May 8, 2012

Common Misunderstandings Regarding Fairness Opinions

Here are some interesting thoughts from Kevin Miller of Alston & Bird related to this blog about a recent WSJ article entitled “Shortcomings of Valuation Opinion in Great Wolf Buyout”:

1. Myth: Fairness Opinions are Valuations

Reality: The financial analyses underlying fairness opinions are not valuations or appraisals, they are merely financial analyses performed by a financial advisor to assess whether it is appropriate to render a fairness opinion. Financial advisors are not engaged to provide valuations and the financial analyses they perform often result in divergent implied valuation reference ranges, not all of which may individually appear to be supportive of the proposed purchase price. However, viewed in their entirety, with different subjective emphases placed on the various analyses based on the financial advisor’s experience and judgment, the financial analyses may be viewed as supporting a fairness conclusion. How do we know that the financial analyses performed by a financial advisor are not valuations or appraisals? Because the opinion and the associated proxy disclosure are unambiguous on that point:

“Any estimates contained in these analyses are not necessarily indicative of actual values or predictive of future results or values, which may be significantly more or less favorable than as set forth below. In addition, analyses relating to the value of the businesses do not purport to be appraisals or to reflect the prices at which the businesses could actually be sold.”

2. Myth: LBO Analyses are Valuation Analyses

Reality: LBO analyses only reflect a private equity firm’s capacity to pay. In contrast to more traditional valuation analyses based on (i) a discounted cash flow analysis, (ii) selected company analyses and (iii) selected transaction analyses, an LBO analysis does not purport to provide any indication of the intrinsic or inherent value of a business but instead merely indicates the price that a private equity firm might be willing to pay based on several critical assumptions including, without limitation, (a) an assumed capital structure; (b) a PE firm’s cost of debt financing, (c) a PE firms cost of equity financing (often expressed as a hurdle rate of return below which the PE firm will generally not make an investment), (d) anticipated cost savings and synergies, and (d) a hypothetical exit multiple.

Financial advisors to the target will often be required to make guesses based on experience and professional judgment with respect to many of these and other assumptions and those guesses may not accurately reflect the private equity firm’s actual proposed capital structure, cost of debt or equity financing or anticipated cost savings and synergies, etc. Such analyses tend to be more useful as negotiating tools – do we think their bid reflects the most they may be willing to pay? – and not as an indication of intrinsic or inherent value. Private equity firms are not always the best buyers and the price they are willing to pay may not fully reflect the intrinsic or inherent value of a business. Among other things, many financial advisors keep reference ranges generated by an LBO analysis off their football fields or otherwise distinguish them from the other more traditional types of financial analyses used to support the rendering of a fairness opinion.

3. Myth: If a Buyer is willing to pay a lot more than the ranges of values indicated by the seller’s financial advisor’s analyses, then the Seller’s financial advisor got it wrong

Reality: Though not relevant to the Great Wolf transaction, sellside financial advisors in a cash transaction do not generally include the potential cost savings and synergies a buyer expects to achieve as a result of the merger in the financial analyses performed to support the rendering of a fairness opinion. Those cost savings and synergies are generally treated as an asset of the buyer and consequently not something that should be taken into account in assessing the fairness of a proposed purchase price to the seller. That can lead to anomalous results as was seen in the 3Par transaction where two bidders, both of which could achieve substantial synergies made bids substantially in excess of the ranges of values indicated by the financial analyses performed by the seller’s financial advisor.

The magnitude of the bids did not indicate that the seller’s financial advisor got it wrong but merely that the competing bidders were willing to share a portion of their potential synergies with the target’s stockholders. The ability of a seller’s board to extract a significant portion of a buyer’s expected synergies in a competitive bidding process is another reason that advisors will often caution a board that merely because a price is fair, doesn’t mean it should be accepted.