It has been a long established practice that when valuing a private company using valuation data from comparable listed companies a control premium should be added to reflect the benefit of acquiring full ownership of the business. This approach has been under challenge for a number of years and recent developments in the US could accelerate its death.
The traditional view
The market prices of listed companies are generally set by reference to a large number of trades of very small holdings. Therefore, by definition, the market capitalisation of the company represents a minority valuation. As there must be value in having control over the business a premium to this minority valuation is needed to determine the overall worth of the enterprise to an acquirer. This would appear to be confirmed by empirical data that takeovers for listed companies are made at a bid premium of 30% to 40% over the pre-offer market price.
This approach has been confirmed in UK case law over many years, notably in Stephen Marks v HMRC (2011), which now appears as a reference point in HMRC’s Shares Valuation Manual, and more recently in Foulser & Anon v HMRC (2015).
The rebels
There are about 2,300 listed companies in the UK of which some 50 to 60 are taken over each year, representing just 3% of the market. The challenge to the traditional view is how can a very small proportion of the market reflect a representative sample of all listed companies? If the other 97% of the market is undervalued why are there not more takeovers? The more compelling reasons are that either only the 3% are undervalued (the other listed companies being fairly priced or over-valued), or that there are special purchasers with the ability to extract value from the targets that is not generally available to the market.
There is no value in control as such, and a premium is only justified if an acquirer can increase the target’s cash flows or achieve a lower cost of capital. If these qualities are absent the company will remain independent and this indicates that no buyer believes that there is value within the entity above the publicly traded price.
Selection bias
A company’s population of shareholders is likely to be diverse, ranging from very optimistic to very pessimistic. As only a small proportion of shares in a listed company are traded at any one time, the quoted price must represent a relatively small intersection between optimistic buyers and pessimistic sellers. In order to secure ownership of the company a bidder will need to pay a premium to convince the more optimistic shareholders to accept the offer. If the company is fairly or only moderately under-priced, or the synergy benefits are modest, the bidder will not be able to justify a premium of 30% or 40% to secure assent from a majority of the shareholders. This demonstrates the selection bias in companies that are subject to takeover bids. The population is unlikely to include the majority of fairly priced companies. More likely, the targets will either be materially under-priced or include those for which the buyer is a special purchaser able to secure substantial synergy benefits that are not available to other market participants.
The value of control
It is generally accepted that there are five rational economic reasons for a takeover of a listed company:
- Synergy benefit to the acquirer.
- The target is under-valued by the market.
- The target is over-valued by the acquirer
- The target suffers from poor management.
- Self-interest of the acquirer’s management.
A synergistic takeover will be a singular event specific to the companies involved. If it were otherwise and the synergy benefits were available to all then the market price would reflect this additional value.
Therefore, unless a company is poorly managed, and in the absence of synergy benefits, there is no reason why a buyer would pay a premium for control. While some companies may be poorly managed this attribute cannot be applied to the whole market in order to justify the blanket application of a control premium.
There are, of course, numerous irrational reasons for takeovers including deal fever and management ambition. Such factors might enable lucky shareholders to sell out at an unusually high price but they should not form a basis for the general valuation of businesses.
Coming from America
The Appraisal Foundation in the US is authorised by Congress to develop valuation standards. In April 2013, it issued an exposure draft with the snappy title, “The Measurement and Application of Market Participation Acquisition Premiums”. This was re-released for consultation last year. In essence, the ED dismisses the use of a general control premium for valuation purposes. In order to justify the use of a premium the valuer must identify the economic benefits that might flow from purchasing the comparator companies used in the valuation analysis. A tall order given the market itself will not yet have identified such benefits.
If enacted as a valuation standard the initial application of the ED will be financial reporting, which inevitably will extend beyond the US. If the proposition that general control premiums cannot be applied in a financial reporting context gains traction, it would be expected to extend into other areas of business valuation.
Where next?
The practical effect of all this is that valuations of businesses based on comparable listed companies might fall if this new approach is adopted. However, we would expect that valuation practice will take some time to change, especially those determined by existing case law, such as tax and litigated valuation disputes.
For further information about this subject please contact:
Simon Chapman
Corporate Finance Partner
M: 07831 255302