Fair Value Measurement Thought Leadership

The Market Participant Acquisition Premium for Fair Value Measurement Timothy J. Meinhart

An ownership control premium is commonly applied when valuing controlling ownership interests in business enterprises for financial accounting purposes. However, there is a diversity of practice among analysts (“analysts”) about how control premiums are measured and applied in fair value measurements. In an effort to develop best practices in the area of control premiums, the Appraisal Foundation issued Valuations in Financial Reporting Valuation Advisory #3: The Measurement and Application of Market Participant Acquisition Premiums (“VFR Advisory #3”). VFR Advisory #3 outlines the factors that analysts should consider when measuring and applying ownership control premiums in fair value measurements.

ntroduction VFR Advisory #3 is intended to set forth best I practices for certain issues that an analyst may Since the enactment of financial accounting guid- encounter in measuring the fair value of control- ance published in Accounting Standards Codification ling interests in business enterprises for financial (“ASC”) topic 805—Business Combinations, ASC accounting purposes. topic 350—Intangibles— and Other, and This discussion summarizes the following topics, ASC topic 820—Fair Value Measurement, there has as discussed in VFR Advisory #3: been an ongoing requirement to properly recognize assets and liabilities at fair value in financial state- n The concept of the market participant acquisition premium (“MPAP”) ments.1 n Conceptual considerations and business In order for financial accounting to be consistent characteristics that influence the MPAP and reliable from entity to entity, valuation ana- lysts (“analysts”) need to provide similarly reliable n Analytical methods for estimating the MPAP analyses. In an effort to promote quality and consistency Background of financial reporting, the Appraisal Foundation has When valuing controlling ownership interests in a issued guidance regarding best practices on certain business enterprise for financial accounting purpos- valuation topics that are used in fair value measure- es, analysts often consider and apply an ownership ments. control premium. Common examples of fair value On September 6, 2017, the Appraisal Foundation measurements utilizing a control premium include issued Valuations in Financial Reporting Valuation the goodwill impartment test under ASC topic 350, Advisory #3: The Measurement and Application of portfolio valuation of investment companies, and Market Participant Acquisition Premiums (“VFR the acquisition method of business combinations for Advisory #3”).2 certain transactions.

www .willamette .com INSIGHTS • AUTUMN 2018 31 In other words, an acquisition price that is in excess of the target company’s publicly traded SEPTEMBER 6, 2017 price may be reasonable if the acquiror expects to increase the cash flow, increase the growth, and/or VALUATIONS IN FINANCIAL reduce the risk of the target company. REPORTING VALUATION ADVISORY 3: In contrast, if no such increases or risk reduc- THE MEASUREMENT AND tions can be made, the acquiror would generally APPLICATION OF MARKET be reluctant to pay an acquisition price that is in PARTICIPANT ACQUISITION excess of the target’s publicly traded price. In such PREMIUMS an instance, the publicly traded price may reason- ably reflect the entity’s control value. VFR Advisory #3 also introduces the concept of an MPAP. The introduction of this new term was intended to: 1. emphasize the importance of the market participant’s perspective when measuring fair value and 2. distinguish this price premium from the more commonly recognized, and often mis- applied, control premium.

VFR Advisory #3 indicates that it is not intended to be an authoritative valuation standard. The work- ing group drafting VFR Advisory #3 recognized that different situations often require different valuation procedures and specific facts and circumstances may support a departure from the recommendations described in VFR Advisory #3. VFR Advisory #3 also indicates that it was devel- oped for measuring fair value for financial account- Over the years, there has been notable incon- ing purposes and is not intended to be valuation sistency regarding the application of control premi- guidance for other purposes. ums. In order to promote consistency and develop Many analysts agree that the overall impact of best practices in the area of control premiums, a VFR Advisory #3 will most likely be (1) more rigor- working group was formed. The results of the work- ous analyses related to control premiums and (2) a ing group are summarized in VFR Advisory #3. greater consistency among analysts in how control VFR Advisory #3 describes the long-standing and premiums are measured and applied in the context generally accepted theory that the publicly traded of fair value measurements. price of a company’s shares represents the value of a noncontrolling (or minority) ownership interest. As such, a “premium for control” should be considered Defining the MPAP when estimating the value of a controlling owner- VFR Advisory #3 defines the MPAP as the difference ship interest, particularly when applying a publicly between: traded company method. However, this concept has been challenged by some analysts in the business 1. the pro rata fair value of the subject con- valuation community. trolling ownership interest and 2. its “foundation.” VFR Advisory #3 addresses the concept that the premium an acquiror may pay over the publicly traded price of an acquisition target does not neces- For purposes of this definition, “foundation” is sarily represent a price premium for merely acquir- measured with respect to the current stewardship ing control. Instead, the price premium reflects the (i.e., management) of the business enterprise. expected increase in value that may be achieved by More specifically, foundation contemplates that exercising control. the prerogatives of control will continue to reside

32 INSIGHTS • AUTUMN 2018 www .willamette .com with the existing controlling shareholder or group In general, the authors of shareholders.3 of VFR Advisory #3 state “[T]he analyst is For purposes of VFR Advisory #3, foundation is that an MPAP should be responsible for iden- considered to be the pro rata fair value of a market- supported by reference to able, noncontrolling ownership interest in a busi- (1) enhanced cash flow tifying and evaluat- ness enterprise. In the case of a publicly traded and/or (2) a lower required ing the feasibility of company, often this is its quoted public price. rate of return from the per- However, as will be discussed below, VFR Advisory spective of a market par- the available value- #3 addresses the use of either an entity’s public ticipant. enhancing strategies stock price or the entity’s total invested capital as a In instances where no measure of foundation. such opportunities exist that may be imple- To further explain the concept of an MPAP and for a market participant mented by market to either enhance cash its foundation, consider a business enterprise with participants.” a founder who owns and controls 80 percent of the flow or lower an entity’s equity. Also consider that ownership of the remain- , the authors ing 20 percent of the equity is fragmented with no conclude that the MPAP is single shareholder holding more than 2 percent of most likely minimal or nonexistent. the stock. The subject entity has several available investment opportunities that would enhance the company’s value. However, the controlling share- Conceptual Considerations holder has chosen not to make any of these invest- VFR Advisory #3 provides several commonly cited ments. examples of prerogatives of control that may be Given this set of facts, there is likely to be an possessed by a controlling owner of a business MPAP that would be applied in the valuation of enterprise. a controlling ownership interest in the entity. In VFR Advisory #3 points out that these pre- other words, the price that may be paid by market rogatives, such as the right to appoint a majority participants for a controlling ownership interest in of the board of directors, the right to recapitalize the company is likely to exceed the price that may the company, or the right to select suppliers and be paid for a noncontrolling ownership interest that vendors, have only limited inherent value in and of reflects the current stewardship of the company themselves. (i.e., the foundation). In other words, these commonly cited rights are According to VFR Advisory #3, the magnitude merely a means through which market participants of the MPAP would be influenced by the perceived may be able to generate incremental economic ben- ability of market participants to exercise the pre- efits. For example, the right of a controlling share- rogatives of control to increase the cash flow and/or holder to elect a majority of the board of directors reduce the cost of capital applicable to the subject does not necessarily convey any economic benefit controlling ownership interest.4 to market participants unless the ability to elect VFR Advisory #3 makes it clear that the analyst the majority of the board enables the company to is responsible for identifying and evaluating the fea- increase its revenue and/or lower its costs. sibility of the available value-enhancing strategies In this case, the expected economic benefit that may be implemented by market participants. In would potentially affect the price that would be paid this regard, the analyst’s estimate of the MPAP will by market participants and, potentially, influence consider the magnitude of the available economic the magnitude of the MPAP. benefits and the degree to which the potential ben- As previously described, VFR Advisory #3 states efits may influence the price that market partici- that an MPAP should be supported largely by expect- pants may pay for the subject controlling ownership ed economic benefits that would arise from (1) interest. enhanced cash flow and/or (2) the lower required VFR Advisory #3 does not state that the poten- rates of return from a market participant’s perspec- tial economic benefits should be precisely quanti- tive. fied, but rather, an analysis should be performed to In this regard, the analyst is tasked with identify- identify which form(s) of economic benefit market ing the economic benefits that would reasonably be participants could reasonably expect to enjoy and available to several market participants rather than some general magnitude of the effects of those ben- any one specific market participant (i.e., buyer). efits on value.5

www .willamette .com INSIGHTS • AUTUMN 2018 33 In other words, the expected economic benefits analysts observe that market participants use a cost that are available to a group of market participants of capital that reflects the anticipated benefits of are generally considered in the MPAP, but benefits increased size and diversification that result post available to only a single market participant are transaction. not. While either measurement may be relevant In terms of economic benefits that arise from when measuring fair value, it is at the discretion enhanced cash flow, VFR Advisory #3 notes several of the analyst to select the measurement that is areas where a market participant may implement most reflective of fair value. In doing so, the analyst strategies that lead to increased cash flow. should not assume that market participants always These areas include, but are not limited to, the incorporate all anticipated economic benefits of following: ownership control in the price they pay for acquisi- tions. n Increased revenue growth Additionally, analysts should not assume that the n Increased operating margins public market has necessarily undervalued noncon- n Working capital efficiencies trolling ownership interests. n Capital expenditures efficiencies As VFR Advisory #3 indicates, the existence of an investment analyst stock price target in excess Regardless of the area that leads to increased of the stock’s trading price does not provide direct revenue or decreased costs, it is important to rec- evidence of the MPAP.7 ognize that to be relevant in estimating the MPAP, the enhanced cash flow must be incremental to the cash flow that was expected under current company usiness haracteristics hat stewardship. B C T Stated another way, the enhanced cash flow that Influence the MPAP gives rise to an MPAP is incremental to the prospec- VFR Advisory #3 discusses several factors the ana- tive financial information that reflects the ongo- lyst should consider when estimating the price mar- ing operations of the business enterprise absent a ket participants may pay for a controlling ownership change of control transaction.6 interest and, ultimately, the MPAP. In terms of economic benefits that arise from The following discussion summarizes the factors a lower required rate of return, VFR Advisory #3 described in VFR Advisory #3. notes there are several reasons why market partici- pants may have a lower required rate of return for a n Acquisition Activity in the Industry— controlling ownership interest than for an otherwise Increased acquisition activity in a par- identical, but noncontrolling, ownership interest ticular industry generally signals that mar- under current company stewardship. ket participants believe there are greater opportunities to generate economic benefits Some of these reasons include, but are not lim- through change of control transactions. ited to, the following: Increased activity may also increase the n Change in number of potential acquirors, which could n Economies realized through increased com- increase the MPAP. pany size n Company’s Life Cycle State—Mature com- n Reduced operating risk panies generally present fewer opportunities for change of control acquirors to enhance While each of the above-described reasons for a cash flow or lower the cost of capital. lower rate of return may potentially be achieved by In contrast, growth-stage companies gen- larger-sized market participants, VFR Advisory #3 erally offer greater opportunities for market points out that there is not a consensus among ana- participants to increase revenue growth lysts regarding the relationship between (1) the size rates and improve margins. Consequently, of the target company and (2) the required return the MPAP is generally lower for mature from a market participant’s perspective. companies than for growth-stage compa- This is because some analysts observe that mar- nies, all else being equal. ket participants use a cost of capital that is consis- n Market Participant Attributes—VFR tent with the target company size when estimating Advisory #3 states that market participants the price to pay in transactions. In contrast, other are generally classified into three categories:

34 INSIGHTS • AUTUMN 2018 www .willamette .com (1) strategic acquirors, (2) financial which have a significant effect on the com- acquirors, and (3) conglomerate acquirors. pany’s operations. These regulatory factors In estimating the MPAP, the analyst should be considered from the market par- should properly identify the market par- ticipants’ perspective when estimating their ticipants and relate the anticipated eco- impact on the MPAP. nomic benefits of ownership control to the n Corporate Governing Documents—When strategies that would be employed by these valuing a controlling interest in a company, potential acquirors. an analyst should review the company’s n Market Participant Size—In many cases, governing documents for any provisions market participants are significantly larger that may restrict or limit the subject inter- than the target company. These larger est’s ability to exercise control over the companies are often able to extract greater company. economic benefit from the target company The magnitude of the MPAP should be than current ownership. correlated with the level of control that As a result, a larger MPAP may be appro- can be exercised by a holder of the subject priate for market participants that are sig- interest. nificantly larger than the subject company. n Transaction Structure—Tax characteristics n Availability of Information—There may be and contingent consideration may have a a difference in the information that is made significant influence on the price paid for available to market participants for a con- a controlling business interest. Analysts trolling ownership interest versus market should consider the influence that transac- participants for a noncontrolling ownership tion structure has on the price paid for a interest. This information asymmetry can business interest and the pricing multiples influence the fair value of a controlling and control premium that are implied by ownership interest and the magnitude of the transaction. the MPAP. n Capital Structure of the Target Company— VFR Advisory #3 states that the above-described The greater the opportunity to change the factors, while not all inclusive, should be consid- target company’s capital structure to a more ered by analysts when estimating the price market optimal mix of debt and equity, the greater participants would pay to acquire controlling owner- the potential MPAP, all else being equal. ship interests. n Management’s Goals and Objectives— Privately held companies are often man- aged with different goals and objectives Analytical Methods than publicly traded companies. Acquirors VFR Advisory #3 states that the MPAP may be may find greater opportunities to reduce expressed as either (1) a dollar amount (i.e., the dif- costs and enhance cash flow in privately ference between the pro rata fair value of a control- held companies than in publicly traded ling interest and its foundation) or (2) a percentage companies. (i.e., the percentage premium by which the pro In these instances, the MPAP for a con- rata fair value of a controlling interest exceeds its trolling interest in a privately held company foundation). may exceed the MPAP for a similar interest Historically, analysts have typically used the in a publicly traded company. equity foundation to calculate the transaction pre- n Quality of Management—If the quality of mium as a percentage. For example, if a stock the current management team is perceived was trading at $10 per share immediately before by market participants to be less than a $12 per share change of control transaction was optimal, there may be an opportunity to announced, many analysts in the valuation commu- enhance cash flow through a change in nity would calculate the acquisition premium as 20 management. The larger the economic percent [($12 – $10) / $10]. impact such a change would have on the This way of measuring a publicly traded com- company, the larger the MPAP, all else being pany acquisition premium was also consistent equal. with the way many of the publicly available trans- n Regulatory Factors—A company may be action databases reported the information in the subject to a variety of regulatory factors, past.

www .willamette .com INSIGHTS • AUTUMN 2018 35 However, VFR Advisory #3 concluded that there The invested capital of both companies, on is a more accurate way to express these acquisi- a controlling interest basis, is $130. Under this tion premiums. More specifically, it concluded that set of assumptions, the MPAP, based on the total calculating the MPAP as a percentage of the equity invested capital foundation, for both companies is foundation is potentially misleading and it distorts $30 ($130 – $100) or 30 percent. However, if we the comparability of the MPAP among companies calculated the MPAP using the more traditional with different capital structures. equity foundation, the result would be significantly The authors suggest that an MPAP as a percent- different. age of the total invested capital foundation may be As presented in Exhibit 1, the $30 MPAP for a better way to express the MPAP percentage given Alpha Company, when compared to its equity foun- that the prerogatives of control enhance the fair dation of $80, translates to an MPAP percentage of value of the entire business enterprise, not just the 38 percent. Alternatively, the $30 MPAP for Beta fair value of the equity. Company, when compared to its equity foundation Exhibit 1 presents an example that illustrates of $40, translates to a much higher MPAP percent- how transactions of similar companies at the same age of 75 percent. purchase price result in the same invested capital foundation MPAP. However, these same target com- As presented in Exhibit 1, 30 percent is a more panies produce a vastly different equity foundation accurate measurement of the MPAP percentage that MPAP due primarily to the difference in the leverage was paid to acquire a controlling ownership interest of the companies. in both business enterprises. Assume the invested capital of both Alpha In contrast, the 38 percent and 75 percent equi- Company and Beta Company, on a noncontrolling ty foundation MPAP, while not necessarily incorrect, interest basis, is $100. Alpha Company has debt of is largely influenced by the specific capital structure $20 and equity of $80. Beta Company has debt of of each company. $60 and equity of $40.

Exhibit 1 Comparison of MPAP Percentages

Alpha Beta Company Company

Fair Value of Equity $80 $40 Fair Value of Debt $20 $60 Fair Value of Invested Capital - Noncontrolling Interest Basis (i.e., foundation) $100 $100

Fair Value of Invested Capital - Controlling Interest Basis $130 $130

MPAP $30 $30

MPAP % Using Equity Foundation: MPAP $30 $30 Fair Value of Equity $80 $40 MPAP 38% 75%

MPAP % Using Invested Capital Foundation: MPAP $30 $30 Fair Value of Invested Capital - Noncontrolling Interest Basis $100 $100 MPAP 30% 30%

36 INSIGHTS • AUTUMN 2018 www .willamette .com VFR Advisory #3 states that best practices n Stated Rationale for include expressing and applying the MPAP on the Transaction—Some “Various publicly basis of total invested capital.8 transactions may Various publicly available databases provide be more financial in available databases details of transactions in which buyers acquired nature while others provide details controlling ownership interests of publicly traded may be more strate- companies. Many of these databases also report the gic in nature. The ana- of transactions transaction premium that was paid by the buyer lyst should research in which buyers over the publicly traded price of the target company. whether the transac- Analysts have routinely used this premium data tion involved a strate- acquired control- when estimating the MPAP for a valuation subject. gic acquiror who based ling ownership The authors of VFR Advisory #3 caution that exclu- its purchase price on sive reliance on these observed transaction pre- buyer-specific post- interests of publicly miums of prior transactions, in most instances, is transaction synergies. traded companies.” insufficient support for a concluded MPAP. Such a transaction would not necessarily While VFR Advisory #3 states that observed historical transaction premiums may provide some be useful for estimat- evidence of the magnitude of economic benefits ing an MPAP. expected by market participants, exclusive reliance n Changes in Market Conditions— on the observed premiums is discouraged without Transactional data that are used in fair value thorough analysis of the subject transaction data measurement is usually dated months, and and the valuation subject. in some cases, years, prior to the date as of VFR Advisory #3 outlines various factors that which an analyst may be making the mea- the analyst should consider when analyzing histori- surement. In these situations, the analyst cal transaction premium data and deciding whether may need to consider changes in economic such data need to be adjusted prior to their use in and industry-specific conditions between estimating an MPAP. Each of the following factors the time of the guideline transactions and can have a significant effect on the premium that is the date of the fair value measurement. observed for a given transaction. In some situations, the analyst may The factors, as described in VFR Advisory #3, choose to adjust the transaction data, or are as follows: disregard the data entirely, if the business n Size of the Interest Transacted—The ana- and economic conditions have changed lyst should attempt to determine whether substantially since the time of the acquisi- the transaction that produced the premium tions. was of a 100 percent ownership interest or n Stock Price and Volume Fluctuations Prior of a smaller controlling ownership interest. to Announcement—In some cases, the stock The size of the acquired interest and the price and the trading volume of a publicly prerogatives of control that are associated traded company can fluctuate significantly with the acquired interest may have influ- prior to announcement of the company’s enced the magnitude of the observed trans- acquisition. The analyst should review this action premium. historical data to ensure that a proper n Financial Condition of Seller—The analyst equity foundation is used in the calculation should research whether the acquired com- of the implied acquisition premium. pany was subject to . Such In some instances, it may be reasonable a situation would undoubtedly affect that to estimate the implied acquisition premi- price that was paid for the target company um based on the average trading price over and the observed transaction premium. a period of several days or weeks. n Relationship of Buyer and Seller—If the n Transaction Structure—Transaction struc- parties to a transaction had a preexisting ture can distort the reported price of a relationship, it is possible that the terms transaction. The analyst should make an of the subject transaction may not be at attempt to understand the transaction arm’s length. In that case, the analyst structure and its impact on the transaction should be skeptical whether the transac- price prior to relying on a premium that is tion can be used as a basis for supporting implied by the transaction. an MPAP.

www .willamette .com INSIGHTS • AUTUMN 2018 37 n Transaction Process—The The underlying premise of VFR Advisory #3 is “VFR Advisory #3 is analyst should attempt to that the MPAP should not be based exclusively on learn whether the com- historical change of control transaction premium intended to provide pany was sold through data. Instead, the MPAP should be supported by a general frame- a robust sale process expected economic benefits that would arise from: involving multiple poten- 1. enhanced cash flow and/or work that results tial buyers or whether 2. lower required rates of return from a mar- in reasonably con- there was a single poten- tial acquirer. ket participant’s perspective. sistent and reliable n Transaction Status— fair value measure- Many transactions that are VFR Advisory #3 describes various business- announced never close. specific factors that may influence the magnitude of ments of control- The analyst should con- the MPAP as well as transaction-specific factors that ling ownership sider how much emphasis should be considered when evaluating historical should be placed on the transaction premium data. interests in busi- data of transactions that VFR Advisory #3 was developed to provide guid- ness enterprises.” had not closed as of the ance regarding the fair value measurement for finan- fair value measurement cial accounting. However, it is not an authoritative date. valuation standard that must be followed by analysts in all instances. It may be impractical for the analyst to evaluate Instead, VFR Advisory #3 is intended to provide each of the above-described factors for all control- a general framework that results in reasonably ling interests transactions. Nonetheless, the list consistent and reliable fair value measurements of provides guidance an analyst should generally follow controlling ownership interests in business enter- when deciding whether a transaction could be used prises. for purposes of estimating an MPAP. Ultimately, the analyst should evaluate the rel- Notes: evance of the transaction premium data by consid- ering the comparability of the acquired companies 1. ASC topic 805, ASC topic 350, and ASC topic 820 are the successors to Financial Accounting to the subject company and whether the acquiror in Standards (“FAS”) No. 141(R), FAS No. 142, and each transaction is reasonably representative of a FAS No. 157, respectively. market participant. 2. The Appraisal Foundation previously issued While VFR Advisory #3 acknowledges that his- two other documents that are meant to pro- torical transaction premium data may be useful in vide guidance on other valuation topics. The fair value measurement, they caution that exclusive two previously issued documents are (1) reliance on these data is not consistent with best Valuations in Financial Reporting Advisory #1, practices. The Identification of Contributory Assets and Calculation of Economic Rents (2010) and VFR Advisory #3 also notes that any MPAP (2) Valuations in Financial Reporting Advisory applied in an analysis or implied by an analysis #2, The Valuation of Customer Related Assets should be the subject of a reasonableness check. (2016). The level of rigor of this reasonable check should 3. VFR Valuation Advisory #3: The Measurement be correlated with the level of influence that the and Application of Market Participant subject MPAP has on the fair value measurement. Acquisition Premiums, 10. 4. Ibid., 11. 5. Ibid. Summary 6. Ibid., 15. VFR Advisory #3 sets forth best practices for certain 7. Ibid., 18. issues that an analyst may encounter in measuring 8. Ibid., 28. the fair value of controlling interests in business enterprises for financial accounting purposes. VFR Advisory #3 introduces the concept of the Timothy Meinhart is a managing MPAP as the difference between (1) the pro rata fair director of the firm and the Chicago, value of a subject controlling ownership interest and Illinois, office director. Tim can be (2) its foundation, which can be stated on either an reached at (773) 399-4331 or at equity or a total invested capital basis. [email protected].

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