June 15, 2011 | Issue #105-3  

The size premium is alive and well

“There has been some talk in recent years suggesting that the size premium no longer exists,” James Harrington (Duff & Phelps) told the audience at the recent CalCPA Business Valuation Conference in San Francisco. “But research that Duff & Phelps has performed (based on data from the Center for Research in Security Prices at the University of Chicago) suggests that the size premium is alive and well.” he added.  To help support this assertion, Harrington presented data from three time periods: 1980−2010, 1985−2010, and 1990−2010 using the portfolio beta and average return for the 25 portfolios from Exhibit B-1 of the Duff and Phelps Risk Premium Report. The results show the size premium still exists in each of the time periods. “These periods are shorter than the longer periods we are used to looking at—but the results are quite compelling, and seem to indicate that reports of the size premium’s death may have been greatly exaggerated, to paraphrase an old saying,” he said. Look for Harrington’s article on this topic in a future Business Valuation Update.

BV trivia question: Which Tax Court judge has taught quantitative analysis to lawyers?  (Hint—think Peracchio)

More hints: In Peracchio v. Commissioner, (T.C. Memo 2003-280), the Tax Court discredited both experts’ determination of minority and marketability discounts for a family limited partnership (FLP) funded with $2 million in cash and securities. The court criticized the taxpayer’s experts for using benchmark averages without examining and adjusting the underlying restricted stock data to fit the facts of the case, and was even “less impressed” by the IRS expert’s “brief analysis of six [unnamed] factors that may influence” the range of the marketability discount, and his “arbitrary selection” of the midpoint.

Since the taxpayer failed to carry its burden of proof, the court settled on the 2% minority discount conceded by the IRS expert and the DLOM in his upper range. “I [wasn’t] there to investigate the facts,” Judge James Halpern told attendees at the recent ASA IRS Valuation Symposium in Los Angeles. “I’m not an expert but a neutral arbiter. You come to me. If [your client] has the burden of proof and you don’t tell a story to support it—you lose. If there is a factual question and neither side puts in [convincing] testimony, then it’s a tie, and a tie goes against the party with the burden of proof.”

Still, after so many years of listening experts’ “stories,” the neutrality of most Tax Court judges now comes with a good dose of sophistication and statistical savvy. Halpern, for instance, has taught quantitative analysis to attorneys at George Washington University. At the ASA Symposium, he presented a paper, authored by Professor Theodore S. Sims (Boston Univ. School of Law), on “Using Market Data on Discounts to Net Asset Value of Closed-End Mutual Funds in Valuing Minority Interests in [FLPs],” based on the Peracchio data. “This is what’s really going on when an appraiser says he has examined the funds, picked data points, etc.,” Halpern said, revealing his understanding of the issues and analysis, something you may want to know when assessing empirical data for your next E&G tax engagement…

Rule 143(g), ‘required’ reading for BV appraisers

Halpern also reminded BV appraisers that the U.S. Tax Court follows its own rules and procedures, analogous to but also departing in significant ways from the Federal Rules of Civil Procedure. Rule 143(g)(T.C.R.), for example, provides that unless the court otherwise permits, an expert’s complete direct testimony is set forth in his/her written report. What this means: “You may not get to open your mouth in my courtroom,” Halpern said. Only if the other side asks for cross-examination will the judge get to hear a “peep” from the expert.

Trial attorney John Porter (Baker Botts LLP), a featured speaker at the recent annual meeting of Valuation Roundtable of San Francisco, seconded the judge’s reminder, advising appraisers to read (and re-read) Rule 143(g). “Even when an appraisal will only initially be used to establish the fair values of an asset in connection with the filing of a tax return, the appraisal report should be in a form which will allow the report to be introduced in subsequent litigation,” Porter said. “Preparation of the report with this potential end-use in mind is not difficult and will avoid the need to have the appraiser prepare a new or revised report in the event the matter proceeds to trial.” Given its importance in any appraiser’s reference library, we’ve made the entire text of Rule 143 (T.C.R.) available as a free download: click here.

Special Report from the NACVA/IBA 2011 Annual Consultants’ Conference

IFRS/GAAP convergence: a profitable area for business appraisers

May 13th 2011 “was a momentous day for valuators,” James Catty (Corporate Valuation Services Limited) told NACVA/IBA Conference attendees in San Diego last week. On that day, FASB issued its 331-page document “Fair Value Measurement (Topic 820), Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRSs.” Now there is a single fair value concept for GAAP and IFRS, and the changes affect almost everyone in the expanding financial world—except some users of national accounting standards. “This is a very lucrative area,” Catty said. “You can charge twice as much, but it is a lot of work and your work will be audited.”

Add sensitivity analysis to your worksheets

Samuel Weaver (Finance Professor of Practice, Lehigh Univ.) advises business appraisers to take advantage of more of the available risk analysis tools—even the seldom-used functions in Excel. For instance, while speaking to over 200 NACVA/IBA members last week in San Diego, Weaver asked how many routinely use sensitivity analysis in their DCF’s.  Only about 15% of the room raised their hands, even though this simple tool (located under data and then “What If Analysis” and then “Tables” in Excel 2007) can “do this in five minutes.”

“Data tables can quickly be created on any cell—COGS, NPV, growth rate,” said Weaver. The range of solutions is similar to a Monte Carlo analyses and looks like a roulette wheel when displayed graphically (“They didn’t want to call this method the ‘Atlantic City’ analysis, even though they also have roulette wheels,” Weaver joked.)

Add probability percents to the ranges of assumptions to enhance sensitivity analysis on such elements as cost of capital.  A range of outcomes may not succeed in court, Weaver noted, but may help business owners to assess risks and outcomes. Software such as Crystal Ball and @ RISK “can really help add value for your clients,” he said.

Three times is the charm for market factors in cost of capital

Roger Grabowski (Duff & Phelps) believes that the market impact on cost of capital has now hit a “blip” for the third time in history (after November 2008 and May 2010).  “In May 2011, the risk-free rate as we generally calculate it [based on 20-year Treasuries] was influenced by major investors abandoning returns in favor of safety of principal,” Grabowski told NACVA/IBA attendees.  Hence, the risk-free rate component of the buildup and MCAPM methods, which attempts to account for inflation expectations, has been at the lowest number when the market has been “risky enough so that my mother calls every day to ask whether she should sell her stock.” Grabowski’s conclusion: “It’s still riskier than it was at the end of 2006.  So, you still have to adjust the market components of the buildup method.”

Calculations vs. conclusions: when and where

The leaders of the new NACVA/IBA standards unification effort commented on this topic, always an issue under any standard: “We do less than 10% of our work in calculations.  For IRS [engagements], you can meet the adequate disclosure requirements so that the gift tax work can be filed and the clock can start to run, and that’s how our engagements are designed,” said Mark Hanson (Schenck SC). Nancy Fannon (Fannon Valuation Group) said she almost never does calculation reports, because her firm focuses on litigation. “You have to understand that divorce is also litigation work, even if the marital assets are small,” she added. Mark Kucik (Kucik Valuation Group) does some calculation reports, particularly when an attorney calls asking for settlement advice. “I have a conversation with them in their conference room, and they can tell me then whether they’re going to step up to a valuation report.”

Congrats to 2011 NACVA/IBA award winners

Kudos to leading volunteers and “Wall of Fame” award winners from NACVA this year:

  • John Marcus received the “Circle of Light” award for educational contributions.
  • Greg Gadawski was honored with the Instructor of the Year award.
  • Mark Kucik earned the Thomas Porter Lifetime Achievement Award.
  • Outstanding members include Peter Agrapides, Ed Giardina, David Mensel, Mark Pawlowski, Greg Reardon, Judith Wagner, David Wood, and Howard Zandman.
  • In a sweep for the Northeast, Kathleen Buzbee, Ed Heben, and Nick Nichols received the State Chapter President Leadership awards. 
  • Lari Maston and Howard Zandman are the newly appointed members of the NACVA Executive Advisory Board.

A special nod to the volunteers on this year’s 2011 Planning Committee: Chair Mel Abraham and members Steve Egna, Mike Kaplan, Karen Kaseno, and Sherry Smith; and a final round of applause to Marc Bello, who chaired the day-long Current Update in Valuations Symposium.

Letter to the Editor: more on company-specific risk

In response to last week’s item “The ‘one size fits all’ company-specific risk doesn’t exist,” Peter Butler (Valtrend) wrote regarding Jim Harrington’s comments on total beta, and his observation that the more important question is comparing the subject company to the selected comparables. “I agree,” Butler wrote. “We apparently only disagree on what you do next.” For example:

1. You can compare your subject company to the average company in Duff & Phelps (portfolio 25) and/or Ibbotson (Decile 10) and then completely guess as to an appropriate company-specific risk premium (CSRP); or,
2. You can use a total beta perspective, which empirically captures the total risk premium and/or CSRP for those exact same companies—some even in the same industry as your subject company—to better triangulate an appropriate cost of equity.

What lawyers want when hiring you

The next time an attorney calls to interview you as an expert, be prepared to answer the questions in “Factors to Consider When Hiring an Expert,” an article by Donald May (Marks Paneth & Shron LLP):

  • How many times have you testified?
  • Of those times, what percentage was for the plaintiff and what percentage was for the defendant?
  • Have you ever been excluded by a court? If so, why?
  • What percent of your income is based on expert testimony?
  • Do you have specific experience related to this matter? What is that experience?

New blog on BV and appraisal review

Mercer Capital has just launched a new blog: The Notebook:  Featuring the latest thinking on business valuation and appraisal review, by attorney Paul Hood and Mercer’s Tim Lee.  Latest post: “Who Says Business Appraisers Agree on Everything?”

BizMiner reports updated to include 4Q2010 data

BizMiner updated the Industry Financial series, Micro-Firm Profit & Loss series, U.S. Market Research series, and Local Market Research series through year-end 2010. More updates: subscribers can now search by NAICS codes. “The transition to a NAICS basis improves the alignment between BizMiner and other statistical information you might use (including current and future government metrics),” says Jon Brandow (BizMiner). If users are still more comfortable with the SIC system, “we have posted a SIC to NAICS conversion chart on our Industry Search Tools page, allowing you to link directly to the closest corresponding NAICS reports,” Brandow says. “This is coupled with complete standardized definitions for the official set of NAICS-2-3-4-5-6 industries.”

Click here for more information on BizMiner.

Opportunity to earn CPE this Thursday

Don’t forget to join Jay Fishman (Financial Research Associates) and Scott Nammacher (Empire Valuation Consultants) for “Valuing Alternative Investment Management Companies: Private Equity and Hedge Funds” this Thursday, June 16, the latest installment of BVR’s Industry Spotlight Series.  During their 100-minute presentation, these two experts will address the valuation challenges inherent in alternative investment management companies and how appraisers can properly avoid common mistakes and misperceptions.

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Valuing Alternative Investment Management Companies: Private Equity and Hedge Funds
June 16, 2011
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