Control Values: the Fallacy of Applying a 'Standard' Takeover Premium

Control values: the fallacy of applying a ‘standard’ takeover premium

Stephen Reid FCA – Partner | Mergers & Acquisitions – Deloitte

February 2021 I often observe takeover premium data or studies (mis)used in valuations. I hope, by writing this article, that we can banish from Australian and New Zealand valuation practice the rote application of ‘standard’ control premiums to comparable company multiples and in determining minority interest discounts.

A typical ‘levels of value’ chart is set out below1.

Synergistic Value

Takeover or acquisition Controlling interest Control premium premium/ minority Marketable minority interest interest Marketability Non-marketable discount minority interest

1 Pratt, Shannon P. (2009) Business Valuation – Discounts and Premiums, Second Edition, Shannon P. Pratt, 2009, page 5 1

The “synergistic value” level in the chart is commonly assumed to be part of the controlling interest value. In the US, there may also be an additional layer to the ‘levels of value’ chart, being a “restricted stock equivalent” level, sitting between “marketable minority interest” and “non-marketable minority interest”.

This article focuses on the difference between a control value and marketable minority interest value, being the premium for control or minority interest discount.

To determine a control multiple for a multiple of earnings valuation or cross check, a valuer will commonly gather evidence of multiples implied by acquisitions of comparable companies (which are generally for control) and multiples implied by share trading in comparable listed companies. In order to bring the multiples of the listed companies to the same ‘level of value’ as the comparable transactions, control premiums are frequently incorporated in the calculation of earnings multiples for comparable companies, by adding a ‘standard’ control premium to the market capitalisation of the listed comparable company2. The ‘standard’ control premium is commonly based on studies of observed premiums in takeovers. The (rough and flawed) logic of this approach is that if a valuer is determining the control value of a company by reference to comparable listed companies, it is necessary to add a premium to the observed market capitalisation of the comparable companies, as the ASX listed price represents the price for a liquid minority interest. The circular presumption is that a control value will always be more than a minority interest value

Similarly, control premium studies are also used as a basis for estimating the level of minority interest discount applied in the calculation of a minority interest value. The minority interest discount is the inverse of the control premium3.

The apparent simplicity of the ‘levels of value’ is appealing, as valuers can readily step up and down between the levels of value with ease, by applying control premiums and minority interest discounts. However, the assumption that takeover premiums exist for all companies, in all industries, at all times, is not established by studies of takeover premiums, as such studies only measure the premiums for companies that were taken over. Nor is it established that there ought to be a standard control premium, of roughly the same amount, that can be applied to any situation. For these reasons, both practices described above are flawed.

The recent 2020 Business Valuation Practice Survey conducted by CAANZ in December (the Survey) had three questions relating to control premiums, which highlights how embedded these practices are:

1. What range do you currently adopt as the standard control premium in the Australian market? The question only enabled respondent to choose high range or low range, with 67% selecting low range. I suggest next year’s survey, if it includes questions on ‘standard’ control premiums, should be more numeric on this point. The 2019 KPMG Valuation Practices Survey noted “Overall, the average standard control premium adopted by respondents was 14% at the low end of the range and 27% at the high end of the range. For Valuation Practitioners, the range increases to 17% to 34%.”

2. Do you adjust for specific factors when calculating a control premium in the Australian market? 55% of respondents said that they do adjust for specific factors when calculating a control premium and, therefore, 45% of respondents do not attempt to adjust their standard control premium.

2 For instance, EBIT multiple = Market capitalisation of comparable company x (1+30%) / EBIT, with 30% being a ‘standard’ control premium 3 Minority interest discount = 1 / (1 + control premium)

3. Can you please describe the factors for which you adjust? The most common factors cited by survey respondents were spread of ownership, voting blocks, degree of control, size, observed industry/sector premiums, control characteristics/levers and the shareholding being valued. Most responses were focussed on the composition of the share register and control levers. Three survey respondents referred to acquisition synergies.

In my opinion, there is no need for a valuer to have a ‘standard’ control premium, indeed it is troublesome to have one.

Control premium Vs takeover premium The terms control premium and takeover premium are often used interchangeably, whereas they are different concepts. A study of observed takeover premium data measures the takeover premiums achieved on completed takeover transactions – there are some nuances in relation to how these studies are compiled, such as the time periods covered by the studies and the periods over which the premiums are measured. The premiums observed reflect the transfer of control as well as the value of any synergy benefits that the bidder may be able to realise. They could also reflect the fact that the target company’s stock is illiquid, or the operations of the business could be poorly understood by the market (and hence mis-valued).

A control premium represents “an amount (expressed in either dollars or percentage form) by which the pro rata value of a controlling interest exceeds the pro rata value of a non-controlling interest in a business enterprise that reflects the power of control”4. It is a possible component of a takeover premium.

Takeover premiums do not just measure control and there is no ready measure of control premiums in isolation. In addition, takeover premium studies, which do not only measure control, measure the premiums that resulted from successful takeovers, but do not provide any information on the premiums that might apply in respect of all the listed companies that were not taken over.

In 2020, about 30 companies were taken over on the ASX, leaving 2,000 or circa 98.5% of companies listed on the ASX. If a control premium applied to every company, given the weight of money seeking to find value on the ASX, every company would theoretically be taken over. So, what is going on here?

There is an interesting interplay between two elements underpinning the ‘levels of value’ chart, liquidity and control, both of which are, in reality, a continuum. A marketable minority interest is highly liquid (although liquidity varies tremendously across ASX listed stocks) and affords a total lack of power. A 100% controlling interest has some liquidity and absolute power/control. Where an acquirer can create or obtain significant benefits from control, the net benefit, after taking account of the reduced liquidity of a controlling interest compared to a marketable minority interest, may justify a takeover of a company at a value that is greater than the marketable minority interest value. However, where the benefits of control are more limited, the value of a controlling interest in a company may be equal to or less than the marketable minority interest value, after taking account of the reduced liquidity associated with control.

Let’s look at the value equation from the perspective of the willing buyer and willing seller.

4 Pratt, Shannon P. (2009) Business Valuation – Discounts and Premiums, Second Edition, Shannon P. Pratt, 2009, page 16

Willing buyer A bidder will determine its bid price based on the cashflows that it expects to derive from the acquisition. That is, the bidder may expect to derive superior cashflows compared to those for the stand-alone listed company. There are two key factors that could contribute to these superior cashflows:

• Poor management – the bidder may seek to install good management in place of poor management, where the target company is being mismanaged. This clearly relates to control, as control enables the management to be swapped out. If the value of a company is $130 based on superior cashflows generated by good management, compared to its standalone value of $100, the resulting control premium is 30%. The control premium is the outcome of the particular circumstances of the target company – it is not correct to say that the standalone value of the company is $100, therefore the control value must be $130 because all companies are equally mismanaged. Perhaps a shareholder in a company that is wildly mismanaged may achieve a higher control premium in a takeover than shareholders of a moderately mismanaged company

• Synergies – the bidder may be able to extract synergies from the business, which it is prepared to pay to the vendor shareholders. The resulting potential cashflow benefit does not relate to control, per se. Obviously the greater the synergies available to a pool of hypothetical purchasers, the greater the potential takeover premium.

The extent to which superior cashflows exceed stand-alone cashflows will depend on the extent of poor management and available synergies, which will obviously vary by company.

It is worth considering the extent to which your valuation, and the information on which your valuation is based, takes account of mismanagement or synergies. If there is no suggestion or indication that a company is being mismanaged and there are limited synergies, there may not be a significant difference between superior cashflows and standalone cashflows.

There may be no need for a discount for minority interest, if you are valuing a minority interest in a widely held mismanaged private company, where the probability of a change of management is low. This would be the case if your expected cashflows are based on the incumbent management’s plans.

It would be double counting to adjust listed comparable company multiples to reflect control, if you are valuing a controlling interest in a company and your assessed maintainable profits reflect a well-managed company and there are limited synergies available to a hypothetical acquirer.

If your assessed maintainable profits reflect a mismanaged business, perhaps it is better to model the benefits of good management, if you are valuing a controlling interest in the company, rather than select an arbitrary ‘standard’ control premium.

Where you are valuing a controlling interest in a company you may, for example, observe that recent transactions in genuinely closely comparable companies are occurring at multiples that are greater than those implied by share trading in genuinely comparable listed companies. This may reflect the fact that there are hypothetical acquirers of comparable companies at a takeover premium, which presumably are able to derive some kind of synergy across a sector. An example of this could be Aconex, a SaaS provider of a global platform connecting teams on construction and engineering projects, which was acquired by Oracle in 2018. In the period prior to this deal there were a number of transactions in the SaaS industry, notably by Oracle, at significant premiums to the liquid minority prices. In this situation, the comparable transaction multiples could be a good source of valuation evidence to inform your valuation, without the need for a ‘standard’ control premium

Willing seller It is often noted that for takeovers to be successful a takeover premium would need to be at least 20% and typically more like 30%. This likely reflects the need for the takeover bid to cause a sufficient number of shareholders to accept the offer to make the takeover successful. Shareholders will have different opinions on the value of the stock - the traded market price of a share represents the price paid by the most optimistic buyer and the most pessimistic seller. The higher the takeover bid price, the more likely a sufficient number of shareholders will be willing to accept the offer to make a takeover bid successful. Where superior cashflows available from a takeover justify, from the perspective of the bidder, a takeover bid only, say, 5 to 10% above the traded market price of a company, the bid will most likely not be made.

Final comment This article focuses on the difference between a control value and marketable minority interest value, being the premium for control or minority interest discount.

The premiums observed in takeover studies are derived from those transactions where bidders believed they could achieve superior cashflows at a level that would support a bid that would induce enough shareholders to accept the offer. To succeed, it was necessary for there to be both superior cashflows anticipated by the bidder and a sufficient premium to motivate the vendor shareholders.

I understand the appeal of the simplicity of the ‘levels of value’ chart, enabling valuers to step up and down between the levels of value with ease, by applying control premiums and minority interest discounts. However, the assumption that takeover premiums exist for all companies, in all industries, at all times, is not logical and is not proved by studies of takeover premiums. Therefore ‘standard’ control premiums should be adopted with extreme caution.

Where the subject company or comparable listed companies are not in the process of being taken over, it should not automatically be assumed that a control premium could be obtained by their shareholders.

My preference is to study the cashflows and projections that I am working with to understand what ‘level of control’ is built into the cashflows and, wherever possible, to take account of level of value issues in the cashflows. I give some examples above to illustrate how to think about this issue. The areas to focus on, that may give rise to possible takeover premiums, are:

• synergies available to bidders and/or

• mismanagement

A valuer should also seek to understand the extent to which the share prices of the company being valued or the comparable companies are affected by poor communication with the market or poor liquidity (given, as noted above, liquidity is a continuum).

This is a complex, interesting topic and I challenge you to reconsider your practices if you are in the habit of automatically incorporating ‘standard’ control premiums in comparable company multiples, to determine the control value of a company, and using takeover bid premia data to determine minority interest discounts, when valuing marketable minority interests. In valuing non-marketable minority interests it may be necessary to consider additional discounts. That issue is beyond the scope of this article.

Stephen Reid FCA is a partner of Deloitte and an Adjunct Fellow of Macquarie University, teaching Advanced Valuation for Corporate Finance in the university’s Master of Applied Finance. He is also a CA Business Valuation Specialist.

Further reading: The issues discussed in this article have been debated for years, mostly in the US, and this article has not delved into all nuances of the debate. Here are some suggestions for further reading

“Valuations in Financial Reporting Valuation Advisory 3: The Measurement and Application of Market Participant Acquisition Premiums”, The Appraisal Foundation, 6 September 2017

“Control Premiums and Minority Interest Discounts in Private Companies” by Eric Nath, Business Valuation Review, June 1990

“The Value of Control: Implications for Control Premia, Minority Discounts and Voting Share Differentials” by Professor Aswath Damodaran, New York University-Stern School of Business, 30 June 2005

Business Valuation Resources webinar, February 2014 (reproduced in “Update on Control Premiums – What the Experts Say”, Business Valuation Resources, May 2015

“Business Valuation – Discounts and Premiums”, Second Edition, Shannon P. Pratt, 2009

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