This article is the second part of a two-part series. In the prior article, I discussed flaws in the M&A deal process that has led to litigation. When litigated, independent valuation analysts are hired to serve as expert witnesses and to provide an opinion of fair value.
Fairness opinions for M&A transactions may be provided by either an investment banker or an independent valuation analyst. When M&A transactions are disputed, an independent valuation analyst (“valuation analyst”) hired by counsel to plaintiffs (or respondents, in the case of appraisal rights) may discover certain analysis performed by the investment banker that is unsupported.
This discussion focuses on the following topics:
- Fairness opinions – differences between the role of the valuation analyst and the investment banker
- M&A deal process – the role of the investment banker beyond the fairness opinion
- Disputed transactions – the role of the valuation analyst as expert witness opining on fair value
- Disputed transactions – examples of flaws in the investment banker’s analysis for the banker’s fairness opinion
Fairness Opinions for M&A Transactions
Valuation analysts may be retained to provide fairness opinions for private company M&A transactions. Many private companies conduct the transaction with in-house staff, or they may be owned by a private equity firm that has M&A expertise.
When a private company is experienced in negotiating M&A transactions, it may be capable of handling the deal process. In those circumstances, a fairness opinion may only be needed for a particular transaction.
Valuation analysts are not advocates for either the potential acquirer or the target company. Consequently, analysts do not accept contingency or performance-based fees as investment bankers do. Instead, fees are typically based on an agreed-upon budget or standard hourly rates. Such fees are usually significantly than the contingency fees charged by an investment banker.
The valuation analyst’s fairness opinion typically consists of a written opinion, and may be accompanied by a financial analysis that includes a range of value. The business valuation approaches (i.e., income approach, market approach, and/or asset-based approach) applied by the analyst are often the same approaches applied by the investment banker.
Unlike the investment banker, the development and the reporting of the valuation analyst’s analysis and work product typically complies with promulgated professional standards. These promulgated standards may include the Statement on Standards for Valuation Services or the International Valuation Standards.
In some cases, publicly traded companies, or private companies that are targets of a public company acquisition, may retain an investment banker to provide M&A advisory services, as opposed to a valuation analyst. This is typically because of the need for additional services including management of the deal process, soliciting bids, and negotiating the terms of the transaction.
M&A Deal Process: The Role of the Investment Banker
The investment banker’s role in M&A transactions may vary based on several factors. The following discussion summarizes some of these factors.
- Were the wheels already set in motion when the investment banker was hired, and was an acquirer nearly decided upon? If so, the investment banker’s role may be confined to managing the rest of the deal process and providing a fairness opinion. Sometimes, when the overture is from a strategic acquirer, the target company already knows the suitor company well. In this case, the investment banker will be used more as a reality check:
- to provide confirmatory analysis; and
- to evaluate the risk and reward of competing offers.
- Was the target company desirous of being acquired, and had it already been approached by a suitor company? If the client intends to be sold and no suitors have been identified, or they have but discussions have not commenced, then the investment banker’s role will be far more extensive. Investment bankers will evaluate bids, which is referred to as buyer qualification, and may involve determining whether the bidders are:
- experienced in making acquisitions, which can affect the speed of the deal process;
- a good strategic fit, which may lead to a higher bid; and
- including contingencies.
During the due diligence process, the target company’s investment banker can weed out bidders who may be “phishing,” where bidders have no intention of making the acquisition, but rather want access to competitive information via the bidding process. One procedure for rooting out this type of potential suitor is monitoring the data room for how long they spend on particular documents, such as the customer lists, and how little time they spend on other documents that a serious acquirer would ordinarily inspect at length.
- Is the target company or the suitor company experienced with M&A? If management is inexperienced, the investment banker will need to spend much more time coaching management, being more involved with negotiations, and assisting with making financial projections.
- Is there a need to accelerate the completion of the transaction? This factor can be a consideration when deciding whether to conduct an auction or a more targeted, high-level solicitation. The more entities poking around in the virtual data room, the longer it takes to complete a transaction.
- Is the best strategic fit with one or two companies as suitors, or is a more competitive bidding process best? It is said that the auction process often produces the highest price. However, there are other important considerations, such as the length of the deal process, which may be longer for an auction. During that time, unforeseen economic events could lead to a lower stock price and a lower resulting takeout price.
Additionally, the more bidders that are involved, the higher the risk that the negotiations will be leaked to the public, leading to a higher stock price of the target (if publicly traded), and potentially spooking suitors. Another risk is that leaks can stoke fear in a company’s suppliers and customers that their treatment under the merged entity will not be the same.
A longer sales process can lead to employees resigning out of fear of losing their jobs. This could also kill a deal, because employees are part of the value of any company.
- How much of the synergies are included in the acquisition price premium offered by the preferred bidder? The acquirer will usually pay a price premium that is less than projected synergies, which is a reasonable posture because otherwise there is no value to the deal for the acquirer.
- Are private equity funds potential acquirers? Every private equity fund has a target internal rate of return (“IRR”). Knowing that IRR, the banker can model five to six years of cash flow projections (a typical investment holding period for a private equity company M&A transaction), make an assumption about an appropriate exit multiple, and backsolve for the acquisition price and implied pricing multiple that would allow the fund to achieve its targeted IRR. Such an analysis would help the target company:
- estimate the price that the private equity fund may be willing to pay; and
- compare that price to offers made by strategic buyers.
- Are any of the final bidders insisting on a stock-for-stock transaction? If so, the investment banker will evaluate both the target company and the acquirer company. The range of value for each company will be used to determine the exchange ratio, or if an exchange ratio has already been agreed upon in principle, to determine if the exchange ratio is fair. Because the acquirer’s stock is the currency with which it will pay the merger consideration, the banker will assess whether the acquirer—and the resulting merged company—is a solid long-term investment.
- How difficult will post-acquisition integration be? Achieving synergies depends on the success of post-merger integration. Investment bankers retained by the acquirer company rather than the target company may also assist with identifying pitfalls to post-acquisition integration. Information technology infrastructure is usually a big part of post-merger integration. The cultural fit is important—some companies have a “coat and tie” culture while others are more informal. Organizational charts are a consideration—the target company may have a simple structure where each employee reports to only one superior, unlike the acquirer. Ignoring the cultural fit can lead to employee defections after the merger.
Disputed Transactions: The Role of the Valuation Analyst
Investment bankers are not typically retained to prepare expert analyses and expert reports—or to provide expert testimony—in connection with litigated M&A transactions. However, the investment banker may be required to testify as a fact witness if the banker provided advisory work and/or a fairness opinion in the disputed M&A transaction. When a valuation analyst is retained as a testifying expert in a disputed M&A transaction, the work product typically consists of a written valuation expert report with exhibits. The valuation analyst’s expert report and exhibits may be more comprehensive than either the investment banker’s work presented in the proxy materials or the investment banker’s materials presented to the board of directors or the special committee.
Settlement discussions may occur in the litigation after the exchange of expert reports. If a settlement is not reached after the exchange of expert reports, each expert may be asked to analyze the work of the opposing expert—and to prepare a rebuttal report. Rebuttal reports respond to the analyses, inputs, and opinions of the expert hired by the opposing party. If a settlement still has not been reached, then deposition testimony, and potentially trial testimony, will follow.
There may be differences in the valuation inputs selected by valuation analysts serving as experts in litigation versus those selected by investment bankers retained for M&A. Among these differences is the valuation date. The valuation date applied by the valuation analyst may be the date the subject transaction closed. The valuation date applied by the investment bankers may be the date the transaction was approved by the board of directors. Due to the passage of time between the two valuation dates, there may be differences in the valuation variables applied by the investment banker versus the valuation variables applied by the valuation analyst. Some of these differences, like the present value discount rate and the debt-to-equity ratio, may be material.
Another difference is the quality of the analysis and the work product. The investment banker’s work product may be produced by bankers who do not have technical training in valuation practices and standards. This lack of valuation training may lead to unsupported judgments, for example, the selected cost of debt for the weighted average cost of capital calculation. The investment banker may ask one of the bank’s fixed-income traders or credit analysts what rate they would charge to the target company. In contrast, the valuation analyst may estimate a cost of debt based on an extensive analysis of market-based yields of guideline debt securities. The valuation analyst may also estimate a weighted average market-based yield if the target company has diverse business units with different credit profiles and different costs of capital.
Disputed Transactions: Examples of Potential Flaws in the Investment Banker’s Fairness Opinion Analysis
In many transactions, the investment banker’s presentation to the special committee or to the entire board of directors—often referred to as the “banker book”—is not required to be disclosed to investors. However, in a merger dispute, the discovery process often reveals both the final banker book and any prior drafts. Differences between drafts and the final analysis may be justified, but these differences may also raise questions.
The valuation inputs used by the investment banker in the fairness opinion analysis may be different from those of the valuation analyst if the transaction is disputed. The same is true for the valuation analysts hired by each opposing side. The following list presents some of the potential differences or, in some cases, flawed analyses:
- Justification for the selected beta – If the target company was publicly traded, there may be a question as to why the investment banker selected a beta based on either comparable or guideline publicly traded companies—rather than the target company’s own beta. The time horizon for the selected beta (i.e., one-year, two-year, five-year) may also be a question. The usage of a Barra beta has in certain cases been rejected in judicial opinions.
- Capital structure – The capital structure used by the investment banker may be disputed. For example, the investment banker may select a capital structure based on an “optimized” capital structure, rather than the target’s actual capital structure, at the time the deal was approved. In contrast, the valuation analyst may base the analysis on the target company’s actual capital structure as of the unaffected date.
- Long-term growth rate – Investment bankers and valuation analysts may disagree about the expected long-term growth rate. Whether the expected long-term growth rate should reflect only inflationary growth or include real growth may be debated.
- Selection of comparable or guideline companies and transactions – The investment banker and the analyst may disagree on the companies that should be considered in a market approach analysis. In litigation, the court has the final say on which, if any, of the guideline companies are appropriate.
These are only some of the inputs that may be disputed. Others include the equity risk premium (historical v. supply-side), the cost of debt, adjustments—such as an underfunded pension plan and tax credits—and tax rate applied to financial projections.
 Verition Partners Master Fund Ltd. v. Aruba Networks, Inc., 210 A.3d 128 (Del. 2019).
 In an opinion by Judge Andre Bouchard of the Delaware Court of Chancery, he wrote that, “Barra calculates predicted, forward-looking betas using a proprietary model designed to measure a firm’s sensitivity to changes in the industry or the market….In Golden Telecom, this Court expressed similar concerns when it rejected the use of Barra beta because Barra did not publicly disclose the weight of each factor used in its proprietary model, did not explain the changes in different versions of the model, and because the expert who relied upon it did not fully understand all details of the model…. The Court emphasized that it was not rejecting the use of Barra beta in all cases, but noted that a record of how Barra beta works and why it is superior would be a necessary prerequisite to its adoption in other appraisal cases.” IN RE Appraisal of DFC Global Corp., Consolidated C.A. No. 10107-CB (Del. Ch. July 8, 2016): 20-23.