Governance, Risk, Investigations and Disputes
Combined Duff & Phelps and Kroll disputes, investigations, cyber, business intelligence, cross-border restructuring and other advisory.Governance, Risk, Investigations and Disputes
The playwright George Ade (1866–1944) is credited with saying, “For parlor use the vague generality is a lifesaver.” The same cannot, and should not, be said about vague generalities in the courtroom. Such is the case with quantifying and employing company-specific risk premiums (CS-RPs) in business valuations. When supported by vague, subjective reasoning, CSRPs continue to be rejected by the courts, as was the case early last year when the Delaware Court of Chancery issued a decision in the case In re Sunbelt Beverage Corp. Shareholder.1 In Sunbelt, the court addressed whether or not the use of a CSRP was appropriate to add to the discount rate in a discounted cash flow (DCF) analysis, which would have resulted in a higher discount rate and therefore a lower value. In rejecting the use of a CSRP, Chancellor Chandler stated, Proponents of a company-specific risk premium thus not only bear a burden of proof but also must overcome some level of baseline skepticism founded upon judges’ observations over time of how parties have employed the quantitative tool of a company-specific risk premium.
In rejecting its use in Sunbelt, the court found that the reasons supporting the application of a CSRP as presented by the defendants’ expert were not, in fact, “company specific” but rather applicable to all industry participants. The court therefore implied that the risks intended to be captured in the CSRP were already captured in the discount rate that was estimated based on industry participants. Given judges’ “baseline skepticism” of CSRPs, it is relevant to review when it may, or may not, be appropriate to apply a CSRP, and how, if appropriate, company-specific risks can be properly captured in a valuation analysis. In this article we (a) provide an overview of the CSRP, (b) highlight methods of ad-dressing company-specific risk in a valuation analysis, and (c) review precedent court cases that addressed CSRPs.
One of the most widely used methods of estimating the cost of equity capital is the capital asset pricing model (CAPM). The assumption underlying the pure CAPM is that the risk of a security’s expected return is a function of market volatility, or systematic risk, which is captured in the application of Beta.2 The pure CAPM further assumes that since investors can hold a well-diversified portfolio of securities, investors should not be “compensated” for unsystematic or diversifiable risk, such as those due to a specific company. In other words, the risk to an investor of relying solely on one security for capital returns is effectively reduced when that security is held as part of a well-diversified portfolio.
Studies suggest, however, that the returns on certain securities cannot be fully explained solely by Beta, as is assumed by CAPM. For example, studies have highlighted the fact that realized total returns on smaller companies have been greater over the long term than CAPM would have predicted. To compensate for this factor, a size premium (estimated as the empirically observed returns in excess of that predicted by Beta; or “small stock premium” estimated as the empirically observed returns of small company stocks in excess of returns on large company stocks) is often added by valuation professionals to the pure CAPM to arrive at an adjusted CAPM.
Another criticism of pure CAPM is the fact that many portfolios are not perfectly diversified, or even well-diversified, and that unsystematic risk is therefore not diversified away. One solution proffered by valuation analysts is to add an additional premium to pure CAPM to account for this lack of diversity, which is referred to as the company-specific risk premium.3
Industry-specific risk is often captured in pure CAPM through Beta. For example, this would be the case when the guideline public companies used in generating Beta reflect the same industry risk characteristics as the subject company.4 However, while industry risk may be reflected in Beta, the Beta used in pure CAPM does not typically reflect company-specific risks, and therefore an additional premium is added by some valuators to capture these risks. The CSRP reflects “unique characteristics that cause investors to view the company’s risk differently” from its peers to which it might be compared.5 In practice these company-specific factors and their associated risks, when added to the adjusted CAPM, often translate into a greater discount rate (via the CSRP), and when applied to the expected cash flows in a DCF result in a lower value, reflecting the additional return investors would require to compensate them for the additional risk.6 The goal of a CSRP is to take into account a firm’s non-diversifiable risks that are clearly different from those impacting its competitors in the industry.
Identifying the need for a CSRP in a DCF analysis, and then quantifying it, is less than a perfect science. In fact, as the court opinion in Sunbelt underscores, the application of the CSRP can be quite controversial.
While there is no prescribed set of criteria in assessing the use of a CSRP, certain aspects of a company are often taken into consideration in deciding whether or not the firm’s characteristics (and risks) are truly unique when compared to its peers. Company-specific adjustments (whether through a CSRP or some other means) can be considered, for example, in the following instances:
In Sunbelt, the defendants’ expert argued that a CSRP was appropriate because Sunbelt: (a) was subject to at-will termination of supplier agreements, (b) faced unique competition, and (c) relied on “generously optimistic” management projections. Chancellor Chandler found that none of these factors were unique to Sunbelt’s situation. Further, Chancellor Chandler highlighted that the application of a CSRP “would not be without its own irony. I do not believe a company should be able to manufacture justification for a company-specific risk premium...simply by adjusting its management projections such that there is a heightened risk in relying on those projections....”
Company-specific risks are too often described only qualitatively, as in the list provided above, or by the defendant’s expert in Sunbelt. As discussed below, judges have been weary of accepting the application of a CSRP based on purely subjective and unsupported reasoning. However, valuators have tools to address the reasonable expectations of judges for more reasoned approaches to capturing company-specific risks. We review three of these tools below.
First, Duff & Phelps issues an annual Risk Premium Report that valuators can use to take into account company-specific information in estimating a discount rate. The annual study identifies the correlation between realized equity returns and company-specific risk as defined through historical company ac-counting information. In particular, the study measures risk stemming directly from the subject company including the following metrics: operating margin, the volatility of operating margin (the coefficient of variation in operating margin),9 and the volatility of return on equity (the coefficient of variation of return on book value of equity).10 The study shows that the lower the operating margin and the higher the earnings volatility, the higher the equity returns of a company. In this manner the Risk Premium Report enables an analyst to estimate a discount rate based on company-specific information, as opposed to a classic CAPM approach that typically only incorporates company-specific information as it relates to the overall size of the subject company (the so-called size premium).11
Second, some valuators consider implications from Total Beta in estimating a cost of capital. As noted above, Beta is a measure of the systematic risk (or volatility) of a security, measured in comparison to the market; Total Beta is a measure of Beta that is adjusted to reflect the total risk of the firm, including unsystematic risk.12 More specifically, Total Beta reflects the investor’s risk exposure to a subject company if the investor does not hold a diversified portfolio. Total Beta takes into account systematic risk, as well as any other risk premiums/discounts identified by the market, including a size premium or other company-specific risks. As a result, from the formula of Total Beta, one can solve for a company-specific risk premium:13
Total Cost of Equity = Risk-free rate + Beta * Equity risk premium + Size premium + CSRP
CSRP = Total Cost of Equity - Risk free rate - Beta * Equity risk premium - Size premium
There is continuous debate, however, as to the proper application of Total Beta and whether it unfairly creates two costs of capital for an investment: one for a diversified investor and one for an undiversified investor (e.g., an owner-operator of a business). Critics of the use of Total Beta stress that the cost of capital should reflect the risk of the investment, not the cost of funds to the investor.14 Said differently, Total Beta runs the risk of confusing investment value (the value to an individual investor, which may be more or less than would be paid in a transaction) with an investment’s fair market value (typically the value assumed to change hands in a transaction between a willing buyer and a willing seller, both under no compulsion and both with reasonable knowledge).15 For example, the risk to an owner-operator of investing all of his assets into his own company can be significantly greater than the risk to a diversified investor who may own equity in a company along with numerous other investments in other companies. As a result, the discount rate or rate of return based on Total Beta (reflecting the risks of the undiversified owner-operator) will be higher, resulting in a lower present value of the cash flows. The opposite would be true using the risk profile for the diversified investor who can reduce diversifiable risk: lower risk translates into a lower discount rate or rate of return and a higher present value of the cash flows.
A third tool to account for company-specific risks in a DCF is simply to adjust cash flows to reflect company-specific risks. Developing scenarios based on varying risk parameters and applying appropriate weights to those scenarios can be an effective means of modeling risks and the alternative outcomes that may occur based on those risks. This process involves the development of a comprehensive set of assumptions about how the future may evolve and how that is likely to impact the firm’s cash flows. In other words, risk-adjusted projected cash flows should account for the company-specific risks that would otherwise be captured in a CSRP. These cash flows will then be discounted using a discount rate that reflects systematic risk. As discussed below, the Delaware Court of Chancery has also recognized this as a potentially superior approach to capture company-specific risks than applying a CSRP to the discount rate.
Much of the precedent-setting opinions regarding CSRP derive from opinions of the Delaware Chancery Court. Given that court’s profound understanding of Delaware corporate law and corporate governance, it is widely seen as the nation’s preeminent business court. This is one of the main reasons why many corporations decide to incorporate in Delaware.
The Delaware Court of Chancery has historically rejected the use of CSRPs in the discount rate. In Union Illinois (1995), the court rejected the use of a CSRP, stating that the court did not want to “heap on a higher risk premium.” In the opinion, Vice Chancellor Strine did note, “Pure proponents of the CAPM argue that only systemic risk as measured by Beta is relevant to the cost of capital and that company-specific risks should be addressed by appropriate revisions in cash-flow estimates.”16 Three years later, in Hintmann v. Weber Inc. (1998), the Delaware Chancery Court once again rejected the application of a CSRP due to insufficient support for the premium and the defendants’ expert’s inability to show how his proposed reasons for the CSRP “translated into extra risk.”17 The court stated further, “If a company specific risk premium is to be added at all, it is to be added in as a cost of equity, to be given its appropriate weight in a company’s capital structure and aver¬aged with the cost of debt; it is not appropriate to tack the full premium onto the WACC.”
More directly, Chancellor Chandler wrote in Solar Cells Inc. v. True N. Partners (2002) how the court was “suspicious” of expert valuations that incorporate subjective measures of company-specific risk premia, since they may be used to “smuggle improper risk assumptions into the discount rate so as to affect dramatically the expert’s ultimate opinion on value.”18 In Gessoff v. IIC (2006), the court reached a similar conclusion and found that the application of the company-specific risk premium was almost entirely based on the ex-pert’s subjective beliefs as to the correct discount rate to apply. The court stated that while some subjectivity is inherent in the calculation of the CSRP, there was no objective financial analysis on which to evaluate the proper estimation.19
On a few occasions, however, the Delaware Court agreed with the application of a CSRP, but qualified its acceptance with criticism of the supporting evidence. In Onti v. Integra Bank (1999), the court accepted a CSRP, but questioned the reasons supporting the calculation of the premium, citing that many of the alleged reasons are applicable to any company in the S&P 500.20 In MRI Radiology v. Kessler (2006), the Delaware Chancery Court stated that a CSRP is often a back-door method of reducing estimated cash flows rather than adjusting them directly. To judges, the company specific risk premium often seems like the device experts employ to bring their final results into line with their clients’ objectives, when other valuation inputs fail to do the trick.21
While the plaintiffs’ expert in MRI Radiology included in his analysis a “subjective specific-company risk premium...the quantification of which cannot be explained by reference to objective factors,” in the end the court decided it would “not quibble” with the premium. The court decided in favor of the plaintiff ’s expert, who provided a more reasonable approach to the equity discount rate “when viewed as a whole.”
Recent opinions on the application of the CSRP have been issued from other courts as well. In late 2008, Chief Judge Bucki of the U.S. Bankruptcy Court for the Western District of New York found, in CNB International v. Kelleher (2008), that the defendant’s use of a small stock premium did not adequately compensate for the additional risks to which the plaintiffs were subject, such as uncertainty surrounding restructuring synergies, single-customer risk and unresponsive management. The judge ruled, “Apart from its status as a small company, CNB encountered risks that were special and specific for its particular busi¬ness activity.”22
Similarly, in spring 2009, the U.S. District Court for the Northern District of Illinois upheld that the bankruptcy court hearing the case of LaSalle National Bank Association, et al., v. Paloian (2009), properly accepted the application of the CSRP in the plaintiff’s expert’s valuation of a hospital.23 Judge Pallmeyer agreed that the CSRP, which was based on a review of the hospital’s “depth of management, fraud occurring at the hospital, management’s reputation, unreliability of financial statements and the greater effect that the Balanced Budget Act of 1997 would have” on the hospital warranted a significant premium.24
There is still no consensus in the professional valuation community or the courts as to the best means of identifying and incorporating company-specific risks into a DCF analyses. What is clear is that purely subjective reasoning will be insufficient in advocating for a higher discount rate to reflect these risks. As was made clear in Daubert v. Merrell Dow Pharmaceuticals, a judge is tasked with “ensuring that an expert’s testimony rests both on a reliable foundation and is relevant to the task at hand. Pertinent evidence based on scientifically valid principles will satisfy those demands.”25
Valuators should consider all available information and all available alternatives, and avoid vague, unsupportable statements. Instead, analysts should present thoughtful, reasoned, and well-developed analyses. In many cases, risk-adjusting the cash flows directly will produce the most reliable and supportable analyses to reflect company-specific risks.
Nevertheless, should the valuator proceed with the application of a CSRP, Sunbelt has reminded us that courts continue to be skeptical of discount rate premiums that are not supported by significant tangible (i.e., quantitative) evidence.
1 In re Sunbelt Beverage Corp. S’holder Litig., C.A. No. 16089-CC, 2010 WL 26539 at *12 (Del. Ch. Jan.5, 2010).
2 The formula for pure CAPM is: Expected return = Rate of return on a risk-free security + Beta * Equity risk premium for the market as a whole. We define CAPM as “pure” in that it does not include any additional adjustments at this point.
3 Although throughout this article we use the term “premium,” we acknowledge that a company-specific adjustment could equally be a discount rather than a premium. The risk adjustments described in this article are equally applicable to discounts as they are to the premium.
4 Shannon P. Pratt and Roger J. Grabowski, Cost of Capital: Applications and Examples, 3rd Edition, Wiley, 2008, pp. 333, 339. Note that in the build-up model for estimating cost of capital, industry risk is typically accounted for through an industry risk pre¬mium adjustment.
5 Id. at 225.
6 As discussed in footnote 4, these additional factors could also result in a lower discount rate, and therefore a higher value.
7 Pratt and Grabowski, Cost of Capital: Applications and Examples, Third Edition, op.cit., pg. 225. See Chapter 14 for a discussion of the application of size premiums.
8 The IRS, for example, recognized the key person discount in Revenue Ruling 59-60, 1959-1 C.B. 237.
9 This is the standard deviation of operating margin over the prior five years divided by the mean operating income for the same years.
10 Net income before extraordinary items minus preferred dividends is divided by book value of common equity in order to arrive at return on book value of equity. The volatility of this result is the standard deviation of return on book equity for the prior five years divided by the mean return on book equity for the same years. A further description of the derivation of the risk premium contained in the Duff & Phelps Risk Premium Report, which is available at: http://corporate.morningstar.com/ib/asp/subject. rel="noopener noreferrer" aspx?xmlfile=1425.xml, www.bvresources.com, and www.valusource.com.
11 Historical accounting metrics such as operating margin may not incorporate all forward-looking risks of a company. For example, while Toyota or BP may have had a stable risk profile based on historical account¬ing figures, recent events involving these companies would significantly alter the current risk factors at these firms. Such contemporaneous risks need to be accounted for in any forward-looking risk assessment.
12 Total Beta equals [Beta / R] or [cis / cim], the relative standard deviation of the returns on the subject security to the standard deviation of returns on the market.
13 Peter J. Butler and Keith A.Pinkerton, “Quantifying Company-Specific Risk: A New, Empirical Frame¬work with Practical Applications,” BVR, February 2007, pp. 2-3.
14 Roger J. Grabowski and Bernard Pump, Company-Specific Risk Premiums: Application and Methods, in Valcon 2010 Educational Materials 110 (2010).
15 This is the IRS’s definition of fair market value (Rev. Rul. 59-60, 1959-1 C.B. 237).
16 Union Illinois 1995 Inv. Ltd. P’ship v. Union Fin. Group, Ltd., 847 A.2d 340 (Del. Ch. Jan. 5, 2004).
17 Hintmann v. Fred Weber, Inc., No. 12839, 1998 WL 83052 at *5 (Del. Ch. Feb.17, 1998).
18 Solar Cells, Inc., v. True North Partners, LLC, No. 19477, 2002 WL 749163 at *6 n.11 (Del.Ch. Apr. 25, 2002).
19 Gesoff v. IIC Industries Inc., 902 A.2d 1130, 1158-59 (Del. Ch. May 18, 2006).
20 The valuation at issue calculated a discount rate for the DCF using the build-up approach, which does not incorporate a Beta directly. Chancellor Chandler explained that, in the absence of Beta, the use of a CSRP was acceptable. However, the court determined that the analysis did not sufficiently support all the factors that contributed to the 3.4 percent CSRP, and ultimately adopted a CSRP of 1.7 percent, half of the 3.4 percent that was presented in testimony. Onti Inc., v. Integra Bank, 751 A.2d 904, 919-20 (Del. Ch. May 26, 1999).
21 Del. Open MRI Radiology Assoc. v. Kessler, 898 A.2d 290, 339-41 (Del. Ch. Apr. 6, 2006).
22 In re CNB Int’l, Inc., 393 B. R. 306, 320-321, (Bankr. W.D. New York Sept. 5, 2008).
23 LaSalle Nat’l Bank Ass’n v. Paloian, 406 B. R. 299 (2009), vacated by 619 F.3d 688 (2010).
24 Id. at 356.
25 25 Daubert v. Merrell Dow Pharm., 509 U.S. 579, 597 (1993).
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