What to do when the WACC and IRR don’t match in a PPA
There might be many reasons why, when valuing a purchase price acquisition (PPA), the weighted average cost of capital (WACC) doesn’t match the internal rate of return (IRR) generated by the forecast and the price—for example, overpaying, tax planning, overestimation of synergies, or management’s desire to show revenue as early as possible. One thing appraisers should not do: abandon sound finance theory by making inappropriate nonsystematic risk (alpha) adjustments, says Alicia Grosman, a valuation director in PricewaterhouseCoopers’ transaction services, who spoke at the ASA's 20th annual conference on Current Topics in Business Valuations this past Monday in Manhattan.
“WACC is based on systematic risk, so adjusting it for unsystematic risk takes it out of the financial theory based in the CAPM approach and your cost of equity analyses,” Grosman told attendees. “It may also be inconsistent with the concept of fair value accounting.” Before adding premiums or using the IRR—practices that can cause problems in the PPA and all future impairment tests—Grosman suggests that appraisers:
- Use the actual purchase price—one that doesn’t include compensation, settlements of other relationships, nonoperating assets, or liabilities, etc.
- Pay particular attention to discount rates when analyzing the intangibles (in the most obvious situation, overpayment will result in higher goodwill, which presents more impairment risks).
- Double-check the comparables and other inputs.
Finally, “remember that there may be good reasons for a gap between WACC and IRR,” Grosman said, “but you need to recognize and justify them.”
Does the tax-affecting debate turn on ‘Occam’s razor’?
Our current online poll on valuing pass-through entities (PTEs) is rapidly collecting a record number of responses (second only to last year’s survey on BV credentials). Even as the number of participants continues to climb, however, the “split” among them has stayed steady, with just over half—55%, as of the most recent count—saying they do not add a PTE premium, but simply consider actual taxes paid by the subject entity. The complexity of the issue as well as the competition among various S corp valuation models may play a part in the split. As one survey participant commented, “To my knowledge, none of the models are widely used by appraisers because none of the models are simple. The principle of ‘Occam's razor’ will determine the winner here”—i.e., that the simplest among competing hypotheses is the best. “So far, no winner.”
As for the new research by Nancy Fannon and Keith Sellers, nearly two-thirds of respondents (61%) say they are still reviewing and processing it. Several are still not aware of it, or believe it will have no impact. A roundup of responses to the research includes:
- “It has broadened our understanding about the markets. We understand that market participants in the public equity market determine the cost of capital. The tax characteristics of the marginal investor in the public market have a meaningful impact on our pass-through adjustment, as these investors define the ‘level of value’ we are starting with when making the final adjustment.”
- “Simply more information to justify not tax-impacting the income stream.”
- “Their research has taken the BV profession in the right direction. There are costs to a company's earnings and cash flows (income taxes). Only after taking this into account can an owner determine their real cash flows available. To ignore the income taxes on the valuation of small business (pass-throughs) is to pretend that the company is worth more than it truly is.”
- “[Their] study has not been subject to Daubert [so I will not rely on it].”
- “We're monitoring the research debate, but we continue to tax affect, [as do] most valuations we see.”
- “There is no practical guidance provided in [the research]. I still ‘tax affect’ the net earnings if there will be distributions paid to shareholders to fund the payment of income taxes on S corp taxable income that flows through to them.”
- “[As a result of their research], I have tended to lower the S corp premium.”
A comprehensive overview of the continuing debate: On Thursday, May 10, join Eric Barr (Fischer Barr & Wissinger) for The Pass-Through Premium: A New Perspective on an Old Issue, which takes a fresh look at how entity structure, applicable tax rates, and business performance impact the credibility of an ultimate value conclusion.
BV appraisers should consider applying to IRS advisory council
The Internal Revenue Service is now accepting applications for the IRS Advisory Council (IRSAC), which provides “a public forum for IRS officials and representatives of the public to discuss relevant federal tax administration issues,” according to last week’s announcement. The IRS will appoint up to seven of the 35 IRSAC members for three-year terms beginning in January 2013; the council members submit an annual report to the IRS commissioner at a public meeting in the fall.
In prior years, Jay E. Fishman (Financial Research Associates) represented the BV community and its concerns on the IRSAC and Will Frazier (HFBE) served four years on the IRS’s Information Reporting Program Advisory Committee. “It’s always good for a valuation person to apply [to the IRSAC],” Fishman says, even though “most of the issues are unrelated to valuation.” During his membership (2007-2010), Fishman floated the idea of forming a group dedicated to valuation, “but it gained no traction.”
“Several of ASA's most important government relations initiatives involved IRS and tax-related valuation issues,” says Peter Barash, government relations consultant to the American Society of Appraisers. “From my perspective, there's only an upside to having the BV community represented on IRSAC.” Even though the council and the IRS decided not to establish a valuation subcommittee, “Jay and Will accomplished a great deal by getting the committee to focus on a couple of important valuation issues and to include, in the reports they issued, some recommendations positive to the professional appraisal community,” Barash says. “Equally important, having two valuation professionals on IRSAC did not go unnoticed by the senior IRS bureaucracy and brought the profession and the importance of tax-related valuation issues to their attention. So I would encourage any BV appraiser who practices in the tax area and who has the time to devote to this kind of service to apply.”
Applications will be accepted through June 15, 2012; for more information, visit the IRS’s Tax Professional’s Page. Questions about the application process can be sent to: *firstname.lastname@example.org.
DE Chancery fires another shot at Goldman
Just four months after blasting investment bankers at Goldman Sachs for using a “relative” valuation technique to “dress up” a suboptimal deal into a fair one in In re Southern Peru Corp., 2011 WL 4907799 (Del. Ch.)(see the December 2011 issue of BVUpdate), Vice Chancellor Leo Strine of the Delaware Court of Chancery charged Goldman Sachs with using “questionable” and “suspicious” valuations to exert a “troubling” influence over Kinder Morgan’s recent billion-dollar bid for El Paso Corp. In reviewing shareholders’ request to enjoin the merger, Strine found that multiple “concealed motives” and conflicted interests had tainted the deal with breaches of fiduciary duty, included among them:
- Goldman Sachs stood on both sides of the transaction, ostensibly advising the El Paso board on the financial soundness of the Kinder Morgan bid (for a $20 million fee) while also owning roughly 19% of Kinder Morgan (worth nearly $4 billion) and occupying two seats on the Kinder board.
- The lead Goldman advisor to the El Paso board failed to disclose that he personally owned $340,000 worth of Kinder stock.
- After Morgan Stanley was brought in to “cleanse” any perceived conflicts, Goldman was able to accomplish the “remarkable feat,” Strine said, of giving the new i-bankers an incentive to favor the merger by tying their fees to the completion of the deal.
El Paso fiduciaries—particularly the CEO—also made “debatable negotiation and tactical choices,” Strine said. Given such “disturbing” behavior, the plaintiffs were likely to prove the deal was tainted, and yet the court declined to grant an injunction, preferring to leave the outcome up to a broader vote. Indeed, El Paso shareholders “overwhelmingly” approved the merger last month, with only one major stockholder, a California pension fund, objecting. (And perhaps preparing a request for statutory fairness and appraisal: Stay tuned.) Read the complete digest of In re El Paso Corp. Shareholders Litig.,2012 Del. Ch. LEXIS 46 (Feb. 29, 2012) in the next Business Valuation Update; the court’s opinion will be posted soon at BVLaw.
Fairness opinions: a new special report from BVR
Fairness Opinions in Today’s Legal and Economic Environments: A BVR Special Report is now available for financial advisors, valuation analysts, corporate business appraisers, and attorneys. Through a collection of expert articles, the new special report examines fairness opinions from several key angles, including the role of independent advisors, the effects of the more recent market conditions on the demand for fairness opinions, controversies surrounding fairness opinions, and the current state of fairness opinions from a regulatory perspective.
Contributors include Gil Matthews, Robert Buchanan, Joel Johnson, Chip Brown, Steve Whittington, Scott Cobb, Nguyen “Wen” Ho, and Jeffrey Tarbell. The special report also contains sample fairness opinions and summaries of all recent important court decisions on the topic. For more information and to review the complete table of contents, click here.
FASB changes direction on managers assessing ‘going concern’
At its meeting last week, the Financial Accounting Standards Board (FASB) said it would revisit its prior decisions on whether to require management to assess any doubt about an entity’s ability to continue as a going concern. This change in direction dovetails with the board’s recent decision “not to pursue going-concern-type disclosures” in its projects on liquidity and interest rate risk disclosures, according to a recent summary. The board will continue to work closely with regulators (the SEC, PCAOB, etc.) and the AICPA on the questions; it also directed its staff to continue with the balloting process for a proposed ASU (accounting standards update) on the liquidation basis of accounting.
At the same meeting—and in the context of its project to define a nonpublic entity—the FASB also decided that for standard-setting purposes, a private company would not include a “for-profit entity that is a conduit bond obligor for conduit debt securities that are traded in a public market.” This will be true “even if the entity otherwise meets the characteristics of a private company as defined in this project,” the summary said.
Last chance to register for the ASA national FV conference
Next Tuesday, May 15, don’t miss the 7th Annual Fair Value Conference, hosted by the national ASA at the Los Angeles offices of PricewaterhouseCoopers. The roster of speakers includes nationally recognized experts such as Ben Couch (FASB), Tony Aaron (Ernst & Young), Jon Isler,and Adam Smith (both from PwC).
Also of note: Dean William Holder will provide an update on fair value education plans at the Levanthal School of Accounting (USC Marshall School of Business), which are increasing significantly. Wendy Pirie, director of curriculum projects at the CFA Institute, will provide educational updates as well. To learn more and register for the conference, click here.
IP exchange still on schedule for 2012
The Intellectual Property Exchange International (IPXI), the “world’s first financial exchange focused on IP rights," is still slated to start operations this summer—or at the latest, by early fall, says the latest IP Law Alert from the Gibbons law firm. The post also links to an article, published last week, which takes an in-depth look at this new market for monetizing IP assets and discusses additional considerations for those contemplating the IPXI for their IP portfolios.
Registration still open for spring ABV exam
The deadline for registering for the spring 2012 ABV exam is May 25. The spring exam will be offered June 1 through June 30; note that a special price of $200 per exam is available when registering two candidates or more from the same firm. For information regarding exam pricing, preparation resources and materials, the registration and scheduling process, and relevant test center information, click here. If you have any additional questions, contact email@example.com.
London summit on valuing complex assets next week
The International Valuation Standards Council (IVSC) is co-producing the 1st Annual V-FI conference on the Valuation of Complex & Illiquid Financial Instruments in London May 15-18. Billed as the “only annual financial valuation summit,” the conference will feature over 40 speakers on such topics as:
- Evolution of independent valuation practices;
- Tackling key valuation issues and challenges;
- Incorporating valuation data into risk management; and
- Modeling, scenario testing, and stress testing.
The agenda and registration materials are available here.
More ‘don’t miss’ CPE in May
On May 15, attorney Daniel Johnson (McKenna Long & Aldridge) and appraiser Patrick McGeehin (FTI Consulting) will be presenting Lost Profits Issues Unique to Government Contracts, Part 10 of BVR’s “Online Symposium on Litigation & Economic Damages.”Still one of the largest employers in the construction and defense industries, as well as other major industries, the U.S. government presents as many pitfalls as it does profitable opportunities for the economic damages expert when analyzing the special legal, factual, and valuation requirements related to federal contracts.
On May 22, healthcare specialists will want to join Robert Reilly (Willamette Management Associates) and attorney John R. Holdenried (Baird Holm) for Issues in Valuing Tax-Exempt Medical Organizations: Hospitals, Physician Practices, and Converting an Entity, Part 5 of BVR’s “Online Symposium on Healthcare Valuation.”The experts will discuss the regulatory reasons why tax-exempt healthcare organizations retain valuation analysts to appraise transactions, assess the reasonableness of compensation, and perform similar fair market value analyses.
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