Company Specific Risk or No Company Specific Risk, THAT is the Question

Transcription

1 Company Specific Risk or No Company Specific Risk, THAT is the Question Presentation By: William A. Johnston, ASA Jason Ross Empire Valuation Consultants Panel Member/Commentary: Anthony Aaron, ASA EY

2 Thinking is the hardest work there is, which is probably the reason so few engage in it. Henry Ford 2

3 Overview Focus of presentation relates to purchase price allocations ( PPAs ) for financial reporting purposes Discussion focused on range of views Don t ever do it (one extreme) Do it if you have done a robust analysis and it makes sense Spoiler alert this is the presenters viewpoint Do as first and final step to reconcile with the IRR (other extreme) Intent to hold a forum on the issue and solicit feedback 3

4 Outline Presentation (30-40 minutes) Game Risk or No Risk? Other Issues Q&A Interactive!!! 4

5 Poll How many include a company specific risk premium ( CSRP ) in valuations? How many people perform purchase price allocations ( PPAs )? How many people sometimes include a CSRP when performing a PPA? Have you received any push back? How many auditors/reviewers do we have? For how many is this a problem? 5

6 Background Valuation specialist performs a PPA for financial reporting purposes (ASC 805) A Weighted Average Cost of Capital ( WACC ) must be developed for the Company as part of the process The WACC is compared to an Internal Rate of Return ( IRR ) Calculation on the Transaction as well as the Weighted Average Return on Assets ( WARA ) If there is a meaningful difference amongst the WACC, IRR, and WARA further rigor is required to reconcile the rates 6

7 Rate Reconciliation Ways to reconcile WACC, IRR, and WARA Revisit IRR assumptions Buyer specific synergies excluded? Type of sale transaction accurate (taxable vs. non-taxable) Other market participant ( MP ) adjustments Growth and margin assumptions Projected cap-x and working capital levels sufficient to grow business Tax rate reasonable? Were projections used to price the transaction? 7

8 Rate Reconciliation (cont.) Ways to reconcile WACC, IRR, and WARA (cont.) Inconsistency reconciled by adjusting WARA Reconsider selected discount rates for certain assets If non-taxable/equity deal assumed in IRR, need to adjust in WARA to include hypothetical tax benefit Does WARA include MP levels of working capital and fixed assets? Are underling assumptions reasonable in determining the asset values? 8

9 Rate Reconciliation (cont.) Ways to reconcile WACC, IRR, and WARA (cont.) Consider if purchase price not reflective of what a MP would pay For example: - Was the sale a distressed sale? - Was there an active bidding/negotiation process? - Do market metrics/multiples suggest that the price was reasonable This outcome is less common but should be considered 9

10 Rate Reconciliation (cont.) Ways to reconcile WACC, IRR, and WARA (cont.) Revisit WACC assumptions Did you pick the correct sample of guideline companies (affects the beta and debt to equity assumptions) Are your beta assumptions reasonable Low R Squared? Thinly traded? Are some companies more comparable? Is your debt to equity assumption reasonable Not always the median! 10

11 Rate Reconciliation (cont.) Ways to reconcile WACC, IRR, and WARA (cont.) Revisit WACC assumptions (cont.) Is your debt rate a reasonable MP rate? Equity rate calculation can vary due to differences in assumptions re: Risk free rate (normalized or not) Model used (CAPM, Duff and Phelps 8 factor model, etc.) Size premium(s) assumed (large cap and if relevant small cap) Previous suggestions to reconcile (slides 4 through 8) are to some extent are auditable However, what if one can not reconcile the rates using these tactics? 11

12 Seeking Alpha If the previous methods are insufficient, what about company specific risk? Including a company specific risk adjustment in the WACC can reconcile it with the IRR and WARA This type of adjustment is common place in the valuation world This type of adjustment is often the easiest solution Being the easiest solution can lead to problems 12

13 Just Say No! Some argue against ever adjusting the company specific risk due to several factors Not easy to audit, if at all possible Some specialists skip other considerations and make this adjustment After making other adjustments to IRR and/or WARA, this should not be necessary It violates CAPM theory Risk is being double-counted 13

14 Do It! Some specialists may look to the CSRP as the primary way to reconcile IRR, WARA, and WACC This approach may greatly ignore adjustments that may need to be made to the IRR and WACC If these are management s projections and they paid $X why would I mess with the IRR? Isn t that the most reliable rate? The guideline companies used in part to develop the WACC are not as comparable as the actual transaction itself 14

15 Thinking Man s Perspective The answer likely falls in between A rigorous analysis of all factors is required While some are too quick to adjust the CSRP, the presumption that this should not be a factor is close-minded and in some cases wrong 15

16 Case for CSRP Reasons why you may have CSRP Acquisition similar to a start up venture Size of target smaller compared to sample used for WACC Projection risk greater than for public companies used to develop WACC (less common) 16

17 Case for CSRP (cont.) Acquisition similar to a start up venture Often a large company may acquire a small company to push its product through its own distribution channels This can lead to a very large increase in sales that the target would likely not achieve on its own While the acquirer may have a successful track record with such ventures, there is still a significant amount of uncertainty as to what its level of success will be 17

18 Case for CSRP (cont.) Acquisition similar to a start up venture (cont.) WACC would be developed for the acquired company as a standalone company Based on public company/peer data on betas and debt to total capital ratios as well as size premiums (large and small cap) However, there is a likely a disconnect between the risk for the company as a stand-alone and as acquired This disconnect likely can not be reconciled through public company data (perhaps VC rates?) Therefore, a CSRP may be warranted in such a case 18

19 Case for CSRP (cont.) Size of target smaller compared to sample used for WACC For smaller company acquisitions, the developed WACC often assumes a size greater than the size of the acquired company However, there is a correlation between size and risk Therefore, a CSRP adjustment may be needed to fully reflect the size of the acquired company For example. 19

20 Case for CSRP (cont.) Risk free rate: 2.75% Equity risk premium: 6.00% Beta 1.00 Micro cap premium 3.74% (9th and 10th deciles) Equity rate (CAPM): 12.49% Average size company in micro cap: Equity purchase price: $227 million $25 million Size subcategory: 10 10b 10z Size premium: 5.78% 8.94% 11.98% Differential w/micro cap: 2.04% 5.20% 8.24% 20

21 Case for CSRP (cont.) Projection risk greater than for public companies used to develop WACC Company just completed a new product expected to dramatically increase sales Company less diversified compared to public companies Product base Geography Management Customers Etc. 21

22 Suggested Approach Make a CSRP adjustment as a last resort People are often too quick to make a CSRP adjustment and not look more closely at the projections, overall analysis, and transaction Make sure you have a sound reason E.g. An answer to account for projection risk is vague, get into specifics Make sure the risk you mention is not already implicitly included in the discount rate calculation 22

23 Common Pitfalls One concern is having projected cash flows too high and arbitrarily including a CSRP to reconcile If the projected cash flows were lower, the CSRP may not have been necessary The following are some common mistakes that can be made that are erroneously fixed by adding a CSRP 23

24 Common Pitfalls Using projections that include buyer synergies Using projections that were prepared post-transaction Should use deal model Sometimes projections not analyzed; in such case posttransaction projections may lack rigor and support for assumptions Unwillingness to consider that intangible values and/or rates not correct (affects WARA) Projected Cap-x and Wkg. Cap levels too low Growth and margin assumptions unrealistic Tax rate too low 24

25 Let s Play the Game! - We will go through 5 examples - Each you will vote Risk (include CSRP) or No Risk (no CSRP) - Our panelist/judge will weigh in on responses - Three other issues following (time permitting) 25

26 Example #1 Growth Assumptions in Forecast - Target is a large, privately held healthy potato chip manufacturer with leading brands - Target is acquired by a financial buyer (private equity) - Target did $200m in revenue in year prior to acquisition with EBITDA margins of 20% and is projecting revenue to increase to $500m in 5 years - In year 3 of the forecast, the projections include revenue from new healthy products: cookies, frozen pizza; this revenue accounts for 20% of revenue in year 3, growing to 35% of revenue in year 5 with combined EBITDA margins from new products of ~ 19% - Reasonable to include CSRP: Yes or No? 26

27 Example #2 Synergies in Projections - Acquirer owns a unique, cutting edge technology platform that no competitors have been able to replicate (only much weaker substitutes exist) - Due to its superior technology, the company produces its products at a lower cost (~ 2.5% of sales), resulting in higher gross profit margins than the market participants - Acquirer has purchased NewCo and in it s deal model, the Acquirer has included this benefit into its forecast for the Target resulting in higher gross profit margins for the Target compared to what its margins were pre-deal - Reasonable to include CSRP: Yes or No? 27

28 Example #3 Structure of Deal Considered - Acquirer purchases Target s equity (non-taxable transaction) for $250m - Projections for Target include growth and margin assumptions in line with market participants - No Buyer Specific Synergies - Projected CapEx and Working Capital Assumptions for Target supported by market participants - Other Considerations - Based on Purchase Price, Target s size is at upper bound of 10 th decile in size premium - Guideline Companies very similar to Target (i.e., beta/ systemic risk makes sense) 28

29 Example #3 Continued - WACC = 15%, assumes 2% CSRP - IRR = 13% - Tax amortization benefit (TAB) included in IRR analysis - Reasonable to include CSRP: Yes or No? 29

30 Example #4 Review All Inputs in WACC - Target s IRR = 15% - Projected revenue and EBITDA determined not to have any buyer specific synergies - 6 Guideline Companies considered to be reasonably comparable to Target - Working capital and capex assumptions for Target compared to all 6 guideline companies - Target s working capital requirements and capex historical ratios in line with Guideline Companies - Working Capital % sales near 10% for all guideline companies - CapEx % sales near 1% for all guideline companies 30

31 Example #4 Continued WACC = 10.50% (Inputs Discussed on next slide) 31

32 Example #4 Continued - Beta input: - Median and Average of Unlevered Beta of Guideline Companies is 0.55 and 0.53 respectively - R 2 for 3 of the Guideline Companies is no higher than Excluding Guideline Companies with low R 2, median and mean beta: Selected Unlevered Beta: Relevered Beta: beta relevered based on Market Participant Debt to MVIC ratios - Debt to MVIC ratios of Guideline Companies ranging from 20% to 30% and median and mean near 25% - Gap between IRR and WACC is 2.5% - Should a CSRP be included to reconcile the rates? 32

33 Example #5 Forecast without Deal Model - Company X (strategic buyer) acquires Target - Management of Company X does not prepare forecast of Target in due diligence (i.e., no deal model) - Management indicates that purchase price based on Rule of Thumb for Target based on earnings multiple - Management of Company X prepares post-deal projections for PPA valuation - Historically, the Target has grown by 8% with EBITDA margins of 10% - Post-deal projections for Target include 25% revenue growth and higher (20%) EBITDA margins - Guideline Companies do not support growth and margin assumptions projected for Target 33

34 Example #5 - Is it reasonable to include CSRP: Yes or No? 34

35 Other Issues #1 How Acquirer Priced the Deal - Acquirer is a large international food marketer specializing in condiments, that decides to enter U.S vitamin and nutritional supplement market - Acquirer purchases Target, which markets vitamin and mineral supplements, amino acids and herbal products - Acquirer pays $100m for U.S. nutraceuticals manufacturer - Implied EBITDA Multiple in Transaction: 35x TTM EBITDA - Industry Median EBITDA multiple: 10x TTM EBITDA - Target Profile: - Projections assume 5 year revenue CAGR of 10% and EBITDA margins to improve from 5% to 10% over forecasted period (cost saving synergies deemed to be market-participant based) - Target s brands moderately well known 35

36 Other Issues #1 Continued - IRR = 7% - WACC = 19%, includes 2% CSRP - WARA = 19% - Working Capital WACC = 6% and Fixed Assets WACC = 7% - Intangible Assets WACC = 18% to 19% - Intangibles: Customers, Formulas, Trademarks - Goodwill Discount WACC = 25% - Issues to Consider in Reconciling WACC & IRR to IRR - How did Acquirer price deal to pay for Target?? 36

37 Other Issues #2 What is the Right Purchase Price? - Target is a consumer goods company with a single high profile product - Company #1 has a product that uniquely complements the Target s core product - Company #1 does due diligence of Target and places a $9m valuation of Target - Valuation of Target based on 6x EBITDA - Reasonable multiple given Target s size, growth, etc. 37

38 Other Issues #2 Continued - Company #1 enters into a blind bidding auction for Target and does not know how many companies have joined auction - Bidding process begins at $10m - Company #1 wins bid at $18m - $18m valuation of Target implies 12x EBITDA multiple - Based on $18m purchase price, IRR is 9% - Should IRR be based on $18m purchase price or consideration given to $10m valuation? 38

39 Other Issues #3 WARA - Target is struggling and having issues financing new inventory purchases - Target and Company X begin due diligence process but can t come to any agreement on purchase price; however, intention of two parties is for Company X to acquire Target - In the interim, Target and Company X enter into a Commercial Agreement where Company X facilitates inventory purchases from Target s vendors and assist Target with the collection of accounts receivables. 39

40 Other Issues #3 Continued - As a result of the Commercial Agreement, the A/R and inventory, along with other working capital items, of Target is moved to Company X s balance sheet. - No working capital items are included in transaction. - 3 months following Commercial Agreement, Company X acquires Target in Asset purchase - WACC = 16% and IRR = 17% - Working Capital in WARA calculation is normalized to reflect market participant at 20% of revenue - WACC = 6% and Fixed Assets WACC = 7% - Intangible Assets WACC = 17% to 18% - Goodwill Discount WACC = 150% 40

41 Other Issues #3 Continued - Are there any adjustments to consider in adjusting the goodwill? 41