Wednesday, September 14, 2016

Fairness Opinions: Fix them or Flush them!

My post on the Tesla/SCTY deal about the ineptitude and laziness that Lazard and Evercore brought to the valuation process did not win me any friends in the banking M&A world. Not surprisingly, it drew some pushback, not so much from bankers, but from journalists and lawyers, taking me to task for not understanding the context for these valuations. As Matt Levine notes in his Bloomberg column, where he cites my post, "a fairness opinion is not a real valuation, not a pure effort to estimate the value of a company from first principles and independent research" (Trust me. No one is setting the bar that high. I was looking for biased efforts using flawed principles and haphazard research and these valuation could not even pass that standard)  and that "they (Lazard and Evercore) are just bankers; their expertise is in pitching and sourcing and negotiating and executing deals -- and in plugging in discount rates into preset spreadsheets -- not in knowing the future". (Bingo! So why are they doing these fairness opinions and charging millions of dollars for doing something that they are not good at doing? And there is a difference between knowing the future, which no one does, and estimating the future, which is the essence of valuation.) If Matt is right, the problems run deeper than the bankers in this deal, raising questions about what the purpose of a   "fairness opinion" is and whether it has outlived its usefulness (assuming that it was useful at some point).

Fairness Opinions: The Rationale
What is a fairness opinion? I am not a lawyer and I don't play intend to play one here, but it is perhaps best to revert back to the legal definition of the term. In an excellent article on the topic, Steven Davidoff defines a fairness opinion as an "opinion provided by an outsider that a transaction meets a threshold level of fairness from a financial perspective". Implicit in this definition are the assumptions that the outsider is qualified to pass this judgment and that there is some reasonable standard for fairness.  In corporate control transactions (acquisition, leveraged buyout etc.), as practiced today, the fairness opinion is delivered (orally) to the board at the time of the transaction, and that presentation is usually followed by a written letter that summarizes the transaction terms and the appraiser's assumptions and attests that the price paid is "fair from a financial point of view". That certainly sounds like something we should all favor, especially in deals that have obvious conflicts of interest, such as management-led leveraged buyouts or transactions like the Tesla/Solar City deal, where the interests of Elon Musk and the rest of Tesla 's stockholders may diverge.

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?
There are appraisers who take their mission seriously and evaluate the fairness of transactions in their opinions, but the Tesla/Solar City valuations reflect not only how far we have strayed from the original idea of fairness but also how much bankers have lowered the bar on what constitutes acceptable practice.  Consider the process that Lazard and Evercore used by  to arrive at their fairness opinions in the Tesla/Solar City deal, and if Matt is right, they are not alone:

What about this process is fair, if bankers are allowed to concoct discount rates, and how is it an opinion, if the numbers are supplied by management? And who exactly is protected if the end result is a range of values so large that any price that is paid can be justified?  And finally, if the contention is that the bankers were just using professional judgment, in what way is it professional to argue that Tesla will become the global economy (as Evercore is doing in its valuation)? 

To the extent that what you see in the Tesla/Solar City deal is more 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?
Given that the fairness opinion, as practiced now, is more travesty than protection and an expensive one at that, the first option is to remove it from the acquisition valuation process. That will put the onus back on judges to decide whether shareholder interests are being protected in transactions. Given how difficult it is to change established legal practice, I don't think that this will happen. The second is to keep the fairness opinion and give it teeth. This will require two ingredients to work, judges that are willing to put fairness opinions to the test and punishment for those who consistently violate those fairness principles.

A Judicial Check
Many judges have allowed bankers to browbeat them into accepting the unacceptable in valuation, using the argument that what they are doing is standard practice and somehow professional valuation.  As someone who wanders across multiple valuation terrain, I am convinced that the valuation practices in fairness opinions are not just beyond the pale, they are unprofessional. To those judges, who would argue that they don't have the training or the tools to detect bad practices, I will make my pro bono contribution in the form of a questionnaire with flags (ranging from red for danger to green for acceptable) that may help them separate the good valuations from the bad ones.

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
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 normal range for a sector, with no credible explanation for difference.
How are you applying closure in your valuation?
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.
What valuation garnishes have you applied?
A large dose of premiums (control, synergy etc.) pushing up value or a mess of discounts (illiquidity, small size etc.) pushing down value.
What does your final judgment in value look like?
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:
  1. 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.
  2. 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.
  3. 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!
  4. 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:

Let's assume that I had been asked to opine on whether a $160 stock price is a fair one for Apple. If I had presented this valuation as a range for Apple's value from $80.81 to $415.63, my answer would have to be yes, since it falls within the range. With a distribution, though, you can see that a $160 price falls at the 92nd percentile, possible, but neither plausible, nor probable.  To those who argue that this is too complex and requires more work, I would assume that this is at the minimum what you should be delivering, if you are being paid millions of dollars for an appraisal.

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:
  1. 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. 
  2. 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.

YouTube Video

  1. The Fairness Questionnaire (as a word file, which you are free to add to or adapt)


Anonymous said...

Pushback from journalists, lawyers, etc? I would ask them to respond to this question: How do you know if a price being paid for anything is fair? I see there being one of two choices: 1. Look at prices being paid for other assets; or 2. compare the price being paid for an asset to the value of the business if it is not acquired and management continues on trying to fufill its business plan. Both the target and acquirer shareholders need to know if the price being paid is "fair" from each of their perspectives.
As to management submitting numbers to the party doing the valuation, I see no issue with this as this business value arises from the Company not being acquired and management working to realize against its business plan. The issue has to do with not just accepting these numbers and coming up with one value based on it, but with sensitizing the numbers for the reasonableness of the management assumptions.
I do agree with the Prof on this: The best way to reduce the gross amount of "noise" in these documents, may be to just use multiples and come up with a number that reflects trading multiples more than anything else. After all, the non sophisticated crowd will only be interested in the price of a stock compared to what is being paid for it by an acquirer, and the premium above that price(most interest to acquirer shareholders).

Unknown said...

Thanks for the post prof. Enjoyed this piece, especially the pro-bono questionnaire!

I think it may be harsh to state that the IB analysts were inept and lazy in their fairness opinions as it may have boiled down to what is legally accepted (though flawed) as a fairness opinion and the fine details of what they were mandated to provide. In providing fairness opinions, I feel it should be the fiduciary duty of the management as well as IBs to the company shareholders. In this case, it seems that Tesla/ Solar City management took ownership of providing the cash flows and hence the fiduciary duty wrt to projected cash flows should lie with them.

While making a projection of future cash flows is anyone's guess and will eventually turn out to be substantially off the mark, imposing punitive damages for inaccurate projecting cash flows is impractical. I however feel that failure to make an attempt to test the basis and realisticness of projected cash flows should be punished.

Apenado said...

All this reminds me one old Warren Buffet's shareholders letter in which he says "While deals often fail in practice, they never fail in projections - if the CEO is visibly panting over a prospective acquisition, subordinates and consultants will supply the requisite projections to rationalize any price."
Thanks for your work, Aswath!

Raj Raina said...

great stuff. Frustrating to see millions being paid for plugging some bad numbers in a spreadsheet to come up with figures that justify the deal. I can see it from banker's and CEO's perspective.

what i don't understand is why shareholders stand for such non-sense. Disillusioned, unaware, dumb or all of them? Who knows!?

anyway, thanks for keeping "bankers" and value "experts" and financial reporters honest!

Hermann P said...

I think you nailed it when you point out that there are no consequences for being wrong.

If I'm paid $1 million to race down the road as fast as possible but in the event of a crash its you that die... well... I'm racing fast and rationalizing why with whatever information I can find :)

Anonymous said...

My read of Matt's article isn't that he's disagreeing with you, he's saying the banks are doing exactly what they were explicitly hired to do. He sums this up nicely in the closing paragraph

"A fairness opinion is not a real valuation ... A fairness opinion says: Given certain explicit assumptions that we've agreed on with management, and running those numbers through certain standard valuation techniques, you can get a pretty wide range of values, and the price of this deal is within that range. It is a sanity check ... confirmation that the deal price can be justified by a rational process in a plausible world. That is not nothing! But it's not much more than that."

I think you both are in agreement. The dissonance seems to be in the What Next. Though if a former GS banker professes that fairness opinions by design are barely more than superficial sanity checks, it's hard to disagree that they should be abolished. Or at least the fees should be orders of magnitude lower.

Unknown said...

An interesting article on WSJ. Finally someone is talking about it....