January 25, 2012 | Issue #112-4  

Current ERP at 5.5%, says new Duff & Phelps estimation

Duff & Phelps regularly reviews fluctuations in global economic and financial conditions that warrant periodic reassessments of the equity risk premium (ERP) used for developing discount rates. Based on current market conditions, Duff & Phelps has just decreased its recommended U.S. ERP to 5.5% for use as of Jan. 15, 2012, and thereafter, until further guidance is issued. The previous Duff & Phelps U.S. ERP recommendation was 6.0%, established as of Sept. 30, 2011.

“In developing our ERP recommendation, we incorporated a ‘normalized’ 20-year yield on U.S. government bonds of 4.0% as of mid-January 2012,” says Jim Harrington (Duff & Phelps). (This implies a 9.5% [5.5% + 4.0%] “base” cost of equity capital estimate for the U.S.) “Had we used the spot yield-to-maturity of 2.6% as of mid-January 2012, we would have arrived at an overall discount rate inappropriately low vis-à-vis the risks currently facing investors,” Harrington adds. The new ERP recommendation also takes into consideration recent positive economic trends, as evidenced by several indicators:

  • the unemployment rate is down, and there has been a declining trend in initial jobless claims;
  • non-farm payrolls have been ticking up;
  • corporatecredit spreads have diminished; and
  • consumer sentiment is rising by some measures.

Further, the new ERP reflects the increasing stabilization of perceived risks to U.S. markets. Despite the recent downgrade of several Euro-zone countries’ credit ratings, the Euro-zone “seems to have pulled back from what some analysts perceived to be its imminent meltdown in the fall of 2011,” says Carla Nunes (Duff & Phelps). Since then, “U.S. broad equity indices have risen significantly (e.g., the S&P 500), and equity volatility has diminished somewhat (e.g., as measured by the S&P 500 VIX index).” Reminder: for valuations dated as of December 31, 2011, the D&P 6.0% ERP estimate is still appropriate, in conjunction with a normalized 4.0% risk-free rate. For all the analysis, data, and information that went into the new D&P recommended ERP, look for Harrington and Nunes’ complete article in the March 2012 Business Valuation Update.

Litigation services aren’t eclipsing ‘bread and butter’ BV

The bread and butter of the valuation business is still non-litigation work, according to BVR’s latest 2011/2012 BV Firm Economics Survey. The ratio of billings attributable to non-litigation work vs. litigation services is still 2:1—a proportion that hasn’t changed significantly since the first survey, in 2006.

Some shifting does appear to be going on among BV firms at either end of the litigation services spectrum. For example, the percentage of BV firms that do a modest amount of litigation work (20% of overall services) has seen a slight uptick, from 48.7% in 2008 to just over half of participating firms (56.7%) in this latest survey. At the same time, however, only 6.5% of participating BV firms now say the bulk of their work (80% or more) is in litigation, compared to 11% in 2008.

Another perspective on the balance of engagements: consider how many firms have “diversified” to provide both litigation and non-litigation services. As the chart below illustrates, nearly 40% of all BV firms now receive substantial revenues from both types of work. Although these firms tend to be larger than their more “specialized” counterparts, many solo practitioners are also successfully straddling both camps. Notably, the percentage of BV firms that do no litigation work has dropped slightly, from 16.9% two years ago to 15.9% now.

2011/2012 percentage of total BV billings resulting from litigation-related services:

DE Chancery: value of preferred stock grounded in contract

Back in 2001, it must have seemed more than reasonable to provide investors an exit within 10 years. That’s what Morgan Joseph Holdings, an investment bank, promised its preferred stockholders in its Certificate of Incorporation: that in 10 years—on July 1, 2011—the company would redeem the preferred stock at $100 per share. Fast-forward through a troubled economic decade—bookended by the 9/11 disaster and the collapse of global markets—and the investment bank merges with another in December 2010, or nearly six months before the mandatory redemption. The resulting entity exchanged a new series of preferred stock for the old—but the former preferred investors rejected the offer and petitioned for an appraisal in the Delaware Court of Chancery. In a motion for partial summary judgment, they argued that any fair value assessment must include the $100-per-share redemption value, as provided in the original certificate. By contrast, the defendants claimed that the mandatory redemption rights were “irrelevant” to any fair value appraisal as-of the merger date.

 “Unlike common stock, the value of preferred stock is determined solely from the contract rights conferred upon it in the certification of designation,” the court held, in agreeing with petitioners. In this case, the redemption of the preferred stock was “not a speculative possibility, but rather a legally required mandate of the Certificate,” it added, thereby sidestepping the problem of subsequent events. Accordingly, at trial, the court will determine the fair value of the investment bank as a going concern on the merger date while also “taking into account the legal rights of the [preferred shareholders] as of the mandatory redemption date.” Stay tuned . . .

In the meantime, a complete digest of Shiftan v. Morgan Joseph Holdings, Inc., C.A. No. 6424-CS (Del. Ch. Jan. 13, 2012) will appear in the March 2012 Business Valuation Update. The court’s decision will be posted soon at BVLaw.

Download Trugman’s ‘11-factor checklist’ for valuing covenants not to compete

A covenant not to compete (CNC) only has value to the extent that it “protects the value of the purchased assets of the business (both tangible and intangible) by restricting the seller’s competitive conduct after the sale,” writes Gary Trugman (Trugman Valuation Assoc. Inc.), in a new article for the February 2012 BVUpdate. As a result, a CNC’s value depends on factors such as:

  • The ability of the seller to compete after closing the sale, which may implicate the seller’s age, health, professional standing, etc.;
  • The derivation of the non-compete; and
  • The losses the buyer (the company) would suffer if the seller, in fact, competed.

In most cases, the first step in valuing a CNC is to determine its “economic legitimacy,” a concept that courts have attempted to define over the years (apart from a CNC’s legal enforceability, which is a separate issue). For instance, in Thompson v. Commissioner, T.C. Memo 1996-468 (available at BVLaw), the Tax Court set forth an 11-factor test to determine a CNC’s economic reality. “Clearly, the facts and circumstances in any individual case are important to consider,” Trugman writes, but Thompson’s 11-point checklist furnishes a good basis for assessing the CNC’s legitimacy as well as the probability of the seller’s competition. Download a complete copy of Trugman’s article, “Valuing Covenants Not-to-Compete: an 11-Factor Checklist,” at BVR’s free resources page.

Could the Bankruptcy Reform Act be a boon for insolvency experts beyond the ‘bankruptcy beltway’?

Last summer, a bipartisan group in Congress introduced H.R. 2533, the “Chapter 11 Bankruptcy Venue Reform Act of 2011.” The proposed legislation would effectively require corporations to seek Chapter 11 relief in the jurisdictions in which they have had their principal place of business (or principal assets) for at least one year, or in which an affiliate already has a bankruptcy case pending.

The proposed bill “would prevent bankruptcy courts in Delaware and New York from playing host to most of the country’s major corporate reorganizations,” says a Business Week report following the first Congressional hearings on the proposal, held in September 2011. In prepared remarks, the Hon. Frank J. Bailey, chief bankruptcy judge in the District of Massachusetts, testified that the current system “simply has not worked out the way Congress intended” by permitting companies to reorganize far from where they operate. The present scheme makes participation difficult or expensive for small creditors, vendors, employees and pensioners, Bailey added—and gives a disproportionate amount of work to the N.Y.- and Del.-based attorneys and turnaround specialists who often drive the filings.

The bill is still tied up in the Judiciary Committee. In the meantime, supporters such as the Commercial Law League of America say the act would ensure that “bankruptcy reorganization process remains within the regions and communities that have the most significant vested interest in the outcome.” Where do BV appraisers weigh in? If passed, would the Bankruptcy Reform Act provide more work for “local” valuation and insolvency specialists? E-mail your thoughts to the editor.

BVR offers exclusive updates on 2 key exposure drafts

Over the next two weeks, BVR webinars will focus on the two current exposure drafts from the AICPA, each featuring a prominent member from the respective working committees:

In addition, BVR’s Online Symposium on Litigation & Economic Damages continues on Tuesday, February 7 with Lost Profits for Construction Claims. Featuring attorney George F. Burns (Bernstein Shur), part 7 of the Symposium focuses on the combined challenges of assessing damages claims with appraisals in the construction industry.

New IRS guidance on tax preparer penalties

Nothing earth-shattering here, but the IRS just issued Rev. Proc. 2012-15, its annual guidance on disclosure procedures for reducing accuracy-related penalties and avoiding tax preparer penalties. In particular, its background section reminds BV appraisers (those who qualify as tax preparers) that:

Section 6694(a) imposes a penalty on a tax return preparer who prepares a return or claim for refund reflecting an understatement of liability due to an “unreasonable position” if the tax return preparer knew (or reasonably should have known) of the position.

A position . . . is generally treated as unreasonable unless (i) there is or was substantial authority for the position, or (ii) the position was properly disclosed in accordance with section 6662(d)(2)(B)(ii)(I) and had a reasonable basis. If the position is with respect to a tax shelter (as defined in section 6662(d)(2)(C)(ii)) or a reportable transaction to which section 6662A applies, the position is treated as unreasonable unless it is reasonable to believe that the position would more likely than not be sustained on the merits.

FASB relieves management from making going-concern assessment

After its board meeting earlier this month, the FASB decided not to require management to assess whether an entity has the ability to continue as a going concern. “A majority of Board members observed that such a requirement would be difficult to apply,” says a recent new FASB release, “and that users of financial statements would benefit to a greater extent from ongoing disclosures about risks and uncertainties.” As a next step in this project, the board directed the staff to develop “a principle for an entity to assess the adequacy of its disclosures about risks and uncertainties and to evaluate how the content of such disclosures could be improved.”

Best of 2011 CPE now available

Last year, BVR presented 50 cutting-edge webinars on issues related to all aspects of business appraisal, from valuing law firms to an advanced workshop on option pricing modeling; from Estate of Gallagher to valuing businesses worth less than $2 million. Featuring top BV and legal experts, these “Best of 2011” programs are now available as BVR’s Conference Training Packs. Think we missed one that should have made the cut? E-mail us your suggestion for best webinar of 2011.



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