Fairness Opinions: The Rationale
Note that while fairness opinions have become part and parcel of most corporate control transactions, they are not required either by regulation or law. As with so much of business law, especially relating to acquisitions, the basis for fairness opinions and their surge in usage can be traced back to Delaware Court judgments. In Smith vs Van Gorkom, a 1985 case, the court ruled against the board of directors of Trans Union Corporation, who voted for a leveraged buyout, and specifically took them to task for the absence of a fairness opinion from an independent appraiser. In effect, the case carved out a safe harbor for the companies by noting that “the liability could have been avoided had the directors elicited a fairness opinion from anyone in a position to know the firm’s value”. I am sure that the judges who wrote these words did so with the best of intentions, expecting fairness opinions to become the bulwark against self-dealing in mergers and acquisitions. In the decades since, through a combination of bad banking practices, the nature of the legal process and confusion about the word "fairness", fairness opinions, in my view, have not just lost their power to protect those that they were intended to but have become a shield used by managers and boards of directors against serious questions being raised about deals.
Fairness Opinions: Current Practice?
the rule than the exception, I would argue that fairness opinions are doing
more harm than good. By checking off a legally required box, they have become a way in which a board of directors buy immunization against legal consequences. By providing the illusion of oversight and an independent assessment, they are making shareholders too sanguine that their rights are being protected. Finally, this is a process where the worst (and least) scrupulous appraisers, over time, will drive out the best (and most principled) ones, because managers (and boards that do their bidding) will shop around until they find someone who will attest to the fairness of their deal, no matter how unfair it is. My interest in the process is therefore as much professional, as it is personal. I believe the valuation practices that we see in many fairness opinions are horrendous and are spilling over into the other valuation practices.
It is true that there are cases, where courts have been willing to challenge the "fairness" of fairness opinions, but they have been infrequent and reserved for situations where there is an egregious conflict of interest. In an unusual twist, in a recent case involving the management buyout of Dell at $13.75 by Michael Dell and Silver Lake, Delaware Vice Chancellor Travis Lester ruled that the company should have been priced at $17.62, effectively throwing out the fairness opinion backing the deal. While the good news in Chancellor Lester's ruling is that he was willing to take on fairness opinions, the bad news is that he might have picked the wrong case to make his stand and the wrong basis (that markets are short term and under price companies after they have made big investments) for challenging fairness opinions.
Fish or Cut Bait?
A Judicial Check
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Question
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Green
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Red
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Who is paying you to do this valuation and how much? Is
any of the payment contingent on the deal happening? (FINRA rule 2290 mandates disclosure on these) |
Payment
reflects reasonable payment for valuation services rendered and none of the payment is contingent on outcome |
Payment is disproportionately
large, relative to valuation services provided, and/or a large portion of it is contingent on deal occurring. |
|
Where are you getting the cash flows that you are using in
this valuation? |
Appraiser estimates revenues, operating margins and cash flows, with
input from management on investment and growth plans. |
Cash flows supplied by
management/ board of company. |
|
Are the cash flows internally consistent?
 |
1.
Currency: Cash flows & discount rate are in same currency, with same inflation assumptions.
2.
Claim holders: Cash flows are to equity (firm) and discount rate is cost of equity (capital).
3.
Operations: Reinvestment, growth and risk assumptions matched up. |
No internal consistency tests run and/or DCF littered with inconsistencies, in
currency and/or assumptions.
- High growth + Low reinvestment
- Low growth + High reinvestment
- High inflation in cash flows + Low inflation in discount
rate |
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What discount rate are you using in your valuation?
|
A cost of equity (capital)
that starts with a sector average and is within the bounds of what is reasonable for the sector and the market. |
A cost of equity (capital) that
falls outside the wacc.xls">normal range for a sector, with no credible explanation for difference. |
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How are you applying closure in your valuation?
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A terminal value that is
estimated with a perpetual growth rate < growth rate of the economy and reinvestment & risk to match. |
A terminal value based upon a perpetual
growth rate > economy or a multiple (of earnings or revenues) that is not consistent with a healthy, mature firm. |
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What valuation garnishes have you applied?
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None.
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A large dose of premiums
(control, synergy etc.) pushing up value or a mess of discounts (illiquidity, small size etc.) pushing down value. |
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What does your final judgment in value look like?
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A distribution of values,
with a base case value and distributional statistics. |
A range of values so large
that any price can be justified. |
If this sounds like too much work, there are four changes that courts can incorporate into the practice of fairness opinions that will make an immediate difference:
- Deal makers should not be deal analysts: It should go without saying that a deal making banker cannot be trusted to opine on the fairness of the deal, but the reason that I am saying it is that it does happen. I would go further and argue that deal makers should get entirely out of the fairness opinion business, since the banker who is asked to opine on the fairness of someone else's deal today will have to worry about his or her future deals being opined on by others.
- No deal-contingent fees: If bias is the biggest enemy of good valuation, there is no simpler way to introduce bias into fairness opinions than to tie appraisal fees to whether the deal goes through. I cannot think of a single good reason for this practice and lots of bad consequences. It should be banished.
- Valuing and Pricing: I think that appraisers should spend more time on pricing and less on valuation, since their focus is on whether the "price is fair" rather than on whether the transaction makes sense. That will require that appraisers be forced to justify their use of multiples (both in terms of the specific multiple used, as well as the value for that multiple) and their choice of comparable firms. If appraisers decide to go the valuation route, they should take ownership of the cash flows, use reasonable discount rates and not muddy up the waters with arbitrary premiums and discounts. And please, no more terminal values estimated from EBITDA multiples!
- Distributions, not ranges: In my experience, using a range of value for a publicly traded stock to determine whether a price is fair is useless. It is analogous to asking, "Is it possible that this price is fair?", a question not worth asking, since the answer is almost always "yes". Instead, the question that should be asked and answered is "Is it plausible that this price is a fair one?" To answer this question, the appraiser has to replace the range of values with a distribution, where rather than treat all possible prices as equally likely, the appraiser specifies a probability distribution. To illustrate, I valued Apple in May 2016 and derived a distribution of its values:
Punishment
The most disquieting aspect of the acquisition business is the absence of consequences for bad behavior, for any of the parties involved, as I noted in the aftermath of the disastrous HP/Autonomy merger. Thus, managers who overpay for a target are allowed to use the excuse of "we could not have seen that coming" and the deal makers who aided and abetted them in the process certainly don't return the advisory fees, for even the most abysmal advice. I think while mistakes are certainly part of business, bias and tilting the scales of fairness are not and there have to be consequences:
- For the appraisers: If the fairness opinion is to have any heft, the courts should reject fairness opinions that don't meet the fairness test and remove the bankers involved from the transaction, forcing them to return all fees paid. I would go further and create a Hall of Shame for those who are repeat offenders, with perhaps even a public listing of their most extreme offenses.
- For directors and managers: The boards of directors and the top management of the firms involved should also face sanctions, with any resulting fines or fees coming out of the pockets of directors and managers, rather than the shareholders involved.
I know that your reaction to these punitive suggestions is that they will have a chilling effect on deal making. Good! I believe that much as strategists, managers and bankers like to tell us otherwise, there are more bad deals than good ones and that shareholders in companies collectively will only gain from crimping the process.
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