet MergerstatH/BVR Control FEQ) quintiles. The statistics show that higher leve- Premium Study database. This method will account for rage is associated with greater takeover premia. The differing equity premia and leverage ratios among the CP, TIC, and EBITDA profit all drop with increases in comparable transactions and applying it to a subject PCTUNAFFEQ, suggesting that using just correla- company. Implicitly, this method assumes, like other tion analysis to assess the relationship between CP and traditional comparable company methods, that the leverage is not enough, as other variables correlated comparable company transactions are similar in all but with control premia should be considered, and, there- the leverage ratio and control premium. Therefore, in the fore, as the next section shows, we develop an adjust- example below, we assume the analyst has identified ment model based upon the results of their multivariate three close transaction comparables in terms of size and regression analysis. industry, varying by leverage and control premia, as shown in Exhibit 3. Two Methods to Adjust the Control Premia The first row of data in Exhibit 3 shows the equity The main conclusion of the previously mentioned control premia for the three comparable transactions, studies is that the observed equity premia, as reported based upon input information from Mergerstat, and for actual transactions in the widely used FactSet the mean of the three figures. The choice of mean MergerstatH/BVR Control Premium Study database, versus median is irrelevant in terms of illustrating the are related to leverage and other factors included in method. The second row of data also provides the database, supporting the Working Group’s best information from Mergerstat and shows the pre- deal Equity/TIC, which is a ratio that can be calculated 3 3See Covrig, McConaughy, and Travers (2015) for the derivation. from information provided in Mergerstat. It is the

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Exhibit 3 Equity Control Premium Calculation—First Method complement of the more traditional leverage ratio, (TIC) of 19.6%, and the following “re-levering” equity-to-assets. TIC is the total invested capital. The formula to determine the adjusted Debt/TIC is 1 2 Equity/TIC. Therefore, when leverage/ equity CP. debt is not present, then Equity/TIC is 100% or 1, and Equity CP ¼ Average Pre-Deal MPAPðÞ TIC = the Debt/TIC is zero. As the debt increases relative to TIC, the Equity/TIC ratio drops. Because many users are ðÞEquity=TIC Subject Company : ð5Þ familiar with the Equity/TIC, we use this ratio as Back to our example, for Comp1 in the above table: a measurement of the leverage ratio, with the appropriate Equity/TIC Subject Company 5 70%; Average Pre-Deal interpretation, namely the ratio drops with an increase in MPAP (TIC) 5 19.6%; Equity CP 519.6%/70% 5 28%. leverage. We see that the leverage-adjusted CP of 28% is lower Row three presents the calculation of the pre-deal than the equity (leverage-unadjusted) of 40.7%, a di- MPAP (TIC) (i.e., re-levered CP) now calculated as rectional difference expected, as the subject company has Equity Control Premium 3 Pre-deal Equity/TIC. This is 70% equity, as compared to the average comparable equivalent to a “de-levered” CP using the capital structure companies’ equity of 53.3%. weights to get the CP at the TIC level. If the analyst were calculating a discount for lack of The de-levering formula is control while controlling for leverage only, he or she Pre-Deal MPAPðÞ TIC could use the calculated 28% equity control premium. This example suggests that if the analyst had used the ¼ Equity CP|ðÞPre-deal Equity=TIC : ð4Þ unadjusted average of 40.7%, the control premium may For example, for Comp1 in the above table: Equity have been overstated by almost 50%. The capital CP 5 50%; Pre-deal Equity/TIC 5 20%; Pre-Deal MPAP structure–based de-levering–re-levering method should (TIC) 5 50% 3 20% 5 10%. The “de-levered” CP for provide an improvement compared to no adjustment Comp1 is 10%, which is significantly lower than the based on our choice of the figures in the example. equity CP, and the average “de-levered” CP across the However, this example, though highlighting the three comps is 19.6%. potential benefit of de-levering the premia to a TIC In the next step we use the subject company’s foundation and then re-levering them to a specific Equity/TIC of 70%, the average Pre-Deal MPAP target’s capital structure, also highlights possible

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Exhibit 4 Adjustment Factor Calibration shortcomings of this method. Notice that although regression cited in Equation 6 above. In terms of the subject (target) Equity/TIC of 70% is higher than PCTUNAFFEQ, we used the above regression to the Equity/TIC values of Comp 1 and Comp 2, the calculate the forecasted CP for a range of PCTUNAFFEQ re-levered subject company’s control premium of 28% from 10% to 100% (no leverage). For example, given is lower than the control premia of Comps 1 and 2. We a PCTUNAFFEQ of 100%, a log(TIC) of 3.194 (log of also notice that the de-levered CPs vary from 10% to mean of 1,562.53 from Exhibit 1), and an EBITDA/Sales 28%, when, ideally, they would be equal or similar. We of 0.104 (the mean from Exhibit 1, above), we determine believe that these results are due to excessive sensitivity the forecasted CP to be 28%. Exhibit 4 shows these of a CP adjustment focused only on changes in leverage results, as well as the results of the calibration process. using the traditional capital structure ratios. Covrig, We use calibration to determine an adjustment factor that, McConaughy, and Travers (2015) show that although when included in a de-levering formula, produces a de- leverage is an important determinant of a control levered (i.e., 100% equity) expected control premium premium, the effect is not as large as the capital structure CP of 28%, the expected CP when one uses the de-levering–re-levering formula of method 1 calculates. regression coefficients from the above regression and This is explained by their multivariate analysis, which the mean of the independent variables from the shows that the control premium is statistically signifi- descriptive statistics. cantly negatively related to size of deal, profitability, Using the regression coefficients and the forecasted and the presence of a financial buyer, as well as (expected) CP for the alternative PCTUNAFFEQ (lever- positively related to strategic buyer. age ratio), we then derived an adjustment factor that will How can one both alleviate the shortcoming of make the de-levered CP for alternative PCTUNAFFEQ the simple capital structure de-levering–re-levering ratios equal to the expected CP when the PCTUNAFFEQ method and take advantage of the descriptive statistics and regression analysis results (i.e., market data) in ratio is 100%. This factor, rounded, was determined to be Covrig, McConaughy, and Travers (2015)? We go 0.5. The result is the determination of a market-linked back to the regression results in Covrig, McConaughy, adjustment factor of 0.5, which can easily be used in and Travers (2015) in their Exhibit 5 and use their a traditional delevering and re-levering method, such as regression model 3 and the descriptive statistics Method 1, discussed above. from Exhibit 1 to extract an adjustment (calibration) Below we will show that applying the adjustment factor. factor of 0.5 in the following formula based on Their regression is as follows: PCTUNAFFEQ, the result calculates control premia for CP ¼ 0:78 0:078 1 logðÞ TIC 0:332 1 EBITDA= alternative PCTUNAFFEQ ratios that provides results that are more consistent with the observed level of Sales 0:22 1 PCTUNAFFEQ: ð6Þ leverage. We then use the log of the mean of TIC and EBITDA/ The de-levering formula, using the market-calibrated Sales from Exhibit 1 for the respective variables in the adjustment factor of 0.5, is

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Exhibit 5 Equity Control Premium Calculation—Second Method

Pre-Deal MPAPðTICÞ In the next step we use the subject company’s Equity/ TIC of 70%, average Pre-Deal MPAP (TIC) of 30.1%, ¼ Equity CP1ð1 ð100% and Equation 8 to “re-lever” back and determine the Pre-deal Equity=TICÞ1 0:5 Þ: ð7Þ equity CP. The re-levering formula, using the market-calibrated adjustment factor of 0.5, is then Equity CP ¼ Average Pre-Deal MPAP ðTICÞ= ð1 ð100% Equity=TIC Subject Equity CP ¼ Average Pre-Deal MPAPðÞ TIC = CompanyÞ1 0:5Þ: ð9Þ ð1 ð100% Equity= For example, for Comp1 in the above table, Equity/TIC TIC Subject CompanyÞ10:5Þ: ð8Þ Subject Company 5 70%; Average Pre-Deal MPAP Exhibit 5 presents the application of this market- (TIC) 5 30.1%; Equity CP 5 30.1%/(1 2 (100% 2 calibrated methodology for the same example (inputs) 70%) 3 0.5) 5 35.5%. used to illustrate the first method. We now see that the control premium of 35.5% The 1st two rows of data, the inputs for the three is as expected: between Comp 2, 40%, and Comp 3, comps, are the same as in the 1st method illustrated 32%. above. However, row 3, the pre-deal MPAP (TIC) (i.e., The main difference between the two methods is re-levered CP) is now calculated with Equation 7 above. that Method 2, through the 0.5 calibration factor, not For example, for Comp1 in the above table: Equity only takes into account leverage but also adjusts for CP 5 50%; Pre-deal Equity/TIC 5 20%, Pre-Deal MPAP other factors obtainable from the FactSet MergerstatH/ (TIC) 5 50% 3 (1 2 (100% 2 20%)*0.5) 5 30%. BVR Control Premium Study database that are known to Notice that the “de-levered” values using this method, affect the control premium. Thus, it implicitly accounts the Pre-Deal MPAP(TIC), are now close to each other at for market data and maps the market data to a simple approximately 30%. This demonstrates the benefit of set of formulas, very similar to the simple capital applying the 0.5 calibration adjustment factor. structure–only de-levering–re-levering formulas of

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Method 1 to calculate a control premium for a subject words of the Working Group, may be “potentially company. misleading.” Summary and Conclusion References Covrig, McConaughy, and Travers (2015) show that Covrig, Vincent, Daniel McConaughy, and Mary Ann takeover premia are related to leverage in a way Travers. “Takeover Premia and Leverage: Theory, consistent with theory. We extend this article by Empirical Observations and Recommendations,” Jour- providing two models with which to adjust control nal of Business Valuation and Economic Loss Analysis premia: Method 1 is based upon the leverage factor alone. 10 (2015):1–17. Method 2 is calibrated based upon regression analysis of FactSet Mergerstat/BVR Control Premium Study,at takeover data. The theory is simple, and the empirical http://www.bvmarketdata.com. observations are conclusive and support the Working The Measurement and Application of Market Participant Group’s best practice recommendation that appraisers Acquisition Premiums. Exposure Draft. Appraisal Prac- incorporate this into their analyses. The leverage impact is tices Board, The Appraisal Foundation. September 15, knowable, and, in some cases where there are large 2015. differences in leverage, the impact of leverage on Pratt, Shannon. 2009. Business Valuation Discounts and takeover premia may be significant. Ignoring this, in the Premiums. 2nd ed. Hoboken, N.J: John Wiley & Sons.

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