Bankruptcy court discredits DCF as too easy to manipulate
If the authors of the recent article “Campbell, Iridium, and the Future of Valuation Litigation” are looking for any more support for their thesis that market evidence—not “paid litigation experts”—should determine company values in bankruptcy, then they’re going to be reading a new case very closely.
Citing dueling experts who begin with the same cash projections but end with values nearly $8 million apart for a relatively small, family-owned company, the federal bankruptcy court (N.D. Ill.) says the “wide” and “striking” disparity between experts “lends credibility to the concept that the DCF method is subject to manipulation and should be validated by other approaches.” In particular, it repeats the warning in Iridium that by using the malleable DCF, “a skilled practitioner can come up with just about any value he wants.”
In this case, the experts’ disagreement largely came down to how each calculated the weighted average cost of capital (WACC) under a CAPM approach, which in turn devolved on their treatment of three inputs—the debt-to-equity ratio, the equity risk premium (ERP), and the size premium—as well as the terminal value. To defend their points, each expert cited Ibbotson’s, Professor Aswath Damodaran, and the Gordon Growth model versus an exit multiple approach. But “each expert generally selected parameters that pushed his valuation in the direction he wanted to go,” the court says. In particular, both overstated the ERP, and both should have used the geometric, rather than the arithmetic, mean.
In the end, the court essentially fell back on “real world” evidence at the time of the company’s acquisition to find that it was solvent, including its lack of debt, its substantial cash in excess of working capital, and its ability to keep current on accounts payable. Read the complete digest of In re Bachrach Clothing, Inc., 2012 Bankr. LEXIS 4807 (Oct. 10, 2012) in the January 2013 Business Valuation Update; the bankruptcy court’s decision is posted at BVLaw.
Should business valuation be an industry, at least on LinkedIn?
Many leaders in business valuation have resisted belonging to an “industry”—foremost among them Shannon Pratt (SPV) (who scolded the BVWire editor, back in 2006, for putting BV in an industrial category). As Pratt once wrote, in one of the very first issues of BVUpdate: “All readers of this newsletter can contribute to a mission that I view as very important: make the legal profession more aware and appreciative of the business valuation profession. Compared to many other professions such as law, accounting or even real estate appraisal, business valuation is both a relatively young and relatively small profession.”
Have times changed? “I have noticed that many of my fellow BV practitioners select accounting, management consulting, or financial services” as their industry affiliation on LinkedIn, says Sean Hayes in a current group posting (membership required). That’s not accurate, he believes, because “we are not auditors, nor McKinsey type C-level strategy management consultants; nor are we financial advisors (i.e. stocks, bonds, retirement planning, college planning, 401(k), etc.).” To make up for the omission—and bring BV current, at least in terms of social media—Hayes suggests following his lead and emailing LinkedIn to request that it add a new industry, "business valuation." Just go to your LinkedIn homepage and at the very bottom, click on "send feedback" to convey the request.
FLP cases and Wandry make a top-10 list of 2012
“As long as the outcome of family limited partnership cases continues to be fact-specific, expert-specific, and sometimes even judge-specific,” says Ron Aucutt, an attorney with McGuireWoods, who just posted a “top 10” list of estate and gift planning developments of 2012, “an FLP case is likely to be one of the ten most watched or most discussed developments of the year.”
From the past year’s cases, it appears that one of the more “crucial bad facts” for an estate is when the FLP’s founder retains sole control as general partner and also retains partnership funds for support, in effect treating the FLP like a trust instead of an “arm’s length” investment. (But aren’t most “arm’s length” transactions “made with the expectation that the investment will produce a return and that the investor might live off that return?” Aucutt asks.) On the other hand, “good” facts for FLP cases arise when asset protection and risk management are “astonishingly self-evident,” Aucutt says.
Number four on his list is Wandry v. Commissioner, the Tax Court’s decision in favor of defined-value clauses in the context of charitable gifts, which the IRS subsequently appealed to the 10th Circuit and then withdrew, substituting instead its notice of its “non-acquiescence.” “The fairest summary of Wandry,” Aucutt writes, is that it “undeniably” extends the scope of prior cases concerning a charitable “pourover” clause. Unlike those cases, however, “Wandry does not represent a consistent body of Tax Court and appellate court jurisprudence, and, as even the charitable cases show, the IRS does not approve of the defined-value technique. Because it is also fair to speculate that many year-end 2012 gifts have followed the pattern of a ‘Wandry formula,’ we should not be surprised to see future cases involving Wandry types of defined-value gifts.”
Get a ‘sneak peek’ at new guide on valuing healthcare compensation, plus two free practice aids
It’s now available: the BVR/AHLA Guide to Healthcare Industry Compensation and Valuation, edited by Timothy Smith and Mark Dietrich. The first (and only) comprehensive authority on compensation valuation (CV) in the healthcare industry, the new guide features 42 chapters and five practice aids and presents a systematic treatment of this new appraisal discipline. Five major sections include:
- Definitions, methods, and techniques of CV;
- Regulatory matters affecting CV;
- Specific topics related to physicians’ CV;
- Appraising compensation arrangements; and
- Advanced issues and special topics in CV.
We’re also offering a “sneak peek” at the guide and two complimentary downloads: a commercial reasonableness assessment tool and reasonable compensation checklist. For more information and to purchase the new, comprehensive guide to CV, click here now.
FASB clarifies scope of disclosure exemption for private companies
Last week, the Financial Accounting Standards Board (FASB) released its Proposed Accounting Standards Update—Financial Instruments (Topic 825): Clarifying the Scope and Applicability of a Particular Disclosure to Nonpublic Entities. The proposed ASU should clarify the scope as well as the applicability of any disclosure exemption that applies specifically to private companies and nonprofits, and that resulted from the recent ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.
The current proposal would clarify that the requirement to disclose “the level of the fair value hierarchy within which the fair value measurements are categorized in their entirety (Level 1, 2, or 3)” does not apply to private companies and nonprofits for items that “are not measured at fair value in the statement of financial position, but for which fair value is disclosed,” says a FASB advisory. Comments on the proposal are due soon, no later than Jan. 22, 2013.
It’s the micro, not the macro economy, says Warner
Among its familiar prescriptions for valuing stock in closely held companies, IRS Revenue Ruling 59-60 suggests that appraisers should carefully analyze “the economic outlook in general and the condition and outlook of the specific industry in particular.” Such an economic analysis is “critically important,” writes Rick Warner (Great Lakes Valuation) at the BVWire News blog, but he believes a micro focus is more important than a macro one.
The difference is one of emphasis as well as efficiency. Macro-economic trends regarding the housing market and the cost of energy are relevant to a degree and may translate into some impact on a company’s future income, “but most of the time the [economic] issues that are likely to impact the earnings of a company are much more ‘micro’ in origin,” Warner says.
So instead of spending too much time on reports from the Federal Reserve and general economic and business publications, “spend more of your analytical time on issues like supply and demand, elasticity of demand and pricing, uncertainty and risk,” he says. “That’s where we earn our fees, [and] the appraisals that you produce for your clients will be the better for it.”
A super lineup of January CPE
BVR’s Advanced Series on Discounts for Lack of Marketability kicks off tomorrow, January 10, with “Restricted Stocks: A Review of Studies and the Market,” featuring John J. Stockdale (John Stockdale Business Valuations). This first of four weekly programs will take an in-depth look at the restricted stock studies, their development as well as their detractors, and their current application. For a full list of programs in the advanced DLOM series, visit our Training & CPE page.
On Tuesday, January 15, Ashok Abbott (West Virginia University) and Robert Schlegel (Houlihan Valuation Advisors) will address “Size and Liquidity Premiums: Proportional Roles” and discuss the latest research on the relationship between size, liquidity, asset returns, and risk in valuing private companies.
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